Rethinking Markets

Jeremy Grantham, principal of GMO, makes an interesting point about quants in his 4th quarter letter to investors (free registration required):

The good old days of the domination of the first generation quant models, where you simply show up with three concepts – value, momentum, and discipline – are over. But, even more critically and, perhaps like career and business risk, out at the limits of arbitrage, is this need for judgmental overrides on rare macro events. Quants like to show off their discipline by marching off the cliff in rows (it is said, I hope apocryphally, that Shaka, the great Zulu Chief, marched an impi, or regiment, off a cliff to impress European observers and I hope it did). Well, in real life it would be nice to stop at the edge and say “I don’t like the look of this, perhaps my model missed something.” The extremely difficult objective is to maintain the advantages of quant discipline 95% or so of the time and hand over to a human being when you reach the edge of the cliff. You can imagine the problems in making this kind of phase change. But only by slowly overcoming this problem and integrating this hybrid approach into the DNA of the investment process can one aspire to being very effective investors in the long run.

His point is that the benefits to quantitative investing are mostly in the fatter part of the outlier events curve. Or, in the language of March and Simon, quants are better at exploitation that exploration. Qualitative investors (stock pickers, in Grantham’s language) by contrast are potentially more helpful when the models depart from reality. An ideal world would have a hybrid model of quals and quants.

But that almost never works in practice. In practice, a qual firm uses quants as showcases to show their ‘balance’, while quants use quals to demonstrate their creative flexibilities. The underlying problem is that the two styles at their best represent different (and incompatible) views of the world. If you believe that human behavioral frailty gets in the way of seeing financial facts for what they are, it makes it difficult to envision a world where a stock picker can accurately tell you when you’re running off a cliff. By contrast, quals are simply limited by human cognitive capacity, combined with all sorts of cumulative social contexts, to never be able ‘really’ know why they are right or wrong. Leaving money on the table is also a form of running off a cliff. Just a different cliff.

Or rather, in Grantham’s story, there is simply no way to tell which 5% of the time is going to be the time when quals are going to be invaluable.

There might be an answer is abandoning the (theoretical) notion of maximizing efficiency, in favor of a more Type I versus Type II error view of the world. A Type I error is a false positive, in this context to believe there is risk where there actually is none. This is the ‘leave money on the table’ problem – if you cut back on the amount of risk you take, effectively you are underperforming the ‘economically efficient’ horizon. Type II errors are false negatives, to believe there is no risk where there actually is some. This results in many more ‘Whoa, we should have seen this coming!’ kinds of mistakes, I think.

In short, there is a collective action problem at work, insofar as we are collectively trained to believe that maximization is desirable. I would guess that 95%+ of the problems of the financial system are not due to institutions shooting for returns of 3% over prime. It’s when we build a system based on 20% over prime returns that we always seem to create incentives to blow up.

I’ve been thinking a lot about institutions lately, in light of my earlier post on check-lists and medical practices. I originally had in mind a post about how the Berger and Luckmann version of institutionalization at the more marco-level is about the crystallization of practices. So what check-lists are theoretically are the same as other kinds of models and technologies: they are congealed expertise. For good and for bad, technologies, models, and checklists act as an alternative to pure expertise and craft knowledge. To the extent that they become taken-for-granted, they become the cognitive institutions envisioned by B&L. This does not imply a break from creativity, or ‘structure’ as the opposite of ‘action’ (insert Giddens here if you like). They enable creative action as well. They also preclude new action or mask the world sometimes, if the world changes but the knowledge remains stuck in a model or technology. But the point is that we can look at institutions broadly as congealed knowledge.

But then I ran across the recent news that Second Life is banning banks. The issue is that virtual banks offer interest, which can then be returned to depositors, but they do not offer protections of real-world banks. Because Linden Dollars can be exchanged for real dollars, SL banks can actually be sources of profit and loss in the real world. And now they’re being banned:

as of January 22, Linden Lab will be removing all objects that are related to in-world banking. Until then, the company hopes that the banks will settle their debts with residents as best they can, but if they are caught trying to operate after January 22, they will be punished by possible suspension, termination of accounts, and (*gasp*) loss of land. Legitimate banks that provide a government registration statement or financial institution charter will be allowed to continue doing business, as will entities conducting marketing or education.

No FDIC in real-life means no banking in Second Life. This is institutions in the more Douglas North, economic sense. Here, banking ‘institutions’ act as rules of the game, and the Linden Labs folks act as rules and structures of SL. And we might be witness to a singular event: a set of runs on virtual banks as customers line up to take their Linden Dollars out before 1/22.

What’s interesting is the power of real-world institutions to actually impinge on a made up reality. After all, SL could have been created with any number of rules and ties to real life. Or no ties at all, as there’s no ‘rule’ in SL that people who cannot fly in RL are also not allowed to fly in SL.

There’s good stuff in between these two visions of institutions. For instance, think about which sets of conventions and rules are reproduced in an SL environment and which are not. Physical laws are often ditched, but those pertaining to land and real estate are kept. Gambling was eliminated because it might have been subject to RL laws and regulations, but laws regarding appraisals and insurance of real estate are left out despite the centrality of those kinds of transactions.

In any event, I’m not sure that institutions are anything, but I do think there are some specific phenomena amenable to one or another institutional distinction.