Book Review: Big Hot Cheap and Right, by Erica Grieder

We’re all about to get dunked[1] by the US Presidential race in a deep-water tank of Texas exceptionalism.

With a year-long GOP primary season ahead of us, get ready for Texas Senator Ted Cruz to explain how extremely small government (plus God!) serves us best. Also, prepare for Texas native son (now Kentucky Senator) Rand Paul to explain the same, but without the God part. We can look forward to former Texas Governor Rick Perry pitching his Texas economic miracle to the rest of the United States. And do not forget GOP favorite Jeb Bush who – like his younger brother W. Bush – grew up in scenic Midland, TX.

Even if you regard Texas with extreme prejudice – as I did before moving here in 2009 – you can’t avoid its prominence as the blueprint of Red State plans for the rest of the country.

I read Erica Grieder’s Big, Hot, Cheap, and Right: What America Can Learn From The Strange Genius of Texas as a kind of primer on the GOP Primaries.

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Ted Cruz

If you’re an East or West Coaster who mostly learns about Texas from the NYTimes’ Gail Collins’ periodic columns on the biggest little state in the Union, I recommend Grieder’s deeper dive into some of the state’s colorful history, characters and traditions.

I read with most interest the parts of her story concerned with the ‘Texas Miracle’ and in particular Texas’ curious tradition with respect to the government’s proper role in economic development.

Here’s the thing that’s struck me since I arrived, and Grieder concurs: Texas political leaders do not actually pursue free-market economics in practice. There’s a strong tradition and ongoing practice, in fact, of the government picking winners and losers in the marketplace.

Before moving to Texas, I associated the rugged libertarianism of, say, Ted Cruz and Rand Paul, with the idea of government’s limited role in an economy. Yet time and again I’ve noticed that Texas governments – both State and City – take very seriously their mandates to subsidize particular businesses and particular industries.

‘Limited government’ in Texas really means limited government services to households, but it does not preclude the government from picking winners among businesses.

Elected officials – both Republicans (at the State level) and Democrats (who dominate all of the major cities in Texas) – always couch these targeted subsidies to businesses in terms of ‘jobs growth.’ The thinking, I guess, is that what’s good for a business owner is generally good for employees, since business owners are ‘job creators?’

As Governor, Rick Perry championed the Texas Enterprise Fund, a general purpose ‘economic development’ fund which handed out $507 million to ‘promising’ companies and institutions, specifically linked to ‘job creation’ achievements.

The State Auditor’s report in September 2014 found “control weaknesses” that made it impossible to verify ‘job creation’ claims by Perry government. The Auditor also found applications from private companies for funds to be insufficient and non-compliant with the original requirements of the Enterprise Fund. As Grieder reports in her book, many recipients of Enterprise Fund money, perhaps unsurprisingly, donated generously to Rick Perry’s campaigns, as much as $7 million to Perry’s reelection funds and the Republican Governors Association.

rick_perry_enterprise_fund

None of these results are surprising to observers of the Fund. What is surprising is Perry’s supposed allegiance with free-market, low regulation, limited government approaches, while spearheading the Texas Enterprise Fund.

The New York Times reported in 2012 that Texas under Perry has the highest rate of tax incentives targeted to specific companies of any state in the nation. Again, not surprisingly, there’s a strong link between beneficiaries of tax breaks and contributors to state officials, as reported by the New York Times.

But this Texas tradition of picking winners and losers in the marketplace is not limited to the GOP. The stakes are lower at the local level, but seemingly just as common.

Among the Democratic-controlled city where I live, every other week it seems a city or county ‘economic development’ group hands out a combination of targeted tax breaks or grants to a particular company.[2] Sometimes my city’s economic development team even directly invests in the equity of startup companies[3], which strikes me as, basically, insane.

This type of government-driven economic development violates everything I believe about:

  1. How actual economic development happens
  2. How winners and losers in an economy should be sorted
  3. How business owners actually decide to ‘create jobs’ or not ‘create jobs,’ in their businesses
  4. How government should best interact with private business
  5. How natural conflicts of interest between public office holders and private capital controllers should be mitigated.

Yet, Texans on both side of the political spectrum don’t seem bothered by these ‘Texas Miracle’ tactics, at least as observed in the press or at the polls. This tradition of direct subsidies to chosen industries and companies – as described in detail by Erica Grieder’s book – does not seem to elicit the kind of visceral reaction it would back where I come from.

texas_flag

Here in Texas, this is all frequently described as ‘incentivizing job creation.’ Where I come from, it’s usually called corruption.

Erica Grieder’s tale of Texas’ peculiar history, characters and economic power cover a wide range of topics, but I appreciated most these parts focused on this peculiarity of Texas government and culture.

I’ll be watching the GOP primaries closely with an eye to how this plays out among all of Texas’ native sons.

Grieder covers other ground in her book as well.

If you’re already a Texas resident with a reading habit – I read Texas Monthly, Texas history books, plus the local paper, – many of Grieder’s story lines and anecdotes will seem familiar already.

At times the book reads like a review of recent political journalism. Grieder’s not providing a ton of data in these sections, but rather journalistic narrative. This makes for a fun book to read, and Grieder’s a talented writer.

We are left short of ‘proof’ that Texas has something to offer distinctive from other states, other than Texan’s belief in their own exceptionalism.

Please see related posts:

City Direct Investments – Ugh

Subsidies all the way down

big_hot_cheap_right

[1] Is waterboarding an appropriate metaphor here? Or is that too much?

[2] Here’s one for a local Caterpillar manufacturer last week. This one for a solar manufacturer was a doozy.

[3] As in this one, in which the City put money into a local private equity incubator, and this recent one, in which the City bought equity in a startup medical device maker, in return for it relocating to San Antonio. I hate this.

 

 

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Book Review: The Turtle of Oman

A version of this review ran in The Rivard Report

An unexpected gift
On the Wednesday morning before a Thanksgiving weekend in Big Bend National Park, the poet and novelist Naomi Shihab Nye dropped off a signed copy of The Turtle of Oman, her recently published novel, for my daughters.

Touched by this unexpected gift, I packed the book for our trip with the rest of our camping gear.
Would my kids like this?

My nine year-old wants magic in her literature.
She has reread the seven Harry Potters so many times the binding glue has cracked on most of them and whole chapter-chunks of the books’ spines split away.

To satisfy her appetite for magic, we’ve read The Hobbit to her, and we’re halfway through Susan Cooper’s The Dark Is Rising series.

But I did not know how she would take to the slower magic of a boy’s relationship with his grandfather, and the growing heartache of saying goodbye to home.

Oman
Reading about Oman in Big Bend National Park
I began reading The Turtle of Oman out loud to my four year-old and nine year-old while driving through the mountains-of-the-moon landscape of Big Bend. We drove and then hiked past water, mountains, and desert.

Aref Al-Amri, an Omani boy, procrastinates before a move from the capital city Muscat in Oman, to Ann Arbor, Michigan, through list-making and serendipitous adventures with his grandfather Sidi.

Although we don’t learn Aref’s precise age, in my mind Aref is the same age as my nine year-old.

Aref plays with Legos, competes in a youth soccer league, and studies in two languages, English and Arabic.

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Old City Muscat, Oman

I was struck at just how familiar Aref’s boyhood world would be to American children like my daughters. The familiarity stems not just from the Legos and the soccer, but also from his struggle with saying goodbye to a place he loves.
Nye captures and helps us meditate on the boy’s emotional journey.

Mountains, deserts, stones
The further we drove, and the more I read, the more familiar Oman began to seem. I paused between chapters to gaze out of our car window.

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I swear the Hajar mountains look just like Big Bend

We learn that Omanis revere the Hajar (or “Stone”) Mountains from Muscat. Have you seen pictures of these mountains? I swear I saw them in Big Bend.

As Aref and Sidi travel by Jeep into the shifting sands of the Omani desert for an overnight adventure, we sped through parched desert ourselves.

Sidi and Aref watch Bedouin camel caravans on the edge of the sandy horizon, just as we scanned the distant mesas from our campsite for imaginary Comanches, hidden just over the cliff border with Mexico.

Nye’s poetic eye lingers on a stone discovered by Sidi with three circular lines like map-route tracings. On our hike in Tuff Canyon, my four year-old stooped to grasp and inspect volcanic rocks, pockmarked and rust-colored.

Peregrine falcons
During dinner at Chisos Basin lodge in the middle of Big Bend, we learned that the peregrine falcon is the fastest animal on the planet, reaching maximum speeds of 220 miles per hour. Peregrine falcons kill prey instantly upon impact. Importantly, a few pairs of peregrine falcons nest in Big Bend near the Rio Grande River.

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Peregrine falcon

In the novel’s most thrilling scene, a falcon trainer in the desert fits Aref with the leather armband needed to launch into the air and receive back a trained peregrine falcon. Sidi holds his breath as the predator turns precise aerial acrobatics at shocking speed. When the falcon lands cleanly on Aref’s arm, Sidi breathes again.

Breathing
Later, Sidi urges Aref to breathe for another reason.

“Sidi kept sniffing and urging Aref to smell the air and breathe deeply. ‘That way, your body will carry the desert back to the city,’ he said. Aref gulped and held his breath.
When they turned around and started walking back to the NIGHT OF A THOUSAND STARS desert camp, Aref stared at the whole picture before them – small tents, purple pom-pom doorways, brown stucco bathroom, painted green stools, metal tables, and one tired sleeping falcon. Everything glistened, an oasis in the sun. He ran circles around Sidi, saying ‘I love this place! I think it might be my favorite place!
‘You will be like my falcon,’ said Sidi. ‘You will fly away and come back. Just as he did. That was beautiful.’ “

The stars at night
At night at Big Bend, snug in our sleeping bags, crowded into our tent, my girls asked me to read aloud more chapters about the Omani boy, Aref.

At least once every night out in Big Bend, I left our tent to breathe deeply, look up at the bedazzled black, to silently recite Emerson:

“If the stars should appear one night in a thousand years, how would men believe and adore, and preserve for many generations the remembrance of the city of God which had been shown!”

When Aref and Sidi leave their desert encampment, Sidi shows his playful side again:

“As they were passing under the arched NIGHT OF A THOUSAND STARS sign at the camp gateway, Aref said, ‘So, Sidi, did you see a thousand stars last night?’
‘Ah, now you remember to ask! No, I only saw nine hundred and ninety-nine. So we will have to keep our eyes open for that last one. What about you?’
Aref just laughed.”

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Big Bend Stars

Not the coming-to-America story we expected
This crescent-moon of a novel waxes nostalgic as Aref’s departure approaches. We expect a typical novel’s narrative arc. We expect to learn about the cultural adventures of an Omani boy arriving in Ann Arbor, Michigan. Instead, two-thirds of the way through the novel, we realized the now-full moon has begun to wane again. In fact, he won’t arrive in Ann Arbor before the novel ends.

Aref is our window into understanding Oman, not America. An Omani boy learning about Michigan is not part of Nye’s plan. The Turtle does not conform.

Naomi Shihab Nye’s reason for that

Aref’s story offers something rarer, something different. Could American children connect with the magic of a childhood in Oman?

I thought about Nye’s plan because of a short story of Nye’s which I recently read when it went viral on Facebook, called “A-4.”

In “A-4,” Nye comforts a Palestinian woman in distress at the Albuquerque airport over a missed airline connection. She finds the woman in full Palestinian traditional garb, crumpled on the floor crying.

The ‘other’ becomes familiar
We’ve watched the news enough to react to a wailing Palestinian woman with some anxiety.

As Nye gently writes in “A-4,” she hesitated before getting involved because, “Well – one pauses these days.”

But in “A-4,” crying turns to laughter, handholding, and hours of shared happiness in the airline terminal. Nye offered a few words in Arabic, and received a gift of a powdered sugar-dusted cookies. Nye marvels at the experience, the common humanity.

The other passengers at the gate soon dropped their normal defenses as well, allowing the shared cookies’ powdered sugar – a kind of peace dust – to coat their laps.

“A-4” hits people somewhere between recognition – we’ve had this surprise connection to strangers when our defenses suddenly drop – and longing – we wish this could happen more often.

I think Nye shares a wish for our children with The Turtle of Oman that she states most clearly in “A-4:”

“…I looked around that gate of late and weary ones and I thought, This
is the world I want to live in. The shared world. Not a single person in that
gate – once the crying of confusion stopped – seemed apprehensive about
any other person. They took the cookies. I wanted to hug all those other
women, too.
This can still happen anywhere. Not everything is lost.”

Could we find our common humanity if we immersed ourselves in another culture? And if not all of us, could our children?
What if we watched a peregrine falcon in flight over the desert, together?

My nine year-old finished the final third of the book on her own during the drive home from Big Bend, too wrapped up in the story to wait for me to read it to her.
The slow magic of this book, with its vivid colors and poet’s eye for detail, worked on her.

Turtle of oman

Please see related post:

Book Review of Going Going by Naomi Shihab Nye

Please see related post All Bankers Anonymous book reviews in one place.

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Book Review: The Mystery Of The Invisible Hand

Looking for a last minute book to purchase this holiday season for the bright business or economics student in your life? Perhaps the student in your life appreciates mixing economic theory with murder, as in The Mystery of the Invisible Hand by Marshall Jevons.

Marshall Jevons is the pseudonym of economics professors Kenneth Elzinga of the University of Virginia and the late Trinity University economics professor William Breit.

Professor Breit was a beloved figure on campus at Trinity in San Antonio, TX before he passed away in 2011, remaining connected to students and his department in the years following his retirement.

Elzinga and Breit created the fictional murder-solving Harvard economist Henry Spearman.

Spearman – who wins the Nobel Prize in Economics at the start of this novel – applies economics principles to solve murders. Think Hercule Poirot meets Milton Friedman.

trinity_university
Trinity University in San Antonio, TX

In The Mystery of the Invisible Hand – the fourth in a series of Spearman mysteries, the economist-detective arrives as a visiting professor at Monte Vista University in San Antonio, TX – a transparent portrayal of San Antonio’s Trinity University.

Each chapter begins with a passage or quip from a famous economist.

Inside jokes of the economics profession abound – like naming a character Bruce Goolsby, a thinly disguised reference to Austan Goolsbee, Chairman of the Council of Economic Advisors under President Obama.

The humor of Breit and Elzinga shines through in their light satire of academic politics and foibles.

We meet the hard-charging Trustee Annelle Cubbage – heir to a Texas ranching fortune – who wants the best that money can buy. Cubbage wants what she wants, when she wants it. Cubbage creates the “Cubbage Visiting Nobel Professorship” that brings the Nobel Laureate Spearman to Monte Vista University.

The anxious scholar Jennifer Kim – untenured – hesitates awestruck in the face of Spearman’s awesome reputation.

Meanwhile, the art professor Michael Cavanaugh resents the high pay of his economist colleagues at Monte Vista. By his view, they lack appreciation of art for art’s sake.

Visiting artist-in-residence and painting genius Tristan Wheeler cuts a romantic swath through the hearts of Monte Vista scholars – including some professors’ wives – before his mysterious death.

Spearman observes – like a careful anthropologist of the academic world – how the seating arrangement at the Monte Vista University President’s dinner establishes the relative ranking of dinner invitees.

Elzinga and Breit clearly met all of these characters on their real life campuses during their academic careers.

San Antonio readers will appreciate the economic explanation of the cost of the Spurs’ stadium, as well as financial theories on the funding of the fictional “Travis Museum,” modeled after the SAMA.

Spearman solves the murder through an epiphany in the midst of an economics lecture at Monte Vista University, applying economic analysis to intuit the motive of the killer.

Those of you who – like me – prefer your financial and economic theories presented with a spoonful of sugar to help the medicine go down, will enjoy this murder mystery set in the Montevista neighborhood of San Antonio.

The three other Marshall Jevons economics mysteries featuring Henry Spearman are The Fatal Equilibrium, Murder at the Margin, and A Deadly Indifference.

Mystery_of_the_invisible_hand

Please see related post, All Bankers Anonymous book reviews in one place!

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Book Review: Flash Boys: Not So Fast by Pete Kovac

Peter Kovac wrote Flash Boys: Not So Fast, as a point-by-point refutation of the major premises of Michael Lewis’ Flash Boys. At the end of Kovac’s book – well actually, after just the first few pages – you’re left with the strong impression that Lewis wrote a tale built on speculation about a dramatic – but not particularly true – conspiracy theory about high frequency trading (HFT) and the US equity markets.

I’m reminded of a core reason I started Bankers Anonymous

After the 2008 crisis I got tired of reading the journalistic errors and omissions about mortgage bonds and credit default swaps. Having worked in those markets, I know how frustrating it can be to read some overly simple or mostly false journalistic narrative in the New York Times or Wall Street Journal.

I would think: “No! That’s not how it works.”

Then I’d end up shouting at the breakfast table, angrily poking the newspaper,[1] scaring my small daughters and leaving my wife eager to get to work as quickly as possible.

That’s one of the reasons I started Bankers Anonymous. To offer better explanations. The other reason was to maybe learn how to write a book.

Speaking of writing a book. Can I admit to a bit of jealousy?[2]

Kovac is a friend. Until recently he worked for a high frequency trading firm. When he read Michael Lewis’ Flash Boys, the errors and omissions about his industry bugged him so much that he decided to write a response.

A few months and 115 pages later, he has written the definitive take-down of Flash Boys.

Kovac is funny, informed, and he has specific examples and excellent metaphors to make the somewhat opaque world of high frequency trading accessible to us.

Who is Pete Kovac?

Kovac’s biography is a key to understanding his response to Michael Lewis’ book.

He started as a programmer for his HFT firm, named EWT, in 2003 and then rose to Chief Operating Officer, overseeing everything from compliance and working with regulators. I’ve footnoted a fuller description of Kovac’s bio here.[3]

As Kovac himself points out, you could read his biography and immediately think: “Oh, just one of those insiders, defending his own industry.”

Naturally, one of the inherent problems of understanding finance is that the experts tend to have a stake in the system somewhere. Outsiders, with no stake, tend to not be experts. Well, Kovac’s an expert and an insider. That seems relevant when evaluating an outsider’s claim about an industry.

Nevertheless, most importantly, he’s the kind of expert that Lewis didn’t consult in the course of writing Flash Boys.

Lewis’ problem in Flash Boys

Lewis’ key advantage over most other financial journalists has always been his semi-insider status. Meaning, he actually worked as a salesman on the Solomon bond-trading floor for two years, and he actually understands the mindset and motivations of the Street better than most scriveners.

Michael_lewis_author
Best-selling author Michael Lewis

And yet, the biggest problem I found with Flash Boys is that he seems to have had no access to actual high frequency traders, making him far more outsider than insider this time. This makes his theories on HFT more speculative than they ought to be. In my earlier review of the book, I felt his lack of specific information or details or access on HFT led him to demonize and simplify their actions.

In his earlier books, the ‘bad guys’ tended to be at least humorous and specifically obnoxious, not facelesslessly manipulative and devious. Unfortunately the HFTs of Flash Boys are more faceless cartoon villains than real villains.

In addition to Kovac, other reviewers of Flash Boys have also pointed out the unusual number of either 1. errors or 2. simplification of equity markets and HFT. Again, Lewis’ lack of access to real live HFTs probably accounts for both.

 

Are HFT engaged in a vast front-running conspiracy against slower investors?

You kind of have to read Kovac’s full refutation of the vast conspiracy, and also know something about market structures and market orders to follow this, but I trust that – at the very least – Lewis was speculating about how front-running by HFTs might work. But Lewis didn’t really have any idea what would work or not.

Kovac goes point by point to show that Lewis’ speculation is basically impossible and nobody Kovac’s ever worked with in the HFT world could make money that way.

In addition – and this is probably the strongest part of Kovac’s book – Lewis’ description of what might have happened is so rife with errors or impossibilities according to the way the US equity market actually works that Kovac is left stunned.
Reading Kovac’s book I’m reminded of me, poking angrily at the morning paper “NO! It can’t happen that way! I can’t believe you’re claiming this and non-financial readers won’t know how to see through your BS! Argh!”

What about Brad Katsuyama, the hero of Flash Boys?

Kovac is sharp-witted about the incredulousness of Brad Katsuyama, the protagonist of Flash Boys. Katsuyama set out to create a (relatively) slow-trading exchange in order to foil the HFTs.

Brad_katsuyama_iex
Brad Katsuyama and the IEX Team

Katsuyama repeatedly appears to believe in HFT actions and schemes that have little basis in the markets Kovac knew and participated in.

Far from a hero to Kovac, Katsuyama represents the legacy model of trading equities – expensive, slow, and self-interested.

When Katsuyama alleges a HFT front-running conspiracy that his new IEX exchange will correct, Katsuyama (in Kovac’s telling) becomes focused on his sales pitch even though his new exchange may be a solution in search of a problem.

Worse, Lewis appears to swallow and then amplify Katsuyama’s sales pitch for IEX, despite data and evidence that refutes their central thesis.

Want to know what else is wrong with Flash Boys?

Kovac’s book is a comprehensive, chapter-by-chapter, point-by-point critique of Lewis’ errors.

Here’s a few more examples that Kovac explains in detail.

rise_of_the_machines

Did Reg NMS in 2007 give rise to the machines as Lewis implied?

Nope, HFT was already 20% of the trading volume on US exchanges prior to 2007. As Kovac points out, Lewis himself provides this data that undermines his own argument. In addition, US equity trading is only one small portion of HFT trading strategies. The others, with currencies, commodities, bonds, and futures, are unaffected by Reg NMS.

Did HFTs cause the 2010 Flash Crash?

A comprehensive review by regulators found no evidence of this, but rather a series of compounding triggers from multiples sources in the equity markets. Lewis dismisses the regulators as either dupes or self-interested, but I trust Kovac’s closeness to that trading situation, his professional contact with regulators, as well as his careful reading of the report.

Is trading data impossible to track and assemble for the purposes of uncovering frontrunning or wrongdoing – or “does the data not exist” as Lewis claims?

Kovac reports that every single trade, in addition to every single text, instant message, trading program and order gets tracked and recorded by all the exchanges and regulators. It would be, and is, possible to track bad behavior from HFTs, says Kovac, who has served in the compliance role at his firm.

Lewis makes the claim that tracking this would be impossible.

On a related note, Lewis paints market regulators as generally either compromised or behind the curve when it comes to regulating markets and high frequency traders in particular. Kovac, who worked professionally with many regulators over the years, found the opposite to be true.

Kovac compares them to the Supreme Court. They often passed judgment he disagreed with, but they were always thoughtful. Regulators laid out extensive reasoning for their decisions, and attempted to create fair markets for the general good.

Criticisms of Kovac’s book

Readers unfamiliar with Lewis’ Flash Boys may not follow along with Kovac’s rebuttals, as he takes a chapter-by-chapter approach to critiquing Flash Boys. It’s undoubtedly more interesting to read this if you already know the original work.

In addition, while Kovac is quite clear in his writing, there are moments of technical explanations – I’m thinking of the explanations of market orders as one example – in which I got lost a bit in the weeds. Less financially-savvy readers may suffer somewhat as well.

Finally, at times Kovac is so astonished by Lewis’ one-sidedness with the HFT narrative that he lapses into sarcasm.

When I’m really mad at someone or something I do this too, so I recognize it in Kovac’s writing as well. It doesn’t happen much with Kovac, but I can hear my own internal editor telling me “don’t do that.”

Final Analysis

As a result of Kovac’s book, I’m convinced that Lewis pretty much blew it in covering the HFT story. I’m still left with some questions – for example ‘how do HFTs really make consistent profits?’ and ‘should we be collectively worried about future flash crashes as a result of algorithmic trading, and how do we prevent that?’

But if you really liked and believed in Lewis’ narrative, you owe it to yourself to hear another side, from someone who actually knows the business.

 

Please see related post: All Bankers Anonymous book reviews in one place!

 

Please see related posts:

Book Review of Flash Boys by Michael Lewis

Book Review of Inside The Black Box by Rishi Narang

 

Would You Like to Understand High Frequency Trading?

The Rise of the Machines

 

[1] Yes, I subscribe to physical newspapers. Yes, kids, I was born when dinosaurs roamed the earth, during the late Mesozoic Era, or Triassic Period. Ha ha ha. Now shut up and keep scrubbing.

[2] File this jealousy under the label “Every time a friend succeeds, a little something in me dies.” I’ve been talking about writing a book for a while now, and he just goes out and does it. And it’s good! Damn him. *Shaking my fist.

[3] In Kovac’s own words: “I am an industry insider, the kind of person who could have saved Lewis from making some really basic mistakes. I started programming trading strategies in 2003. After years in the trenches, I moved into management and ultimately became chief operating officer of my firm, EWT. I handled regulatory compliance, risk management, finance, trading operations, and a portion of the IT and software development teams – and I had to know every aspect of the stock market inside and out. By 2008, our company was one of the largest automated market-making firms in the U.S., trading hundreds of millions of shares of stock daily, and had expanded into many other asset classes domestically and internationally. I left it all three years ago when EWT was sold to Virtu Financial (in which, in the interest of full disclosure, I still retain a small stake).

Those eight years at EWT provided me with a front row seat to all the events described in Flash Boys, and much more. During that time, I shared my experience and perspective in discussions with regulators and lawmakers here and abroad, advocating for the continued improvement of the markets discussed in the book. Many of my comment letters on these topics are publicly available on the SEC website. Even though I no longer work in trading, I can still get answers from a diverse set of close sources when a truly new question arises.”

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Book Review: Help Thanks Wow by Anne Lamott

anne lamottMy latest book recommendation for anyone who, basically, knows how to read: Help Thanks Wow: The Three Essential Prayers by Anne Lamott.

It’s a bit hard to describe exactly why you, specifically, may need to read this book. But I’m assuming:

  1. Each one of us needs to work on our soul in some way, at least some of the time
  2. Prayer, broadly defined, is a good way to do that, and
  3. Lamott has a magical way of explaining the ways and hows that prayer works for her, and may work for you.

Not a finance book

Help Thanks Wow does not speak to the traditional themes of Bankers Anonymous.

Except in this sense:

Money and finance can be a source of emotional stress for many people. What’s blocking us from realizing our goals may not be the actual dollars in our bank account, but something far less rational.

And also, in this other sense.

I find Lamott’s forgiveness of failure and pain an inspiration.[1] Her acceptance is a helpful tonic for my otherwise competitive, rational mind.

I kind of have this sense that finance – in all of its aspects – would be a lot more pleasant for everyone involved if it wasn’t so damned rational and competitive.

But it is.[2]

So I try with Bankers Anonymous to make finance more pleasant to engage with, through clear explanations and a tiny bit of humor.

Lamott as a guide to writing

My value proposition for readers of Bankers Anonymous has been to offer thoughts on finance to a general audience of educated people.

My major self-interested reason to launch the Bankers Anonymous blog was to learn how to write for a general audience of educated people.

That’s been the trade-off. You get to learn about finance. I get to learn about writing.

I mention this because I first discovered Anne Lamott through her well-known Bird by Bird: Some Instructions On Writing And Life, which is a totally awesome guide to both topics.[3]

Could you use a good cry?

I really appreciate a book more if – like a good wedding – it makes me cry.

One of the hazards of reading Help Thanks Wow: The Three Essential Prayers in public is that, as the hammer of her prose hits your emotion-bone, you feel that ache in your adam’s apple and an inadvertent welling in the lower eyelids. Once in a restaurant, and then later, waiting at the gate to board a plane back to Texas, I put the book down, blinking rapidly in a lame pretense that the air had suddenly become dusty.

Lamott celebrates her weaknesses as proud life tattoos. You find yourself drawn in by her admitted flaws, and then possibly admitting those same flaws in yourself. She’s wickedly funny about herself, which takes the venom out of noticing that you yourself are a flawed person.

Looking for some grace

Lamott is a real 12-stepper. I am merely a “recovering banker” inspired metaphorically by 12-steppers.

Whether you are a real 12-stepper, or just a flawed person trying to step clumsily around your own ego to find some grace, Help Thanks Wow can put you in the right frame of mind.

Are you willing to take a risk and ask for help? What’s holding you back? Do you understand just how lucky you are? Could you feel beloved today? Did you notice, I mean really notice and give thanks, for the incredible miracle that you’re still alive? These are all questions I’m asking myself, today, after finishing Help Thanks Wow.

 

Please see All Bankers Anonymous book reviews in one place!

Please see related posts:

Book Review of Peace and Plenty by Sarah Ban Breathnach

Book Review of Why Smart People Make Big Money Mistakes by Gary Belsky and Thomas Gilovich

It’s A Wonderful Life: A Failed Banker Origin Story

Help Thanks Wow

Bird by Bird:

[1] My attempt to wrestle with forgiveness of failure and pain is addressed here.

[2] Ironically, the worst finance book of all time, Peace and Plenty by Sarah Ban Breathnach, is an attempt to make personal finance less rational and more emotionally accessible. Ban Breathnach fails miserably in the attempt. Its 10 times longer than Lamott’s book, has nothing useful to say about personal finance, plenty of terrible ideas, a cringe-worthy writing style, and its dull-as-toast boring. Other than that though, it’s a nice try.

[3] And presumably a guide to writing without using clichéd phrases like ‘totally awesome.”

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Book Review: A Random Walk Down Wall Street

First published forty years ago, A Random Walk Down Wall Street by Burton G. Malkiel is one of those books – much like Benjamin Graham’s The Intelligent Investor – more referred to than actually read.

Malkiel’s central thesis – that equity markets are so efficient at pricing stocks relative to their risk that the vast majority of investors would do best to buy an index mutual fund rather than invest in individual stocks or buy an actively managed mutual fund – has utterly demolished the other side in the battle of investment ideas, even if the war of investment ideas rages on in the world, oblivious to the total intellectual victory of one side.

Since a majority of individual equity investors – in addition to institutional investors – do not yet embrace in practice the Random Walk’s Efficient Market Hypothesis, more should probably read this book to realize that the battle has already been decided.

Lately it does feel as if the tide is turning – as both more individuals and more institutions realize that although some individuals and some managers may ‘beat the market’ some of the time, few managers beat the market often enough to justify their fees. And further, that even if some managers did regularly beat the market in the past, it’s quite difficult to know in advance which ones will beat the market in the future. The resulting logical choice that more and more people make – despite the extraordinary marketing efforts of the Financial Infotainment Industrial Complex – is to purchase index funds.

 A Random Walk‘s impact

How important is Burton Malkiel and his book? One measure of his book’s impact is the index mutual fund industry.

At the publication of the first edition of A Random Walk in 1973, the ‘index fund’ did not yet exist, and instead was something Malkiel mused about:

“What we need is a no-load, minimum management-fee mutual fund that simply buys the hundreds of stocks making up the broad stock-market averages and does no trading from security to security in an attempt to catch the winners. Whenever below-average performance on the part of any mutual fund is noticed, fund spokesmen are quick to point out, ‘You can’t buy the averages.’ Its time the public could”

Shortly thereafter, John Bogle at Vanguard proposed the creation of the S&P 500 index, which became available to the general public in 1976. Malkiel became a director at Vanguard fund and may take considerable credit for the intellectual authorship of this superior idea.

The Tide is Turning

After reading Malkiel’s A Random Walk, I was fascinated to learn about the following shifts in the mutual fund landscape in favor of indexing:

For eight years in a row leading up to 2013, domestic (US) actively managed equity funds experienced net outflows, while domestic index funds experienced inflows.

rise_of_index_investing
Steady Growth of Index Fund Investing. Source: icifactbook.org

Of the $167 Billion in net new money invested in mutual funds1 in 2013, $114 Billion went to index mutual funds.

As a result of these trends, equity index funds, as a share of all equity mutual funds, has hit a high of 18.4% in 2013, up in a steady increase almost every year from just 9.5% in 2000.

Malkiel’s book does not explain all of this shift, nor did it cause it, but it has provided the popular intellectual justification behind the investment of hundreds of Billions of dollars per year. That’s a pretty cool legacy that should at least be added to his Wikipedia page or something.

Great writing

Malkiel carefully navigates that difficult ridge line between technical writing that includes academic research, including probabilities and statistical methods, and fundamental security analysis – upon which he bases his ideas – and popular interpretations and advice for the average investor.

While stock prices may be random, his writing is anything but random. He’s careful and logical and subtly funny too.

I expected the academic case for the Efficient Market Hypothesis – for which A Random Walk is most famous – but I am pleasantly surprised at how practical, accessible and prescriptive the rest of the book is on constructing an individual’s investment portfolio.

How to value stocks – two ways

Malkiel posits two ways to determine the value for any stock.

Fundamental valueBenjamin Graham in The Intelligent Investor taught us the theory and technique for determining the fundamental value of securities.

In plainest terms, you have to determine all of the future cash flows of a security, and then apply the discounted cash flows formula to determine the present value of all future cash flows. The sum of all discounted cash flows equals the fundamental value of a security.

The great thing about this technique is that you can know the actual worth of a stock, for example.2

Furthermore, asset prices periodically revert back to fundamental values, so if you can do this technique you can know in a sense where prices are headed, at some point in the future.

Many investors – including probably the majority of mutual fund portfolio managers, Wall Street analysts, and stock-picking hedge fund managers – employ fundamental valuation techniques when selecting stocks. Certain bottom-up investors, also known as value investors, believe that they can achieve impressive results using fundamental valuation techniques.

warren_buffett_fundamental_investor
This guy has practiced fundamental investing pretty successfully

Graham’s most famous student Warren Buffet seems to have done pretty well using this technique.

The terrible thing about this technique is that:

a)    Its incredibly hard – ok it’s impossible – to actually know what all future cash flows of a stock will be – so we end up adopting models of the future that include substantial guesswork about earnings growth (or shrinkage);

b)   The appropriate mathematical discount rate for determining the present value of all future cash flows is also always an estimate, introducing a further element of imprecision to what appeared at first to be a precise process, and;

c)    Market prices can remain widely divergent – above and below – from fundamental value for long periods of time. “The market can remain irrational longer than you can remain solvent” is an old Wall Street phrase that captures just this type of problem with fundamental analysis. It’s an unfortunate but true statement that sentiment and irrational factors – the eternal struggle between fear and greed – and technical factors such as the ebb and flow of investment funds – can set the price of stocks far away from fundamental value for long periods of time.

So fundamental value techniques, explained by Malkiel as well as critiqued by Malkiel, are a commonly used technique but not a panacea for stock market investing.

Investor Sentiment – Malkiel credits Economist John Maynard Keynes as an early proponent of the truism that the combined madness and wisdom crowds – also known as investor sentiment – can carry along the price of individual stocks as well as the general level of the market, irrespective of fundamental value. Believers in the theory of investor sentiment may invest with the idea that they can anticipate future interest in a stock or in the market by understanding investing crowd psychology.

When it comes time to sell, the price of a stock will be buoyed by other believers in the ‘story’ of the stock or the market, willing to buy in at the same or higher prices. Even for fundamental value investors, an owner in equities has to depend to some extent on the future participation of others in order to receive value in the secondary market for any shares sold.

This is sometime described by the shorthand phrase ‘The Greater Fool’ theory of investing. Meaning, I don’t necessarily need to know anything about a stock’s fundamentals as long as a Greater Fool than me is willing to buy my shares when I want to sell.

The great thing about ‘investor sentiment’ investing – which by the way I would posit 99.5% of all individual investors depend on much more than fundamental value investing – is that you don’t need to do much homework or heavy math. Just get a ‘feel’ for the direction of the market or the ‘story’ of the stock, and away you go. Again, this is basically how everyone invests in stocks in practice.

I mean, do you know any non-professional stock investors who model out all future cash flows and then apply an appropriate discount to obtain a present value? No? Me neither.

The problem with investing largely on this theory, however, should be obvious for a number of reasons:

a)    While irrational exuberance (and its evil twin “irrational lugubriousness”3) can dominate for some time, it’s a ridiculously blind way to invest. We all do it of course, but we’re blind. And we should acknowledge our blindness in advance.

b)   Bubbles grow out of Greater Fool theory investing, and the end of bubbles is always ugly and painful.

c)    Sentiment can and does change much faster than fundamentals, adding unwarranted volatility to markets as well as possibly to unwarranted activity in our own investing. We humans change our minds twice a day before breakfast and four times on Thursdays. That kind of volatility of sentiment tends to hurt our investment portfolios.

financial_bubbles
Financial bubbles arise from ‘investor sentiment’ investing

So which way of investing is right? Neither!

As investors we often adhere – at least in theory – to one of these two methods.4 But neither tends to serve us well, or well enough, to achieve an edge over any other investors.

Malkiel advances the Solomonaic wisdom5 that both theories are right, and both are wrong.

Certainly both fundamental value and investor sentiment do determine market prices in a confusing, seemingly random, combination. The problem is that with most stocks we compete with hundreds, thousands, or tens of thousands of extremely smart and knowledgeable investors. With so much competition to achieve the best returns for our capital, we rarely have the chance to outguess others in a profitable way.

We try and try, but as Malkiel’s and others’ academic research has shown, precious few professionals can achieve a better result than the market as a whole. As individuals we have even less chance to outperform than the professionals.

‘Tis The Gift To Be Simple

tis the gift to be simple

Malkiel’s famous conclusion in A Random Walk is that most people would do best by trying to simply earn the market returns of the broad market – rather than attempt vainly to ‘beat’ the market.

As the old Shaker dance goes, ‘tis the gift to be simple, ‘tis a gift to be free. The modest, simple, low-cost index fund beats managed funds most of the time, and it also beats an overwhelming majority of actively managed funds over extended periods of time.

 

Since all mutual funds in aggregate are made up of the entire market, logically the aggregate returns of all mutual funds will reflect the aggregate returns of the entire market. Roughly half will ‘beat the market’ in any given year, and roughly half will underperform the market. However, past performance – as the clichéd disclosure goes – does not predict future results.

With each successive year you compare actively managed mutual funds to market returns, fewer and fewer actually ‘beat the market.’

In practice this is what academic studies confirm, except for the fact that actively managed mutual funds tend to lag, in aggregate, market returns by approximately the fees they charge. Which fees tend to range from 0.75 to 1.5% of assets.

Index mutual funds by contrast tend to charge 0.1% to 0.35% fees and so tend to underperform their respective markets by a much smaller amount.

Forty years later, hundreds of billions of dollars flow into index mutual funds annually, in large part due to Malkiel’s popular presentation of these simple ideas.

 

Final thoughts and caveats on index investing

S&P500 not entirely diversified

About one third of all indexed investment money currently resides in S&P 500 index mutual funds. The S&P 500 Index consists of the largest 500 US companies, which make up 75% of total stock market value in the United States. As such, this index serves pretty well as a proxy for market exposure, but investors should understand that it consists of only large companies and only US-based companies.

SP500_Share_of_index_money
S&P500 share of Index Funds. Source: ICIFactbook.org

Investors in the most popular index fund do not get the diversification of ‘mid-cap’ or ‘small cap’ companies, many of which may ‘beat the market’ in any given year or even long period of years. Furthermore, some research suggests that smaller capitalization stocks may outperform larger capitalization stocks in the long run. This may be because smaller companies appropriately offer higher returns because they are smaller and possibly inherently riskier. I don’t think the research is definitive on this point, but at the very least investors in the S&P 500 should know that they’re only getting exposure to 75% of the US stock market, and only the biggest companies.

Perhaps more importantly, investors in the S&P500 index forgo exposure to the majority of public companies – approximately 60% – that are not listed on the US stock exchanges. S&P500 index investors miss direct exposure to the public companies of Europe, Japan, Australia, Africa, Latin America, China, and India – any of which may ‘beat the market’ represented by large cap US companies. Of course, equity markets are linked and responsive to one another, and the largest US public companies have extraordinary exposure to non-US growth, but the effects are indirect. S&P 500 index investors should know they are not as geographically diverse as they could, and probably should be.

Author Lars Kroijer argues in his book Investing Demystified, persuasively I think, that the logical approach for someone who embraces the Efficient Market Hypothesis of A Random Walk is to invest in an ‘all world equities’ index. This product exists, and offers a cheap, maximally diversified way to wholly embrace Malkiel’s approach.

Market-weighting indexes have drawbacks

The next problem with the S&P 500 index is that it is designed as a market-weighted index, meaning investors get their money allocated to the component stocks of the index in their current market-capitalizations proportion.

Here’s the problem with that. If Apple Inc makes up 3% of the S&P 500 index, and investor sentiment pushes up the value of Apple shares when the iShoe gets announced, such that the weighting of Apple becomes 3.1% of the largest 500 companies in the US, then index funds are forced to buy more Apple, to remain in line with market-weightings.

The_iShoe
Admit it. You would totally buy the iShoe

This type of forced buying acts to further push up shares of Apple. A self-reinforcing market mechanism – when buying forces more buying – creates a troubling feedback loop that probably pushes the stock away from fundamental value and possibly creates opportunities for non-indexed money to take advantage of index money.

Its not terribly hard to see how the largest capitalization stocks could be pushed to prices higher than fundamentally warranted as a result of too much S&P 500 index money for example, which would tend to dampen returns for investors in the largest capitalization stocks.6

As Malkiel describes repeatedly throughout A Random Walk, certain smart investments cease to be as smart when everybody does them. The success of the S&P 500 index mutual funds in particular may make future investing in the S&P 500 index less attractive for the purposes of achieving broad market returns.

In this case a simple solution is to diversify into a broader market index like the Wilshire 5000, or the kind of total world equities index advocated by Kroijer.

a random walk

Please see related post, All Bankers Anonymous book reviews in one place!

Please see related book reviews:

The Intelligent Investor Benjamin Graham

The Signal and The Noise by Nate Silver

Investing Demystified by Lars Kroijer

And related posts:

Nate Silver on the Efficient Market Hypothesis

Lars Kroijer on Agnosticism over Edge

 

 

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  1. Defined by the report as “new fund sales less redemptions combined with net exchanges”
  2.  Or annuities, private companies, bonds, longevity insurance, oil and gas leases, or income-generating real estate. If a financial instrument has cash flow, this is the way to value it. By the way, as a side note, how do I know gold isn’t a real investment? No cash flow.
  3. Thank you. Thank you very much. In the future, when I am Fed Chairman, I will just whip that phrase out during a Great Recession to show how the market is excessively pessimistic and stocks are about to soar. Then later I will have it trademarked. Who wouldn’t buy my next book titled ‘irrational lugubriousness?’ It has a nice ring to it.
  4.  In practice, as I mentioned before, 99.5% of all individuals just punt with the investor sentiment method.
  5. By that I mean: Split the baby in half, leaving nobody happy.
  6. That, Alanis, is a much better example of irony than the proverbial black fly in the Chardonnay, which is really just an example of something that’s kind of a bummer.