‘Back to the future’ Dynamic Retirement Planning

back to the future ii header


Great Scott!! – It’s the week of ‘Back To The Future Day’, the date in the second movie that they travel to in the Doc’s DeLorean – which, incidentally, doubles as the perfect retirement planning tool as he spends much of the 3-movie franchise trying to determine his own longevity.

This is also the week that I can finally introduce my own ‘dynamic’ retirement planning software, which isn’t quite as sexy or effective as a time-travelling DeLorean, but can draw on the practical and theoretical lessons in risk that I have learned and developed since first being introduced to them by a real doctor of mathematics soon after the original Back to the Future was made in 1985!

Since starting this company, I’ve never been entirely happy with the financial planning tools available to me – I will still be using the excellent CashCalc, but I wanted to be able to use the techniques that I’ve learned to illustrate with simple charts better answers for clients to questions like, ‘what is the chance that my money lasts my lifetime?’. And that can only help discussions about ‘risk’ and ‘loss’.

I had hoped to do this using some readily available dedicated software, but the few on offer weren’t versatile enough and I wanted to eventually apply more than one type of forecasting model. So, I decided to go ‘back to the future’ and write my own – and over 2000 lines of code later the first edition is finished and as it aims to look at a retirement plan and to sum it all up, that’s what I called it – SumItAllUp.

 

Over 1000 ‘What-if?’ calculations per month for each of five case studies


For a more thorough comparison with Dr Emmit Brown’s DeLorean take a look below, but SumItAllUp is no slouch. It can calculate over 1,000 ‘What-If?’ changes each month of a forecast and that can amount to over 1 million formulas in just 1.73 seconds on a standard laptop.  And it also rebuilds itself for every individual case study – hence the ‘dynamic’ in the description.

But the biggest requirement was that I wanted not one ‘flux capacitor’ in the application, but five.


sumitapp example 2

back to the future dashboardDashboard Envy

Even I have to admit that the DeLorean dashboard has a bit more going for it than the ones I designed for SumItApp – but, I reckon it has more features.

And there’s only ever been one model of DeLorean – I’ll be adding another two models once I’ve added even more ‘number crunching’ power. Why shouldn’t you have access to the same pricing techniques as a fund manager?


And being able to crunch five case studies at once means that I can choose to either compare different investment strategies and tax wrappers, for example a pension versus an ISA. Or, if more detail is needed, break an investment’s projected performance into different asset classes. But, it can also be used to combine the results of different case studies together, like the drawdown pensions of a couple.

The individual factors affecting your future pension income don’t all move in straight lines either and nor should your planner.  So input changes like contributions or withdrawals can be made monthly, whereas some programs only update annually – that’s a big difference.

If you’d like to know more about this additional service please contact me.

SumItAllUp is exclusive to Pearce Wealth Management and I am offering it as an add-on to our normal planning service for no extra fee.

 


 

Time-Travelling Delorean

Designer – Dr Emmit ‘Doc’ Brown. With the help of plutonium stolen  from Libyan rebels

Hardware/Software – One singe engine DeLorean fitted with a ‘flux capacitor’.

Energy Use – 1.21 gigawatts. According to a Buzzfeed article, that’s equivalent to 484 wind turbines, a nuclear power plant or 8 billion spinning hamster wheels.

Forecasting ability – perfect!

Price – You can find a variety of second hand and refurbished DeLoreans here. Unfortunately, they come without the ‘flux capacitor’ optional extra….and they’re in Texas.

SumItAllUp

Designer – my good self, using approximately 2000 lines of code and drawing on a variety of data sources including longevity data from the Office of National Statistics.

Hardware/Software – Standard laptop fitted with SumItAllUp

Energy Use – Approx 60 watts

Forecasting ability – However, sophisticated I make it, it remains a really useful forecasting tool – it can never be a guarantee of investment performance.

Price – There is no additional cost for using our SumItApp dynamic retirement planning service on top of our already comprehensive proposition.

Please remember:

  • ‘Pension Theft’ is unfortunately a reality. If you are cold-called by unknown companies or advisers offering you something that seems too good to be true, then it probably is – all qualified advisers are listed in the FCA Register;
  • Past performance is no guide or guarantee of future returns;
  • Investment risks apply to all kinds of pensions. Values can rise and fall over time, so it is quite possible to get back less than what you put in, depending upon timing;
  • This blog does not constitute financial advice and is provided for general information purposes only.

Are CoCos Nuts?

I was going to write about peer-to-peer loans this week, but instead I am going to concentrate on another new type of investment that offers high headline rates of interest.  They are known as CoCos and this week the Financial Conduct Authority used a new tool in its armoury to effectively ban their sale to retail investors.

Any resemblance between myself and this coconut is purely coincidental.
Any resemblance between myself and this coconut is purely coincidental.

The ban states that contingent convertible instruments, to give CoCos their full name, are ‘risky and highly complex instruments’. And indeed they are and I certainly welcome this pre-emptive ban. If a product can’t reasonably be understood by a private retail investor or, frankly, those advising them then clearly trading in it should be restricted to those with far more experience.

But I thought I’d give you a bit of insight into what they are and why they exist. And it’s not a story about financial recklessness, quite the opposite. They are a tool intended to aid financial stability – although with billions now in existence, that has yet to be tested.

One of the great realisations of the recent crisis was that some financial institutions were ‘too big to fail’. In other words, they had become so large and so complex that if they became troubled, that trouble would quickly spread to other financial institutions and threaten the whole financial system. I have written in previous blogs about a ‘network effect’ and this made the financial sector especially vulnerable.

And the poster child of this problem was an investment bank called Lehman Bros. When it failed in 2008 it set off waves of destructive ripples through the balance sheets of other financial institutions that were more severe than regulators in the States or elsewhere expected.

They had hoped that through a process known as ‘resolution’, the bankruptcy of Lehman could actually be orderly and give confidence to the rest of the market. And it’s true to say with other failing banks this did work, such as Washington Mutual. But with Lehman, which had a large and highly leveraged international operation, it patently did not.

And that realisation meant that regulators around the world knew that, given the resolution process was so inadequate, that they would have to keep their major financial institutions alive – even if that meant providing them with vast tax payer funded loans.

Now you don’t need me to tell you how unpopular those bailouts were and remain. And institutions, such as the Bank of England have been looking at ways ever since to improve that process of resolution so that if a bank gets into trouble it can be resolved in a more orderly fashion – and without resorting to the national purse.

To do that it wants to insure that, not only do banks have sufficient capital as a buffer against losses, but also that those who provide that capital via loans (bonds) and equity (shares) know that if that buffer gets depleted they are first in line to meet those losses – not depositors, not those who have lent the bank money that is secured against an asset for example and not tax payers.

So how do CoCos make this process more orderly? Well, the buffer I mentioned above is officially known as Tier 1 capital and a loan to a bank that helps meet this buffer has very little protection in the event that a bank needs to use the loan to meet losses.

What then normally happens is that there is a long drawn out process where the lenders meet with the bank to see how much of their money they will get back and only when it becomes clear it will be very little will lenders reluctantly accept shares in the bank as compensation for losing the value of their loans – known as a debt for equity swap.

Now, long drawn out processes are not good for market confidence or stability. Investors like certainty and this is why the Bank of England has championed the development of CoCos, because they have this whole process already built in.

If you own a CoCo loan with a bank, you already know that if the Tier 1 capital is threatened your loan will be converted to shares in the bank. The Lloyds Bank CoCos convert if the Tier 1 capital falls to 5%. And from the Bank of England’s perspective, they have control over this simplified process as they are responsible for announcing the conversion has been triggered.

It also ensures that at exactly the time that a troubled bank needs the benefit of swapping a loan for shares it is able to do so. You could call it repayment insurance for the original loan.

One of the proponents for these types of convertible loans or bonds is Andrew Haldane, the Executive Director for Financial Stablility at the Bank of England. He laid out the case for their use in banking and other areas in a speech titled ‘Debt Hangover’ in 2010.

I got to hear him speak on the more recent topic of ‘This Market’s Nut’s’ at Camp Alphaville, which I mentioned in my last blog. He was one of several speakers on the topic and it was not his choice of title, but there was clearly awareness that all this liquidity central banks have created, coupled with a low interest rate environment have led to a chase for high interest rate investments – whatever the risk profile.

And I suspect this is also in part where this ban has come from. Not only do the Bank of England and the FCA want to avoid poorly informed investors holding such products at this time, but if the Bank of England ever pulls the conversion trigger on one of these loans they do not want to be dealing with a bunch of retail investors claiming they never understood the risks.

Far better to be dealing with experienced investors, used to valuing other complicated hybrid investments such as convertible bonds – my own specialist area for several years.

And even where investments are allowed it’s important to know their limitations or know someone who does. And this whole series of blogs is designed to help you do that. It’s so easy to get over confident as I have mentioned before.

My wife and I still have the emotional scars from the time, given a background in art, I offered to apply her makeup for her. I was hoping for the subtle look of Coco Chanel, but she got the more distinct appearance of Coco the Clown. The pictures are here.

But that’s enough cocos for one day!

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

Gone Camping – Robots, Fraud and Peer to Peer Lending

Most of the posts in this series have been aimed at making you more informed about investment in general. And I take a rather different approach than just putting some charts and tables in front of you that all contain rosy examples.

Before you even start investing I want you to understand a bit more about the risks involved in decision making and how the economic world is wired. And I draw in part from my own experience and knowledge, but also from my own ongoing research which involves a lot of reading.

But I also make a point of attending seminars where I think I can learn something. And that normally means ones where leading investment groups and fund managers also attend hoping to do the same – but where I very rarely meet another financial adviser.

So a few weeks ago I headed off to London to a large tent in the grounds of the HAC (Honorable Artillery Company) to attend the first ‘Camp Alphaville’, hosted by Financial Times Live. Alphaville is, in the FT’s own words, their own ‘irreverent financial blog’ and is part of the online edition of the FT.

(The ‘alpha’ part of the name is what we are supposed to paying fund managers for – investment returns above that expected for the amount of risk taken. Some might call it skill, others luck.)

Large tents sometimes come with clowns inside and proceedings got off to an inauspicious start as two members of the audience started swinging at each other. Why? I have no idea. I initially thought it was a pre-arranged side-show, but no, they had taken a genuine dislike to each other. They clearly hadn’t read the promotional slogan for the event of ‘Peace. Love. Higher Returns’.

After their early eviction, we were left with a variety of investors, strategists, bloggers and policy makers discussing a variety of topics across one main stage and four inflatable ‘igloos’. Most of the speakers were in person, but some appeared in the form of an AwaBot telepresence robot – which is basically a tablet with front facing camera on a movable base, which is controlled by the person on the tablet screen.

What is the collective noun for a group of AwaBots?
What is the collective noun for a group of AwaBots?

I have to say, I think this form of remote control skype on wheels will take a bit of getting used to. One of the robot controllers explained later that one lady, thinking that the screen was just a TV on a stand, used its reflection to adjust her bra – he chose not to say anything and look away. And what if you were enjoying a quiet drink in a bar, when one of these rolls up controlled by your better half and asking when you will be home?

While I may have had some reservations about the AwaBots, they did fit with one of the main themes of the event – how robots could disrupt the labour force. Other leading subjects were China and its outlook, how markets have gone nuts and the rise of digital currencies. And on this last topic, which is very interesting, at times mind-melting and largely about Bitcoin, I’d note that we were asked to bring good old fashioned cash to pay for food and drinks.

My main focus, however, was elsewhere. I was intent on meeting two gentleman from different companies that have had considerable success at spotting fraud at listed companies. I also wanted to attend a debate on peer to peer lending. And I’m pleased to say I managed all three.

Why the interest in fraud? It’s simple, you’ll learn more from those who spot when things go wrong and there are simple lessons to be learned from both Carson Block of Muddy Waters fame and John Hempton of Bronte Capital. Spotting fraud can be a long drawn out and difficult process and there’s no question in my mind they are creating genuine alpha for their investors.

They are very different characters, but they share an understanding to always question the apparent hard facts in front of them, ask themselves constantly are we wrong in some way and perhaps the most glaring point for me, they are used to getting their hands dirty – something one can only hope the economist community does more of.

When I say getting their hands dirty, I mean what you might imagine to be rather simple stuff like tracking the activities of known fraudsters to see where they surface next. Checking the authenticity of published documents or perhaps the credibility of auditors. Looking at the meta-data on published reports to see if dates have been changed and even hiring students to count lorries entering and leaving factories to see if a company really is doing the amount of business they say they are.

Of course, this takes time and costs money and doesn’t fit with an investing world dominated by spreadsheets and a blind trust in theoretical models. And that is why they have an ‘edge’.

But it’s not just about looking for fraud, the same approach is used when investing in companies that others might hate. In an ironic twist John Hempton’s fund has invested in a US drink and food supplement company called Herbalife, which has itself been accused of being a pyramid scheme by a leading hedge fund manager. This is an ongoing situation and you can read about it at length in John Hempton’s blog, which is necessarily a bit technical.

He told me this stock has been his best performer in the past year and as he explains in his blog his edge is that he has made the effort to visit Herbalife distributers and the weight loss classes they hold in several countries and has concluded the business is largely real. He may yet be wrong, legislators in the States may take a different view, but he has been very thorough and well rewarded to date.

Finally, I headed for the debate on peer to peer lending. There are plans by the Treasury to make these direct loans between peers (eg. consumer to consumer), as an eligible ISA investment. And I did get into a bit of a discussion about risk with a board member of one the longest established firms, Zopa. We were a little bit at crossed purposes, but as someone who used to deal with the most complicated forms of corporate debt I was trying to learn as much as I could about how they assessed the risk of their loans. But, I’ll leave much of what I learned for next week.

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

 

 

It’s a Small World – Part Two, ‘What’s the chance of that happening?’

chanceIn the first of these two blog posts, I highlighted how good and bad economic events are much more likely than you might expect. And this is partly due to the way the economic world is wired. There is a ‘network effect’ that also applies to many other complicated systems, such as our bodies.

I also described how some students in the States had developed a game that demonstrates this effect called the ‘Bacon Game’. The game is based upon linking actors to Kevin Bacon, either through appearing in the same movie as him or having acted with someone who has….and so on. And what we discover is that the acting universe is far more connected to the star of such movie greats as ‘Tremors’, than we would think if they only knew each other randomly.

But this second blog is about how, even if things did just happen randomly in the same way as tossing a coin or rolling a dice, unlikely events still happen more often than we expect. Or to put it another way, when the world gets as big and complicated as it is, coincidences are very likely even though we might imagine that the chances of them happening are extremely small.

Now I am not attempting to rubbish any beliefs you might have about ideas such as fate, for example. I am merely demonstrating that we ought to consider how likely coincidences are before we assign them any special spiritual or paranormal significance.

And in investing terms, it means that yours truly is especially sceptical when looking at a presentation from an expensive fund manager showing magnificent potential returns for my clients. After checking whether I think the data is real, I then need to consider whether they’ve just been lucky. Maybe they have just been ‘fooled by randomness’ as Nassim Taleb put it in the book of the same name.

One of the best examples used to demonstrate how more likely coincidences are than we expect is this question – What is the chance that two children in the same class at school have the same birthday? Statisticians know this question as the ‘birthday problem’ or ‘birthday paradox’.

And the answer?

Well, assume there are 30 kids in a class and that birthdays are evenly spread over the year. Given there are 365 days in a year, the answer would seem pretty unlikely. But, the mistake we make is that we tend to think in terms of any two children sharing a specific date such as the 12th November, rather than the chance of sharing any date in the year.

The answer is 50% – actually, it’s a little over a half as you only need a class of 23 to get a chance of 50%. Or to put it differently, if we had two classes of children, we would expect one of the classes to have two children sharing a birthday.

There are several ways of calculating this theoretically and if you contact me I can send the most straightforward one to you. But, we can also get the same answer using a mathematical technique of trial and error called a ‘Monte Carlo simulation’.

If you create a column of 23 random dates in an excel spreadsheet and keep hitting the F9 key to recalculate those random dates, you’ll find that half the time two of those 23 dates will match. This is a very simple example of this technique and I use it far more extensively when making financial plans.

Of course, the other option is to ask your own children or remember your own school days. And at my school I was that kid in my maths class that shared their birthday with a girl in the same class. I don’t think my teacher appreciated the statistical likelihood of that outcome – he was just demonstrating data selection techniques and had come up with his own early version of a dating service using holes punched in cards.

Alas, while his experiment was a perfect example of the’ birthday problem’, as an exercise in matchmaking it didn’t work. We’d have been a pretty odd couple. The girl in question was six inches taller than me at the time and went on to become a national karate champion – I was more into art.

I did, however, marry the girl in the next classroom whose birthday is two days after mine. And here we are together over 30 years later – what’s the chance of that happening?

Apparently, a little more that I’d give Sheldon and Amy in the ‘Big Bang Theory’.

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

It’s A Small World : Part One, ‘The Bacon Game’

This is the first of two blogs that will show you why it is a small world after all.

The world and its economy is far more connected that you might imagine. And while that does have some negative consequences, it also provides considerable benefit for the general growth of the economy and that is particularly rewarding for long term investors.

It might be my least favourite ride at Tokyo Disney Resort, but it is a small world after all.
It might be my least favourite ride at Tokyo Disney Resort, but it is a small world after all.

Normally, I tend to go a little ‘off-piste’ at this point in the hope that I can maintain your interest. However, in this case I am fortunate that, 20 years ago, three Albright college students did that for me when they dreamt up a game that very effectively demonstrates how complex systems, like the economy, benefit from a network effect. It is known as the ‘Six Degrees of Kevin Bacon’.

The aim of the game is to discover how connected any Hollywood actor is to Kevin Bacon – the hero of such cinematic treats as ‘Tremors’, which I admit is only good because it is so bad. The idea is to work out the shortest number of links or ‘degrees’ between any random actor and Kevin.

If the actor and Mr Bacon have appeared in the same movie, that’s one degree of separation. If the random actor was not in a film with our star, but appeared in another movie with an actor who has appeared with him, that’s two degrees – and so on.

So, you might ask, how well connected is the movie world in this way?

In his excellent book, ‘The Origin of Wealth’, Eric D. Beinhocker describes a study using data from several US universities that show the highest degree or ‘Bacon’ number for any American actor is 4. He goes on to state, ‘90% of the roughly 570,000 actors in the world had some connection to Bacon, the highest Bacon number in the world was ten, and 85% had a number of three or less.’

Those are pretty amazing numbers. And it shows that the movie world and, by extension, the economic world is far more ‘connected’ than you would expect if the links were just random.

Why is this the case?

When you have lots of different clusters of people linked by different themes, such as their profession and then have random links between those clusters you get much better connections than by random chance alone.

It is possible to quantify this mathematically and two gentlemen Newman and Watts have shown that in a population of 1000 people if each person has 10 friends and 25% of them are random, then the average degree of separation is only 3.6. If each person has 10 friends and none are random, it’s 50!

In light of those numbers, it’s easier to see how social media companies like Facebook grew so quickly using the biggest economic network, the internet. And Facebook uses its considerable knowledge of its own network structure and its connectivity to entice advertisers. It also, in part, explains some of the extraordinary valuations of companies in the sector and why a simple application like Snapchat spurned a $3 billion offer from Facebook – but I stress, only ‘in part’. Some of these companies are priced as though they will achieve networking perfection and late investors are very likely to be disappointed.

And, of course, not all network effects are beneficial – the recent financial crisis laid bare the dangers of contagion and that in extreme environments, different types of investment are far more linked that we would like or that traditional theory suggests. Which leads me back to my previous blog about volatility. Simply put, market prices and movements are showing real signs of complacency.

I’ll leave you with a short video of Kevin Bacon, who given his networking credentials fronts the current advertising campaign of the EE mobile and broadband network. Here he is challenging Jamie ‘never wash your hands’ Oliver to make the best bacon sandwich.

And I’d really appreciate it If you could help me add to the ‘small world’ network effect by clicking the ‘like’ button at the end of this blog.

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

An Introduction to VIX – the Fear Index


If I said to you the word ‘Vix’, chances are you would be thinking that I was talking about ‘Vaporub’. However, in this case I am referring to one way in which we measure how ‘fearful’ financial markets are.


Not that Vicks Vaporub doesn’t have its uses in life. Aside from the obvious one of relieving nasal congestion it also serves as a reasonable clue to the health of a marriage. If you are happy sharing a bed with a sniffling partner covered in the stuff, chances are you’re both onto a good thing.

The Vix measures emotion between these two extemes. Pick a button.
The Vix measures emotion between these two extemes. Pick a button.

To give it its full title, VIX refers to the Chicago Board Options Exchange Market Volatility Index. That sounds very grand and a bit complicated, but as ever, I’ll try to break it down into a simple concept that is easier to understand. And I’ll leave most of the mathematics to those of you who want to contact me directly for a much fuller explanation.

The ‘options’ referred to in the title are essentially just price guarantees that can be traded for a fee. Some allow you to guarantee the price at which you can buy the stock index – others give you a guarantee to sell at a certain price.

And it’s the fee, or premium that you have to pay that gives us a clue to how relaxed or fearful the overall stock market is.

Why? Well if I am going to provide you with any form of guarantee, whether it’s on a household good or perhaps the insurance on a car, I need to work out how likely it is that I will have to pay out that guarantee and whether, on average, it will cost more that the fees I am charging.

When it comes to a stock index, the chance that I will have to pay out depends largely on one factor, how volatile that stock market is, or more importantly, how volatile it is expected to become. The more wildly it is moving around, the more likely that I will have to pay out on the guarantee and therefore the more I want to charge upfront for providing it.

And that is what the VIX attempts to do. It looks at the prices being charged in the market for a variety of options or price guarantees and comes up with a value that tells us how volatile those prices are telling us the stock index is expected to be. And that number is a percentage of the current stock index price.

A figure of 20% means that there is almost a two thirds chance that the market will remain in a range up or down 20% in the next year. A lower figure would mean that expectations are for a much calmer market, a higher figure for a more volatile market.

And at the moment the figure is a mere 11%, which is very low – the lowest level in fact since the start of the financial crisis in 2007. Then it was a spectacular misjudgement given what happened over the next two years.

 

But are current levels justified?


There are all sorts of indicators that are suggesting the financial markets are having one enormous ‘goldfish’ moment where they have completely forgotten the last business cycle. And the reason for this is extreme confidence in the actions of the central banks.

I am nowhere near as sure as to the level of their competence, but low expectations of volatility can last for a long time – you know that it will increase but it is very hard to say when. As I’ve mentioned several times, it suggests it’s time to be a bit more cautious. It also means that I am finally prepared to look at some defensive structured products, but that will be on an individual client basis.

And I repeat that if you’re into natural logs (mathematical not fire wood), rules of dispersion, letters of the Greek alphabet and want to pick the brains of a volatility watcher since 1985 – I’d be happy to answer your questions.

 

 It’s all part of the service.


Answering your questions is all part of the service, and living eight years in Asia gives you an insight into great service. Here is a short topical story about the service I received during the 1990 Italian World Cup, while staying at the Oriental Hotel, Bangkok.

My wife and I were there to spend a delayed honeymoon in the splendour of this fine hotel. Our original honeymoon was just a couple of days in Bournemouth and as exotic as that location is, we felt we deserved another break.

The problem was it was during the World Cup and given the time difference between Bangkok and Rome I needed to know the Oriental Hotel was putting the games on in the early hours.

I needn’t have worried. The Thais are fanatical about football. And I realised this when on the day of England’s first game against Ireland I entered the designated room at the hotel.

There was a huge projector screen at one end and about one hundred chairs in front of it and about the same number of staff standing around the edges of the room that refused to sit down even when I invited them to – and I was the only hotel guest there.

It was a rather bizarre environment. As the game started none of the staff made a sound, so nor did I. Then a senior looking member of staff came over to me and said, ‘excuse me sir, are you English or Irish?’

I replied, ‘English’ and he returned to the other staff to let them know.

The next time England got the ball, they all cheered, and when Lineker scored after 8 minutes I could have been on the terraces. It finished 1-1, but believe me when I tell you it’s hard to match Asia for service!

Sex & Drugs & GDP

On a trip to the coast a fortnight ago, I went inside a café to order a couple of ice-cream cones. Ahead of me in the queue was a father, who was looking a little stressed. He was waiting for a few burgers and hotdogs for his family and it was taking a little longer than expected.

He wasn’t the only one who was a little tense. The staff were feeling the heat of the kitchen as well – and I was wondering how I managed to get on the wrong queue again. His order did finally arrive and everything seemed to relax a bit as the lady behind the counter entered his order into the digital till.

In anticipation, the dad stood there with a twenty pound note in his hand and I doubt he expected much change. However, the final total on the till suggested he had under-clubbed it a bit. The price for some soft drinks and a few burgers and hotdogs? £26,000.

A bit pricey for a few burgers and drinks.
A bit pricey for a few burgers and drinks.

 

He quite calmly said, ‘I wasn’t thinking of spending that much’. And from the back of the kitchen came a distant voice, ‘has the till gone wrong again?’

They settled on an amount nearer £15 and my own bill was a more moderate £3.20 as we resorted to the old analogue system of a notepad to record the trade and cash to pay for it.

I mention it because, for a fleeting moment there, the Gross Domestic Product (GDP) of the UK was artificially raised by approximately £25,985.

I am jesting, of course, but last week we learned that the Office for National Statistics will attempt to add the oldest industry in the economy to their quarterly estimate of how the economy is faring. From September, as part of other changes that will lift GDP by 2.3%, they will include the value of drugs and prostitution.

It’s important to emphasise the word ‘estimate’. GDP figures are reported and debated in the media as though they are factual, but they are subject to revisions as some parts of the economy are far harder to assess than others and not all the data arrives at the same time.

In this case, the Office for National Statistics kindly give us a separate Excel spreadsheet that shows us their assumptions. In total, it amounts to £9.7 billion, based on 2009 prices, or approximately 0.7% of the then GDP – and it breaks down as follows:

Prostitution        £5.27 billion        54%

Drugs                  £4.43 billion        46%

In the case of prostitution they reached that number by estimating there are 60,879 prostitutes in the UK – each with 25 clients a week paying £67.16. If £67.16 seems ridiculously precise, it’s an old figure of £50 adjusted for inflation. Take off costs of £44 million, which were borrowed from a Dutch estimate and you get the final figure.

And for the drugs industry, cocaine in its various forms represents 71% of the total (42% crack, 29% powder). Those numbers allow for the cost of importing it, so the sales figures are even higher with cocaine accounting for 77% of the grim total.

So why are they attempting to do this?

Ostensibly it is to meet European Union rules to establish common practice among member countries. The Dutch, for example, have reported parts of these figures for years as prostitution and certain drugs as are legal. However, the overall changes are also in line with international guidance from the likes of the US and Australia.

It’s hard to argue with the idea of trying to measure all areas of the economy and some countries have a lot of work to do. In April the IMF endorsed a near doubling of Nigeria’s GDP to $510 billion as new industires were added and prices updated. As the Economist newspaper pointed out, the new numbers aren’t fiddled, it’s the old numbers that were wonky.

So what’s most important is that the numbers as a whole are regarded as credible. And the numbers of two countries stand out as being questionable.

The government of Greece, endorsed by some economists, justified higher levels of national debt before the recent crisis due to the estimated size of its black economy. At the time, as now, it wasn’t even collecting normal levels of tax on its legitimate one. We know how that one turned out.

And then there’s China, where the GDP figures miraculously meet official annual targets near 7%, despite the sheer scale and complexity of their calculation. Mathematically, continuous growth of 7% is a notable number – it means the economy is doubling in size every ten years. And if an economy of that size is really growing at that rate, they are more likely to bump into problems – especially rising levels of debt.

Michael Pettis, a professor of finance at Peking University, whose blog we have followed for some time, now makes the case that it can’t continue that way – the country needs to rebalance towards lower growth nearer 3 or 4%. I’m not sure the investment world fully appreciates that.

I’ll leave the final comment to the lyrics of Ian Drury, from whom we borrowed the title of this blog. He knew a thing or two about simple explanations of complicated subjects. My favourite has to be these two verses about two well known gentlemen from ‘There Ain’t Half Been Some Clever Bastards’ –

Van Gogh did some eyeball pleasers

He must have been a pencil squeezer

He didn’t do the Mona Lisa

That was an Italian geezer.

The next verse isn’t quite as factual, but brilliant nonetheless

Einstein can’t be classed as witless

He claimed atoms were the littlest

When you did a bit of splitting-em-ness

Frighten everybody shitless

 

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.

fernbritain

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.

Sleep

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.

flashboys

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.