The Finance Book Club

Update April 2022: the second book poll is complete and I'm on hiatus working on personal projects. Let me know if I should work on the books in the current poll when I return or anything else you'd like to see.

I've learned a lot more useful knowledge from books than I have from days of reading internet forums. Or Twitter!

1. Books are a great source of useful information
2. They are often too long (blame the publisher).
3. Some books are not even worth the time it takes to read.
4. Knowing what we can learn from the most important books, and avoiding the ones that are mostly charlatanry, is valuable.

So what have we learned so far?
Clemmo's Canon of Trading
1. Clemmo's First Lemma

1. Simple patterns like candlesticks, MA crosses, double tops/bottoms exist in market data but anticipate nothing; they are 'fool's gold'
   1. The market is a pattern-erasing machine; by the time we see something it's no longer useful
   2. Smart people want to 'figure things out' and find order in chaos; they get stuck down rabbit holes
   3. Pragmatic traders just want chaos and a method of dealing with it; one method is enough

Supporting Evidence:

1. Mark Tier: Learn from the Greats. Forecasting doesn't work and diversification is neutering.
2. Robert Shiller: Finance is a technology. Being very clever and good at maths are not by themselves enough to avoid making basic trading errors like staying out of a long-running bull market. Another way to say the same thing: there's more to trading than fundamental analysis.
3. David Aronson: Common technical analysis methods, and simple strategies based on TA don't work.
4. Nicholas Nassim Taleb: Randomness is tricksy. People are pattern-detecting machines even where none exist. The vast majority of traders and money managers are self-delusional. The rare event is where real profit lies.
5. Al Brooks: When you see everything, you focus on nothing. You can make a living selling trading books as long as they are confusing enough and you repeat yourself often.
6. Brent Penfold: Serious traders focus on price not indicators. Pragmatists use Dow theory, breakout, (inter)market, spread, volume and statistical analysis,

2. Clemmo's Second Lemma

1. Momentum is real
   1. Markets have inertia; this cannot be obfuscated, distorted or manipulated beyond observation
   2. Trending markets tend to continue trending
   3. The trend is your (fair-weather) friend; use it but don't depend on it
   4. Avoid biases and trade what you see

Supporting Evidence:

1. Jesse Lauriston Livermore: Wait for the market to react. Set some money aside. Buy rising instruments, and sell falling ones. A stock is never too expensive to rise or too cheap to fall. Complex charts and systems are suspect. Keep your own records and data.
2. Nekritin&Walters: Patterns generally fail but the ones that don't fail ('Big Shadows') make use of 'big' candles, in other words momentum is the real signal.
3. Omer&Lizotte: if price can move n pips it's more likely (than not) to move another n pips where n is limited to a reasonable daily range; that's because trends exist
4. Laurent Bernut: rising floors and falling ceilings (not examined in this thread yet)
5. Neiderhoffer & Osborne: A sequence of two moves in the same direction is more likely to be followed by a move in the same direction than by a reversal
6. Jeff Cooper: A stock in motion tends to remain in motion.

3. Clemmo's Third Lemma

1. Sensible Money Management is Critical
   1. There is much random and uncontrollable behaviour in market prices
   2. As a result we have to treat any system probabilistically and size positions logically
   3. Determine odds, payoffs and expectancy
   4. Use a money management system that dovetails with our trading system
   5. Define realistic expectations about the rate of returns, and monitor that rate

Supporting Evidence:

1. Jesse Lauriston Livermore: The Great Plunger died broke or close to it. You can be a great trader and still lose the war if you don't manage your battles.
2. Brent Penfold: Money Management is the key to survival. It is one of the three pillars of success along with methodology and psychology.
3. Kirill Emerenko: Poor Money Management can take a positive expectancy system and ruin it. Kelly's formula is theoretically optimal.

4. Clemmo's Fourth Lemma

1. Price is Cyclical
   1. Unfortunately this cyclicality seems to be difficult to forecast, if at all
   2. Using shifted/phased averages might offer some benefit in forecasting trends

Supporting Evidence:

1. JM Hurst: The Profit Magic of Stock Transaction Timing - the 'FLD'. (not covered in the book club yet)
2. Manesh Patel - the Ichimoku Kinko Hyo indicator seems to be able to avoid ranges better than any Moving Average

The next big questions: What about regression analysis, and its tools like envelopes, channels and bands? Is there anything useful in Elder or Ehlers many methods? What about investing? Is trading even worthwhile compared to investment profits?

Table of Contents
The Winning Investment Habits of Warren Buffett and George Soros by Mark Tier- B (good general advice)
Global Financial Markets Coursera Course by Robert J Shiller------------------------ B- (somewhat academic)
Fooled by Randomness by Nassim Nicholas Taleb------------------------------------- A- (entertaining and thoughtful if pessimistic)
Evidence-Based Technical Analysis by David Aronson--------------------------------- B+(educational but tiresome and ends with a whimper)
Predicting Price Action by Owens & Lizotte--------------------------------------------- B (short but sweet)
Reminiscences of a Stock Operator by Edwin Lefevre--------------------------------- A (absolutely essential)
Reading Price Charts Bar by Bar by Al Brooks----------------------------------------- D (more useful as a cautionary tale)
Naked Forex by Nekritin & Walters----------------------------------------------------- C+ (some good ideas marred by imprecision)
The Ultimate Handbook of Forex Trading Basics & Secrets by ForexHero------------ B- (more basics than secrets but a quick read)
Hedgehogging by Barton Biggs--------------------------------------------------------- B (entertaining like Market Wizards but less informative)
The Physics of Wall Street by James Weatherall -------------------------------------- B+ (good intro to history of econ modelling but modern examples are weaker)
High Probability Trading Strategies by Robert Miner ---------------------------------- C (makes promises it cannot keep)
The Universal Principles of Successful Trading by Brent Penfold --------------------- A (money management explained if not settled)
The Black Book of Forex Trading by Paul Langer -------------------------------------- C (not terrible, but far from great, just another trading book)
Making Money in Forex by Ryan O'Keefe ---------------------------------------------- D (one interesting idea does not a good trading book make)
Hit and Run Trading by Jeff Cooper ---------------------------------------------------- C+ (some promising ideas but barely scratches the surface)
Bird Watching in Lion Country by Dirk Du Toit----------------------------------------- D (some fresh ideas poorly detailed and almost unreadable)
Technical Analysis for the Trading Professional by Constance Brown ----------------- F (deliberately misleading. the goal is to sell books & courses)
The Art of Currency Trading by Brent Donnelly ---------------------------------------- A (vital reading for anyone using fundamental analysis)
Day & Swing Trading the Currency Market by Kathy Lien ----------------------------- B+ (a hefty data dump with somewhat less insight than data)
Trading with Ichimoku by Manesh Patel ------------------------------------------------ A- (despite all of its flaws this might actually reveal a useful TA tool)
The City: London and Global Power of Finance by Tony Norfield ---------------------- B (an analysis of British finance from a Marxist perspective, not about trading)
New Concepts in Technical Trading Systems by Welles Wilder ------------------------ B+ (a classic of tech. analysis that seems about as useful the rest of TA)
The Market Wizards (series) by Jack Schwager ---------------------------------------- A (indispensable classics, praised by industry giants)
Trading From Your Gut by Curtis Faith -------------------------------------------------- C (not neuroscience or even science, and not clearly useful)
The New Trading for a Living by Dr. Alexander Elder ---------------------------------- A- (some novel insights, lots of info and maybe even a useful system)
Trade Your Way to Financial Freedom by Van K. Tharp -------------------------------- (skipping it as the short summary here has everything you need to know IMO)

Please vote in the poll or suggest new books to add to the reading stack!

The first FBC title I've selected is one I mentioned in my trading journal (linked in my profile). I'm going to skip the prefatory notes that I made in my journal post and go straight to the meat of this book which is the general principles, one per chapter. I recommend that you read my post though, as the seven investment sins of which there are only really 4, are just as important, maybe more so, than the good habits.

The Winning Investment Habits of Warren Buffett and George Soros by Mark Tier

What's bad: Mostly the title and the cover. The title is obviously trying to leapfrog off the reputation of these formidable billionaires, and most of the knowledge in this book is not particularly secret or even unknown, although it is thorough. The author attempts to draw intersections between the very different trading styles of these two figures but what's amazing is that he sometimes succeeds. Subtitle: "Harness the Investment Genius of the World's Richest Investors". Hyperbole, obviously, but we'll blame the publisher, not the author.

What's good: The 'habits' are good advice, and I found it remarkable how many of these hew closely to my own philosophies. Clearly there are some common areas of general good practice when it comes to trading/investing and if you don't know what these are, you are probably going to flounder, if not fail outright. While knowing these won't make you a successful trader or investor on their own, not knowing these things, will surely hinder you.

The book outlines 23 habits that successful investors and traders use to dominate markets. The second half of the book is mostly a rehash of these principles with the view of applying them to your own system, asking a bunch of questions that you would already be able to ask yourself once you know the habits, so I've omitted it.

The summary
https://docs.google.com/document/d/1...it?usp=sharing

For my next act I'm not going to review a book but instead provide quick summaries of a course I'm taking (for free, my fave price!) on Coursera by Professor Robert J. Shiller. Shiller is a famous and esteemed (by some) academic and a permabear who has been calling for a decline in the stock market since at least 2013. Well, he finally got his wish and now we can (maybe) learn what he knows, if anything. For some background on Shiller, here is a critical piece that sums him up nicely I think and explains why some very intellectual investors aren't always good at making money in markets, if ever.

Just some highlights:

1. Conviction and intellectual rigor intersect but are eventually diametrically opposed to one another. Finance is all about doing the right amount of analysis. Academia is about doing all of the analysis.
2. There comes a point where analysis reaches diminishing financial returns, and then there’s a point where too much analysis will cause you to lose conviction as you get lost in the weeds of various risk factors.
3. Finance is for magpies, academia for the pertinacious.

Great stuff. Michael Foster is someone I've followed for a long time on Seeking Alpha, but I am not endorsing SA or even advising you to read it. Ever.

Of course Shiller's Wikipedia page, offers a very different view which you should also check out.

As for the course, it's probably not too late to enroll. https://www.coursera.org/learn/finan...l/home/welcome

Robert Shiller's 'Financial Markets' course.

My comments will be in this British Racing Green
More useful stuff (in my opinion) will be in bold.

Week 1

1. Discuss the relevance of this course in everyday life and the importance of ethical judgements[sic] in finance.
   1. Finance isn't just about making money it's about financing what's important (which makes the USA experiment a complete financial failure, no?)
   2. It's how we 'get things done' in society. What are we getting done? Making America Great Again?
   3. Organizations are more effective than individuals
   4. Finance is used to trick people, so we need regulators
   5. If you make a lot of money in finance give most of it away
   6. Poorer countries don't need foreign aid they just need the right principles
   7. Carnegie said give away all your money when you're young, retire early, become a philanthropist, because wealth will destroy your children
   8. This is a course on how to make your mark on society, now how to get rich (because he doesn't know how)

2. Understand the main sources of risk a security is subject to, and the main methods used to evaluate risk of an entire portfolio.
   1. VaR
      1. 'Value at Risk - Invented after stock market crash of 1987
         • Value at risk is usually quoted in units of $ for a given probability and time horizon
         • 1% one-year VaR of $10 million means 1% chance that a portfolio will lose $10 million in a year

   2. Stress Tests
      1. Dodd-Frank Act 2010 requires the Federal Reserve to do annual stress tests for nonbank financial institutions it supervises for at least three different economic scenarios
      2. European Banking Authority, created 2011
      3. Critics of stress tests such as Anat Admati find them inadequate. (Did they work in '08? Did they protect us from coronavirus? The stress test is a palliative to soothe the wealthy client who loses all their money from black swans/mismanagement -it's a cover-your-ass technique)

   3. The real world is a battle
   4. The 'stock market is amazingly unstable'
   5. The market 'is very hard to forecast' (esp. when you don't change your mind for years at a time)
   6. Nobody knows the future
   7. Investing is difficult because 'noise dominates'.
   8. 'Idiosyncratic risk' - risk that is outside the risk of general stock market moves - restricted to a single company.
      1. A regression line is a single line that best fits the data in your scatter plot.
      2. Vertical distance between a given dot and the regression line is that dot's residual.
      3. The least squares method can be used to get a better fit
      4. "variance of the return of a stock is equal to its beta squared times the variance of the market return (systematic risk) plus the variance of the residual in the regression (idiosyncratic risk)" (not sure that's right, but even so, who cares?)

   9. Normal Distribution
      1. the 'bell curve' we know from so many natural phenomena
      2. Central Limit Theorem in Statistics says that, averages of a large number of independent identically distributed shocks or random variables is approximately normally distributed,
      3. It isn't a good fit for financial data (for more info read Mandelbrot's 'misbehaviour of markets')
      4. the Cauchy distribution is a better fit as it shows the fat tails of higher risk - fat tails - kurtosis - look it up

   10. Taleb's Black Swan
       1. Just read the book! (I'll do a summary for the book club)

3. Understand the principle of risk diversification.
   1. Covariance
      1. A lot of mathy gobbledygook but what matters is investors want low covariance because it means the risk isn't compounded by investing in two different companies
      2. Low covariance evens out idiosyncratic risk, this is the main idea behind diversification. To see what I (and Buffett/Soros/Icahn) think about diversification, read the previous book notes.
      3. 'gold moves opposite your other investments - that's the theory' and the theory is bogus

   2. The CAPM model is an abstraction, an idealization - scorned by many including Mandelbrot

4. Identify the qualitative differences between the normal and fat tail distributions, and give examples of risk pooling, moral hazard and selection bias.
   1. Risk pooling - what is a risk for one person is not a risk for society at large; the source of all value in insurance
   2. "by the Law of Large Numbers, the number of bad outcomes are fairly predictable" - this is a gross overstatement, the law actually says the average of the observed random values will be stable, in the long run
   3. the average of the results obtained from a large number of trials should be close to the expected value
   4. a casino may lose money in a single spin of the roulette wheel, its earnings will tend towards a predictable percentage over a large number of spins
   5. Moral hazard occurs when people, knowing they are insured, take more risks - like 'too big to fail' corporations, banks and stock market investors gambling on perennial Fed cash infusions?
   6. Selection bias - a risk to insurance companies -supposedly; the people who sign up for insurance are people who need it, i.e. sick people

5. List the key events in the history of insurance, and how insurance differs between the state and national level in the U.S.
   1. Obamacare - health insurance companies may not take pre-existing conditions into account; also there is a tax penalty for not signing up
   2. Life insurance is a relic of the day when people died young
   3. States have guaranty funds in case an insurance co. goes bankrupt
   4. Unlike stocks and bonds that are regulated federally, insurance is regulated at the state level which creates a chaotic system
   5. To address this a non-profit called National Association of Insurance Commissioners, NAIC, run by the industry
   6. Insurance companies expect government to step in to assist with correlated risks like terrorist attacks, floods from climate change events

6. Describe why an investment may be considered high risk, and the sources of the so called 'disaster risk.'
   1. If an investment weren't risky it wouldn't provide a return
   2. People boast about their investing skill with regard to individual assets. But they shouldn't because you win some and you lose some. It is the average that matters.

7. Explain the Capital Asset Pricing Model (CAPM), and the role of short-selling within the model.
   1. The CAPM is a model of the ideal investment portfolio
   2. Diversification is a main idea
   3. It's difficult for small investors to properly diversify because they must by fractional shares
   4. Investment trusts became mutual funds
   5. The fallacious risk/return pyramid doesn't even include currencies! Does that make them hyper-speculative?
   6. CAPM says not matter your risk aversion level you should invest in all asset classes
   7. The 'equity premium' over 200 years was only 3.9% - that is, inflation-adjusted returns, with bond returns subtracted, for staying in the stock market over 200 years was only 3.9%. This seems patently ridiculous, but OK. The puzzle in the equity premium puzzle is why one issue can do so much better than another no I misunderstood - he's saying why is the premium so high! So high??? No rich person would be satisfied with 4% per annum return, what are you smoking, Shiller?
   8. A very muddled section on whether past prices affect future prices. "things are moving too fast" to tell. Baloney. And settled by Mandelbrot again. Spoiler alert - they do.
   9. systematic risk < idiosyncratic risk in a diversified portfolio, starting to repeat ourselves
   10. The CAPM describes a relationship between the expected return on an asset and its beta
   11. The CAPM implies that the expected return on the ith asset is determined from its beta
   12. "only a half-truth" the problem is not everyone is holding an idealized portfolio
   13. A negative beta stock moves opposite the risk (the mythical gold example?)
   14. Short sales
       1. 'a negative quantity' of some assets
       2. you borrow shares and sell them
       3. the CAPM assumes short sales won't happen because the optimum quantity of a short for an idealized portfolio that everyone holds is basically infinite
       4. "interest rates are starting to go up so maybe wait five years" no wonder he doesn't forecast. incredibly naive.
       5. "If you invest in businesses, then you'll be less likely to vote for a strong man leader who will corral businesses" The strong man leaders ARE businesses!
       6. "So the US has set an example to the world about. Just letting some of these things happen." Yes, the. result is socialism for the rich.
       7. Note to Americans - the free market system and free markets are NOT an American invention. The only 'example' you spread is unfettered unregulated, plutocratic control of markets

8. Recall how to compute optimal risk-return portfolios.
   1. Hedge funds did well in the past, now they're facing challenges; they represent as the best investors but charge high fees (was it luck the whole time or is it increased competition?)
   2. Advisors play the role of physician to family firms
   3. Systemic risk - risk that a whole system will collapse
   4. Because black swans are rare, we don't have enough data about them (coronavirus)
   5. If you help people manage risks, they will take more risks, which is a good thing (wasn't he arguing the opposite near the start?)
   6. The market can stay irrational longer than you can stay solvent - a good example of that is happening right now in US equities. The S&P 500 is rising right as the world seems to be preparing for a new dark age
   7. Traditional financial models are based on rationality but you'll never find a perfectly rational human
   8. 3 equations - portfolio expected value; portfolio variance; portfolio standard deviation
   9. Portfolio standard deviation is the square root of the portfolio variance - a linear relationship
   10. You can obtain any return you want by adjusting leverage
       1. If you want 100% expected return on your $1 portfolio. First, borrow, AKA "short", $8 from the risk free market, and now you have $9 to play with. Invest all $9 in the risky asset. This provides you with an expected return next period of 20%. So your portfolio now has $10.80 on average. Pay back what you owe which is 8*1.1 or $8.80, you're left with $2 in your portfolio and you have thus doubled your initial investment on average. Remember though, you took on an 8 to 1 leverage ratio to get here. Using the formula the standard deviation of your portfolio return was 9*5%, or 45%. If the risky asset realized any return less than -2.2% which is half of one standard deviation away from the mean, you would have to file for bankruptcy.

   11. Positive covariance is bad for your portfolio (correlation)
   12. CAPM assumes variances will be stable over time (which they most definitely fucking aren't! - again, sorry to beat a dead horse, Mandelbrot speculated variance in financial series could be 'nearly' infinite)

9. Understand the concept of efficient frontier in portfolio management.
   1. Expresses the standard deviation of the portfolio in terms of r the expected return on the portfolio
   2. Attached Image (click to enlarge)

      
   3. A picture is worth 1000 words, quite literally in this case
   4. It used to be like a religion - you had to do things the 'right' way - still is.
   5. Since the lowest deviation sacrifices some return, you have to pick a point on this graph that satisfies your 'tastes'
   6. "Once you add oil there's more... there's more opportunity to achieve expected return without risk. " Ironic.
   7. "There is something inherently unsatisfying about investing in the stock market because you are putting yourself on the line for risks in so many different ways." The coward dies a thousand deaths, but the hero only once.
   8. "I think what we've learn[sic] about human society is that as funny as this system looks, it's a good system." Says the turkey until the farmer comes over with his axe.

10. Gordon growth model
    1. Myron Gordon
    2. Present value = x/r- g, where r is the rate of discount and g is the rate of growth.
    3. A useful formula because a lot of possible investments have a growth rate.
    4. If risk is known and low (like in a government bond) r is the risk-free rate; otherwise it is the greater R as measured by beta in the CAPM
    5. A pattern makes itself known through history - railroad stocks were overvalued in 1830, by 1840 there was a bubble and they became old hat, tulips, Bre-X, dot-coms, bitcoin; the lesson seems to be to get into new speculative issues fast and then get out before they explode; the problem for the neophyte, casual, retail investor, is that by the time you hear about what's 'hot' it's already overvalued.

https://docs.google.com/document/d/15X1AI9NZ5Ptc9M6mPQohqtnOrgMPU71vc69Zj1StcHI/edit?usp=sharing

Robert Shiller's 'Financial Markets' course.

My comments will be in this British Racing Green
More useful stuff (in my opinion) will be in bold.

Week 2

1. Understand the concept of limited liability and its connections with psychology, risk diversification and corporate finance.
   1. Innovation takes time
   2. People are slow to adapt
   3. The state of financial theory (economics) is pre-Copernican compared to other sciences
   4. People like lottery tickets
   5. We need to reframe risk so that good risks (for the economy) get taken and what about reframing greed so that natural capital can rebound?
   6. Limited liability - Divide up an enterprise into shares, and no shareholder is liable for more than he or she put in -or for the mistakes of the company, an idea that has enriched a few and made the rest of the world a shithole
      1. Other states were very skeptical
      2. New York produced many failed corporations, a few spectacular success
      3. NY became a business mecca

      
      

2. Describe inflation indexed debt, and monetary innovation designed to tackle hyperinflation
   1. In Japan - a bond that could be repaid in rice instead of currency in case the currency became devalued
      1. The problem is the price of rice isn't stable relative to other prices
      2. The solution is a price index - tying the debt to a contract

      
      

   2. The first indexed debt was developed in the revolutionary war to pacify soldiers whose pay was devalued by currency devaluation
      1. The bond had to pay out in inflation-indexed terms
      2. This wasn't attempted again until 1997 and Shiller isn't sure why
      3. "People are getting the real value of their debt (note here debt means money in the weird parlance of economics) wiped out by inflation, don't they care?" People are dumb. Maybe fairer to say, childish. I mean look at how many people are following this thread. They don't want to learn. They want to be spoonfed. They either want to shrink or eliminate the government or have the government protect them, often at the same time.

      
      

   3. Unidad de Fomento - unit of development
      1. Chile was experiencing hyperinflation in the 1960s.
      2. Money has several functions. It's a store of value and a unit of account and a means of measuring transactions
      3. The Unidad de Fomento (UF) was tied to the CPI
      4. 1 uf is 25,655.55 pesos. Now you might wonder, why did they pick such a big number? They didn't, they picked some small, maybe it was one to one, I don't know exactly, in 1967. But they've had so much inflation in their peso, that it's up to 25,000 pesos per 1 UF. And that is worth, at the current exchange rate, between peso and dollar, $35.92. So there's been a huge increase, even though Chile has gotten its inflation more under control, the price level has still increased 50-fold, over 50-fold, since 1977
      5. The US is not a haven of price stability either. Would you believe it, prices in the US have gone up 24-fold since 1913?
      6. We have something like a 50 million fold increase in prices in Chile.
      7. They think it's a national embarrassment because it reveals how much inflation they've had. I said, no, you are the world's leader, and the world ought to copy you. Eventually, they will.

   
   

3. Understand the basics of the real estate market, assumptions behind forecasting the stock market, and the basic framework to price a stock.
   1. Real-estate risk management devices
      1. Value of homes is a major source of risk
         1. Casualty insurance
         2. Securitized mortgages
         3. Home price futures and options (the website referenced in the slide isn't up, but I found this http://web.mnstate.edu/sahin/FINC_35...WhitePaper.pdf )
         4. Equity-protected mortgages
         5. "I thought it would be a good thing if people could short the housing market."
         6. Prevent bubbles, protect housing values (really?)
         7. If the value of your house falls, your mortgage would also
         8. You can buy a put option on your house to protect you against the big fall
         9. Livelihood insurance - an insurance against cuts in wages and jobs

   2. Forecasting
      1. in fact this is mostly about the efficient market hypothesis so I'll skip a section

   
   

4. Describe the key intuition and definitions behind the Efficient Market Hypothesis, and why it might only be half-truth.
   1. Representativeness heuristic. People don't behave like forecasters. They think that something they saw in the past is representative of what will happen in the future. See my journal posts and research into the FXStreet forecasts
   2. random walk/drunken walk theory Pretty much discredited now though there is some 'noise' in the form of some type of Brownian motion
      1. The students in Shiller's experiment produced 'plausible' graphs based on past behaviour but they weren't forecasts , proper what's interesting is that even during the intervening 4 years the student's 'forecasts' are more useful than a straight parabolic zoom which is what the statistician would infer
      2. We're not psychologically attuned to understand a random walk - we see patterns in everything even when there are none
      3. A random walk cannot produce steady trends though, which is what we see in the stock market chart
      4. What about a random walk with some mean-reversion? AR-1.
      5. The mean reversion value is rho and if it's around 1 then we have trouble seeing if the market is a random walk or not
      6. "If stock prices are an AR-1, then it means you should stay out of the market when the price is too high and go back in when the price is too low. but obviously, that's a meaningless statement until you define what you mean by 'too high' and 'too low'
      7. There have been proposals to limit or reduce that short-term speculative component [of market investing].
         1. transactions tax on securities trades.
         2. a capital gains tax that distinguishes between short-term and long-term capital gains.
         3. Mike O'Brennan at UCLA proposed that we should create separate markets for corporate dividends at various horizons, so that you're focused on a dividend that some day in the future you're making an investment

         
         

      8. Human psychology is not easily managed
      9. "I wish we had lithium which is what they use for irrational exuberance and bipolar disorder, but it is not functioning in the stock market. " Classic bear. It's not irrationally exuberant when the Fed is protecting you from actually incurring any risks.

      
      

   3. Intuition of efficiency
      1. Reuter used pigeons to send market news
      2. Morse invents the telegraph No it was David Atler in 1837, but Morse invented a version. Another example of early entry being a disadvantage
      3. So many smart people (and now robots) are processing information so quickly that it must be hard to beat the market
      4. If we didn't have the markets, we wouldn't know what anything was worth
      5. Fabozzi, "Publicly available, relevant information will lead to correct pricing of freely traded securities in properly functioning markets."
      6. Harry Roberts 3 forms of market efficiency
         1. Weak form: information in past prices can't help you to forecast
         2. Semi-strong form of efficient markets: all public information is already incorporated in the market prices
         3. Strong form is that all information including inside information held by the companies is already incorporated in the stock prices, prices because it leaks out. Companies can't keep secrets.
         4. Shiller: I think this semi-strong form is the one that we focus on.

         
         

      7. Buying stocks with low price earnings ratios has paid off historically for a long time.
      8. Reasons to Think Markets Ought to Be Efficient
         • Marginal investor determines prices
         • Smart money dominates trading
         • Survival of fittest
      9. The price of a stock should be the present discounted value of expected dividends
      10. Efficient market theory has to explain why some companies are priced higher relative to their earnings than others.
          1. If you believe the Gordon model, it has to be something about risk or growth opportunities. If your company is priced high relative to earnings it would either have to be because it's low risk as measured by beta, so we are willing to pay more for it because it's low risk. Or it would have to be that people have reason to think that earnings growth rate -g- is high.

          
          

      11. The smart guys are the ones that trade regularly. They trade fast and immediately, and they dominate trading.
      12. There can also be psychological reasons for high p/e -for ex. the Japanese stock market in 1980s.
      13. Also differences in accounting standards

      
      

   4. There are a lot of smart people investing. But a lot of that smartness is devoted to marketing and manipulation of your psychology.
   5. The stock market has a tendency to fall before a recession - Is it doing that now?? Is the recession over? These kinds of statements are meaningless without a time horizon
   6. "The Great Depression wasn't that bad." Says the boomer born in 1946.

   
   

5. To describe and provide examples of the wishful thinking bias and of cognitive dissonance.
   1. Behavioral Finance:The Role of Psychology
   1. Prospect theory
      1. Daniel Kahneman and Amos Tversky in an economic journal, Econometrica, 1979
      2. Replaced expected utility theory
      3. Utility theory assumes everyone is happy according to how much marginal utility they consume
      4. They replaced the utility function with what they called a value function.
      5. They replaced the probabilities with subjective probabilities determined by a weighting function in terms of the actual probabilities.
      6. People have a skewed representation of probability, and they do not treat gains and losses equivalently.
      7. People will take big risks to avoid losses and they won't take small bets
      8. Financial theorists like to develop beautiful models, but a financial engineer wants a beautiful device that works in various conditions with real people.
      9. More about Amos & Tversky - to really learn about prospect theory (and many other useful psych insights) read 'Thinking Fast and Slow'.

      
      

   2. Overconfidence
      1. Wishful thinking bias - Dunning Kruger, people think they are better at things than they really are, think they're above average in many things where they aren't. This bias single-handedly pays the bills for retail brokerages
      2. Overconfidence in friends and leaders - a book by Rakesh Khurana - The Search for Charismatic CEO- let's add it to the list
      3. Fooled by Randomness -Nassim Taleb - I'll definitely cover it
      4. Irving Fisher - a permaBull, predictably mocked here, but he lost everything proving the adage about solvency and the market - "a great speaker, not a great forecaster"

      
      

   3. Cognitive dissidence
      1. Mental conflict that occurs when one learns one’s beliefs are wrong, avoidance behavior
         1. Ads for recently purchased cars - while ignoring other ads - trying to avoid buyer's remorse
         2. Disposition effect - the tendency of investors to sell assets that have increased in value, while keeping assets that have dropped in value.
         3. Investors tend to forget the times when they were wrong
         4. We live in an economy that incentivizes people to capitalize on your psychological quirks. And they strongly incentivize people to do that. That's what the profit motive is all about.
         5. You can't start your own for-profit lottery because laws are designed to protect us against our own psych failures (yet casinos and forex are OK)

         
         

   4. Mental Compartments
      1. Hurt & Shefrin - Investors have a “safe” part of their portfolio that they will not risk, and a “risky” part of their portfolio that they can have fun with even though this is at odds with CAPM

      
      

   5. Attention anomalies
      1. You can't pay attention to everything
      2. “No arbitrage assumption” of financial theory: No ten-dollar bills lying around on the sidewalk. Does not require everyone is paying attention
      3. Some stocks get overpriced and others are just forgotten, they're underpriced because people aren't thinking about them

      
      

   6. Anchoring
      1. We can be influenced by an initial frame of reference
      2. Stock prices anchored to past values
      3. Kahneman and Tversky - wheel of fortune experiment

      
      

   7. Representativeness heuristic
      1. People judge by similarity to familiar types, without regard to base rate probabilities
      2. Adding features to something makes it less likely that it will be part of a category even though we tend to associate some features with certain stereotypes

      
      

   8. Disjunction effect
      1. People aren't good at predicting how they'll feel after an outcome
      2. • Inability to make a decision that is contingent on future information
      3. Shafir & Tversky: People who took one of Samuelson’s lunch colleague bet (flip a coin: heads you win $200, tails you lose $100) were asked if they would take another. Most took the second bet whether or not they won the first. But most would not take second bet before outcome of first was known
      4. Reaction of stock market to news, Making stock strategies to trade on news
      5. The general public is innumerate - can't handle concepts like compound interest, etc. PPM of CO2 in the atmosphere, etc

      
      

   9. Magical thinking
      1. Term invented by B.F. Skinner from one of his animal experiments
      2. Refers to the belief that something you did provoked a positive outcome when there is no association

      
      

   10. Quasi magical thinking
       1. Newcomb's paradox - complicated and worth looking up
       2. People think that decisions made in the future can affect events in the past
       3. People will bet more on a coin not yet tossed, as though they could influence the outcome
       4. Talk to your financial advisor when in need just as you would seek out a doctor when you're ill

       
       

   11. Culture
       1. Social cognition, collective memory
       2. Durkheim, 1897, suicide rates differ across countries for no more reason than different cultural themes
       3. A global culture in today’s world
       4. Moral anchors for the market in the form of human stories
       5. 1929 is still remembered, and with associations of moral
       6. Narrative psychology: Robert Abelson, Jerome Bruner
       7. Identity, ego involvement heightens effect of stories

   12. Antisocial personality disorder
       1. Identity: egocentric, self-esteem from personal gain
          • Self-direction: absence of prosocial internal standards
          • Lack of empathy, incapacity for intimacy
          • Manipulative, deceitful, callous, hostile
          • Irresponsible, impulsive, risk-taking
       2. Sociopath - a classic 'powerhouse' CEO
       3. They call it a disorder but these are the alpha males who create empires. They need to be reined in during the age of mass DIY destruction though

       
       

   13. From Theory of Moral Sentiments, Adam Smith, 1759 to Behavioral Economics
       1. Adam Smith: people have a desire for praise
       2. But don’t enjoy being praised for something they did not do
       3. As people mature, if they mature successfully, the desire for praise morphs into a desire for praiseworthiness
       4. That’s very different from the usual assumption in economics, that one wants to maximize consumption.
       5. The profit motive determines how much coal is dug

       
       

   14. Everything is half truth in life.
   15. Aspects of Psychology Play a Role in Many Economic Institutions
       • Insurance and loss aversion
       • Corporate stocks and gambling
       • Bonds and Money Illusion
       • Banks and trust
       • Central banks and Bubbles
       • Investment banks and framing
       • Exchanges and sensation seeking
       • Options and salience

   
   

Google Doc

Robert Shiller's 'Financial Markets' course.
My comments will be in this British Racing Green
More useful stuff (in my opinion) will be in bold.

Week 3

1. Describe the implications and institutions associated with the short term interest rate, and describe how to compute single and compound interest.
2. Term structure - the time you have to keep your money in an investment before you can get it out
3. Interest rates are much lower than in the 1980s, in some cases even negative - they did rise slightly after the Great Recession but they're back down and likely to go even lower after coronavirus
4. The federal funds rate is the shortest term interest rate in the US - useful to banks mostly as individuals don't usually borrow money overnight
   1. European counterpart - EONIA, European Overnight Index Average.

   
   

5. It's costly for banks to store cash - vaults, trucks, etc.
6. A basis point is a hundredth of a percentage point
7. Eugen Bohm von Bawerk 1884, Capital and Interest, which said, "Interest rates tend to be small positive numbers like 3% or 5% because of technical progress, time preferences and advantages to round aboutness." The interest rate corresponds to the 'rate of progress'.
8. People are naturally impatient - so money is more valuable now than later.
9. Irving Fisher - Theory of Interest 1930
10. monetary policy is a very blunt tool. You may feel that you have to cut interest rates to help the economy move ahead, but it doesn't affect everyone the same. And any time it doesn't, that, it has a potential to raise inequality - for example pensioners who are retired and living off savings interest.
11. Compound Interest

     

    1. If annual rate is r, compounding once per year, balance = (1+r)t after t years
    2. If compounded twice per year, balance is (1+r/2)2t after t years
    3. If compounded n times per year, balance is (1+r/n)nt after t years
    4. Continuous compounding, balance is ert

    
    

12. Identify the difference between coupon and discount bonds, and calculate the present discounted value of discount bonds.
    1. Discount Bonds

        

       1. No coupon payments, just principal at maturity date (conventionally, $100).
       2. Initially sold at a discount (less than $100) and price rises through time, creating income.
       3. Term T, Yield to Maturity (YTM) r
       4. Valuable because it is discounted (less than full value) even though it bears no interest; thought with negative interest rates they may no longer technically be 'discounted', and trade for more than face value
       5. typically, bonds pay interest rate every six months

       
       

    2. Present Discounted Value (PDV)

        

       1. considers the value of money in the future
       2. PDV of a dollar in one year = 1/(1+r)
       3. PDV of a dollar in n years = 1/(1+r)n
       4. PDV of a stream of payments x1,..,xn

       
       

    3. Conventional Bonds Carry Coupons

        

       1. Conventional Bond Issued at par (100), coupons every six
          months.
       2. Term is time to maturity

       
       

    
    

13. Determine the origin, the meaning and the valuation of two debt securities: consols and annuities.
    1. Consol and Annuity Formulas (both known as 'perpetuities' in some circles)

        

       1. Consols are bonds with no maturity date - they are paid (nearly) forever, but have apparently all been redeemed since 2015
       2. Consol pays constant quantity x forever
       3. Growing consol pays x(1+g)^(t-1) in t
       4. Annuity pays x from time 1 to T

       
       

    
    

14. Understand the meaning of forward rates and to describe how to calculate them
    1. Forward Rates

        

       1. Forward rates are interest rates that can be taken in advance using term structure
       2. J. R. Hicks Value and Capital 1939
       3. Curiously no one is sure who invented the concept of forward rates, including Sir Hicks when he was alive

       
       

    2. Expectations Theory

        

       1. Forward rates equal expected spot rates
       2. Slope of term structure indicates expected future change in interest rates.

       
       

    3. Inflation and Interest Rates

        

       1. Real interest rate - the interest rate adjusted for inflation - concept invented by John Bates Clark in
          1. The nominal interest rate is quoted in currency
          2. Inflation decreases the value of currency
          3. The real rate is quoted in terms of a basket of ??? that underlies the CPI (consumer price index)
          4. Nominal rate quoted in dollars, real rate quoted market baskets
          5. Nominal rate usually greater than real rate

          
          

       
       

    4. Index Bonds

        

       1. Bonds that pay coupons defined in real terms and a principal
       2. coupons are tied to the inflation rate so you know in real terms what you are getting
       3. Treasury Inflation Protection Securities. (TIPS) not issued by US Treasury until 1997 so a 217 year lag from when the were first issued in Massachusetts (maybe the invention of Paul Revere)
       4. In the UK they are called index-linked Gilts, in 2006 they were 25% of national debt
          France recently issued Euro Index bonds

       
       

    5. Leverage
       1. Leverage is used when a company or an individual borrows money to buy assets
       2. a double edged sword
       3. Leveraging means you are putting more money into the asset than you have
       4. Borrowing increases risk but also profits
       5. The start of the 2008-9 world financial crisis had to do with home buyers in U.S. and elsewhere borrowing to buy homes
       6. China today is a highly leveraged economy, arousing concerns
       7. Debt leads to bankruptcies, possible world crises
       8. Irving Fisher “The Debt-Deflation Theory of Great Depressions” Econometrica 1933

           

          1. Deflation redistributes real wealth from debtors to creditors
          2. Borrowers tend to be optimists; Creditors tend to be the more cautious
          3. (Recent (2008) crisis has not been mostly deflationary, but inflation has fallen short of expectations)
          4. The overall level of debt in the economy (hence leverage) rises in real value because of deflation.

          
          

       9. Shiller asks why debt isn't indexed to inflation
       10. In the 2008 financial crisis, mortgage holders could borrow 97% of their purchase
       11. "Lenders are not evil"

       
       

    
    

15. Define the meaning and how to calculate the market capitalization of a company.
    1. market capitalization is the price per share multiplied by the number of shares
    2. “America is for sale”
    3. “The US stock market is not America”
    4. General limited liability law was invented in the US and may have given it a headstart in its huge stock market valuation
    5. Flow of Funds Accounts 2014
       1. Table B-101 gave household (incl nonprofit) assets as $98.3 trillion and liabilities of $14.2 trillion and hence net worth of 84.1 trillion
       2. Of this, corporate equities only $13.9 trillion (mutual funds another $7.8 trillion, pension funds 20.6 trillion)
       3. Real estate is bigger than holdings of equities, $23.7 trillion

       
       

    6. Market capitalization of the stock market; $26 trillion
    7. “ I think it might be a very smart policy not to buy a home, to rent a home and invest in a broadly diversified portfolio which should be less risky.”

    
    

16. Explain the structure of corporations in the U.S. and the implications of owning shares in a company.
    1. Corporation:
       1. from latin ‘corpus’ meaning body. The organization has a body like a person and is endowed with some of the same legal status as a person.
       2. Roman government hired private companies (publicani) to collect taxes and these companies traded shares, not much data is left from that period
       3. The Corporation is a body corporate legally authorized to act as a single individual, an artificial person created by royal charter, prescription, or act of legislature, and having authority to preserve certain rights in perpetual succession. (OED)

       
       

    2. Board of Directors
       1. In US, Board is commonly chaired by CEO but CEO is hired by the Board
       2. In Germany, firms have two boards of directors. There is the Aufsichtsrat (Supervisory Board) and the Vorstand (Management Board).

       
       

    3. Non-profits vs. For profit corps.:
       1. Non-profits are not owned by anyone - they are perpetuated by appointing new directors on their own
       2. The non-profit exists for whatever the charter of the non-profit says- it promotes some cause.
       3. For profits exist for the benefit of the shareholders
       4. A for-profit corporation has a price per share, whereas a non-profit corporation is not traded in the market.
       5. A for-profit corporation is subject to corporate profits tax, which is not the case for a non-profit corporation.
       6. A for-profit corporation is owned by shareholders, whereas a non-profit corporation has self-perpetuating directors.
       7. Nonprofits can still earn as many profits as they wish but they don’t distribute them to shareholders
       8. For-profit corporation is owned by shareholders, equal claim after debts
       9. paid, subject to corporate profits tax
       10. Non-profit is not owned, self-perpetuating directors. Not subject to
       11. corporate profits tax
       12. For-Profit exists to benefit shareholders, non-profit does not
       13. So, for-profit has a price per share, non-profit does not
       14. Ideally, for-profit has value only because the company is dedicated to
       15. advancing the shareholder, either through dividends or through share repurchase

       
       

    
    

1. 1. Shares and market capitalization
      1. My ownership of a company equals my shares divided by total shares
      2. Splits are essentially meaningless
         1. Companies do it for a variety of reasons including making it easier to buy fractional shares
         2. Berkshire Hathaway does not split and now a single share is worth thousands of dollars, so you need to be wealthy to be a shareholder
         3. Buffett has defended his choice by saying it keeps those who are able to hold on to the stock and discourages the rest (riffraff)

         
         

      3. Delaware makes concessions to companies to encourage them to incorporate there and they make money doing this
      4. The corporate law in the state defines the rights and responsibilities of shareholders and the board of directors.

      
      

   
   

2. Identify the differences between common and preferred stocks, and the concepts of dilution and dividends.
   1. Common vs. Preferred shares
      1. Common means ‘held in common’ = equity
      2. Preferred stock has a specified dividend that doesn’t grow over time, like common stock it doesn’t have to be paid
      3. Common stock: dividend is at discretion of firm, subject to legal restrictions
      4. Preferred stock: Specified dividend does not have to be paid, but firm cannot pay dividend on common stock unless all past preferred stock dividends are paid
      5. Corporate bonds: Firm is contractually obligated to pay coupons and there is a maturity date when principal must be paid
      6. US bought preferred shares in corporations to bail them out (GM bought back all its govt. preferred shares in 2010, $2.1 billion, govt. still has common)

      
      

   2. Dividends & Dilution
      1. If the company pays a dividend, the value of the share should go down by the amount of the dividend per share (because the company has less money now)
      2. Ex dividend date - shareholders of record on this date will get paid, new holders will have to wait for the next one
      3. If the company does something to increase the value of the company without increasing the number of shares, my shares gain value
      4. It is all in the ratio, total value of company divided by total number of shares. If you affect numerator and denominator equally, then there is no effect on price per share
      5. One reason to hold shares is to gain dividends
      6. A dividend is a distribution of money from the company's earnings to its shareholders.
      7. Historically, over 100 years, dividends are more important than increases in share prices
      8. “The U.S. government, if it were to be buying common stock this would be socialism.” It is socialism, just socialism for the rich. Borrow and invest without risk as long as you’re rich enough to get bailed out.

      
      

   3. Classes of Shares
      1. Berkshire Hathaway, A Class have voting rights (close to $200,000 per share), B do not (Listed NYSE)
      2. New York Times, Class A has less voting rights than Class B, which allows descendants of Adolph Ochs still to control (not publicly traded)
      3. Facebook: Mark Zuckerberg owns 28% of its shares but 57% of its voting shares (2012)

      
      

   4. How Do Corporations Raise Money?
      1. In principle, whenever a company wants to raise new money, say to build a factory, it could issue new shares
      2. This dilutes existing shareholders, since they now own a smaller fraction of the company, but, offsetting that, it creates new earning power for the company
      3. Shareholders at a meeting could ideally vote on whether they think the prospective profits are worth the dilution, and prospective purchasers of the issue could ponder whether they feel the diluted shares are worth purchasing

      
      

   5. Why Do they Call It Equity
      1. Equity means equal share. Term goes back only to 1904, originates in US (OED)

      
      

   6. Stuart Myers Pecking Order Theory
      1. Firms really don’t like to issue new shares, because public gives them a bad price, mistrusting management, and it is costly and difficult to issue shares
      2. Stewart Myers, “The Capital Structure Puzzle, J. Fin. 39:575-92, 1984 proposes “pecking order” theory: firms like to raise money through retained earnings first, through borrowing second, equity only as last resort
      3. He says most firms (as of 1984) had not done a single equity offering in the last twenty years, and did not contemplate doing one 1973-82 62% of capital expenditures came from retained earnings, only 6% from net equity issuance, rest from net borrowing

      
      

   7. Karl Marx on shares
      1. Karl Marx said all this trade in stocks is trading mostly existing shares. It doesn't bring money into the company. All this transaction, it's just gambling, It's only when the company issues shares that share price matters economically. And Marx thought they don't do that very much. Stewart’s research supported this.

      
      

   8. Fama & French criticism of Myers JFE 2005
      1. But Fama and French point out that even 1973-82, 67% of firms issued some equity (Myers referred to net equity at 6%), up to 86% for 1993 to 2002
      2. Equity issues include issues of stock to employees via options and grants

      
      

   9. Dilution 2
      1. Sometimes a company pays a dividend in shares; these are not taxed
      2. These also don’t increase your total equity in the company since everyone is getting the same share increase - it’s ‘fishing for fools’
      3. If the company gives away new shares, my shares become worth less; that is dilution
      4. They do give away shares
      5. If the company sells new shares at market price, that generally does not lower the value of my shares because the company has the money
      6. If the company issues a stock dividend at 5%, then that lowers the value of my original shares by factor 1/1.05, but I am not worse off since I have an additional .05/1.05 of value in the new shares
      7. NASDAQ would list companies that never paid dividends, once upon a time the NYSE would not

      
      

   
   

3. Describe how and why companies repurchase their shares.
   1. Share Repurchase
      1. The opposite comes when a firm buys its own shares on the market.
      2. The value of the firm should go down by the amount they spent.
      3. I as a shareholder, however, now own a larger share of the company.
      4. If the firm repurchases shares instead of paying dividends, then my shares do not lose value, the company loses value but I have a bigger share in it.
      5. “It's just the same thing as paying a dividend.”

      
      

   2. Reasons for Share Repurchase
      1. Tax break for investors (obsolete in the sense that tax rate on cap gains=that on dividends, but cap gains tax can be postponed).
      2. This is mainly to ‘fool the IRS’ so they aren’t done regularly like a dividend
      3. Firms’ unwillingness to cut dividends, uncertainty that current earnings will continue.
      4. Price pop after a repurchase. Buybacks taken as a signal. But price pops are fading.
      5. Now investors sometimes view repurchase as a sign that the firm is “old economy.” NASDAQ firms are less likely to repurchase shares, as they think value is too high.

      
      

   
   

4. Describe the basics of corporate governance.
   1. Corporate Charter
      1. The Basic Corporate Charter Says All Common Shareholders Treated Equally
      2. Charter does not say that the firm ever has to raise debt, Board (and officers they appoint) decides
      3. Charter does not say that the firm ever has to pay dividends, Board decides
      4. Charter does not say the firm ever has to repurchase shares, Board decides
      5. Charter does not say that the firm ever has to issue warrants, convertible debt, anything else But, the shareholders elect the board!!

      
      

   2. Berle and Means
      1. Berle and Means said that, while in practice we have shareholder democracy, in practice the democracy is imperfect. It's really self-perpetuating Boards of Directors.
      2. Adolf A. Berle Jr., and Gardiner C. Means, The Modern Corporation and Private Property, 1933
      3. Separation of ownership and control
      4. “ownership is so widely scattered that working control can be maintained with but a minority interest.”
      5. The “quasi-public corporation” is constrained by law to serve other interests.

      
      

   3. Regulatory Efforts to Improve Voting forCorporate Control
      1. 1935 SEC under authority of Securities Exchange Act of 1934 established rules for proxy contests. Outside parties may solicit proxies but must register with SEC
      2. 1956 Amendments made proxy contests very difficult: required registration of all proxy communications
      3. 1992 Relaxed 1956 amendments, resulting in many more proxy contests

      
      

   
   

5. Further understand the pricing of stocks and the price-to-earnings ratio.
   1. Price as PDV of Expected Dividends
      1. If earnings equal dividends and if dividends grow at long-run rate g, then by growing consol model P=E/(r-g), P/E=1/(r-g). (Gordon Model)
      2. So, efficient markets theory purports to explain why P/E varies across stocks in terms of r and g
      3. Low P/E does not mean that the stock is a “bargain,” it only means that earnings are rationally forecasted to decrease in future (low g) or that risk is high (high r)
      4. Efficient markets denies that any rule works other than simple diversification
      5. Value investing says invest in low P/E

      
      

   2. Most of the return people have gotten historically from stocks is in dividends, not in capital gains
   3. It's correct to think that efficient markets implies that what you're really pricing in the stock market is a claim on dividend
   4. The notion that stocks are the best investment varies in line with the rise and fall of the stock market price - this leads Shiller to prefer the value investing (Ben Graham) model
   5. Why Do Firms Pay Dividends?
      1. Even when there was a strong tax advantage to capital gains, firms paid dividend
      2. Hersch Shefrin and Meir Statman: Self-control theory of dividends. (analogy to Christmas clubs, overwithholding) Rule of thumb spending rule.
      3. Prospect theory interpretation: framing matters. Dividends framed as income.
      4. University endowments once required high-yield investments to provide income

      
      

   6. Dividend Signalling
      1. By raising dividends, the firm shows it can court bankruptcy.
      2. Battacharya, Hakansson, Ross
         1. Dividends are largely about signalling
         2. Why go to college? It’s to signal that you’re smart and worthy of future job opportunities

         
         

      3. Problem: alternative signaling methods are cheaper taxwise

      
      

   7. Lintner Model of Dividends
      1. DIVt-DIVt-1= ρ(τ × EPSt-DIVt-1)
      2. ρ=adjustment rate, 0< ρ<1
      3. τ=target ratio, 0< τ<1

      
      

   8. General Public Utilities Corp
      1. President Kuhn proposed to substitute stock dividends for cash dividends, and offered to sell the stock dividend for any stockholder for minimal transaction cost. (ca. 1968)
      2. Direct saving to shareholder: $4 million a year
      3. Intense negative shareholder reaction
      4. People don't think about taxes, even high income people who might own shares, which goes to show why I don't really believe in efficient markets

      
      

   
   

Google Doc

Robert Shiller's 'Financial Markets' course.
My comments will be in this British Racing Green
More useful stuff (in my opinion) will be in bold.

Week 4

 

1. Understand the history and key concepts of mortgages.
   1. I. History of mortgage lending
      1. OED says word mortgage comes from Latin Mortuus vadium (dead pledge), via French which made it into mort gage (gage meaning pledge in French) reached English by 1283
      2. Verb mortgage means commit property as collateral for a loan. Could mortgage your soul to the devil
      3. Valerie Hansen, professor of history here at Yale, has been studying Tang Dynasty 618-907 documents regarding the Silk Road trade with the east. Many detailed loan records survive.
      4. Chinese documents usually prescribed fines, including fines on relatives, for failing to pay
      5. Iranian documents, in Sogdian language, involve collateral, real estate, goods or slaves, and pledges to maintain the collateral well. [Sogdian language went extinct in 9th century, but modern Iranian is related to it]
      6. The word mortgage began to be common in the late 18th century, as part of the democratization of finance
      7. Property law wasn’t so developed as to allow a lively mortgage industry
      8. Grundbuch invented in Germany that gave clear title, late 19th century

      
      
      

   2. II. Commercial Real Estate Vehicles
      1. In order to buy in to a real estate partnership you have to be an accredited investor, which is defined by the Securities and Exchange Commission in Washington D.C. as in terms of your wealth and your income. Now it used to be you had to have more than $1 million of investable wealth in your name, excluding your house. Or an income of $200,000 a year or more.

      
      
      

   3. Real Estate Partnerships as the Major Example of a DPP
      1. For accredited investors
      2. Real estate limited partnerships represent the most important example of a Direct Participation Program (DPP), a class of investments that also includes oil and gas exploration programs and equipment leasing programs
      3. “Direct participation:” DPPs are “flow-throw vehicles” and investors can deduct program losses on personal taxes
      4. “Tax shelters” until the Tax Reform Act of 1986: losses used to offset “passive income.” Now, genuine businesses
      5. DPPs escape the corporate profits tax
      6. IRS requirements, notably limitation of life
      7. General partner runs the business, does not have limited liability
      8. General partner must own at least 1%
      9. Limited Partners are passive investors, with limited liability, rights to vote, can replace general partner
      10. General partner or associate usually runs the offering to sell units to investors
      11. Give additional performance-oriented compensation to the general partner

      
      
      

   4. Real Estate Investment Trusts (REITs)
      1. were created by US Congress in 1960 to allow small investors access to real estate investments
      2. Before 1960, public companies that owned real estate would be considered businesses, for which their earnings would be subject to corporate profits tax. So, until 1960, real estate was typically owned by partnerships, not suitable for small investors
      3. Today, institutions invest in REITs too

      
      
      

   5. Restrictions on REITs
      1. 75% of assets must be in real estate or cash
      2. 75% of income must be from real estate
      3. 90% of their income must be from real estate, dividend, interest & capital gains • 95% of income must be paid out
      4. No more than 30% of income from sale of properties held less than four years – These prevent regular businesses from being REITS

      
      
      

   6. The 3 REIT Booms
      1. First boom: Late 1960s: interest rates rose above deposit rate ceilings at banks, depositors fled to mortgage REITs. But, with the recession of 1974, many REITs defaulted. The Economic Recovery Tax Act of 1981 favored partnerships.
      2. Second boom: Tax Reform Act of 1986 eliminated advantages of partnerships, so investors switched to REITs.
      3. Third boom: Starting 1992, many private real estate companies found it advantageous to go public as REITs, specialized REITs developed.

      
      
      

   7. III. Residential Real Estate Vehicles (mortgages)
   8. Size of Mortgages USA
      1. • $13.2 trillion mortgage debt
      2. There are 48 million mortgaged homes
      3. 10.9 million of these mortgages were under water (Corelogic) after the financial crisis when home prices bottomed in 2012
      4. In 1920s, 5-year term loans common, balloon payment due in five years, or refinance or sell house
      5. In 1930s, decline in nominal home prices and rise in unemployment caused massive defaults
      6. Mortgage lending industry turned to long-term annuities

      
      
      

   9. Constructions costs
      1. Construction costs have actually remained stable re: CPI so housing price bubbles are largely psychological

      
      
      

   10. Federal Housing Administration
       1. 1934 Required 15-year loans
       2. Insures the lender against loss
       3. The Government is betting on its own people!
       4. Recently, FHA in trouble
       5. Raised insurance premium from 0.5% to 1.5%, which is killing real estate

       
       
       

   11. Kinds of Mortgages
       1. Conventional, fixed rate mortgage (amortizing, long term)
       2. Adjustable rate mortgage (ARM)
       3. Price level adjusted mortgage (PLAM) payment adjusted to inflation so constant in real terms
       4. Dual rate mortgages (DRAMs) same as PLAM but interest rate floats
       5. Shared appreciation mortgages (SAMs)
       6. First mortgages: on purchase of home
       7. Home equity loans

       
       
       

   12. IV. Real Estate Bubbles and the Origins of the 2000s financial crisis in real estate finance
       1. There was a housing shortage after WW2
       2. Overoptimistic mortgage lending led to a bubble
       3. Home prices were stable for nearly 100 years then in the 1990s they started going up
       4. The price of land is a small component of housing prices
       5. “It had something to do with the I don't know the culture with the story about the emerging world. About the rich Chinese or rich Russians or whatever they are coming in and buying out properties they just got exaggerated and so it led to a bubble.”
       6. Wishful thinking bias - new home buyers are most likely to think real estate is the best investment for long-term holders who can hold through ups and downs
       7. How can millions of people be wrong? Well, history shows they've done it again, and again.
       8. “PERHAPS the best evidence that America's house prices have reached dangerous levels is the fact that house-buying mania has been plastered on the front of virtually every American newspaper and magazine over the past month.” You could say the same thing about some stocks and indices

       
       
       

   Attached Image (click to enlarge)

   
   
   
   

1. 1. “You'd be stupid not to buy a house, everybody thought that. You've got to get into this market. And there weren't enough people saying, hey, wait a minute, [LAUGH] maybe this is a bubble. Nobody used the word bubble yet.”
   2. And there's a folklore that it usually takes several years longer than you ever imagined for it to finally turn. And then it finally does. But if you are a short seller, you might go bankrupt before that time is reached. “The market can stay irrational longer than you can stay solvent.”
   3. “I would call it an epidemic because epidemics don't just disappear. You know, they go a while then they recede and then they come back again. I think it's an epidemic too because it sort of suggests that it's contagious. Right? Right. I think I like epidemiology which is a course in the medical school, because it also suggests why it is that bubbles appear so mysteriously. It's the same way that let's say an influenza epidemic appears. Suddenly hospitals are reporting, there's lots of new cases. Do they know why? Well let's say maybe the virus mutated and suddenly it's more infectious. It's the same way with stock market bubbles. So suddenly the market goes up. It wouldn't be a virus or a story or a theory. And the theories mutate the same way viruses do. Like there's some news thing or some politician says something and suddenly it's more contagious, a better story that people will tell, they'll influence each other. I use the word bubble because I think I know what people mean by it. But I think it's really epidemic, the word we want to use.”
   4. “We know that some people have crazy beliefs, right. Well there's nothing to stop them from going in and bidding up the price of some stock to some crazy level, and everybody else knows it's crazy. Unless you can short sell, that means borrow shares and sell them enough so you can offset all of these. But what if all these people buy up all the shares and they hold them personally so that they're not available for shorting, maybe you can't short sell. So what's to stop it?”
   5. And in some countries like China for example it's been very difficult to short sell. If you can't short sell, there is nothing to stop crazy people from bidding up the price. It’s not easy for any but the most elite investors to short sell.

   
   
   

2. Explain the relationship between the 10 year treasury bond YTM and the 30 year mortgage rate.
   1. They correlate because there is one interest rate
   2. The mortgage rate is slightly higher because mortgages have a management cost

   
   
   

3. Describe the housing market before the bubble, and what led to the crash in 2007.
   1. Recessions
      1. Shiller ‘wrote a book with George Akerlof called, "Animal Spirits" and it's about the psychology of markets and recessions. We concluded that recessions are substantially psychological. So it's difficult for anybody, a central bank, central government to deal with them.’
      2. “In history there were times when inflation was just going through the roof and someone said, you know you've got to take tough medicine. Shoot the short rate up really high which is what banks can start a recession and that will bring the inflation rate down, and out of desperation they actually did that.”
      3. Stock market drops may be a leading indicator of a recession

      
      
      

   
   
   

4. Define CMOs and CDOs
   1. Private Mortgage Insurance (PMI)
      1. Companies, such as MGIC, insure Fannie & Freddie against losses on their mortgages.
      2. Both Fannie & Freddie require that mortgagors buy mortgage insurance if down payment is less than 20%.
      3. Controversy: with recent real estate price increases, LTV has declined below 80% for many homeowners still paying for mortgage insurance. The PMIs don’t notify them.
      4. PMI Group Inc. declared bankruptcy in 2011.

      
      
      

   2. Collateralized Mortgage Obligations (CMOs)
      1. CMOs divide the cash flow of a mortgage pass-through security into a number of tranches in terms of prepayment risk.
      2. Sequential-pay CMOs (first created 1983): First tranche receives first principal payments, after it is paid off the second tranche receives principal payments.

      
      
      

   3. Collateralized Debt Obligations (CDOs)
      1. Hold securities, typically mortgage securities as their assets
      2. Typically hold subprime mortgages
      3. CDOs divide the cash flow into a number of tranches in terms of default risk
      4. CDO debt crisis 2007
      5. Criticism of rating agencies for not downgrading them

      
      
      

   4. Many people continue to pay for PMI (private mortgage insurance) long after it was necessary. That's capitalism. They have no incentive to notify you. They also didn't necessarily hold enough reserve. So in a financial crisis, at least one of them, PMI Group Inc. declared bankruptcy. So insurance companies are not necessarily reliable.

   
   
   

5. Describe microprudential and macroprudential regulation, and the concept of regulation.
   1. MicroPrudential vs Macroprudential Regulation
      1. Most regulation just prior to the 2007-2009 crisis emphasized microprudential
      2. Macroprudential was nobody’s business
      3. Macroprudential is regulation to help prevent big crisis, big events, the macro economy. And it's a revolution in regulation that occurred since the financial crisis, that regulators are not just there to protect you as a stockholder, or you as a purchaser of a product. It's to protect the whole economy,

      
      
      

   2. ‘Liars Loan’ mortgages given to those who were highly likely to default, then these were packaged as investors and sold to fools
   3. A Fix Begun in Europe
      1. 5% mortgage originator must hold 5% of mortgages, European parliament
      2. Dodd-Frank copies this idea
      3. Qualifying Residential Mortgages (QRMs) are exempt from requirement in USA
      4. But discord has prevented US government from defining QRMs as of 2012

      
      
      

   4. Requirements for QRM (as of 2014 Rule)
      1. Regular periodic payments that are substantially equal;
      2. No negative amortization, interest only or balloon features;
      3. A maximum loan term of 30 years;
      4. Total points and fees that do not exceed 3 percent of the total loan amount, or the applicable amounts specified for small loans up to $100,000;
      5. Payments underwritten using the maximum interest rate that may apply during the first five years after the date on which the first regular periodic payment is due;
      6. Consideration and verification of the consumer's income and assets, including employment status if relied upon, and current debt obligations, mortgage-related obligations, alimony and child support; and
      7. Total DTI ratio that does not exceed 43 percent
      8. Bankers have to sell the mortgages to get money to make new mortgages, they're in the mortgage origination business. And mortgages are inherently not held by banks, somewhat by banks, but often not. So they just generally want to qualify.

      
      
      

   5. Excess Reserves
      1. Excess reserves are the reserves that banks hold beyond what they're required to hold by regulation.
      2. Banks used to hold as little excess as possible, beyond what they were forced to hold
      3. Now they hold more because they don’t know what to do with excess cash; there’s no place to invest it
      4. ‘Secular stagnation’ - banks are letting money lie fallow
      5. it's a sign of some kind of fundamental weakness in the world economy, that came on with the financial crisis. Moral hazard and adverse selection are fundamental issues
      6. Any business in insurance or banking or finance more generally, has to worry about adverse selection, moral hazard, and they have to worry about their being manipulated or deceived.
      7. And bankers then use their gut intuition and their information to decide whether to make loans, or whether to take risks. Which sounds like a perfectly terrible way to make loan decisions. Subject to a host of typical biases.

      
      
      

   
   
   

6. Define tunneling and give examples.
   1. Tunneling
      1. Theft by a minor shareholder often subtle and devious
      2. Attached Image

         
      3. Examples include selling assets at below-market prices to a crony in exchange for unspecified future favours
      4. Dilutive share issues
      5. Complexity obscures the money trail
      6. Excessive executive compensation (esp. problem in the USA)
      7. Johnson, LaPorta, Lopez-de-Silanos, and Shleifer, AER May 2000
      8. Tunneling = Expropriation by minority shareholders (figuratively, as by an underground tunnel)
      9. More common in civil law countries (especially French) than in common law countries (LaPorta et al. 1998). Hence, a higher proportion of private and family-owned companies in civil law countries.
      10. Common law countries deal better with tunnelling since laws can be enacted by specific new cases

      
      
      

   
   
   

7. Describe the differences between state and national regulation in the U.S.; describe the role of the SEC.
   1. Regulation and Human Behavior
      1. Regulation is substantially aimed at dealing with human problems, manipulation and Deception
      2. Regulation goes beyond this, in dealing also with making the system work better, such problems as monopoly and externalities, such as “too big to fail”

      
      
      

   2. Business Wants Regulation
      1. Without regulation, people are forced to do things in a competitive system that they think are bad for society
      2. ‘The Phishing Equilibrium’ is Shiller’s name for this
      3. Forced to lowest common denominator
      4. Analogy to having a referee at a sports event
      5. Players hate referees, but without them they know game would deteriorate into something ugly

      
      
      

   3. Five Levels of Financial Regulation
      1. 1. Within-firm regulation
         1. The Board of Directors
            1. The Board of Directors acts like a regulator
            2. Outside directors represent a broader community
            3. In last lecture I emphasized that society functions to quarantine people with personality disorders, and people derive reputations
            4. Putting outsiders of known reputations on a board is a signal to outsiders of regulation

            
            
            

         
         
         

      2. 2. Trade Groups
         1. Buttonwood Agreement 1792
         2. “At the heart of the Buttonwood Agreement was the need for fairness, responsibility and trust. Just two months earlier, Colonel William Duer, a wealthy former assistant secretary of the treasury, had defaulted on his debts, causing a brief panic in the New York financial markets. The importance of being able to trust those with whom you deal, paramount in the minds of the 24 merchant-brokers, remains central to this date.”
         3. It was basically collusion - an agreement not to compete with each other.
         4. William Duer was a man of questionable ethics, who borrowed heavily to buy into a stock market bubble, deceiving others, manipulating • The US stock market crash of 1792 created macroprudential problems as well, to be resolved, some thought, by not trading with dubious people Regulation of Commissions on Natural Monopolies
         5. May Day May 1, 1975 SEC under chairman Ray Garrett Jr. (BA Yale College, appointed by Nixon), under President Ford (Yale Law School) abolished fixed commissions (also begin of National Market System NMS)
         6. Big Bang London October 27, 1986, Margaret Thatcher abolished fixed commissions to eliminate “elitist old boy’s network.”
         7. Deutsche Boerse attempted to buy NYSE and Nasdaq 2010, but Intercontinental Exchange bought NYSE, Nasdaq still independent
         8. Deutsche Boerse is trying to buy LSE 2016 (apparently it tried for ~2 years and failed due to regulatory concerns)

         
         
         

      3. 3. Local Government Regulation
         1. Banking Regulation
            1. Belonged to states until the National Banking Act of 1863
               1. Under President Lincoln during the Civil War, created a system of national banks that were regulated by the federal government instead of the state government

               
               
               

            
            
            

         2. Securities and Exchange Commission
            1. Louis Brandeis, Other People’s Money, 1914 was the intellectual origin.
            2. 1920s were period of much fraud, manipulation

            
            
            

         3. Blue Sky Laws
            1. Regulates the offering and sale of securities to protect the public from fraud, regulates brokers and advisers
            2. Require registration of Securities
            3. blue sky law was enacted in Kansas in 1911 at the urging of its banking commissioner, Joseph Norman Dolley, and served as a model for similar statutes in other states. Between 1911 and 1933, 47 states adopted blue-sky statutes

            
            
            

         
         
         

      4. 4. National Government Regulation
         1. Local Regulation Failed
         2. SEC part of Roosevelt’s New Deal, 1934
            1. Initially viewed by business as a radical, almost socialist, institution. Peculiar that it started in US, imitated by other countries

            
            
            

         3. Arthur Levitt Take on the Street
            1. Recounts an atmosphere of denial of problems among many prominent Wall Street people
            2. Recounts “vivid” memories of reactions from some of the self regulatory organizations (SROs) when he proposed tightening of standards
            3. Bull market of the 1990s: after deregulation of commissions in 1975 analysts fell to “the bottom of the food chain” and eventually became conspirators in selling securities to maintain their income
            4. Arthur Levitt was another chair of the Securities and Exchange Commission, who after he retired, wrote a book called, "Take on the Street", meaning Wall Street. It was sort of like up against the wall on the street type thinking. He had a tough time as SEC commissioner, because his effort to police what he thought was clear wrongdoing, led to attacks on him. Congressmen would call him up, who had been bribed essentially by some financial interest, would call him up and try to threaten him. Not mafia-type threatening, but some sort of government regulation threatening. You think this sort of thing isn’t alive and well today?

            
            
            

         4. Public vs. Private Securities
            1. Motive was repeated examples of exploitation of minority or unobservant shareholders.
            2. Public securities: undergo approved process of issuance under SEC surveillance.
            3. Public companies must file public statements. EDGAR database on www.sec.gov.
            4. Initial Public Offering (IPO) is SEC procedure for going public.
            5. Reverse direction: going private.

            
            
            

         5. Hedge Funds
            1. For wealthy investors only
            2. Those structured as 3c1s can take no more than 99 investors, and they must be “accredited investors” as defined by the SEC which means income of $200,000 or investable assets of $1,000,000 (SEC proposal in 2006 to raise to $2,500,000 did not happen)
            3. Those structured as 3c7s can take 500 investors, but they must be “qualified purchasers” as defined by the SEC, individuals with net worth of at least $5 million or institutions with net worth of at least $25 million.

            
            
            

         6. William O. Douglas
            1. Yale Law School Professor
            2. leader in what was called the "Legal Realist Movement". It's something like the behavioral economics revolution that came much later, but this is a revolution in law schools.
            3. We know from Gillian Tett, different divisions of a university don't speak to each other generally. That's what she calls The Silo Effect.
            4. So this was a law school movement, which I think enhanced the law enormously, recognizing human limitations. That there was too much of putting in legal documents, things in the fine print, that you know nobody is going to figure out. So, the idea is that you have to force companies, or financial institutions to put it out in a clear and consistent standardized way.

            
            
            

         
         
         

      5. 5. International Regulation
         1. European Supervisory Framework Created 2010
         2. European Systemic Risk Board (ESRB) Frankfurt
         3. European Banking Authority (EBA) London
         4. European Securities Markets Authority (ESMA) Paris
         5. European Insurance and Occupational Pension Authority (EIOPA) Frankfurt
         6. “They spread them over different cities, that's the European Union style.”
         7. Bank for International Settlements
            1. Created 1930 by Hague Agreements
            2. Has 57 member central banks, who are in turn national regulators
            3. Basel Switzerland

            
            
            

         8. Basel Committee
            1. Created by the G10 1974 to coordinate banking regulation
            2. Basel I 1988
            3. Basel II 2004
            4. Basel III 2009 Adopted by G20 at the Seoul Korea summit in 2010

            
            
            

         9. G-7 countries
            1. Finance ministers of Canada, France, Germany, Italy, Japan, United States, UK, 1976, when Canada joined

            
            
            

         10. Group of Twenty Finance Ministers and Central Bank Governors (G-20, G20, Group of Twenty
             1. Founded 2008
             2. Met in Ankara, 2015

             
             
             

         11. Financial Stability Board
             1. Created by G20, April 2009, from the former Financial Stability Forum (which was founded 1999 by the G7 countries)
             2. Makes recommendations to the G20, which may end up adopted in many countries
             3. Basel Switzerland

             
             
             

         12. Regulation has to continually change through time as technology changes
         13. World economy dominates more and more, and so regulation will shift to international

         
         
         

      
      
      

   
   
   

8. Give examples of front running, insider trading, and how brokerage failure can impact the stock market.
   1. Insiders vs. Outsiders
      1. Insiders are people with special access to information about a company.
      2. Inside information represents wealth
      3. SEC tries to define access to this wealth, by disclosure rules.
      4. Regulation FD (Full Disclosure) 2000: requires that when a company tells any material fact to an analyst, it must immediately tell the public.
      5. Germany did not have any laws against insider trading until 1994
      6. Some argue insider trading is good. Hayne Leland

      
      
      

   2. Results of Market Surveillance
      1. May 1995 secretary at IBM was asked to Xerox documents related to secret plans to take over Lotus, to be announced June 5.
      2. She told husband, a beeper salesman.
      3. June 2 he told two friends who immediately bought.
      4. By June 5, 25 people spent half a million dollars to buy on this tip: pizza chef, electrical engineer, bank executive, dairy wholesaler, schoolteacher, and four stockbrokers. All caught by surveillance.

      
      
      

   3. Front Running and Decimalization
      1. Front-Running occurs when a broker buys shares in front of a large order that will boost stock price.
      2. Decimalization on NYSE and Amex began January 29, 2001. (NASDAQ April 2001)
      3. Decimalization favors front-running.
      4. NYSE Surveillance has not found a serious problem.

      
      
      

   4. Goodbody & Co. Failure, 1970
      1. Top-five Brokerage firm Goodbody & Co. ran into financial difficulties, trouble maintaining SEC capital requirements
      2. Fears for the accounts of of their 225,000 retail clients
      3. At the request of the New York Stock Exchange, Merrill Lynch took over company 1970
      4. New York Stock Exchange pledged $30 million to cover losses Merrill might incur
      5. None of Goodbody’s retail customers lost anything, because of the “heroism” of Merrill, NYSE

      
      
      

   5. ‘Ratings Shopping’
      1. Banks who are issuing mortgages or other mortgage originators would call the ratings services, Moody's and S&P and Fitch and others. And they would say, we're thinking of floating this kind of security. Can you give us any indication of what the rating would be before we send it to you and have you officially rate it? And if the rating agency gave it on the phone a bad rating, they'd say, okay, I think we'll rethink that, we'll talk to you later. And they never called them back. That's called rating shopping

      
      
      

   
   
   

9. Identify the role of regulatory bodies, and forwards and futures.
   1. Financial Accounting Standards Board
      1. Not a federal body
      2. FASB was officially recognized as authoritative by the SEC in 1973. Though the SEC has statutory right to make accounting standards, prefers the private sector to do it.
      3. FASB (Norwalk CT) defines Generally Accepted Accounting Principles (GAAP), used for EDGAR
      4. http://accounting.rutgers.edu/raw/fasb/facts/index.html

      
      
      

   2. Earnings Definitions
      1. GAAP Define “Net Income” which is the bottom line, traditionally, and “operating income,” revenue minus cost of doing business
      2. Operating earnings, Core Earnings, Pro Forma Earnings, EBITDA, and Adjusted Earnings are not GAAP
      3. FASB is at work on developing new definitions, but this takes years.
      4. Great confusion today about earnings

      
      
      

   3. SEC Rules
      1. Every broker must register with SEC
      2. Every stock exchange must register
      3. Every security issue must register
      4. Registration does not literally mean SEC approval

      
      
      

   4. Securities Investor Protection Corporation (SIPC)
      1. Similar idea to the FDIC, the Federal Deposit Insurance Corporation.
      2. To plan for such events (brokerage failures?) in the future, SIPC was created by US Congress 1970 (Sen. Ed Muskie)
      3. Protects customers of brokerage firm or clearinghouse against failure up to $500,000 per account, $100,000 for cash.
      4. SIPC much criticized. Very defensive, pays more to the lawyers than to claimants.
      5. Disallows claims that were not filed “promptly.”
      6. “not blanket protection that returns your money in all cases,” “doesn’t cover fraud claims” (SIPC web site)
      7. SIPC extremely slow to pay.

      
      
      

   5. The 2008 Financial Crisis as Result of Regulatory Failure before Crisis
      1. Many home buyers were put into unsuitable mortgages, later to default
      2. Leverage ratio of the financial sector was allowed to reach historically high levels
      3. Banks and governments used off-balance-sheet accounting to conceal liabilities
      4. Home appraisers were in effect bribed
      5. Rating shopping compromised security valuation process

      
      
      

   6. Dodd-Frank Act 2010
      1. Creates Financial Stability Oversight Council
      2. Creates Bureau of Consumer Financial Protection

      
      
      

   
   
   

Google Doc (includes my footnotes and more comments)

Robert Shiller's 'Financial Markets' course.
My comments will be in this British Racing Green
More useful stuff (in my opinion) will be in bold.

Week 5
This week we finally start getting into some of the good stuff, including options! Shiller seems to be ambivalent about options for the most part, arguing that hedging has additional costs. I mostly agree with him, but he mentions one interesting difference between options and stop-loss orders for risk management. Namely, that options will protect you from a choppy market whereas SLs will get you out of one bad trade only to put you right back into another (if your system works that way). I think it might make sense to use options for some markets/trading types but that's out of my wheelhouse (for now).

 

1. Recall key vocabulary of options, the concepts of options contracts, and the reason options exist.
   1. Student loans
      1. Income contingent student loans - the loan would vary depending on your income including spousal income
      2. Bankruptcy will not expunge a student loan
      3. As more students graduate and school becomes more expensive student loans are a type of bubble

      
      
      
      
      

   2. Options
      1. Options have buyers and sellers (writers)
      2. A call option is an option to buy
      3. A put option is an option to sell
      4. With a call option, you are buying the right to buy something which is specified in the contract at a predetermined price.
      5. With options, one pays money to have a choice in the future.
      6. Essence of options is not that I buy the ability to vacillate, or to exercise free will. The choice one makes actually depends only on the underlying asset price.
      7. Options are truncated claims on assets.
      8. Terms of Options Contract
         1. Exercise date
         2. Exercise price
         3. Definition of underlying and number of shares

         
         
         
         
         

      9. Bid-ask spread is how the dealer makes money.

      
      
      
      
      

   3. Why Have Options?
      1. A. Theoretical
         1. Theoretical Reason: In his classic 1964 article, economic theorist Kenneth Arrow argued that a major source of economic inefficiency is the absence of markets for risks.
         2. Financial theorist Stephen Ross made Arrow’s theory into a raison d’etre of options markets. In his 1976 article “Options and Efficiency,” he argued that financial options have a central place in the form of “completing the market.”

         
         
         
         
         

      2. Why Have Options: B. Behavioral
         1. Salience and Attention
         2. People buy insurance, do not want to give up up side of investment
         3. A put option is like insurance on a stock
         4. Peace of mind, with put option
         5. Shefrin and Statman, “Silver lining theory” - basically states that people might regret a choice but recall the beneficial aspects of some hedging choice they made.
            1. it opens up the possibility for sales people to kind of manipulate you and deceive you into buying options.

            
            
            
            
            

         
         
         
         
         

      3. Shefrin and Statman quote Gross 1982 The Art of Selling Intangibles: How to Make Your Million($) by Investing Other People’s Money
         1. “And so, this argument to sell and call options, makes no sense. It can only make sense if he puts numbers on those three sources of profit and then you add them up. You're supposed to do that but apparently, a lot of people don't think that way.”
         2. Probably still worth reading. Scripts for how to sell to clients. “How would you like to have 3 sources of income every time you buy a stock” = phishing

         
         
         
         
         

      
      
      
      
      

   4. Ubiquity of Options
      1. Recourse states can take legal action to pursue you if you default
      2. Non-recourse states only allow the lender to take the property
      3. Limited Liability makes stocks into an option, gives peace of mind
      4. Mortgages involve an option to default (in non-recourse states).
      5. Mortgages have a prepayment option. When you sell, you do not have to buy your way out of the mortgage.
      6. Home Price Decline Protection Obama 2009: gives mortgage servicers additional incentives to modify after home price decline.

      
      
      
      
      

   5. Options Exchanges
      1. Options are as old as civilization. Option to buy a piece of land in the city
      2. Chicago Board Options Exchange, a spinoff from the Chicago Board of Trade 1973, traded first standardized options
      3. Futures exchanges trade options on futures
      4. American Stock Exchange 1974, NYSE 1982

      
      
      
      
      

   6. Hedging with Options
      1. The primary purpose for options is to manage risk
      2. To put a floor on one’s holding of stock, one can buy a put on the same number of shares
      3. Alternatively, one can just decide to sell whenever the price reaches the floor (using a stop-loss order if necessary)
      4. Doing the former means I must pay the option price, doing the latter costs nothing.
      5. Why then, should anyone use options to hedge?
      6. One reason is to avoid getting chopped up in a ranging market.
      7. Expensive puts and high SKEW might predict a market crash (or not)
      8. The really big stock market crashes didn't happen in 30 days. For example, the 1929 stock market crash is remembered everywhere. And people remember it as October 28, 1929. The bottom fell out of the market. But what they forget is that the market came right back up on October 30, 1929, and they kept bouncing around. The real decline took over almost three years. It wasn’t until '32 that it bottomed out.

      
      
      
      
      

   
   
   
   
   

2. Understand the role of investment banks and underwriting.
   1. Not mentioned once - next week maybe??

   
   
   
   
   

3. Explain financial instruments used in commodities markets, and the future of such markets.
   1. Forwards and Future Markets
      1. Derivatives - not as simple as stocks
      2. The public mistrusts these markets that they don’t understand
         1. They think of them as playgrounds for the rich
         2. “The markets are not a game”
         3. Storing grain is a vital part of the industry
         4. American respondents to Shiller’s survey actually thought it would increase shortages (storage)
         5. “People are worried about the value of their houses, they may end up trading in the future market but as of yet they haven’t done that.”
         6. We have no explanation for why some markets exist and others don’t.

         
         
         
         
         

      3. Public Lack of Appreciation of Derivative Markets
         1. A derivative market is a market in another market. There is some “underlying market”
         2. Charles Conant “Wall Street and the Country” “The Function of the Stock and the Produce Exchanges” 1904

         
         
         
         
         

      
      
      
      
      

   2. First Futures Market: Osaka
      1. Begun at Dojima, Osaka, Japan, in the 1670s. World’s only futures market until the 1860s.
      2. Dojima was a center for rice trade, with 91 rice warehouses in 1673. Rice is the underlying primary market.
      3. Dojima futures exchange had precise definitions of quality, delivery date and place, experts who evaluated rice quality, and clearinghouses for contracts. These are the derivatives.
      4. Trading floor, daily resettlement, burning fuse, and watermen.

      
      
      
      
      

   3. Futures - “creates a meaningful price and it creates clarity for the future”
   4. Contango - an upward sloping futures curve
   5. Backwardation - a downward sloping curve
   6. The speculator (a noble profession) just has an intellectual curiosity about markets and is thinking broadly on a broad plane and he may actually have wisdom to see that there's something wrong with the price.

   
   
   
   
   

4. Identify the role of regulatory bodies, and forwards and futures.
   1. Most farmers don’t hedge in the futures market due to complexities but the warehouser (storer) always hedges because it’s a tight margin business and they need to know the price they can unload their product
   2. Forward Contract
      1. Forward is just a contract between two counterparties to deliver at a future date (exercise date or maturity date) at a specified exercise price.
      2. Example: Rice farmer sells rice to warehouser.
      3. Example: Foreign Exchange (FX) forward. Contract to sell £ for ¥.
      4. Both sides are locked into the contract, no liquidity.
      5. What will the warehouse think if a rice farmer tries to get out of the contract?
      6. Futures contracts offer some solutions to these problems

      
      
      
      
      

   3. Futures markets
      1. “You want to trade? You can call up a broker tomorrow and trade.”
      2. Futures contracts differ from forward contracts in that contractors deal with an exchange rather than each other, and thus do not need to assess each others’ credit.
      3. Futures contracts are standardized retail products, rather than custom products.
      4. Futures contracts rely on margin calls to guarantee performance.
         1. When an investor uses margin to buy ourselves securities. They are paid for using a combination of his or her own funds as well as money borrowed from a broker.

         
         
         
         
         

      
      
      
      
      

   4. Speculators, they may have a gambling impulse, but on top of that, the speculators that I think of as important are those who think as intellectuals about big-picture drivers of prices, and then they think that this price is wrong today, I can't prove it, but I strongly suspect it's wrong, and I'm just gonna take a position against it, even though I'm not hedging because I don't have any reason. I'm not storing something, I'm not running a business that's vulnerable, I'm just in it because I'm interested in where the market is going.
   5. “If there weren't speculators, I think the markets would be even crazier than they are because there would be nothing tying them (prices?) down accurately.”
      1. The investor receives a margin call from a broker if the securities in the portfolio decrease in value past a certain point. After which the investor must either deposit more money into the account, or sell some of the assets.
      2. Initial margin - the security required to control the trade
      3. Maintenance margin - the margin call margin that you need to add to hold on to the trade or get stopped out

      
      
      
      
      

   6. FX Forwards and Forward Interest Parity
      1. FX Forward is like a pair of zero coupon bonds.
      2. Therefore, forward rate reflects interest rates in the two currencies
      3. Forward Interest Parity:

      
      
      
      
      

   
   
   
   
   

https://lh3.googleusercontent.com/v8...iMTddOoKKpW-un

 

1. Forward Rate Agreements
   1. Promises interest rate on future loan.
   2. L = actual interest rate on contract date
   3. R = contract rate
   4. D = days in contract period
   5. A = contract amount
   6. B = 360 or 365 days
   7. https://lh5.googleusercontent.com/Mc...Bm-gJoGP6tP6Vx

   
   
   
   
   

2. Futures markets reduce the severity of shortages by the mechanism of price discovery - if there’s a drop in the curve the commodity producer will make decisions to reduce risks
3. Buying or Selling Futures
   1. When one “buys” a futures contract, one agrees with the exchange to a daily settlement procedure that is only loosely analogous to buying the commodity. One must post the initial margin with the futures commission merchant.
   2. Usually, one has no intention of taking delivery of the commodity.
   3. Same as when one “sells” a futures contract, no intention of selling the commodity. Again, post margin.
   4. Daily Settlement
      1. Every day, the exchange defines a price called the “settle” price, which is essentially the last trade on that day.
      2. Every day until expiration a buyer’s margin account is credited (or debited if negative) with the amount: change in settle price ´ contract amount.
      3. If the contract is cash settled, on the last day the margin account is credited with (cash settle price-last settle price) contract amount.
      4. If the contract is physical delivery, on the last day the buyer must receive the commodity.

      
      
      
      
      

   
   
   
   
   

4. Arbitrage - Shiller gives the most rambling long-winded and incomprehensible definition of arbitrage I’ve ever heard. Arbitrage is about taking advantage of temporary mispricings between two similar products trading on different markets. Shiller talks about corn futures, and trucks and settlement dates, and S&P index futures but never gets around to defining arbitrage, which makes me wonder if he actually knows what it is.
5. Fair Value in Futures Contract
   1. https://lh3.googleusercontent.com/pZ...WSDaRo6t_zGl63
   2. r = interest rate
   3. s = storage cost
   4. r + s=cost of carry
   5. Futures price is normally above cash price (contango) (otherwise, “backwardation”) (See http://www.indexarb.com)

   
   
   
   
   

6. Arbitrage Enforcing Fair Value
   1. If a commodity is in storage, there is a profit opportunity that will tend to drive to zero any difference from fair value.
   2. If commodity is not in storage, then it is possible that:https://lh3.googleusercontent.com/8T...OGtRZcyJ-6b245
   3. Storage costs can go negative in some situations where a producer wants to ensure that they don’t have a shortage

   
   
   
   
   

7. Nature of Oil Storage
   1. Most stored oil is “moving through the pipeline” of oil tankers, refiners, distributors and retailers.
   2. Estimated oil inventories can be found on web site www.api.com.

   
   
   
   
   

8. Pegging of Oil Prices by Texas Railroad Commission
   1. Founded 1891 to regulate railroad rates
   2. 1917 Pipeline Petroleum Law declared pipelines common carriers under the control of the Commission
   3. Stabilized oil prices until 1970s

   
   
   
   
   

9. OPEC
   1. Organization of Petroleum Exporting Countries established 1960 by Iran, Iraq, Kuwait, Saudi Arabia and Venezuela
   2. Qatar (1961), Indonesia and Libya (1962), Abu Dhabi (1967), United Arab Emirates (1974), Algeria (1969), Nigeria (1971), Ecuador (1973), and Gabon (1975)
   3. OPEC is weak today because of conflict in middle east, hence low oil prices

   
   
   
   
   

10. First Oil Crisis, 1973-4
    1. Arab countries’ retaliation for US support of Israel in YomKippur war 1973.
    2. Triggered sharp recession around the world.
    3. 1973-4 is the second sharpest stock market crash in US history. S&P Composite lost 53% of its real value between Dec. 1972 and Dec. 1974. (Only worse two-year experience was June 1930 to June 1932.)

    
    
    
    
    

11. Second Oil Crisis, 1979-80
    1. 1979: Iranian revolution, expulsion of the Shah of Iran, Ayatollah, capture of US Embassy hostages in Tehran Nov. 1979.
    2. Iran-Iraq war erupts 1980, disrupts oil supplies.
    3. US CPI inflation reached 18%/year in March, 1980.
    4. The “great recession”of 1981-82 is the worst recession since the Depression of the 1930s.

    
    
    
    
    

12. Collapse of OPEC Cartel, 1986
    1. After suffering bombing by Iraq, Iran demands that Iraq be given the same oil export quota as everyone else.
    2. Other arguments about the disproportionate share of some OPEC states.

    
    
    
    
    

13. Government Oil Reserves
    1. Strategic Petroleum Reserve (created 1975) in caverns in Louisiana and Texas – 572 million barrels, only 60 days supply. Not used to stabilize prices.
    2. In 2000, President Clinton established a 2 million barrel heating oil reserve in New York and New Haven to help stabilize US heating oil prices. US consumption of heating oil is about 100 million barrels a year.
    3. Today, heating oil reserve is in Groton CT and Revere MA.
    4. Gov’t has sold from reserves on a number of occasions since 2000 when price triggers were hit.

    
    
    
    
    

14. Persian Gulf War, 1990-1991
    1. August 2, 1990, Surprise invasion of Kuwait by Iraq.
    2. UN Security Council deadline for Iraq to withdraw by January 15 1991.
    3. January 16, 1991 Air bombardment of Iraq and its Kuwaiti positions begins.
    4. February 24, 1991 Allied ground invasion begins.
    5. War is over February 26, 1991.
    6. Brief interruption of oil supplies mark recession: NBER dates July 1990-March 1991.

    
    
    
    
    

15. Second Gulf War Oil Spike
    1. In anticipation of war, oil rises to nearly $36 per barrel February, 2003.
    2. US invaded Iraq, March 19, 2003.
    3. Symbolic end of war: after capture of Baghdad, crowd topples Hussein stature April 8, 2003.
    4. Oil falls to $28 per barrel by April, 2003

    
    
    
    
    

16. Volatile Oil Prices after 2008 World Financial Crisis
    1. In 2008, at height of financial crisis, price per barrel hit $113/barrel
    2. In 2016, oil price fell below $30/barrel
    3. Fracking technology responded to the 2008 high oil prices with a lag

    
    
    
    
    

17. And now (2020) we have oil trading at negative prices. But what is the point of all this oil volatility history? What’s the underlying theme/lesson??
18. Fundamental problem with the oil market - ‘property rights are not clear’
19. “We do have speculator induced volatility, but we also have a price that makes some general sense. It would be much worse without the speculators.”
20. Stock Price Index Futures
    1. Cash settlement rather than physical delivery
    2. Settlement is 250*(Indext -Futurest-1)
    3. Fair value:

    
    
    
    
    

https://lh4.googleusercontent.com/bu...-e9Ja-LBNGDg_a

1. 1. 1. “So the federal funds futures market is watched a lot. Often the people are paying attention to the near-term market. So they're trying to predict the Federal Funds Rate just months into the future. There's a lot of thought that goes into this. So this is a futures market that I think would be filled with a lot of intelligent speculators who want to really hit the target. And as such I think it is a successful market that the price reflecting expectations of future federal funds rate is widely accepted as a barometer of the likely outcome of the next FOMC meeting.”

      
      
      
      
      

   2. Federal Funds Futures Market
      1. Created by CBOT 1988.
      2. Settlement price is 100 minus annualized federal funds rate, averaged over contract month.
      3. Show timing of expected actions of the Federal Open Market Committee.
      4. One-month-ahead forecast errors typically in the ten to twenty basis point range.

      
      
      
      
      

   
   
   
   
   

2. Describe the put-call parity relationship.
   1. Value of an option = intrinsic value
   2. If a call option’s intrinsic value is not greater than the underlying stock the option is worthless on its last day before expiration (out of the money)
   3. If it's in the money on the exercise day, the option is worth the difference between the stock price and the option price. For put options, it's different. This is the right to sell. So you only exercise it if the option price is below the stock price.
   4. Put-Call Parity Relation
      1. A relationship enforced by arbitrage between a put price and a stock price that have the same underlying issue, the same strike price and the same exercise date.
      2. Put option price – call option price = present value of strike price + present value of dividends – price of stock
      3. Price of stock = call price + pdv strike + pdv dividends – put price
      4. For Intel Corp $31.63 strike 27 for r=0, midpoint
      5. (6.05+6.2)/2+27+2.08-(2.62+2.71)/2=$32.54
      6. For European options, this formula must hold (up to small deviations due to transactions costs), otherwise there would be arbitrage profit opportunities
      7. Before expiry options are never worthless, even though its intrinsic value may be worthless
      8. “Here's a good job for you, drop out of college and invest in disparities between put-call parity and you make money for sure. So you might as well just push it to the limit and borrow millions of dollars and just do it on a big scale. So it's so simple and obvious, once you look at it. You can be sure that there are guys out there right now, arbitrageurs making profits from the tiny discrepancies and put-call parity.” But much like the ten dollar bill on the ground example, there are only so many opportunities and they become increasingly difficult to exploit.

      
      
      
      
      

   5. Limits on Option Prices
      1. Call should be worth more than intrinsic value when out of the money
      2. Call should be worth more than intrinsic value when in the money
      3. Call should never be worth more than the stock price

      
      
      
      
      

   
   
   
   
   

Google doc (with additional comments by me)

Robert Shiller's 'Financial Markets' course.
My comments will be in this British Racing Green
More useful stuff (in my opinion) will be in bold.

Week 6
This week was a mega-week with 3 lessons and a lot of videos. Lots of notes, and while it's all quite interesting, it's a lot of reading, even in note-form. The notes about IPOs, order flow are useful and worth knowing though. The notes about Goldman Sach's corporate culture are also illustrative. Next week is the last week and the biggest, then I'll resume reviewing finance books. If you have a request, send it here! Feel free to discuss anything posted here. I feel like I've scared people off with my initial post.

1. Understand the causes and consequences of sovereign default or sovereign debt repudiation. A first look at public finance.
   1. Repudiation
      1. The government announces it will never repay - Russian and Chinese Communist governments repudiated their debt
      2. Rarely employed since lenders will never lend again
      3. Odious debt - debt that is damaging to the borrower
      4. Countries that are in danger of defaulting have to pay higher rates to borrow
      5. A collective action clause (CAC) allows a supermajority of bondholders to agree to a debt restructuring that is legally binding on all holders of the bond, including those who vote against the restructuring. Bondholders generally opposed such clauses in the 1980s and 1990s, fearing that it gave debtors too much power.

      
      
      
      

   2. Carmen Reinhart on Sovereign Default
      1. Public misunderstands default—rarely do governments repudiate entire debt
      2. More common is that governments inflate the currency
      3. Greece defaulted 2015 but it was only partial default and Tsipras promised new austerity
      4. Other hotspots for default today: Ukraine, Puerto Rico
      5. These defaults may follow a cycle

      
      
      
      

   
   
   
   

2. Understand how and why a government can get involved in the corporate sector.
   1. The distinction between Private Sector and Public Sector is Tenuous
      1. Governments all over the world regulate business. Sometimes governments will own shares in private businesses.
      2. Private businesses know they may be nationalized in the future.
      3. “The United States government is the least likely to own shares in business.” HAH!!

      
      
      
      

   2. Fukushima reactors were owned by Tokyo Electric Power Company (TEPCO).
      1. TEPCO is fourth largest electric power company in the world (Symbol TKECF traded OTC in US)
      2. TEPCO was mostly nationalized in July 2012, the government owns 50.11% and can own 88.69% if the government converts preferred shares.
      3. One reason countries have corporate profits taxes is recognizing this limited liability.

      
      
      
      

   3. Bankruptcy Laws Make Govt a Shareholder in All Businesses
      1. Chapter 7 – Liquidation
      2. Chapter 11 – Reorganization
         1. For example General Motors

         
         
         
         

      3. If a company messes up and is sued for damages, the government may pay the damages.

      
      
      
      

   4. Personal Bankruptcy
      1. Every individual is like a business with the government as a partial shareholder, because it allows you to take risks and then declare personal bankruptcy if it goes badly.
      2. Lenders are like shareholders in your personal enterprise • Government is like a shareholder.
      3. “Government as Risk Manager of Last Resort” David Moss

      
      
      
      

   5. Exchanges, Brokers, Dealers, Clearinghouses
      1. Brokers bring together buyers and sellers
      2. A dealer always acts for herself. In other words, as a principal in the transaction for which she makes a markup. So that's a fundamental difference. So if you're buying from a dealer, the dealer owns some of the shares that you're buying. And the dealer sells it to you at a price. There's no commission but the price is higher because you're buying.
      3. Brokers act on behalf of Others as their Agent for which they earn a Commission

      
      
      
      

   
   
   
   

1. A Dealer always acts for Himself, in other words as a Principal in the transaction for which he makes a Markup

1. Dealers
   1. Stands ready to buy and sell at posted prices, bid and asked, profit from bid-asked spread rather than commission.
   2. Analogy to antiques dealers.
   3. Why are antiques dealers’ bid-ask spreads so much wider than stock dealers?
   4. An inter-dealer broker facilitates exchange between dealers.

   
   
   
   

2. Broker-Dealer
   1. A firm doing business as a broker or dealer must register with the SEC as a BD.
   2. A person can never be both a broker and a dealer in the same transaction.
   3. Never make both a commission and a markup on the same trade.

   
   
   
   

3. Why Are there Virtually No Real Estate Dealers?
   1. In US a problem is that dealers pay ordinary income on capital gains. Real estate has to be held for a substantial time between sales anyway, so you could qualify for long term capital gains if not a dealer.
   2. Immobilienmakler in Germany.

   
   
   
   

4. Good & Bad Broker Behavior
   1. Good brokers do not churn.
      1. SEC penalizes “rogue brokers” who churn.
      2. Stockbroker Robert Magnan was convicted of criminal offense of churning, and barred from the securities industry for life, 1999.
      3. Magnan’s clients had an annual turnover rate of 11, and investments would have had to earn an annual return of 50% to pay transaction costs.

      
      
      
      

   
   
   
   

5. Exchanges
   1. The Traditional Four Markets
      1. First Market: NYSE
      2. Second market: NASDAQ National Market (replaced the “pink sheets” in 1971)
      3. Third market: Nasdaq small cap
      4. Fourth market: large institutions trade amongst themselves without the use of a securities firm
      5. New York Stock Exchange, established 1792 by the Buttonwood Agreement among 24 brokers.
      6. Exchanges provide standards and codes of ethics for broker members, standards for stocks.
      7. Exchanges must register and are regulated by SEC
      8. National Best Bid Offer (NBBO) via Intermarket Trading System (ITS)
      9. Regional Exchanges: Philadelphia Exchange, Cincinnati Exchange now National Stock Exchange
      10. Listing requirements for stocks. Delisting too.

      
      
      
      

   2. Information Technology and Exchanges
      1. Stock exchanges did not flourish until the 19th century when basic information technology was developed: cheap paper, typewriters, carbon paper, filing cabinets,
      2. Samuel F. B. Morse (1792-1871, graduated Yale 1810) patents a telegraph 1837 and invents Morse Code, famous demonstration 1844, “What hath God wrought?”
      3. Morse College

      
      
      
      

   3. Markets to Lend (Not Sell) Shares
      1. “Loan Crowd” on floor of NYSE 1926-33 led active market
      2. Wall Street Journal reported “Loan Rate” often negative (Charles Jones & Owen Lamont)
      3. J. Edgar Hoover, Crash of 1929

      
      
      
      

   4. Why Does Listing Matter
      1. A paper by our former student Ning Zhu and two coauthors at Tsinghua University “Does the Location of Stock Exchange Matter?
      2. Finds that Chinese investors tend to trade stocks that are locally listed.
      3. Stocks co-move more with co-listed stocks.
      4. No information advantage.
      5. “non-information-based familiarity bias”

      
      
      
      

   5. Limit Order Book
      1. Quotes come from all registered users - shows examples of level 2 quotes, but there’s not much to latch on to here.

      
      
      
      

   6. High frequency trading
      1. High Frequency Trading
         1. Computer programs can trade algorithmically
         2. Trades can be flashed for a millisecond, and only computers will respond
         3. Speed of transmission matters
         4. Fully automated markets gaining ground over less automated markets such as NYSE
         5. “Not really socially viable” but not a big issue because it’s ‘only billions of dollars a year’

         
         
         
         

      
      
      
      

   7. Payment for Order Flow
      1. Brokers drum up orders, deal with customers.
      2. Brokers sell the order flow to crossing networks, who profit from the order flow.
      3. Not outlawed for fear of creating exchange monopoly power and it might increase the bid/ask spreads demanded
      4. Broker must disclose what they’re paying and report execution quality
      5. November 2000 SEC posted rules that brokers must post composite statistics on fraction of order flow going to various places.
      6. Firms must also report statistics on their order-execution quality.

      
      
      
      

   8. Kinds of Orders
      1. Market Order
      2. Limit Order
      3. Stop Loss Order – Market orders dangerous for thinly-traded stocks – ECNs may not allow market orders

      
      
      
      

   
   
   
   

1. Identify how local governments typically make use of the money generated by municipal bond issues.
   1. Basic Motivation of Local Debt
      1. People move in and out of locality, sometimes there is a reasonable prospect of future population inflow.
      2. With steady population growth, cities should borrow to finance construction of roads, sewers, etc. to be ready for them, and THEY SHOULD PAY FOR IT WHEN THEY ARRIVE by paying taxes to pay the debt.

      
      
      
      

   2. State Constitutional Prohibitions against Deficit Spending
      1. Connecticut adopted a constitutional amendment in 1991 against deficit spending on the general account at time that it instituted a state income tax (Gov Lowell Weicker’s greatest achievement, was not re-elected).
      2. Can still run a deficit on capital account.

      
      
      
      

   3. Revenue Bonds
      1. If the city issues debt, why doesn’t it issue equity?
      2. It does with revenue bonds, but only when they are doing a project that yields them improvements.

      
      
      
      

   4. Chapter Nine Bankruptcy for Municipalities
      1. Between April 29, 1975 and January 29, 1980, 34 petitions from 30 different state legislatures were submitted to Congress on the subject of a Balanced Budget Amendment.” For the federal government no amendment followed.
      2. Schuldenbremse (debt brake) was adopted in Germany in 2009.
      3. Switzerland adopted too (Wikipedia).

      
      
      
      

   5. You go to the mayor or the governor of the state and you say, "I have an idea that can be financed by revenue bonds." Now governors like this better when you come and say, "It's an idea for something you can do and you don't have to raise taxes. You can issue revenue bonds." It sounds more saleable. So remember, revenue bonds, that's an alternative to your budding dreams of becoming an entrepreneur. You can participate in local government in an entrepreneurial-like activity.

   
   
   
   

2. Understand why and how governments got involved in insurance which thus became part of public finance.
   1. Origins of Social Insurance f
      1. German social thinkers in 1870s: Lujo Brentano, Gustav Schmoller, Adolph Wagner. Stressed insurance principles.
      2. Otto von Bismarck’s government: instituted sickness insurance (Krankenversicherung) 1883, accident insurance (Unfallversicherung) 1884, old-age insurance (Invaliden und Altersversicherung), 1889.
      3. Unemployment insurance, UK, Lloyd George, 1911.

      
      
      
      

   2. Gustav Schmoller Reviews 19th Century “The triumph of insurance in every imaginable area was one of the century’s great advances in social progress. It was an entirely logical development that insurance spread from the upper classes to the lower classes, that it had to attempt, as far as possible, to eliminate poverty; and that the older charitable relief funds for the workers were more and more constructed on the sound principle of insurance.”
   3. Social (Governmental) Insurance
      1. Progressive Taxes (US 1913)
      2. Free public education and services
      3. Social Security: OASDI, Old Age, Survivors and Disability Insurance (US 1935)
      4. Health Insurance: Medicare, Medicaid (US, both 1965) US is the only major developed country without comprehensive health insurance.
      5. Workers Compensation (US before 1920)

      
      
      
      

   4. Failure of First US Income Tax
      1. After the Civil War, compliance declined, estimated that in 1872 only 10% of eligible taxpayers actually paid.
      2. Failure attributed to “incapacity of the lower officers and dishonesty of the higher ones.” (Harry Smith, The United States Federal Internal Tax History from 1861 to 1871, 1914. 94 282-96.
      3. Tax rescinded 1872

      
      
      
      

   5. “Well, so why does the government get involved with these things? Well I think it has to do with the private sector can manage certain things well, but not everything. And it's hard to sell some of these to the public. They're mistrustful.”
   6. The church provided insurance. The earliest insurance contracts seemed to be religious documents.
   7. Withholding of Income Taxes
      1. Important human engineering element of income tax system
      2. Endowment effect Thaler
      3. Fairness issues
      4. Underground economy flourishes where withholding is impossible.

      
      
      
      

   8. Survivors Insurance
      1. Created in 1939 Amendments to the Social Security Act
      2. Government life insurance
      3. For most people, bigger than their life insurance
      4. Surprising lack of opposition from the insurance industry in 1939 because of...
      5. Framing: calling it survivors insurance

      
      
      
      

   9. Recap
      1. Public finance shares many aspects of private finance and insurance.
      2. Finance is always about incentivization in a risky world, people have purposes and fears, and they choose alternative financing methods to achieve them.
      3. First principle of this course: you should have purposes beyond making money, beyond abstract finance.

      
      
      
      

   
   
   
   

3. Describe what nonprofit organizations are and illustrate some of their purposes and motives.
4. Understand the role of investment banks and underwriting and their influence.
   1. Investment Banks
      1. Don’t accept deposits, not member of FDIC
      2. Don’t make loans
      3. Underwrite securities
      4. Difference in US between Investment Banks and Commercial Banks
         1. Investment banks do not accept deposits, and have not been regulated as banks
         2. Investment banks traditionally are not members of the Federal Reserve System, and do not normally access discount window
         3. Investment banks underwrite securities rather than make loans

         
         
         
         

      5. Traditional US bulge-bracket firms:
         1. First Boston (acquired by Credit Suisse),
         2. Goldman Sachs (now a bank holding company),
         3. Merrill Lynch (now part of Bank of America),
         4. Morgan Stanley (now a bank holding company),
         5. Salomon Brothers (merged into Citicorp),
         6. Lehman Brothers (bankrupt 2008).
         7. Originally were usually partnerships, but partnership form has been disappearing, resulting in greater risk taking and crisis.

         
         
         
         

      
      
      
      

   2. Finance is a technology - it exists to do good even if the public perception is dubious
   3. Underwriting of Securities
      1. Underwriting Syndicate
         1. “An underwriting syndicate is a band of investment banks and broker dealers who come together to sell new offerings of equity or debt securities of a firm to investors when the issue is too large for a single firm to handle. The syndicate takes on inventory risk by committing to purchase the full issue upfront, and selling it afterwards to investors in the market. It is compensated by the underwriting spread, which is the difference between the price paid to the issuer, and the price received from investors.”

         
         
         
         

      2. Issuance of shares and corporate debt
         1. Seasoned issue versus IPO
         2. Underwriter provides advice for issuer, distribution of securities, sharing of risks of issue, and stabilization of aftermarket.
         3. Underwriter also “certifies” the issue by putting its reputation behind the issue.
         4. Investment banks have a consulting function too, with an ‘army’ of advisors

         
         
         
         

      
      
      
      

   4. Moral Hazard Problem Mitigated by Investment Banks
      1. Firms have incentive to issue shares when they know their earnings are only temporarily high.
      2. This problem can be “solved” by resorting to bank loans instead of new equity
      3. The problem can also be solved by issuing security with an investment bank that has a reputation to protect.
      4. Studies show that investment banks that repeatedly underprice or overprice issues suffer a market share loss afterwards.

      
      
      
      

   5. Two Basic Kinds of Offerings
      1. Bought deal (synonym: Firm commitment offering): The underwriter agrees to buy all shares that are not sold
      2. Best efforts: the underwriter says that if the issue is not sold, the deal collapses.

      
      
      
      

   6. The Underwriting Process
      1. Pre-filing period
         1. Advise issuers about their choices
         2. Agreement among underwriters, designates manager, fees
         3. Filing of registration statement with SEC, begins cooling-off period
         4. Cooling off period – distribute preliminary prospectus (red herring), nothing else

         
         
         
         

      2. Call prospective clients for indication of interest
      3. Due diligence meeting between underwriter and corporation
      4. Decide on offering price, underwriting agreement, which underwriter sells what
      5. Dealer agreement, dealers purchase from underwriters at a discount from public price
      6. Effective date
      7. Support the price in the aftermarket

      
      
      
      

   7. Stabilization
      1. A form of market manipulation by the underwriter near the time of the issue that is permitted by the SEC
      2. Underwriting syndicate legally allowed to conspire to “fix” prices in market until entire issue is sold out - they can purchase flagging securities to cause the price to rise and keep early investors happy with the underwriter
      3. From a 1929 Textbook on Investment Banking: “In floating any new issues of securities, therefore, the seller desires to have conditions so shaped that the price of the issue will remain stable, or perhaps it will rise slightly, during the period in which the securities are being absorbed by the market. . .establishing a favorable psychological attitude of investors. . The term manipulated market is not altogether a misnomer.”

      
      
      
      

   8. Initial Public Offerings (IPO)
      1. Price tends to jump up immediately after an IPO is issued.
      2. Apparently leaves money upon the table.
      3. Poor Long-Run (average) Performance of IPOs: Jay Ritter, Journal of Finance, 1991. Although the average IPO earns a +16% return on its first day, this return tends to be offset over the next three years.
      4. Why? Impresario Hypothesis: analogy to sellers of tickets to concerts. The promoter has to hype their act, and underprice the tickets somewhat so that you get lineups and fill the halls, ‘create buzz’. Once the buzz dies down prices subside to a baseline. Is this a reversion to the mean?

      
      
      
      

   9. Goldman Sachs
      1. Charles Ellis - The Partnership
         1. “Making money—always and no exceptions—was a principle of Goldman Sachs. Nothing was ever done for prestige. In fact, the most prestigious clients were often charged the most.
         2. “Absolute loyalty to the firm and to the partnership was expected.
         3. “Personal anonymity is almost a core value of the firm.” p. 3569
         4. Ellis -“The real culture of Goldman Sachs was a unique blend of a drive for making money and the characteristics of “family” in ways that the Chinese, Arabs, and old Europeans would well understand.” location 3548
         5. Loyalty to the firm is not among Whitehead’s principles.

         
         
         
         

      2. John Whitehead’s Goldman Sachs Principles (orig 1970s)
         1. 1. Our clients’ interests always come first
         2. 2. Our assets are people, capital and reputation
         3. 3. Uncompromising determination to achieve excellence in everything we undertake
         4. 4. We stress creativity and imagination in everything we do
         5. 5. (Whitehead, 1922-2015, was chairman of Goldman Sachs for 38 years)

         
         
         
         

      3. Whitehead’s Guidelines
         1. “The boss usually decides—not the assistant treasurer. Do you know the boss?”
         2. “You never learn anything when you’re talking
         3. “The respect of one person s worth more than acquaintance with 100”
         4. “There’s nothing worse than an unhappy client”

         
         
         
         

      4. And there was just a settlement in the news the other day about Goldman had to pay $5 billion for dishonest marketing of mortgage securities, so they've slipped a little bit. Also they lost their partnership structure, which gave it less of a sense of family.

      
      
      
      

   
   
   
   

5. Explain why rating agencies exist.
   1. Rating Agencies as Barriers to Adverse Selection
      1. Henry Varnum Poor published a book in 1860, History of Railways and Canals in the United States
      2. John L. Moody (1868-1958), founded the first rating agency 1909
      3. Gave letter grades. AAA is best rating
      4. Poor’s 1916, merged with Standard Statistics in 1941 to become Standard & Poor’s
      5. In his 1933 book The Long Road Home Moody described his moral mission
      6. Agencies would not accept money from the people they rated.
      7. That broke down in the 1970s.
      8. Part of the financial crisis is the agency problem that developed.
      9. Rating agencies gave AAA ratings to CDOs holding subprime mortgages, now a scandal.
      10. Commercial banks are an older solution to the agency problem.

      
      
      
      

   2. Moody - "I always, like any other young person, wanted to become a millionaire someday," but he said, "you know, I had other impulses, as well. And one of my impulses was to tell the truth and tell everybody I don't feel like someone who should keep secrets. I wanted to publish it and get it out there and those bastards who were playing tricks, they'll be exposed everywhere."

   
   
   
   

6. Name and describe the key feature of the Glass-Steagall Act.
   1. Glass-Steagall Act 1933
      1. The modern concept of “Investment Bank” was created in the Glass-Steagall act (Banking Act of 1933). Glass Steagall separated commercial banks, investment banks, and insurance companies.
      2. Carter Glass, Senator from Virginia, (Henry B. Steagall Rep from Alabama) both Democrats believed that commercial banks securities operations had contributed to the crash of 1929, that banks failed because of their securities operations, and that commercial banks used their knowledge as lenders to do insider trading of securities.
      3. Same act created FDIC
      4. “You cannot be both an investment bank and a commercial bank”

      
      
      
      

   2. Repeal of Glass Steagall
      1. Other countries (Germany, Switzerland) have always allowed universal banking.
      2. In the 1990s, regulators nibbled away at Glass Steagall by allowing commercial banks to engage in certain securities operations.
      3. President Clinton November 1999 signed the Graham-Leach Bill which rescinded the Glass-Steagall Act of 1933. This led to a wave of mergers.

      
      
      
      

   3. Mergers among Commercial Banks, Investment Banks & Insurance Companies
      1. Travelers’ Group (insurance) and Citicorp (commercial bank) 1998 to produce Citigroup, on anticipation that GlassSteagall would be rescinded. Brokerage Smith Barney
      2. Chase Manhattan Bank (commercial bank) acquired JP Morgan (investment bank) (2000) for $34.5 billion
      3. UBS Switzerland bought Paine Webber (brokerage) 2000
      4. Credit Suisse bought Donaldson Lufkin Jenrette (investment bank) 2000

      
      
      
      

   4. Volcker Rule Goes Into Effect Oct 2011
      1. Commercial banks cannot directly own hedge funds or other risky investments, they can still underwrite securities
      2. Paul Volcker (former Fed chairman) proposes 2009 that we restore Glass Steagall in the sense that commercial banks no longer be allowed to own hedge funds or do proprietary trading
      3. Incorporated into Dodd Frank Section 619

      
      
      
      

   
   
   
   

7. Explain the biggest assets and liabilities in US households.
   1. II. Professional Money Managers and their Influence
      1. Assets of US Households & Nonprofits (Table B-101) 2015 in $Billions
         1. Real estate $25276
         2. Pension funds $20972
         3. Equity in non-corporate business $10739
         4. Deposits $10693
         5. Corporate equities $13311
         6. Mutual funds $8119
         7. Consumer durables $5240
         8. Treasury Securities $1272
         9. Corporate and foreign bonds $296
         10. Municipal bonds $1515
         11. Life insurance $1331
         12. Other (???)
         13. Total $101,306 (Billions) so $101T

         
         
         
         

      2. Liabilities & Net Worth of US Households & Nonprofits (Table B-101) 2015 in $Billions
         1. Home mortgages $9491
         2. Consumer credit $3533
         3. Loans & other $1486
         4. Total liabilities $14510
         5. Net worth = $101306-$14510=$86, 796T
         6. (Per capita net worth $270,000)

         
         
         
         

      3. But I have to qualify that, you remember we have great income inequality in the United States. So that's the average household. The median household would be much lower than that and the bottom ten percentile would have assets of just about zero.

      
      
      
      

   2. Mutual Fund History
      1. Goetzmann says first mutual funds appeared Holland, 1770s (p.382) Eendraght Maak Magt
      2. In 1920s, many investment companies bilked small investors • Massachusetts Investment Trust (MIT) in 1920s had only one class of investors, published portfolio, redeemed on demand
      3. Became model for mutual fund industry
      4. Investment Company Institute

      
      
      
      

   3. ETFs vs. Mutual Funds
      1. First Exchange Traded Fund: Standard & Poors Depositary Receipts (SPDRs, Spiders), AMEX 1993
      2. SPDRs hold portfolio of S&P index
      3. Management fee: low, like 12 basis points
      4. Automatic creation and redemption
      5. QQQs, I-Shares
      6. Mutual funds are called open-end funds because you can pull your money in and out. You're owning a share in a portfolio, and you can get it out at market value at 4:00 pm every day.
      7. A closed-end fund is different from a mutual fund in that you buy a share in the fund on a stock exchange. That closed-end fund then is a share that you can't go back to the fund and say, "I want my money back." The fund invests the money, and it pays dividends out, but it doesn't redeem. It has an IPO. It issues shares and drops them on the market, but you can't go back to them and ask for it. Instead, you have to sell your shares.
      8. Now, the advantage to closed-end funds over mutual funds is that closed-end funds are trading continually all day long. So if the market is crashing in the morning, you don't have to wait until 4:00 pm to get your money out.
      9. The disadvantage of a closed-end fund is that it doesn't track the value of the underlying assets necessarily because it has its own market, and sometimes they sell at premiums and sometimes they sell at discount.

      
      
      
      

   
   
   
   

8. Describe the prudent person rule and the role of financial planners and advisors.
   1. “... with the care, skill, prudence and diligence under the circumstances then prevailing that a prudent man acting in a like capacity and familiar with such matters would use in the conduct of an enterprise of a like character and with like aims. It's the strangest regulatory demand, but it's telling investment managers to do what somebody else would do in this circumstance.”
   2. Employment Retirees Income Security Act (ERISA, 1974): Prudent Man
      1. As stated in the prudent man rule, found in ERISA Section 404(a)(1)(B), fiduciaries must act:
         1. With the care, skill, prudence and diligence under the circumstances then prevailing that a prudent man acting in a like capacity and familiar with such matters would use in the conduct of an enterprise of a like character and with like aims.

         
         
         
         

      
      
      
      

   3. Dodd-Frank Act 2010
      1. Dodd-Frank never refers to the “prudent person” but does refer to “prudential standards” 34 times. The new idea is not to rely on fiduciaries to use their own judgment as to what is prudent, but to impose regulatory standards.

      
      
      
      

   4. Financial Advisors
      1. Anyone who advises others on the value of securities or advisability of investing, or who publishes analysis
      2. Excludes bankers, lawyers, reporters, professors
      3. Excludes Broker Dealers whose advice is only incidental to their business

      
      
      
      

   5. National Securities Markets Improvement Act of 1996 (NSMIA)
      1. All advisors managing more than $30 million must register with the SEC.
      2. Those managing less than $25 must register with the state securities regulator.
      3. The act does not mention “prudent person” but does bar convicted felons from serving as an adviser.

      
      
      
      

   6. Financial Planners
      1. Comprehensive planning for life, rather than just picking stocks • Not regulated, not licensed in most countries
      2. In U.S., financial planners must be registered as a financial advisor first.
      3. In US, Financial Planning Association, FPA.ORG
      4. Certified Financial Planner (CFP) designation, awarded by Certified Financial Planner Board of Standards, Inc.
      5. Dodd-Frank asks only for a “study of financial planners” (comptroller general) and recommendations for possible regulation

      
      
      
      

   7. We have organizations like the Financial Planning Association, which certifies people as Certified Financial Planners. The Dodd-Frank Act, even though it's 1,000 pages long, asked for only a study of financial planners.
   8. Then you might think that financial advisor would be one of the last jobs that a machine would replace. But it is happening. And the machines, you know, I guess an adviser always asked similar questions: what's your risk tolerance? What are your goals in life? How old are you? Things like that. Well, a machine can answer them and give stock answers as well. This is a big trend in our society and it's replacing a lot of jobs.
   9. But I'd like to see some payment for financial advice to lower income people.

   
   
   
   

Google doc (extra comments and footnotes)

Robert Shiller's 'Financial Markets' course.
My comments will be in this British Racing Green
More useful stuff (in my opinion) will be in bold.

Week 7

Last week of the course. I powered through this so that I could enjoy the weekend 'social distancing', hopefully outside though. This course earned some scathing reviews, mostly for being disorganized I think, (which it was) but I feel like I learned at least a few things. At least I have a sense of what economists think is important, and I saw how they attempt to justify their hoarding and careerist tendencies by looking at ways to make developed economies more 'financial', more leveraged and greedier. Overall I thought Shiller was an engaging fellow but I can see why he prefers the academic side of the business.

Next week - Nassim Taleb's 'Fooled by Randomness' which nearly everyone on this forum, and most traders dearly need to read or at least understand, but which few will and even fewer will take its central warning seriously.

1. Illustrate the potential impact of future demographics on economics and finance.
   1. Thomas Malthus 1766-1834
      1. “An Essay on the Principle of Population” first edition 1798, 6th & last 1826
      2. From the first edition: “ . . . population, when unchecked, increased in a geometrical ratio; and subsistence for man in an arithmetical ratio.” “That population, when unchecked, goes on doubling itself every twenty-five years or increases in a geometrical ratio.”
      3. Malthus is much maligned because he got his estimates so wrong (predictions about the future, etc.) but his base case still stands I believe. There is a finite limit to planetary resources and population. We are butting up against it now and have been since the industrial revolution.
      4. “Malthus may be right in the really long run. Talking centuries”. Really? Come to 2020 and tell me that.
      5. “Quotes from Malthus 1st Ed.
         1. In the next twenty-five years, it is impossible to suppose that the produce could be quadrupled. It would be contrary to all our knowledge of the qualities of land.
         2. “no possible form of society could prevent the almost constant action of misery upon a great part of mankind, if in a state of inequality, and upon all, if all were equal.”

   2. There will be Wars & Chaos
      1. There is no world government, never will be
      2. Organizations like the United Nations, G20 nations, are tenuous
      3. Try not to think of finance as something run by the government
      4. Regulations represent a common consensus, and will survive changes in government

   3. Finance Survives Changes in Government, Religion
      1. Example: World War I, German stocks, reparations
      2. In Iran, after Ayatollah Ruhollah Khomeini displaced the shah in 1979, the new radical Islamic government made good on the pensions that government employees had been awarded under the Shah.
      3. In South Africa in 1994, after a fundamental turnover of the government from whites to a black majority at a time of great bitterness due to a history of repression and apartheid, financial securities, insurance, and pensions were not confiscated

   4. Of Course, Wars Can Disrupt Finance
      1. Socialist theory allowed Vladimir Lenin, Lazaro Cárdenas (Mex), Mao TseTung, Mohammed Mossadegh (Iran), Gamal Abdul Nasser, Indira Gandhi, and other leaders to justify major confiscations of property and nullifications of financial arrangements
      2. After World War II, US government forced the zaibatsu (the big four are The Big Four zaibatsu (四大財閥? , shidai zaibatsu) of Mitsubishi, Mitsui, Sumitomo and Yasuda) to sell their assets & invest in nominal yen bonds
      3. “So I think a war is kind of risky, ought to be very risky for financial contracts, but it isn't always the end of them because of underlying there is a certain civil society that respects individuals and thinks that individual signed contracts, they acquired property by buying it, by working hard and earning money and buying it. Why would you just abrogate those contracts after a war?”

2. Explain a new and popular alternative to nonprofit organizations and cooperatives: benefit corporations.
   1. Benefit Corporation
      1. First such corporation created in Maryland, 2010
      2. Now 11 30 states have them
      3. Company charter must state a social or environmental purpose, and is required to pursue that as well as profit
      4. Halfway between for-profit and non-profit
      5. Example: Grower’s Secret and NPK balance of planet
      6. It's for profits and for some social or environmental purpose that is stated in the company's charter.

   2. The Future for Philanthropy
      1. As years go by, new financial forms will be developed
      2. Psychology, neuroscience will play a fundamental role
      3. Leads ultimately to more satisfying lives
      4. “So these are growing rapidly, it's still too soon, it's only at six years now. It's still soon to see whether they'll be a success. I'm thinking that they may well be a success.”

3. Describe the motives behind cooperatives and their differences with profit and nonprofit organizations.
   1. Jointly owned businesses controlled by consumers, producers, workers
   2. It's a business that may distribute profits. So, it is not a non profit, but it doesn't do it in the same way. The voting system is different, that is it's one person, one vote. So in a sense, this allows it to be taken over by someone with very little money. But the assumption is, that it won't happen and it will bring idealists together.
   3. Rochdale Society
   4. https://lh6.googleusercontent.com/j4...DcvKDoOpY9spIH
   5. Yale Cooperative Society 1885
   6. “They have a funny habit of failing, cooperative societies.”
   7. Need to charge higher prices or lower wages (Why?)
   8. Aim is to maximize the welfare of the group

4. Describe what nonprofit organizations are and illustrate some of their purposes.
   1. Nonprofit organizations
      1. In 2013, there were 1.41 million nonprofits in the U.S., their revenues amounting to 5.4% of U.S. GDP.
      2. 10.2% of the U.S. workforce (including volunteers) in nonprofits in 2013 (7.4% in 13 countries for which data are available).
      3. This does not include government employees, another 16.5% of the U.S. workforce in 2013.
      4. Non distribution constraint. Effectively, there are no owners. Tax exempt. Board of trustees appoints their own successors.

   2. Percentage of Workforce in Nonprofits by Country 2013
      1. Israel 12.7%
      2. Australia 11.5%
      3. Belgium 11.5%
      4. New Zealand 10.6%
      5. United States 10.2%
      6. Japan 10.0%
      7. France 8.9%
      8. Norway 8.2%
      9. Portugal 4.4%
      10. Brazil 3.7%

   3. Nonprofits in History
      1. Darwin is said to have been an independent scholar, but he studied at a university (Christ’s College Cambridge) and he was financed by private citizens who believed in him.
      2. His botany professor John Stephens Henslow helped him get financing for his 2-year Beagle expedition.
      3. Henslow saw scientific work as religious natural theology, and was passionate about Darwin’s ideas, in a way that would not fly if one asked Parliament to fund it.

   4. Nonprofits Give Bonuses Just as For-Profits
      1. 42% of all nonprofits have a formal executive bonus system in place (2007-2008), and the percent is increasing.
      2. Nonprofits have to compete with for-profits.

   5. Why Set Up a Nonprofit?
      1. It may not be much different to you than setting up a for profit, and it gives you the moral high ground.
      2. Peter Tufano, HBS, Doorways to Dreams, Prize-linked savings, tax-time saving .
      3. Dean Karlan here at Yale Innovations for Poverty Action founded 2002. $25 million income 2010, staff of 500 people.
      4. More typical story: You decide that your town needs a hospital. You create a nonprofit hospital. You go to the biggest church or temple in town, ask to use their name and help.

   6. Human Impulse to Hoard
      1. Normal people like to accumulate, a sort of instinct
      2. In extreme form, it is a mental illness, “compulsive hoarding”
      3. DSM-IV calls this a form of OCD, but DSM-V will probably classify it as a separate mental illness

   7. Richistan Chapter on Growing Trend towards Social Entrepreneurs
      1. People with entrepreneurial spirit do not want to stay confined to “politically correct” traditional charities.
      2. Political correctness means, for example, that one might not be able to hire talented people, since it means salaries would seem “unfair.”

   8. “I think ultimately giving away is essential to civil society.”

5. Interpret some of the reasons for wealth, poverty, and inequality.
   1. Animosities due to disparities of wealth are fundamental to most revolutions of our time
      1. “The concern about inequality is increasing dramatically.”
      2. Part of the problem has to do with failure to democratize finance.
      3. Popular theory: inequality is because of political power, evil people
      4. Alternative theory: inequality is due to unmanaged risks

   2. Wealth and Monuments
      1. One can build a monument to oneself, and this can achieve some kind of immortality. For example, arch capitalist J. P. Morgan built his home at 36th and Madison in New York, and from 1906-10 added to it a library, which further housed his art collection. He died in 1913.

   3. Deal Making Trumps Scientist Paradox of Value
      1. That is to the ex-ante benefit of the scientist, who is more focused on making the discovery than on spending the vast wealth it might create, about which he or she has no ideas. Moreover, the scientific community has a pattern of sharing of ideas as they come, incrementally, with the work of many different people, and so they do not readily identify major breakthroughs with any one individual.

   4. Mathematical Finance
      1. The world will never be the same again because of the development of mathematical finance
      2. The theory of allocation of scarce resources was not understood by most people in early 20th century Behavioral Finance
      3. Behavioral finance is the salvation of mathematical finance, for it explains the frictions that inhibit it.
      4. Hardcore mathematical finance people have a tendency to be irrelevant.
      5. Law schools are as necessary as the math, finance people.

   5. Behavioral Finance
      1. Behavioral finance is the salvation of mathematical finance, for it explains the frictions that inhibit it.
      2. Hardcore mathematical finance people have a tendency to be irrelevant.
      3. Law schools are as necessary as the math, finance people.
      4. Interesting that he compares financial theory to Newton, as I’ve mentioned before the science of economics is in its pre-Copernican state, possibly because of a foolish insistence on mathematical definitions for everything
      5. "Don't buy, rent." That means that you are not taking the risk of putting of your own home value collapsing along with your wage.” And what if there is norental property to rent? Landlords don’t want the risk either.

   6. “They talk a lot about, for example, in rural areas there will be a factory set up, and people buy their homes adjacent to an isolated factory that was put there because the people there were low wage and so there was a benefit to hiring there. But now you have a community built around a factory. Then they find, the business finds that it can get an even lower wage in some less developed country so they shut down the factory and leave. The people who were there, unfortunately, didn't have financial contracts to protect them against that risk. So when the factory shuts down, not only do you lose your job, but you lose your house because the house isn't worth anything anymore. People only wanted houses there because there was this factory employment there. I may be giving an exaggerated situation, but people weren't advised about this. You shouldn't buy a house next to this factory because you're staking everything on the success of this factory.”
   7. “So, there is something about allowing people to take risks and make money, and the result is a more lively society at the expense of a more unequal society. So the study that I'm referring to here looked at the primitive societies, and found that some societies are less focused on dealmaking and wealth accumulation, of those that are though, have more inequality and more wealth as well.”

6. Give examples of different critiques of finance and financial markets.
   1. Public vs. Private
      1. “There are historical attitudes that certain kinds of businesses are better run by private and some by the government. So typically, countries have education as a government run [enterprise] more often than they have steel production as government run.”
      2. “It's not just an issue of government versus for-profit, there's also in-between type organizations, like nonprofits. Right here we're sitting in a nonprofit, Yale University is a nonprofit, and this building was the gift of Mr. Evans who was the CEO of Macmillan Publishing.”
      3. “private companies might be more important for more likely to do tricks of the marketing form, of misrepresenting their product, of jumping on. One example that Akerlof and I gave in our book "Phishing for Phools" was of patent medicine before regulation of medicines. So regulations on drugs that could be sold to the public began in various countries around 1900. But before 1900, generally you could sell anything. The only remedy is if you bought some medicine at the drugstore, and you gave it to your child and the child died right after taking it. You could sue them for that. But if it wasn't clear cut like that, they could just keep selling it indefinitely. So most medicines were fake. They didn't test them at all. They just put something on that they claim. It's fraud. But those regulations now are not very controversial. Although, one of Donald Trump's, one of his nominations for the government said that he thought that we should not require proven effectiveness of medicines before they're marketed. Now that is something of a somewhat extreme libertarian view.”

   2. Finding your Purpose in a World of Financial Capitalism
      1. Critics 1: Adair Turner Between Debt and the Devil Oct 2015
         1. LSE, FSA, INET
         2. Corporate debt is a kind of “economic pollution” that needs to be taxed

      2. Critics 2: Rana Foroohar Makers & Takers May 2016
         1. Newsweek, Time, CNN
         2. After Steve Jobs death 2011 Apple began borrowing billions
         3. Tax evasion
         4. Is exploitation of tax law inconsistent with creativity in business as she suggests?

      3. “Because we are increasingly living in a world of financial capitalism where things are run along modern financial principles. And you can't escape it.”
      4. That's profits, and wages and salaries in finance. And I hear he's going back to 1850. It was only 1%, this is just for the US here, 1% of US GDP. And it's grown to something like 7%.
      5. ‘Rent seeking’ is a term coined by Anne Krueger, an economist, referring to just grabbing what I can get rather than creating anything.
      6. The business world doesn't always reward the most mathematically sane person.

   3. Finance for the People
      1. Offsetting Adair Turner’s trends are trends towards involvement of broad public
      2. Internet can be a great democratizer
      3. Shiller’s - Finance and the Good Society - listening to it now - it seems to be a ‘weighty’ alternative to this course
      4. Crowdfunding
      5. “Now you notice this (crowdcube) is a UK company not a US company. That's because British regulators seem to be more open to experimentation and the U.S. regulators are more worried about abuse.”
      6. U.S. SEC Final Rules for Equity Crowdfunding 2016 “Permit a company to raise a maximum aggregate amount of $1 million through crowdfunding offerings in a 12-month period; Permit individual investors, over a 12-month period, to invest in the aggregate across all crowdfunding offerings up to: If either their annual income or net worth is less than $100,000, than the greater of: $2,000 or 5 percent of the lesser of their annual income or net worth. If both their annual income and net worth are equal to or more than $100,000, 10 percent of the lesser of their annual income or net worth; and During the 12-month period, the aggregate amount of securities sold to an investor through all crowdfunding offerings may not exceed $100,000.”
      7. “We live in a better world than before and that involves things like pension plans, health plans, insurance. The other thing is that as it gets more and more, it always impresses me how complicated the financial world really is. So Jamilla and I were talking about the SEC. We need to expand that organization because there's so much more to do in that. I was impressed looking at the proposed rules for crowdfunding that the SEC just issued and it was so long and there were thousands of pages and I thought, can it be that complicated? I started trying to read it and decided that maybe this is awfully complicated.”
      8. It's not about getting rich. It's about making civilization work better. I think that it's good to have a society in which people feel part of the action. Where they're not just, a passive bystander, but they're someone who knows where some insights and where the opportunities are.
      9. I won't be motivated to take a risk on it, unless I feel that I have some ownership of this idea, that it's part of me to understand this kind of thinking.
      10. Transformation of Russia and China - people are more business-oriented
      11. Nudge - Sunstein and Thaler - libertarian paternalism - motivating people to make the ‘right’ decision with subtle coercions rather than direct regulation
      12. “Some people are not too smart”, “history is filled with examples of people not seeing the obvious.”

   4. Examples of the Wonders of Finance: Conservation Foundations
      1. Nature Conservancy
      2. World Wildlife Fund
      3. Wildlife Conservation Society
      4. Specialized charities: – African Wildlife Foundation – Jane Goodall Institute – Diane Fossey Gorilla Fund – Cheetah Conservation Fund

7. Discover possible pathways for financial careers.
   1. So some young people are very idealistic, And might consider eschewing any connection with finance, immediately right now as they're young. But my thought on that is, if you want a perfect career morally, do you really stay out of business?
   2. Bill Gates, Buffett Giving Pledge
   3. Dramatic Change in Finance, our Economy
      1. Experience of last century suggests dramatic changes in the next
      2. Information technology unleashes a cascade of other changes in the economy
      3. Other technology transforms the world economy, creating opportunities and challenges

   4. Risk and Chance over Careers
      1. Century-long personal outlook
      2. Reflections on upheavals in last century
      3. Stock market risk is compounded by individual career risk
      4. Illusion of invulnerability

   5. Desire for Perfect Career
      1. Giving away 90% of my income now, when young, won’t make me very helpful. Must launch out on a career where I make money first.
      2. Bill Gates, Gates Foundation, the largest transparently operated charitable foundation, endowment of $38.7 billion from Gates and Buffett

   6. Muhammad Yunus
      1. Ph.D. economics Vanderbilt 1969
      2. Assistant Professor of Economics Middle Tennessee State University • Founded Grameen Bank 1976
      3. Grameen means “of the village”
      4. He and the bank won a Nobel Peace Prize 2006

   7. The Next Few Decades
      1. The most exciting prospect: the developing world catches up
      2. Financial Markets will be everywhere, dominating people’s lives
      3. Financial booms and crashes will be even bigger than before
      4. Worse things have happened in history!

   8. Human Capital, Positioning, and Meaning
      1. The FSB stands for the Financial Stability Board which is an international body that monitors and makes recommendations about the global financial system.
      2. Maintain an orientation towards history in the making, rather than to one’s own point in the life cycle
      3. Maintain human capital, strategically oriented
      4. Maintain humanity in an unforgiving business world

   9. Ecclesiastes IX 11 “I returned and saw under the sun that the race is not to the swift, nor the battle to the strong, neither yet bread to the wise, nor yet riches to men of understanding, nor yet favour to men of skill; but time and chance happeneth to them all.”
      1. What you see is all there is fallacy is probably affecting your thinking (Amos & Tversky), and you're not thinking creatively enough. About how things will be really different in 50 years or 100 years. We have an illusion of invulnerability, but things surprise us.

   10. The book, Fooled by Randomness by Nassim Nicholas Taleb (up next!), have you heard that book? I recommend that, I should have maybe put it on the reading list, but it's about life and chance. If we blame ourselves too much for failures, we let our successes go to our heads, it's largely just randomness. So the question is, what do you do? Well, first of all, you want to study risk management and finance. But more importantly, you have to think about your human capital, your positioning in history. One of the most important talents I think that some people have over others is that they're thinking about how I fit in to historical events right now. Rather than thinking about where I am in my own personal life cycle?

Interviews and guest speakers
Interview with Richard Ferguson
The Carnegie Foundation for the Advancement of Teaching establishes Teachers Insurance and Annuity Association of America (TIAA) to provide guaranteed retirement income and life insurance to educators.

 

1. Millisecond trading again impugned, but it’s not clear why - most of the comments seem complimentary - ‘it dries up small imperfections’.
2. “secular stagnation is the idea that we're going to have 0 interest rates, maybe high unemployment, maybe low growth for decades. >> Right. >> What do you think? >> Well, I am skeptical in part because the history of the idea of secular stagnation started not at Yale, but at Harvard with Alvin Hanson, as you know. >> Right. >> And he proposed that idea shortly after the end of the second World War. Well, it turned out to not be accurate. And so, one of the reasons I'm always skeptical about this theory is I think it under weights the ability of societies to grow, to evolve, etc.”
3. “So what you are doing at TIAA, which I think I applaud, is generating opportunity for real and important diversification. >> That is absolutely right. And what I like about it is this is true not just for the senior faculty at a great place like Yale, etc, but also for the buildings and groundspeople. And we make the same alternative investment diversified portfolio available to everybody.”

Interview with Lei Zhang

1. But I truly believe you have to be a doer. You can't just be a thinker.
2. “It's about spotting those opportunities. It's applying common sense. Sometimes common sense is hard to get by. Now, a lot of people have the impression that markets are efficient and that they're so competitive that you can't win at this game, but somehow, you had confidence otherwise. Why didn't you believe this efficient market story? >>Right. That was why I went to school here and was taught right market efficiency theory. But at same time, it's a dynamic concept. There were so many conditions and assumptions on that market efficiency. And I think the opportunity I spotted back then about China's investment opportunities was so big. It was such a transitional economy that over time actually I developed my theory. Initially, I thought of myself as a value investing, as conventional sense of value investing which is more about discovering value. What are the value? Maybe that discovering various starting from the secret bet, deep value investing. Over time I changed, I would say. I am more not only about discovering value but also about adding value. And also about like investing value not as a static concept, but a dynamic growth concept. So that's my test, if you will, on the value investing. >>But is your twist related to your personal ability to judge people and business ideas? >>Right. Yeah. I think about myself not so much as an investor in a way. So, I think I'm a kind of entrepreneur who happens to be an investor.”
3. “So, you are following something like the Swensen approach? Yes, absolutely. I think in the end about that thinking, about long-term orientation, the focus on equity, focus on the residual free cash flow of the nature of the business and focusing on residual returns. So that's what I learned from David. I mean, those are philosophies, very much the same core philosophy of what do we do. But then, I would say we combine that with actually a lot of Chinese philosophy. One thing I always talk about that then so the Chinese put this in a way talking about, how do you do when thousands of drops of water when you only need a bottle. So, how do you think about that focus? How do you win a conventional markets using unconventional thinking, that's Taoism thinking. There's also the thinking about how do you be focused and also have peace of mind, don't get bothered about the market movement. There are a lot of those philosophies, I would say, combine with what I learned here at school of management and with David Swensen, I would say. So, those form the foundational of my investing philosophy. You've been through some big market movements in China. Right. How did that make you feel? The market was going crazy. It must have seemed that way. Right. Yeah, absolutely. I think that's exactly the opportunity. When there's people chasing up and downs, when the volatility drives so much opportunity for long term investors with long-term orientation, you should have an inherent advantage over other people. I was asked actually to speak with the Chinese [inaudible] Manager Association. They're like, "Lei, we love what you do about long term investing, but how do you make money despite being a long term investor?" But that's he whole point, right? It's like you want to be long term, because that's actually how you think you can make money.”

Georgia Keohane

1. Georgia is executive director of the Pershing Square Foundation, which is a family foundation in New York City that has purposes other than maximization of anyone's fortune. She's also connected with the Columbia University program and social enterprise. But what brings her here most directly is her recent book, Capital and the Common Good which is all about innovative technology in finance.
2. ‘The dismal science’ = economics, coined by Thomas Carlyle
3. 529 accounts = A 529 plan is a college savings plan that offers tax and financial aid benefits.
4. Currently, I am executive director of the Pershing Square Foundation, which is a foundation that uses both grants and impact investments to address issues of health, education, economic, development, social justice. Very happy to save some time at the end to talk to you about both our grant making and our impact investing strategies. But I also teach in the Social Enterprise Program at Columbia Business School and have written a couple of books. One on social entrepreneurship, and one, this one, on innovative finance.
5. [After hurricane Sandy] ...With that degree of damage, the MTA (subway) found itself uninsurable in the traditional insurance markets. And without insurance that meant they couldn't get the subways and buses up and running. And what the folks there did was extremely creative and extremely entrepreneurial and extremely innovative. And they said, you know what, we need to be a little bit untraditional about how we think about insurance. And they went to something called the catastrophe bond markets which is typically used to re-insure insurance companies have typically been used really to protect and ensure private property not public infrastructure. They went to cash rebond markets and pulled like a municipal finance first. I think this was very creative and innovative and led me to think wow. You know maybe there are other people who are thinking really out of the box about ways to take really sort of age old and traditional financial instruments and products and apply them to new circumstances. So I started to look at things like vaccine bonds and green bonds, which aren't always all green, and social impact bonds, which aren't even bonds, and a whole range of financial instruments. And this started to become a book.
6. Financial innovation, I tend to think of as sort of engineering that's really strictly designed to improve market efficiency and to increase profits, and that could be things like speed trading, or subprime mortgages, maybe even payday lending. I mean those are really engineering for engineering's sake, whereas I'd consider innovative finance to finance that's deliberately intended to solve political and market failures and problems to help serve the poor and help meet the needs of the underserved. So we'll see today that things like microinsurance and agriculture are pay-as-you-go financing for solar electricity or ways to make public transportation more affordable.
7. The same thing is true clearly for millions of low income New Yorkers who need to commute. So it's estimated that in aggregate, New Yorkers are overpaying $500,000 a day because they can't afford the upfront costs. And this seems like something that's quite easy to fix. Maybe the MTA should address it. They haven't.
8. o 2007 or so, Safaricom, the telecom company, comes to Kenya, where maybe 75% of the population doesn't have a phone and is certainly unbanked. Fast forward 10 years, now about 80% of the population in Kenya has a mobile phone and using the M-Pesa platform. Pesa is Swahili for money. People are also now enough banked. They have access to the digital payment platform, and by some estimates, 40%, 50% of the Kenyan GDP is flowing through the M-Pesa platform. Kenya's M-Pesa have clearly led the way, other companies have followed, other countries have followed. Were a little bit of a laggard in the US, but we're catching up. What's interesting to me about the M-Pesa story is that while 80% of Kenyans are effectively now banked in some capacity, because of the M-Pesa technology, about that many are also still living off the electrical grid in Kenya. And two billion people, by the way, globally are not on the formal electrical grid. So what does this mean? This means that they are relying on other sources of energy, that are often very expensive and noxious, and, in some cases, toxic. So for example, people are using single use lead batteries or they're using candles, or they're using lanterns or they're using diesel generators. Often, what they're using is kerosene. Kerosene is very expensive, but you can buy in small quantities to make it a little bit less expensive per use. But over time, it's a huge expenditure. It earns. It poisons. It's a major contributor to global warming through CO2. So all around, kerosene is a really bad source of energy. And of course, if you're a Kenyan household, you're spending more than $200 a year which most are on kerosene. You know, it makes perfect economic sense to install a solar panel but only cost a $199. Again, it's the Alice Financial problem. Its the MetroCard problem. Most of those families do not have $199 upfront to make the investments. So people know it makes sense. It's not that people are making bad decisions. They just do not have the upfront cash for car. Again, entered into the Kenyan market and now we're seeing a proliferation of these companies like M-Kopa. Kopa means borrow in Swahili. As you all see Swahili is effectively the language, the lingua franca of innovative finance. And what M-Kopa does, is that not only installs a solar panel in your in your home, but it installs an electronic payment and tracker, so that you can make essentially layaway pay-as-you-go payments for the solar panel in small increments over time. Again, layaway is not new, pay-as-you-go is not new. What's new, and what's innovative is the application to alternative, and ultimately more affordable energy sources for families who wouldn't otherwise be able to make them.
9. Justine Zinkin, Uptown at Neighborhood Trust". And I didn't know Justine but I sort of played along I said, "Yeah of course, I know Justine Zinkin." And then again, hopped in the subway and went uptown to a little bit further uptown to Washington Heights, where Neighborhood Trust is. And Neighborhood Trust turns out to be started life really as a credit union and is now one of the most innovative finance institutions serving the poor certainly in the New York area and even nationally. And the reason Justine has been very successful at least what I was told on the front end was that, she has really been a wizard in helping get technology companies to develop terrific technologies that serve better sort of Fintech for the underserved. So, they use smartphone technologies to let some of their very low income clients do banking. They have a whole range of savings apps on those phones that people can try to save. They have socially responsible credit cards that allow people to start to pay down their household debt. We were discussing these type of Fintech companies earlier, they're even working with employers to think about payroll technology. So, they work with employers to develop essentially software that allows people to get paid when they need the money rather than having to wait a two-week pay period.
10. In some ways, we spend 40 times responding to crises and responding to catastrophes than we do preventing them. So for example, we know that investing in a vaccine is a whole lot cheaper than trying to grapple with the costs of a full-blown disease. Even when we get a full-blown disease, we know that containing a full-blown disease here is a lot cheaper and much more cost effective than when it really metastasizes to a pandemic and trying to contain a pandemic. Responding to drought is easier than when it becomes famine. Job training certainly beats mass incarceration. And even when it comes or maybe especially when it comes to climate change, for example. So, abating climate change or investing in for example, low carbon technologies, as expensive as those are, they're a heck of a lot cheaper than dealing with the catastrophic and very long term effects of climate change. Therefore, really a host of those various political reasons, for economic reasons we don't make those upfront investments.
11. Social impact bonds, not bonds, they're basically public private partnerships that exist as contracts between governments, typically local government, social service provider and an investor. And what they do is focused on prevention in some ways. What they essentially do is, allow the investor, which is often not a commercial investor, but in my experience, in the last several years has typically been a foundation. Loans money, loans working capital effectively to a nonprofit to provide some preventive service. If that preventive service works, so these contracts usually are only over a relatively short time period, maybe a year two or three. If the intervention works, then the government repays the investor. If it doesn't work, the taxpayers, the government, are off the hook for the investment, and the investors lose their investment. -> example of prisons in Peterborough and the recidivism rate.
12. I think the problem or the challenge of green bonds is exactly what you describe. So, the reason people are interested in fixed income products, like bonds in general and then green bonds in particular, is because again, I allude to that social impact bonds. We're talking about which aren't bonds by the way, they're clearly more of an equity structure but their sort of $400 million. We're thinking about fixed income, we're thinking about in the billions and, in some cases, trillion dollar market. So if you want to really think about bringing private capital to bear that sort of where the action is. The problem or the trick as you described is there aren't really standards. So, what makes a green bond? A green bond is a little bit in the eye of the beholder. So, there's no dark green and light green and greenish bonds. Like I said, they're essentially self-descriptions for bond issuances that are for environmental purpose but that environmental purpose could be almost anything at the moment. And the initial green bond movement was led by development finance institutions like the World Bank or the IMF and the IFC. In a few years ago, issuances of green bonds, which by the way this year passed like 150 billion and it was a record, 2017 was record issuances for green bonds. It's now corporates and municipal cities and states that are issuing green bonds much larger than the development finance institutions. But what does that mean? So that means if Toyota issues a green bond, who might issue a green bond to help people buy Priuses. The World Bank is grappling with hydro, big hydro, it's not a green. It's not a green. Little hydro is green. So there aren't necessarily these definitions and every financial institution and every investor is on the one hand saying, we really want to understand what these are really doing and are they really, the yields are ain't different, the returns aren't different than typical bonds. So, how are they different and is there really sort of greenwashing going on here.
13. But people have been concerned that the nonprofit social service provider also needs to have some incentive for performance beyond sort of reputational, et cetera.
14. Some nonsense about Bitcoin thrown in at the end.

Busy couple of weeks dealing with life and my own trades. I developed what I hope will be a killer system, but I've been lucky before, and luck, both good and bad, is a terrible edge. So we'll see. I'm happy that I was finally able to bash my way to some clarity after struggling for several days to figure out what I needed. I had a sense that I was on to something, a sense honed by experience, but my conscious/subconscious mind really had to chew things over before I 'broke through' which is either a sign that this is something significant or I'm just getting old and slow, possibly a bit of both.

Anyway, without further with just a little more ado here are the notes for one of the most important books any trader can read. I enjoy revisiting it as an audiobook while running. The only other trading books that I'd consider re-reading would be the Market Wizard books by Schwager as they're chock full of lessons.

Fooled by Randomness - Nassim Nicholas Taleb

Preface

1. Taleb warns it's just an essay, not a scientific treatise
2. We constantly see the tension that Taleb feels between the 'professional [...] trying to resist being fooled by randomness and trick the emotions associated with probabilistic outcomes and, on the other, the aesthetically obsessed, literature-loving human being willing to be fooled by any form of nonsense that is polished, refined, original, and tasteful.' I get the sense that Taleb resents having to do something as un-artistic as trading to make his money when he'd rather be a fêted author, well, now he's both.
3. This edition has been 'added to by more than a third' specifically in chapter 11 so there's a good reason to revisit it.
4. hindsight bias - past events will always look less random than they are
5. you can mispredict everything for all your life and still think you will get it right next time
6. 'my principal activity is to tease those who take themselves and the quality of their knowledge too seriously.'
7. It certainly takes bravery to remain skeptical; to confront oneself, to accept one’s limitations
8. scientists are seeing more and more evidence that we are specifically designed by mother nature to fool ourselves. Recalls one of my favorite sayings by Feynman.
9. The word 'probability' is used in a literary, qualitative sense, presented as flowing from Hume’s Problem of Induction (or Aristotle’s inference to the general) as opposed to the paradigms of gambling literature.
10. Probability is the acceptance of the lack of certainty in our knowledge and the development of methods for dealing with our ignorance.
11. while we may have some understanding of the probabilities in the hard sciences, particularly in physics, we don’t have much of a clue in the social “sciences” like economics, in spite of the fanfares of experts
12. Taleb is not saying that all successful people are just lucky. Instead, “it is more random than we think” rather than “it is all random.”
13. Of course chance favors the prepared! Hard work, showing up on time, wearing a clean (preferably white) shirt, using deodorant, and some such conventional things contribute to success—they are certainly necessary but may be insufficient as they do not cause success.
14. the fact that every intelligent, hardworking, persevering person becomes successful does not imply that every successful person is necessarily an intelligent, hardworking, persevering person (it is remarkable how such a primitive logical fallacy—affirming the consequent—can be made by otherwise very intelligent people
15. Luck is democratic and hits everyone regardless of original skills.
16. It is not a mistake to use logic without statistics
17. A large population of random investors will almost necessarily produce someone with Warren Buffett's track record just by luck.

Good to learn. Thanks and
Regards

Fooled by Randomness (continued)
Prologue

1. about luck disguised and perceived as nonluck (that is, skills) and, more generally, randomness disguised and perceived as non-randomness (that is, determinism).
2. It manifests itself in the shape of the lucky fool, defined as a person who benefited from a disproportionate share of luck but attributes his success to some other, generally very precise, reason.
3. some primitive tribesman scratched his nose, saw rain falling, and developed an elaborate method of scratching his nose to bring on the much-needed rain, we link economic prosperity to some rate cut by the Federal Reserve Board, or the success of a company with the appointment of the new president “at the helm.”
4. Bookstores are full of biographies of successful men and women presenting their specific explanation on how they made it big in life (we have an expression, “the right time and the right place,” to weaken whatever conclusion can be inferred from them).
5. the economist proudly detects “regularities” and “anomalies” in data that are plain random.
6. Symbolism is the child of our inability and unwillingness to accept randomness; we give meaning to all manner of shapes; we detect human figures in inkblots.

Chapter One - IF YOU’RE SO RICH, WHY AREN’T YOU SO SMART? (Skewness, Asymmetry, Induction)
This is something my dad used to say to me (though in reverse - the ‘original’ saying). Without the money all your book learning smarts are merely decoration. Here, Taleb switches it around and points out that intelligence and wealth are not tightly coupled.

1. Story of Croesus and Solon
   1. Croesus was the richest king of his day
   2. Solon was the Athenian governor - known for his wisdom and moral traits
   3. Croesus was bragging, showing off, and wanted Solon to confirm that he was the happiest man who ever lived but Solon wouldn’t bite
   4. Solon said the equivalent of ‘count no man happy who is not dead’ since fortunes can change’
   5. Legend has it that years later Croesus had lost a battle to Cyrus and was about to be burned alive when he shouted something like ‘You were right, Solon!’ and Cyrus, curious, asked him what he meant. Croesus told him about Solon’s warning and this impressed Cyrus so much he let him go.

   
   

2. An illustration of the effect of randomness on social pecking order and jealousy
   1. Buffett has famously said that it's not money that makes the world go round, it's envy.
   2. Taleb illustrates it by creating two characters that are probably based on himself and someone he used to know.
      1. Nero Tulip is a thinly-disguised Taleb. Kindly, an aesthete with a passion for trading, unkindly, an effete snob of a trader.
      2. Tulip got into trading for ‘entertainment’
      3. Specialized in ‘quantitative financial products’ and was briefly ‘hot’
      4. However to stay in demand requires hunger for power that Nero doesn’t have
      5. Switches to prop trading
      6. Extremely conservative trader: extreme risk aversion; modest but steady income
      7. Loves taking small losses
      8. Skeptical of the whole market so he keeps his own funds in treasuries
      9. Lazy - likes prop trading since it takes less time than other professions
      10. With his free time he can pursue varied interests

      
      

   3. “John” - the high yield trader is Nero’s opposite
      1. Intellectually non-curious. Enjoys wealth trappings like fancy cars, big houses.
      2. His wife is boastful; they like to show off their wealth
      3. Nero is contemptuous of John This insecurity (envy) is a recurring theme in all of Taleb’s books
      4. Psychologists (who?) have shown people would prefer to make less money as long as they are paid more than their peers - this is the ‘pecking order’ theory
      5. Nero suspects John will ‘blow up’ because he has too little experience with the markets and no knowledge of history
      6. John thinks of Nero as an overeducated loser. Naturally or he wouldn’t be a good foil for Nero.
      7. Of course John does blow up, gets fired, loses everything.

      
      

   
   

3. Modern life changes rapidly
   1. Lucky fools do not bear the slightest suspicion that they may be lucky fools
   2. Behavioral scientists believe that one of the main reasons why people become leaders is not from what skills they seem to possess, but rather from what extremely superficial impression they make on others through hardly perceptible physical signals—what we call today “charisma,” for example
   3. You can spot a winning trader by their demeanour; it’s hard to conceal emotions

   
   

4. The concealed rare event
   1. Past events need to be considered in the context of what might have happened in alternate universes. Just because a lucky loser won the lottery doesn’t mean that loser won the lottery in 1000 similar universes.
   2. Dentists are richer than rock stars on average
   3. Myths can be more potent and provide us with more experience than ‘reality’.

   
   

I have uploaded a Google doc that I'll work on in tandem to these chapter updates. They are identical apart from some additional footnotes in the Google doc.

Chapter Two - A BIZARRE ACCOUNTING METHOD

1. On alternative histories,
   1. There is a big difference between earning $10M dollars playing Russian Roulette or earning $10M doing dentistry
   2. Even though, in both cases, you get $10M, in the former case if you keep playing this dangerous game you will eventually lose badly
   3. In order to judge the quality of a decision, we can’t just look at the outcome of the decision - we have to judge what could have happened in an ‘alternative history’.
   4. Probability is a qualitative subject (i.e. not just mathematical)

   
   
   

2. a probabilistic view of the world,
   1. Certainty is something that is likely to take place across the highest number of different alternative histories; uncertainty concerns events that should take place in the lowest number of alt worlds
   2. Philosophy, physics and economics have examined ‘possible worlds’ - Taleb cites Kripke, Everett, Leibniz, Arrow and Debreu
   3. The economic examination is particularly relevant - this analytical approach to the study of economic uncertainty is called the “state space” method—it happens to be the cornerstone of neoclassical economic theory and mathematical finance.
   4. simplified version is called “scenario analysis,” the series of “what-ifs” used in, say, the forecasting of sales under different world conditions and demands
   5. Reality is even more vicious than Russian Roulette since it delivers the ‘bullet’ even more infrequently (in the form of black swans)
   6. ‘Generator’ is the source of income - for example, winning a roulette when there is no bullet in the barrel. Interesting overlap with Mandelbrot’s use of the term ‘generator’.
   7. The generator is rarely visible to the naked eye, we see wealth created, but not the process, and this can make people call something risky by a ‘low risk’ name
   8. People don’t usually see the need for insurance when their factory doesn’t burn down
   9. Taleb sees people distributed across two polar extremes - those who dismiss the notion of randomness and those who are tortured by it
   10. Less introspective people are likely to fall foul of randomness - for ex. The 1980s businessmen who traded exotic options and whose failure rate was very high

   
   
   

3. Intellectual fraud, and the randomness wisdom of a Frenchman with steady bathing habits.
   1. In the 1990s a different type of person came to wall street to try to make it rich
   2. It was said that every plane from Moscow had at least its back row full of Russian mathematical physicists en route to Wall Street (they lacked the street smarts to get good seats). This reminds me a lot of the current state of MQL5.com
   3. The failure rate of these scientists only slightly better than that of MBAs; because on average they were devoid of the smallest bit of practical intelligence
   4. it was as if they understood the letter but not the spirit of the math
   5. Kenny - one of Taleb’s bosses
      1. Calm, measured, presentable, good listener, trustworthy appearance, articulate, charming
      2. Unable to grasp the concepts of survivorship bias
      3. Technically incompetent
      4. Kenny was proud of his trader’s success, pride that Taleb scorns because eventually they all left the business (including Kenny) because they eventually fell afoul of randomness

      
      
      

   6. Jean-Patrice, another boss
      1. Moody, explosive temper, hyper-aggressive
      2. Made his subordinates uncomfortable, anxious
      3. He cared only about the ‘generator’ not the results
      4. A ladies man, frequents nightclubs, often unreachable
      5. Obsessed with hidden risks, encouraged Taleb in his study of randomness
      6. Deference for science and scientists
      7. His career was not as successful as Kenny’s

      
      
      

   
   
   

4. How journalists are bred to not understand random series of events.
   1. It’s tempting to wonder if Caesar, Alexander and other great historical generals were just lucky, while Hitler and Hannibal were simply unlucky
   2. The George Will and Robert Shiller interview
   3. Couldn’t find the actual interview but here is Will’s column about Shiller’s book. http://www.jewishworldreview.com/cols/will051100.asp
   4. Amusingly this column came out Mar 2000 and the big ‘dot com’ plunge started in September, where the S&P went from about 1500 to about 760 so Shiller was exactly right
      Considering how often Shiller is wrong though (about the market since then, about BTC) it’s tempting to assign Taleb’s distaste for Will to his hatred of journalists.

   
   
   

5. Beware borrowed wisdom: How almost all great ideas concerning random outcomes are against conventional sapience.
   1. Kahneman showed that people would rather buy an insurance policy that protected them against terrorist attacks even though such an event is extremely rare
   2. Also in a convention of forecasters, most thought it more likely a deadly flood would occur anywhere but in California, where they were
   3. People are more alert to vivid (‘available’ in availability bias) dangers than abstract ones
   4. scientific fact that both risk detection and risk avoidance are not mediated in the “thinking” part of the brain but in the emotional one (the “risk as feelings” theory).
   5. It means that rational thinking has very little to do with risk avoidance.
   6. rational thinking seems to rationalize one’s actions by fitting some logic to them.
   7. journalism may be the greatest plague we face today—as the world becomes more and more complicated and our minds are trained for more and more simplification.

   
   
   

6. On the difference between correctness and intelligibility.
   1. most poetic sounding adages are plain wrong. Borrowed wisdom can be vicious.
   2. Einstein’s remark that common sense is nothing but a collection of misconceptions acquired by age eighteen
   3. almost all the smart things that have been proven by science appeared like lunacies at the time they were first discovered.
   4. The generator of reality is not observable - so a risk manager’s job is to play politics, even though it appeals to Taleb economically (because risk managers don’t get fired as often as traders), they oscillate between false positives and false negatives
      1. False positive - doctor tells patient they have cancer when they don’t
      2. False negative - doctor tells patient they are healthy when they have cancer
      3. Risk managers need some margin of error in their business
      4. Less to do with actual risk reduction and more to do with the impression of risk reduction

      
      
      

   5. Epiphenomenalism - for Taleb it’s the illusion of cause and effect; by watching risks are you reducing them?
   6. Taleb’s paradox - his business is to help people avoid falling prey to randomness but if everyone wised up he would have no clients.

   
   
   

Chapter Three - A MATHEMATICAL MEDITATION ON HISTORY

 

1. On Monte Carlo simulation as a metaphor for understanding a sequence of random historical events.
   1. Monte Carlo methods consist of creating artificial history (alternative histories) mathematically
   2. invisible histories have a scientific name, alternative sample paths, a name borrowed from the mathematics of probability called stochastics
   3. a sample path can be either deterministic or random
   4. A random sample path, also a random run, is the math name for a succession of virtual historic events from one date to another; the word random does not necessarily mean all paths are equally probable
   5. Body temp during a fever, a casino run, a tech stock price, can all be modelled using monte carlo methods
   6. Stochastic = greek word for random
   7. Stochastic processes refer to the dynamics of events unfolding with the course of time
   8. Monte carlo simulations are computer programs, their casino name is a reference to its casino-like simulations; Taleb calls them ‘toys’
   9. Monte Carlo is brute force; ‘true’ mathematicians don’t like it, says Taleb
   10. Many compulsive gamblers, who otherwise would be of middling intelligence, acquire remarkable card-counting skills thanks to their passionate greed
   11. ‘Quants’, like physicists have more interest in the tool’s usefulness than in the tool itself
   12. The dividend of the computer revolution was in the sudden availability of fast processors capable of generating a million sample paths per minute.
   13. Suddenly, my engine allowed me to solve with minimal effort the most intractable of equations. Few solutions became out of reach.

   
   
   

2. On randomness and artificial history.
   1. Einstein’s article on the theory of the Brownian movement can be used as the backbone of the random walk approach used in financial modeling
   2. Keyne’s Treatise on Probability - he blew up his trading account after experience opulence - people’s understanding of probability does not translate into their behavior
   3. While simulating ‘idiotic bulls’ and ‘impetuous bears’ traders Talebe discovered that options traders have more ‘staying power’ because they can buy insurance against inevitable blowups
   4. “I can no longer visualize a realized outcome without reference to the nonrealized ones. I call that “summing under histories”
   5. Learning from history does not come naturally to us humans, a fact that is so visible in the endless repetitions of identically configured booms and busts in modern markets
   6. Sometimes we fail to learn from our own history too
   7. Characteristically, blown-up traders think that they knew enough about the world to reject the possibility of the adverse event taking place
   8. Things are always obvious after the fact.
   9. Our minds are not quite designed to understand how the world works, but, rather, to get out of trouble rapidly and have progeny
   10. A vicious effect of such hindsight bias is that those who are ‘very good’ at predicting the past will think of themselves as good at predicting the future
   11. Ergodicity: roughly, very long sample paths end up resembling each other. The properties of a very, very long sample path would be similar to the Monte Carlo properties of an average of shorter ones.

   
   
   

3. Age is beauty, almost always, and the new and the young are generally toxic.
   1. Journalists, dealing as they do with ‘new’ things, are generally focused on noise
   2. (on conditional probability) For an idea to have survived so long across so many cycles is indicative of its relative fitness
   3. When in doubt it is better to systematically reject a new idea, always
   4. inference stripped of probabilistic thinking would lead one to believe that all new technologies and inventions would revolutionize our lives. Here we only see and count the winners, to the exclusion of the losers
   5. The opportunity cost of missing a “new new thing” like the airplane and the automobile is minuscule compared to the toxicity of all the garbage one has to go through to get to these jewels (assuming these have brought some improvement to our lives, which I frequently doubt).
   6. Information is generally toxic
   7. a minimal exposure to the media as a guiding principle for someone involved in decision making under uncertainty.
   8. Shiller: Prices swing more than the fundamentals they are supposed to reflect, they visibly overreact by being too high at times (when their price overshoots the good news or when they go up without any marked reason) or too low at others
   9. The ratio of undistilled information to distilled is rising, saturating markets.
   10. Older traders are to be favored over younger since they have survived - survival of the fittest

   
   
   

4. Send your history professor to an introductory class on sampling theory.
   1. A dentist who is a successful investor (95% probability of success in a any year) will be emotionally drained if he checks the performance of his investments every day, (where probability of success is no better than 50%); happier is the one who only checks his portfolio quarterly or less often
   2. Reminds me of “"Progress disappoints in the short run, but surprises in the long run." - Jim Keller
   3. When I see an investor monitoring his portfolio with live prices on his cellular telephone or his handheld, I smile and smile. (Taleb - because the investor is a fool and Taleb’s business is safe)
   4. If an event is important enough - it will find a way to my ears
   5. My sole advantage in life is that I know some of my weaknesses, mostly that I am incapable of taming my emotions facing news and incapable of seeing a performance with a clear head. Silence is far better.

   
   
   

Google Doc (contains my footnotes)

Chapter Four - RANDOMNESS, NONSENSE, AND THE SCIENTIFIC INTELLECTUAL

 

1. On extending the Monte Carlo generator to produce artificial thinking and compare it with rigorous nonrandom constructs.
   1. ‘Originating in Vienna (The Vienna Circle) in the 1930s’ scientists (physicists) wanted to extend their approach to the humanities
   2. They wanted to ‘strip thinking from rhetoric’
   3. They did this by declaring statements could be
      1. Deductive - 2+2=4; incontrovertibly flowing from a precisely defined axiomatic framework (like the rules of arithmetic)
      2. Inductive - verifiable in some manner (experience, statistics, etc.), like “it rains in Spain” or “New Yorkers are generally rude.”
      3. Anything else is ‘music/metaphysics’ i.e. meaningless

   4. a scientific intellectual can usually recognize the writing of another but that the literary intellectual would not be able to tell the difference between lines jotted down by a scientist and those by a glib nonscientist
   5. Fashionable Nonsense by Alan Sokal - seems worth checking out
   6. By dumping the kitchen sink of scientific references in a paper, one can make another literary intellectual believe that one’s material has the stamp of science.
   7. Science is method and rigor; it can be identified in the simplest of prose writing.
   8. Using a monte carlo generator you can generate random ‘literary discourse’ but it is not possible to randomly generate a scientific one

2. The science wars enter the business world.
   1. Some business speeches are just as random and meaningless
   2. Hegel was the ‘father of pseudothinkers’

3. Why the aesthete in me loves to be fooled by randomness.
   1. Taleb can tolerate randomness and deceit in the arts, but not in science

Google Doc (includes footnotes)

Chapter Five - SURVIVAL OF THE LEAST FIT—CAN EVOLUTION BE FOOLED BY RANDOMNESS?

 

1. A case study on two rare events.
   1. On ‘emerging market bonds’ - “Emerging market” is the politically correct euphemism to define a country that is not very developed
   2. Investors rushed into these bonds in the 1990s
   3. emerging market traders are a collection of cosmopolitan patricians from across the emerging-market world that remind Taleb of the international coffee hour at the Wharton School.
   4. They are too conformist to be true leaders
   5. Carlos bought and held bonds based on economic fundamentals. He did not believe it made sense to sell.
   6. He initially did so well that he could not keep up with his capital expansions (the bank’s allocations in his fund)
   7. He bought dips
   8. Summer 1998 the last dip did not translate into a rally. Up to that point he had earned $80M for his bank but he lost $300M in one quarter.
   9. Instead of cutting his losses he listened to excuses from his ‘friendly sources’
   10. His bonds included some of the Russian variety (when Russia defaulted on its debt). Carlos averaged down and he ignored the price in view of the ‘value’.
   11. He gradually lost his composure. Yelling at people in the office. “Stop losses are for schmucks!” “Had we gotten out in October 1997 after our heavy loss we would not have had those excellent 1997 results,”
   12. A trader’s mental construction should direct him to do precisely what other people do not do.
   13. Veteran trader Marty O’Connell calls this the firehouse effect. He had observed that firemen with much downtime who talk to each other for too long come to agree on many things that an outside, impartial observer would find ludicrous (they develop political ideas that are very similar).
   14. “Economics Schmeconomics. It is all market dynamics.”
   15. at any point in time, the richest traders are often the worst traders.
   16. The second case study is ‘John’ but we already know what we need to know about him
   17. John and Carlos share the traits of the acute successful randomness fool
       1. An overestimation of the accuracy of their beliefs in some measure, either economic (Carlos) or statistical (John).
       2. Currencies can be random
       3. Tendency to ‘marry’ their positions
       4. Tendency to change their story - switching between ‘traders’ and ‘investors’
       5. No precise game plan ahead of time as what to do in the event of losses
       6. Absence of critical thinking - no stop losses, not considering their methods of valuation may be wrong
       7. Denial - no clear acceptance of what had happened
       8. One can make money in markets purely from randomness - from market cycles

2. On rare events and evolution.
   1. Bad traders have a short and medium term survival advantage over good traders

3. How “Darwinism” and evolution are concepts that are misunderstood in the nonbiological world.
   1. Jacques Monod bemoaned a couple of decades ago that everyone believes himself an expert on evolution (the same can be said about the financial markets)
   2. Many amateurs believe that plants and animals reproduce on a one-way route toward perfection. Translating the idea in social terms, they believe that companies and organizations are, thanks to competition (and the discipline of the quarterly report), irreversibly heading toward betterment.
   3. Darwinian ideas are about reproductive fitness, not about survival
   4. A regime switch corresponds to situations when all of the attributes of a system change to the point of its becoming unrecognizable to the observer.

4. Life is not continuous.
   1. Viz. Quantum mechanics

5. How evolution will be fooled by randomness.
   1. on average, animals will be fit, but not every single one of them, and not at all times. Just as an animal could have survived because its sample path was lucky, the “best” operators in a given business can come from a subset of operators who survived because of overfitness to a sample path

Google Doc (with footnotes)

Chapter Six - SKEWNESS AND ASYMMETRY

 

1. We introduce the concept of skewness:
   1. essayist and scientist Steven Jay Gould diagnosed with cancer, finds out that the median survival rate and the expected survival rate are very different things
   2. People who die from his type of cancer die quickly but the survivors have nearly the same lifespans as healthy people so the median rate (because of its asymmetry) is misleading
   3. Mean - aka average or expectation
   4. Asymmetric outcomes means the odds of each outcome aren’t equal
   5. Gambling strategy
      1. 999/1000 chance of making $1 (event A)
      2. 1/1000 chance of losing $10,000 (event B)
      3. If we multiply the probabilities by the outcomes we get (0.999x1.00)+(0.001x[-10000])= 0.999 - 10 = -9.001 an expectation of a loss of 9 dollars.
      4. the frequency or probability of the loss, in and by itself, is totally irrelevant; it needs to be judged in connection with the magnitude of the outcome
      5. You’d likely make money playing this game for a while. It’s more likely that you’d win than lose to begin with, but it’s not a good idea to play it at all because when the loss does come it is so severe.
      6. This is a simple point but many in financial markets don’t internalize it
      7. Why do people confuse probability and expectation (probability and probability(payoff))? Because of schooling with symmetric examples says Taleb

2. Why the terms “bull” and “bear” have limited meaning outside of zoology.
   1. bullish or bearish are often hollow words with no application in a world of randomness—particularly if such a world, like ours, presents asymmetric outcomes
   2. Wall Street “economists” or “strategists,” make pronouncements on the fate of the markets, but do not engage in any form of risk taking, thus their success is dependent on rhetoric rather than actually testable facts - Taleb calls them ‘entertainers’
   3. For Taleb the meeting was ‘pure intellectual pollution’.
   4. The story of Taleb explaining that he thought the market would go up but that he had options to short the S&P500. The audience couldn’t figure out what he meant until he said “my opinion was that the market was more likely to go up (“I would be bullish”), but that it was preferable to short it (“I would be bearish”), because, in the event of its going down, it could go down a lot. Suddenly, the few traders in the room understood my opinion and started voicing similar opinions”

3. Rare Events
   1. Taleb’s business in the market is “skewed bets,” that is, rare events that do not tend to repeat themselves frequently, but, accordingly, present a large payoff when they occur.
   2. The rarer the better as human psychology is not equipped to handle them
   3. Even some experienced trading veterans do not seem to get the point that frequencies do not matter. Jim Rogers doesn’t buy options because he found out that 90 percent of all short option positions make money. If he wants to use options to be bearish, he sells calls.
   4. However, the statistic that 90% of all option positions lost money is meaningless, (i.e., the frequency) if we do not take into account how much money is made on average during the remaining 10%.
   5. Taleb is far more aggressive than Nero (who avoids rare events) and goes one step further ; I have organized my career and business in such a way as to be able to benefit from them. In other words, I aim at profiting from the rare event, with my asymmetric bets (crisis hunter)
   6. Many disciplines remove outliers from data as they skew results, but when financiers (and climate scientists) do this they are deceiving themselves since rare events have large effects
   7. Sometimes market data becomes a simple trap; it shows you the opposite of its nature, simply to get you to invest in the security or mismanage your risks.
   8. Currencies that exhibit the largest historical stability, for example, are the most prone to crashes. This was bitterly discovered in the summer of 1997 by investors who chose the safety of the pegged currencies of Malaysia, Indonesia, and Thailand (they were pegged to the U.S. dollar in a manner to exhibit no volatility, until their sharp, sudden, and brutal devaluations).
   9. We could be either too lax or too stringent in accepting past information as a prediction of the future.
   10. things that never happened before in one area (of history) tend eventually to happen
   11. rare events exist precisely because they are unexpected. They are generally caused by panics, themselves the results of liquidations
   12. Common statistical method is based on the steady augmentation of the confidence level, in nonlinear proportion to the number of observations. That is, for an n times increase in the sample size, we increase our knowledge by the square root of n. Suppose I am drawing from an urn containing red and black balls. My confidence level about the relative proportion of red and black balls after 20 drawings is not twice the one I have after 10 drawings; it is merely multiplied by the square root of 2 (that is, 1.41).
   13. statistics becomes complicated, and fails us, is when we have distributions that are not symmetric, like the urn above. If there is a very small probability of finding a red ball in an urn dominated by black ones, then our knowledge about the absence of red balls will increase very slowly—more slowly than at the expected square root of n rate.

1. A vicious child wrecks the structure of randomness.
   1. there is even worse news. In some cases, if the incidence of red balls is itself randomly distributed, we will never get to know the composition of the urn. This is called “the problem of stationarity.” Think of an urn that is hollow at the bottom. As I am sampling from it, and without my being aware of it, some mischievous child is adding balls of one color or another. My inference thus becomes insignificant. I may infer that the red balls represent 50% of the urn while the mischievous child, hearing me, would swiftly replace all the red balls with black ones. This makes much of our knowledge derived through statistics quite shaky.
   2. The very same effect takes place in the market. We take past history as a single homogeneous sample and believe that we have considerably increased our knowledge of the future from the observation of the sample of the past. What if vicious children were changing the composition of the urn? In other words, what if things have changed?
   3. The “science” of econometrics consists of the application of statistics to samples taken at different periods of time, which we called “time series.” It is based on studying the time series of economic variables, data, and other matters.
   4. I wondered whether the time series reflecting the activity of people now dead or retired should matter for predicting the future. Econometricians who knew a lot more than I did about these matters asked no such question
   5. Lucas Critique - dealt a blow to econometrics by arguing that if people were rational then their rationality would cause them to figure out predictable patterns from the past and adapt, so that past information would be completely useless for predicting the future
   6. If rational traders detect a pattern of stocks rising on Mondays, then, immediately such a pattern becomes detectable, it would be ironed out by people buying on Friday in anticipation of such an effect. There is no point searching for patterns that are available to everyone with a brokerage account; once detected, they would be self-canceling.

2. An introduction to the problem of epistemic opacity.
   1. Scientism - the idea that science can answer social science questions in the absence of controlled experiments
   2. technicians thought that their mathematical knowledge could lead them to understand markets. The practice of “financial engineering” came along with massive doses of pseudoscience.

3. The penultimate step before the problem of induction.
   1. Measuring risks using past history as a guide - the mere possibility of the distributions not being stationary makes the entire concept seem like a costly (perhaps very costly) mistake

Google Doc (with footnotes)

Nassim Taleb's 'Fooled by Randomness' continued

Chapter Seven - THE PROBLEM OF INDUCTION

1. On the chromodynamics of swans.
   1. Philosophy of interpreting/analyzing scientific knowledge = epistemology
   2. A well known inference problem is the problem of induction
   3. The randomness of social sciences compounds this problem’s harmful effects
   4. Nowhere is the problem of induction more relevant than in the world of trading—and nowhere has it been as ignored
   5. Hume, the Scottish philosopher said, “No amount of observations of white swans can allow the inference that all swans are white, but the observation of a single black swan is sufficient to refute that conclusion.”

   
   
   
   

2. Taking Solon’s warning into some philosophical territory.
   1. Hume was ‘irked’ by a swing from deductive reasoning in science to empiricism as championed by Francis Bacon.
   2. Hume warned that without a proper method, observations can lead you astray

   
   
   
   

3. How Victor Niederhoffer taught me empiricism; I added deduction.
   1. pure empiricism implies necessarily being fooled by randomness
   2. His work looked for anomalies in financial data, and found some, in opposition to the efficient market theory
   3. He showed that financial news conferred no predictive advantages
   4. Since then, an entire industry of such operators, called statistical arbitrageurs, flourished
   5. any “testable” statement should be tested, as our minds make plenty of empirical mistakes when relying on vague impressions
   6. A testable statement is one that can be broken down into quantitative components and subjected to statistical examination. For instance, a conventional-wisdom, empirical style statement like ‘automobile accidents happen closer to home’
   7. Supposing the data supports this hypothesis we have to be careful of making a naive error. This doesn’t mean you are less likely to have an accident when you are far from home.
   8. Data can be used to disprove a proposition never to prove it
   9. For instance, the statement ‘The market never goes down 20% in a given three-month period’ can be tested but is completely meaningless if verified
   10. It simply means it hasn’t happened YET. It can be rejected if a counterexample can be found, until then it remains theoretical.
   11. No matter how many white swans you count (without finding a black swan) it doesn’t prove black swans don’t exist.
   12. GW Bush has been alive for 58 years, and never died once therefore he is immortal - clearly absurd.
   13. Niederhoffer’s downfall came from his selling naked options based on his testing and assuming that what he saw in the past was an exact generalization about what could happen in the future. He relied on the statement “The market has never done this before,” so he sold puts that made a small income if the statement was true and lost hugely in the event of it turning out to be wrong. When he blew up, close to a couple of decades of performance were overshadowed by a single event that only lasted a few minutes.
   14. Markets cannot be approached like a game like squash - with defined rules.
   15. Maximizing the probability of winning does not lead to maximizing the expectation from the game when one’s strategy may include skewness, i.e., a small chance of large loss and a large chance of a small win. If you engaged in a Russian roulette–type strategy with a low probability of large loss, one that bankrupts you every several years, you are likely to show up as the winner in almost all samples—except in the year when you are dead.

   
   
   
   

1. Why it is not scientific to take science seriously.
   1. extreme empiricism, competitiveness, and an absence of logical structure to one’s inference can be a quite explosive combination.
   2. Taleb ‘has to discover things by himself. These self-discoveries last.’

   
   
   
   

2. Soros promotes Popper.
   1. George Soros’ forte is not in philosophical speculation. Yet he considers himself a philosopher.
   2. His first book, The Alchemy of Finance - does not show much grasp of philosophical concepts. He conducts what he calls a “trading experiment,” and uses the success of the trade to imply that the theory behind it is valid. This is ludicrous: I could roll the dice to prove my religious beliefs and show the favorable outcome as evidence that my ideas are right. The fact that Soros’ speculative portfolio turned a profit proves very little of anything.
   3. One cannot infer much from a single experiment in a random environment—an experiment needs a repeatability showing some causal component.
   4. [Soros] like [Taleb] is ashamed of being a trader and prefers his trading to be a minor extension of his intellectual life even if there is not much scholarship in his essays.
   5. although Soros did not deliver anything meaningful in his writings, he knew how to handle randomness, by keeping a critical open mind and changing his opinions with minimal shame (which carries the side effect of making him treat people like napkins)
   6. He self-identified as fallible and this gave him power

   
   
   
   

3. That bookstore on Eighteenth Street and Fifth Avenue.
   1. This is where Taleb, at a Barnes and Noble read Popper’s ‘The Open Society’ and supposedly, everything else he wrote.
   2. Popper is the ‘no-nonsense’ philosopher
   3. Popper came up with a major answer to the problem of induction
   4. Popper’s idea is that science is not to be taken as seriously as it sounds
      1. There are only two types of theories:
         1. 1. Theories that are known to be wrong, as they were tested and adequately rejected (he calls them falsified).
         2. 2. Theories that have not yet been known to be wrong, not falsified yet, but are exposed to be proved wrong.
         3. Why is a theory never right? Because we will never know if all the swans are white

      
      

   5. Taleb goes on to malign Newtonian physics, but as someone who knows a bit more about it, Newtonian physics is not ‘wrong’ it simply cannot account for what happens at a quantum level, hence the need for quantum physics. They are not necessarily incompatible.
   6. A theory that does not present a set of conditions under which it would be considered wrong would be termed charlatanism—it-would be impossible to reject otherwise.
   7. A trader who does not have a point that would make him change his mind is not a trader
   8. Popper and Keynes refused to blindly accept the notion that knowledge can always increase with incremental information—which is the foundation of statistical inference. It may in some instances, but we do not know which ones.
   9. Popper - “[scientists] work with bold conjectures and severe attempts at refuting their own conjectures.”
   10. Popper’s detractors called him a ‘naive falsificationist’ a term of pride for Taleb
   11. we are not genetically fit to be rational and act rationally
   12. Induction and Memory
       1. Memory in humans is a large machine to make inductive inferences.
       2. What is easier to remember, a collection of random facts glued together, or a story, something that offers a series of logical links? (the latter of course)
       3. Causality is easier to commit to memory. Our brain has less work to do in order to retain the information.
       4. Induction is going from plenty of particulars to the general. It is very handy, as the general takes much less room in one’s memory than a collection of particulars. The effect of such compression is the reduction in the degree of detected randomness.

   
   
   

4. Pascal’s wager.
   1. The philosopher Pascal proclaimed that the optimal strategy for humans is to believe in the existence of God. For if God exists, then the believer would be rewarded. If he does not exist, the believer would have nothing to lose.
   2. Taleb pledges to use statistics where it is beneficial but not to rely on it for risk management.
   3. “Accordingly, I will use statistics and inductive methods to make aggressive bets, but I will not use them to manage my risks and exposure.” all the surviving traders I know seem to have done the same.
   4. Unlike Carlos and John, they know before getting involved in the trading strategy which events would prove their conjecture wrong and allow for it (recall that Carlos and John used past history both to make their bets and to measure their risk). They would then terminate their trade. This is called a stop loss, a predetermined exit point, a protection from the black swan. I find it rarely practiced.
   5. I believe that I cannot have power over myself as I have an ingrained desire to integrate among people and cultures and would end up resembling them; by withdrawing myself entirely I can have a better control of my fate.

   
   
   
   

Google Doc (with footnotes)