Ineichen looks back (way back) to see future

26 December 2007

With 2007 about to go into the history books, we wondered how the year compared to others in the annals of financial history. One of the keenest observers of financial history has got to be UBS’s Alexander Ineichen. You may remember Ineichen for his 2006 tome Asymmetric Returns (see AllAboutAlpha reviews: parts one, two & three, and our exclusive interview). His primary thesis in that book was that risk management was a source of alpha – that returns which are skewed to the upside (such as hedge funds) are often a better long term investment than traditional equities. A well read student of several disciplines, he drew upon a rich set of historical anecdotes to make his point.

Ineichen presented his latest ideas in a conference hosted by UBS’s “Alternative Investment Solutions” team in November. His notes were assembled into a document that he passed along to us last week and which are available here. For anyone looking for a thought-provoking “big picture” view of financial history, this will surely be of interest. For example, to make a point about time frames for risk analysis he presents a timeline that begins at the Big Bang and ends with the implosion of the sun into a white dwarf. That’s a 21 billion year window. Talk about long-term horizon.

He makes a point that we also raised last week in our discussion of “black swans” – that volatility is itself volatile. Says Ineichen:

“To predict a major spike one needs to predict the event that causes the spike. For instance, to predict the spike in June 1914 one would have had to predict that Franz Urban, the driver of Archduke Franz Ferdinand of Austria, would take a wrong turn that led the 1911 Gräf & Stift Rois De Blougne tourer of Franz Ferdinand right in front of Gavrilo Princip, the assassin, who just came out of a sandwich shop after learning that earlier assassination attempts had failed. What are the chances?”

He backs up this notion with the following chart:

Since so many cases of extreme “non-normal” market volatility are event-dependent, we suggest that it may be no wonder they lay beyond the bounds of the familiar bell curve. Given a thousand “re-do’s” of the 20th century, perhaps we might find that human history would take several other similarly consequential, although materially different paths. Who’s to say that these random events wouldn’t eventually adhere to a normal distribution? Ineichen’s free-ranging discussion of gargantuan time frames seems strangely useful all of a sudden.

But without the benefit of a thousand re-runs of history, the magnitude and frequency of events is impossible to predict. Therein lies the danger of assuming that what you see is what you get over the recent past, says Ineichen.

“Financial economics is a very new discipline. Economics is about 250 years old, while financial economics is about 60 years old. We are still operating with the first set of theories. The business of institutional investment management is even younger. Unlike many other fields of human endeavor, financial economics has not yet witnessed a paradigm shift where, either gradually or in one dramatic moment, old theories become obsolete and are replaced with new ones.

“There is obviously no clear-cut definition of what is ‘unorthodox.’ Prospect theory, one could argue, became ‘orthodox’ in 2002 when psychologist Daniel Kahneman picked up a Nobel Prize in Economics…When related to risk and risk management, equilibrium theory’s assumption of ‘in the absence of external influences,’ one can argue, removes the theory too far from reality to be of practical use.

“Chaos theory might be the better theory when thinking about human affairs, markets and risk management. Small, trivial-seeming (and most often, random) events can result in material changes in the course of events. This is apparent whether we choose to examine the shaping of the universe, the origin of species, Archduke Franz Ferdinand’s driver taking a wrong turn in Sarajevo, market mayhem, or corporate defaults. Perhaps we could agree that some of our ‘first generation’ theories in economics might help explain matters ‘under normal circumstances.’ However, when we assess risk, it is the ‘non-normal’ circumstances that require the closest examination. Here equilibrium theory is not much help. Chaos theory at least helps us to understand and acknowledge that anything can happen, and be caused by anything, as conditions are recognized to be nonlinear, unpredictable, and random by definition. An open mindset, therefore, is a prerequisite in matters related to risk and uncertainty.”

Ineichen also echoes Keynes’ famous observation that “markets can stay irrational longer than you can stay solvent”. He advocates a theory that any 1999 tech investor is sure to love:

“A better theory, potentially, is the ‘Theory of Rational Beliefs.’ The Theory of Rational Beliefs relaxes some of the stringent assumptions of rational expectations, including notions of equilibrium and pricing model certainty. Agents act rationally on what they believe is true. Several hundred years ago it was rational to believe that the sun orbited the Earth. Decisions based on this belief were rational but later turned out to be misguided. Only after the flaw was revealed and replaced with a new ‘truth/belief’ could one (wrongly) accuse the decision maker as ‘irrational.’ Buying internet stocks in the late 1990s was not irrational: the buyers believed that another market participant would later purchase the securities from them at a higher price. Buying the stocks, therefore, was rational with respect to the belief of being able to sell at a higher price. Whether the multiples on future earnings were high or not is irrelevant when assessing rational decision making under uncertainty. As long as one’s belief is not contradicted by past or present reality, one can be considered ‘rational’ under rational belief theory. This ‘new’ theory suggests that when markets behave erratically and are excessively volatile it is not due to investors behaving crazy or irrationally, but rather investors are simply making best guesses given limited understanding of how the world works, changing their minds often, and occasionally, in tandem.”

Ineichen goes on to cite several AllAboutAlpha favorites such as: Andrew Lo, Benoit Mandelbrot, Nassim Taleb, & Peter Bernstein. As you take time off during the holidays to ponder the big picture, we’d suggest you add these conference notes to your reading list.