Lessons on Risk from Fern Britain and Fern Britton

In 2004, the book The (Mis)behaviour of Markets by Benoit Mandlebrot was published – well ahead of the financial mess in 2008. And it’s a shame more financiers didn’t read it.

In it Mandelbrot lays out the history of his challenge to the traditional way of thinking about risk in finance. He shows very clearly that the use of models based on ‘tossing a coin’ and a ‘random walk’ that fit very nicely in a spreadsheet, underestimate the likelihood of extreme events.

And he draws his evidence and his mathematics from nature itself. Indeed, he is credited with creating a new branch of mathematics called ‘fractal geometry’.

Now, rather than get drawn into a complex explanation of how we should measure risk, I’ll try to get my point across by using two pictures linked to the name of a celebrity.

That celebrity is Fern Britton, who as well as demonstrating a little risk awareness in the video at the end of this blog, shares her name phonetically with two common examples of fractal maths.


To state the obvious, one is a fern leaf and the other the coast of the Britain. And both the leaf and the coastline hold clues to the fractal geometry that more adequately explains the risks in the world we live in.

If you look at the simple structure of a fern leaf you can see that the shape of the overall leaf is mirrored in each individual leaflet. And that shape is then copied again within the leaflet…and so on. In other words the design repeats, scaling up and down. You can clearly see the pattern of its growth.

But it can also be applied to more complicated examples. The pattern of the coastline is far ‘rougher’ than the leaf, but fractal geometry still allows us to describe it – to give it a number that shows how rough it is. And we can do this by assuming we are measuring the length of the coastline with different lengths of ruler – the shorter the ruler, the longer the overall measurement of the coastline will be. I hope this is obvious since a shorter ruler would fit into more nooks and crannies.

And it turns out when you compare the resulting measurements you also get a scaling number or fractal. The UK coastline has a fractal dimension of 1.25 and the smoother Australian coastline 1.13. But the important point to take away is that a similar approach can also give us insight into the roughness or risk of other naturally occurring complex events like flooding and turbulence.

The book describes the similar work of H.E Hurst, a British civil servant sent to study the flooding of the Nile in the 50s. He found the range from highest Nile flood to lowest was far wider than you would expect if was a random event, like tossing a coin. Also, extreme events seemed to cluster – a flood would be followed by another flood. As a result, if you were to build a dam, it would need to be higher than suggested by traditional theory – you should expect more extreme values, more often.

The ‘Nile Pattern’ that Hurst saw and Mandelbrot describes with fractals is also replicated in finance. And as we headed into the recent financial crisis the traditional banking dams were based on efficient market theory and were not high enough. They had even been effectively lowered with all their off-balance sheet activity and light regulation.

Unfortunately, even if you had been aware of this in advance, it didn’t mean you could pick the perfect day to sell all your investments. However, you did have a major advantage. You were able to see that risk was being severely under-priced, especially by banks, and you could adjust your own exposure accordingly. And it’s beginning to be the case again – encouraged by governments borrowing stability from the future.

As investors does this mean we run for the hills? Well, it’s important to realise that the extremes work both ways – positive economic developments are also not distributed like the roll of a dice. It just means it’s especially important to be disciplined and choose investments with as much financial integrity and transparency as possible – be very wary of chasing yield.

Finally, as promised, here is Fern in her own words, describing the risks of closing a sash window (from 30 seconds in). She clearly is a fellow sufferer of that most debilitating of afflictions – ‘the giggles’. It’s got me in a bit of bother a few times, but that’s for another post.


Please remember:

  • past performance is no guide or guarantee of future returns;
  • the value of stock market investments can rise and fall over time,  so it is quite possible to get back less than what you put in, depending upon timing

A Close Shave

In recent months I have, hopefully, shown you how different investing lessons can be learned from activities as diverse as eating marshmallows, buying trousers and assembling Ikea furniture. This week, I am looking at one man’s approach to problem solving that also helps us to navigate the modern financial world.

He is no modern ‘Flash Boy’ as depicted in the book I reviewed in my last blog. William of Ockham (c. 1287 – 1347) was an English Franciscan friar and scholastic philosopher who lived in the Surrey village of the same name and gave us the misspelled ‘Occam’s razor’.  And Ockham should certainly be proud of him.

My own town of Spalding doesn’t quite hit the same heights on the philosophical map of the world, although I would be delighted to be corrected. We do have a blue plaque commemorating the visit of Jean-Jacques Rousseau almost 250 years ago, but he was here for just nine days.rousseau plaque

William was no medieval Victor Kiam – the man who loved his Remington electric razor so much he bought the company. William was clean shaven, as was his tonsure, but ‘razor’ in this context is a rule of thumb in philosophy that rules out unlikely explanations for problems.  It simply states that the most likely explanation for a problem is the one with the fewest assumptions. In other words, the most obvious when you think logically. And I’d wished I’d thought of applying it when I mislaid something a few years ago.

Unfortunately for me, the ‘something’ in this case was my youngest daughter who was seven at the time. My wife and eldest daughter were out for the day, and I was somewhat engrossed in setting up our new TV when I noticed she had gone.

So I followed a different philosophical maxim, ‘if in doubt, panic!!!’

I shouted after her, but there was no reply in the home and having pegged it up and down the street outside there was still no sign of her. I returned to the house and was on the verge of calling up a ‘posse’, when I noticed the cardboard box for the new TV in the middle of the lounge. I opened it to find this peaceful scene.


So, I’d missed two pretty obvious things. Given it was most likely she was in the house, it did not occur to me that she wasn’t answering me because she was asleep – I’d automatically assumed the less likely worse-case scenario. And a large cardboard box to a child is manna from heaven.

In the world of investing Occam’s razor is an invaluable tool in all sorts of situations, from debunking conspiracy theories to interpreting news. But a very simple application is perhaps better described with the phrase, ‘if it’s too good to be true, it probably is’.

This simple analysis raises the red flag for some of the poorer investment schemes. I deliberately keep an old email address alive just to capture the latest too good to be true offers of wonderful growth on land in Brazil, vintage wine or carbon trading schemes.

And on a larger scale, there have been outright frauds perpetuated where the returns offered could not reasonably be possible – not only were the returns too high, but too consistent and, therefore, likely to be fake. However, in order to understand this you also needed to understand all the underlying investments – and few do.

Equally, there are other legitimate investments where the returns available can only imply greater risk, whatever the marketing material might say. That is not necessarily a problem, where it is appropriate, but not where the return is being relied upon – or where the underlying instrument is poorly understood.

It is important to appreciate that I am not making a case against investing – far from it. The case for investing to meet long term financial goals is very sound. But before making our choices, we need to use as many tools as possible to increase our chances of success. And Occam’s razor is another weapon in our armoury.

Next week I will be revealing all about Fern Britain.  Now before you think I am about to challenge the hegemony of OK!, Hello! and Bella, the clue is in the spelling.

Please remember:

  • past performance is no guide or guarantee of future returns;
  • the value of stock market investments can rise and fall over time,  so it is quite possible to get back less than what you put in, depending upon timing

Flash Boys – A slightly different review of the Michael Lewis bestseller…

I am not sure quite what constitutes a ‘No1 International Bestseller’, but the non-fiction author and financial journalist Michael Lewis has one with his latest book ‘Flash Boys’ – an account of the impact of ‘high-frequency trading’ on the US stock market.  And it has certainly created a bit of a stir in the world of finance.


The timing of its release has also been impeccable.  There are currently several investigations into this type of rapid electronic trading in the States by the New York Attorney-General, the FBI and the US Department of Justice.  And a high frequency trading (HFT) company called Virtu Financial delayed a planned equity fund raising due, in part, to the controversy caused by the book.

There is something deliciously ironic about the information in a book that took months to create disrupting a business that deals in information in milliseconds.  I suppose when your main business activity is akin to looking through an investment microscope at thousands of minor financial imperfections, it’s hard to notice an author creeping up behind you and about to slap you around the head with the literary equivalent of a big wet fish.

The inside sleeve of the book promotes itself as follows:

‘If you thought Wall Street was about alpha males standing in trading pits hollering at each other, think again. That world is dead.

Now, the world’s money is traded by computer code, inside black boxes in heavily guarded buildings. Even the experts entrusted with your money don’t know what’s happening to it. And the very few who do aren’t about to tell – because they are making a killing.

This is a market that’s rigged, out of control and out of the sight; a market in which the chief need is for speed; and in which traders would sell their grandmothers for a microsecond. Blink, and you’ll miss it’.

That, to put it mildly, sounds quite serious.  And there is plenty more hyperbole throughout the book, which follows a traditional Hollywood path of good versus bad.

On one side we are told about the secretive development of the hardware and software to support the need for trading speed between the HFT firms and the various exchanges – who collectively are our ‘baddies’.  On the other, we have our real life heroes led by Brad Katsuyama, an equity trader at the Royal Bank of Canada in New York.

Having finally worked out how the HFT firms are using the speed of their systems to pickpocket his own trades, Katsuyama seeks to level the playing field. First by getting his team to design an order routing system for his own clients that negates the HFT speed advantage and finally by attempting to set up, with others, his own fairer exchange.

There are other supportive subplots and by the end of the compelling narrative you are likely to feel enraged at the status-quo but hopeful something is being done about it.

It’s a great read, but is it fair and accurate?

To answer that let me give you a brief history of electronic trading to better explain where we are today and what the problems are.

As the book itself points out, the move towards electronic trading worldwide has been evolving over some time and is almost complete – bar a small amount of activity on what remains of the New York Stock Exchange floor.   The London Stock Exchange made the switch in 1986 and in Tokyo the option to trade all blue chip stocks electronically began in 1991.

I was in Tokyo at that time as the head of stock index products for a broker called James Capel and this was an important development. It meant it would be possible to instantly replicate the Nikkei 225 index by simultaneously trading in all 225 of its constituent stocks. And it set off a bit of a race between the competing brokers to develop their own systems to do just that.

When I say race, it was less of a ‘Space Race’ and more like the Red Bull Flugtag challenge. There were some pretty basic and expensive mistakes being made.

The main problem was that you had to find a solution to communicating with the Tokyo Stock Exchange hardware that each broker had in their offices.  Our solution was just one evolutionary step up from two tin cans and a piece of string as our owners, HSBC, decided the technology budget was closed for the year.  So the local chairman and I decided to pay for it ourselves.

And it worked. It involved a set of 3 weighty Toshiba laptops that together had far less processing power than your current mobile phone.  One machine generated a floppy disc with the orders on that was then thrown across the office to be put in the Tokyo Stock Exchange kit, the others were for amending orders and retrieving prices.

By modern standards it was patently archaic, but within a month our little team executed the largest client order ever taken by the company in Asia at that time. And our domestic staff were especially happy as the large order screens that adorned every dealing room in Tokyo were filled with 225 trades slowly scrolling upwards with the words  ‘James Capel’ next to each one.

Fast forward to today and the equivalent of throwing a floppy disc across a trading room is now done in milliseconds. In the States there are also now 13 different exchanges and 40 dark pools (mini exchanges within brokers that match their own inventory). However, the time it takes to communicate with each exchange is different by a tiny but, as Katsuyama found out, significant amount.

What Katsuyama discovered was that in the time it took his orders to reach the different exchanges, the market appeared able to react. The book alleges HFT firms were ‘noticing his demand for stock on one exchange and buying it on others in anticipation of selling it to him at a higher price’. And he puts this down to the speed advantage paid for by the HFT firms in order to link the exchanges together efficiently and make a ‘killing’.  It also is why the book and Katsuyama himself have claimed the system is ‘rigged’.

You might ask, if this is correct, why don’t current regulations prevent this? Well the irony is that the current rules were established in 2007, two years after five specialist firms based on the floor of the New York Stock Exchange were fined $241m in penalties for trading ahead of customer orders.  One of the rules mandates the equivalent of a supermarket price-match between the exchanges, but the time lag in its calculation gives HFT firms a window in which they can “make rapid and often risk free trades before the rest of the market can react” – to quote Eric Schneiderman, New York Attorney General.

Whether or not the book is fair and accurate will depend in part upon the outcome of the current investigations and there is clearly a serious case to answer. However, I certainly doubt that the gulf in morality between the two sides is as wide as is portrayed.  As just one example, all our heroes are introduced via their individual emotional experiences of 9/11.  No doubt, there are HFT employees with equally harrowing tales to tell.

For their part, the HFT companies say their activities are legal and add significant liquidity to markets and have lowered the cost of trading for everyone, especially smaller investors. By liquidity they mean that prices are more fluent and volumes are higher – in other words, when you want to trade you can.

My own experience is that the smaller investor is currently paying less, but market liquidity will prove to be as fickle as ever if volatility increases. And given the current stretched market valuations, that is certainly possible. For larger investors and those managing the money of others the book has represented something of an embarrassing awakening and the resulting concern has meant some, such as Fidelity, are seeking to establish their own trading platforms. Others are calling for the return to one central exchange as a utility.

But not all large investors are negative. Bill McNabb, the chairman of Vanguard and a champion of low cost index funds for small investors, backed HFT in an article in the FT saying it had helped cut trading costs and the overall market isn’t rigged. The head of the same company’s index group was a little less sanguine, suggesting some undertake activities that are “arguably legal but not necessarily right”.

In terms of overall cost, I am far more concerned about the systemic issues HFT can potentially create. Their strategies have to be written in code in advance and systems that can place orders in milliseconds can also withdraw those orders in milliseconds and make errors in milliseconds. We had the Flash Crash in 2010 and in 2012 HFT firm Knight Capital managed losses of $440 million in less than an hour due to a trading error.

For private investors, this is just another reason why you need to be disciplined and there is more than one approach to achieving this aim.  However, they all require a long term outlook.  It is difficult to keep emotions in check with so much apparently easy money to be made but, as I wrote in my last blog, it’s time for a little caution – time to be a little less ‘flash’.

Please remember:

  • past performance is no guide or guarantee of future returns;
  • the value of stock market investments can rise and fall over time,  so it is quite possible to get back less than what you put in, depending upon timing.