How did Ed Thorp Win in Blackjack and the Stock Market?

My earlier post laid out some important lessons on behavioral economics learned from Santa Fe Institute’s conference on Risk: the Human Factor.  The specific lecture that first caught my eye when I saw the roster was Edward Thorp’s discussion on the Kelly Capital Growth Criterion for Risk Control.  I had read the book Fortune’s Formula and was fascinated by one of the core concepts of the book: the Kelly Criterion for capital appreciation. Over time, I have incorporated Kelly into my position-sizing criteria, and was deeply interested in learning from the first man who deployed Kelly in investing.  It's been mentioned that both Warren Buffett and Charlie Munger discussed Kelly with Thorp and used it in their own investment process.  Thus, I felt it necessary to give this particular lecture more attention.

In its simplest form, the Kelly Criterion is stated as follows:

The optimal Kelly wager = (p*(b+1)—1) / b where p is the probability (% chance of an event happening) and b is the odds received upon winning ($b per every $1 wagered).

It was Ed Thorp who first applied the Kelly Criterion in blackjack and then in the stock market.  The following is what I learned from his presentation at SFI. 

Thorp had figured out a strategy for counting cards, but was left wondering how to optimally manage his wager (in investing parlance, we’d call this position sizing).  The goal was a betting approach which would allow for the strategy to be deployed over a long period of time, for a maximized payout.  With the card counting strategy, Thorp in essence was creating a biased coin (a coin toss is your prototypical 50/50 wager, however in a biased coin, the odds are skewed to one side).  This question was approached from a position of how does one deal with risk, rationally?  Finding such a rational risk management strategy was very important, because even with a great strategy in the casino, it was all too easy to go broke before ever attaining successful results.  In other words, if the bets were too big, you would go broke fast, and if the bets were too small you simply would not optimize the payout.

Thorp was introduced to the Kelly formula by his colleague Claude Shannon at MIT.  Shannon was one of the sharpest minds at Bell Labs prior to his stint at MIT and is perhaps best known for his role in discovering/creating/inventing information theory.  While Shannon was at Bell Labs, he worked with a man named John Kelly who wrote a paper called “New Interpretation of Information Rate.”  This paper sought a solution to the problem of a horse racing gambler who receives tips over a noisy phone line.  The gambler can’t quite figure out with complete precision what is said over the fuzzy line; however, he knows enough to make an informed guess, thus imperfectly rigging the odds in his favor. 

What John Kelly did was figure out a way that such a gambler could bet to maximize the exponential rate of the growth of capital.  Kelly observed that in a coin toss, the bet should be equal to one’s edge, and further, as you increase your amount of capital, the rate of growth inevitably declines.

Shannon showed this paper to Thorp presented with a similar problem in blackjack, and Thorp then identified several key features of Kelly (g=growth below):

1. If G>0 then the fortune tends towards infinity.
2. If G<0 then the fortune tends towards 0.
3. If g=0 then Xn oscillates wildly.
4. If another strategy is “essentially different’ then the ratio of Kelly to the different strategy tends towards infinity.
5. Kelly is the single quickest path to an aggregate goal.

This chart illustrates the points:

The peak in the middle is the Kelly point, where the optimized wager is situated.  The area to the right of the peak, where the tail heads straight down is in the zone of over-betting, and interestingly, the area to the left of the Kelly peak corresponds directly to the efficient frontier. 

Betting at the Kelly peak yields substantial drawdowns and wild upswings, and as a result is quite volatile on its path to capital appreciation.  Therefore, in essence, the efficient frontier is a path towards making Kelly wagers, while trading some portion of return for lower variance.  As Thorp observed, if you cut your Kelly wager in half, then you can get 3/4s the growth with far less volatility. 

Thorp told the tale of his early endeavors in casinos, and how the casinos scoffed at the notion that he could beat them.  One of the most interesting parts to me was how he felt emotionally despite having confidence in his mathematical edge. Specifically, Thorp felt that the impact of losses placed a heavy psychological burden on his morale, while gains did not have an equal and opposite boost to his psyche.  Further, he said that he found himself stashing some chips in his pocket so as to avoid letting the casino see them (despite the casino having an idea of how many he had outstanding) and possibly as a way to prevent over-betting.  This is somewhat irrational behavior amidst the quest for rational risk management

As the book Bringing Down the House and the movie 21 memorialized, we all know how well Kelly worked in the gambling context.  But how about when it comes to investing?  In 1974, Thorp started a hedge fund called Princeton/Newport Partners, and deployed the Kelly Criterion on a series of non-correlated wagers. To do this, he used warrants and derivatives in situations where they had deviated from the underlying security’s value.  Each wager was an independent wager, and all other exposures, like betas, currencies and interest rates were hedged to market neutrality. 

Princeton/Newport earned 15.8% annualized over its lifetime, with a 4.3% standard deviation, while the market earned 10.1% annualized with a 17.3% standard deviation (both numbers adjusted for dividends).  The returns were great on an absolute basis, but phenomenal on a risk-adjusted basis.  Over its 230 months of operation, money was made in 227 months, and lost in only 3.  All along, one of Thorp’s primary concerns had been what would happen to performance in an extreme event, yet in the 1987 Crash performance continued apace. 

Thorp spent a little bit of time talking about the team from Long Term Capital Management and described their strategy as the anti-Kelly.  The problem with LTCM, per Thorp, was that the LTCM crew “thought Kelly made no sense.”  The LTCM strategy was based on mean reversion, not capital growth, and most importantly, while Kelly was able to generate returns using no leverage, LTCM was “levering up substantially in order to pick up nickels in front of a bulldozer.”

Towards the end of his talk, Thorp told the story of a young Duke student who read his book called Beat the Dealer, about how to deploy Kelly and make money in the casino.  This young Duke student then ventured out to Las Vegas and made a substantial amount of money.  He then read Thorp’s book Beat the Market and went to UC-Irvine, where he used the Kelly formula in convertible debt to again make good money. Ultimately this young built the world’s largest bond fund—Pacific Investment Management Company (PIMCO).  This man was none other than Bill Gross and Thorp drew the important connection between Gross’ risk management as a money manager and his days in the casino.

During the Q&A, Bill Miller, of Legg Mason fame, asked Thorp an interesting two part question: is it more difficult to get an edge in today’s market? And Did LTCM not know tail risk and/or realize the correlations of their bets?  Thorp said that today the market is no more or less difficult than in year’s past.  As for LTCM, Thorp argued that their largest mistake was in failing to recognize that history was not a good boundary (plus the history LTCM looked at was only post-Depression, not age-old) and that without leverage, LTCM did not have a real edge. This is key—LTCM was merely a strategy to deploy leverage, not one to get an edge in the market.

I had the opportunity to ask Thorp a question and I wanted to focus on the emotional element he referenced from the casino days.  My question was:  upon recognizing the force of emotion upon himself, how did he manage to overcome his human emotional impediments and place complete conviction in his formula and strategy?  His answer was a direct reference to Daniel Kahneman’s Thinking, Fast and Slow, whereby he used his system 2, the slow thinking system, in order to force himself to follow the rules outlined by his formulas and process.  Emotion was a human reaction, but there was no room to afford it the opportunity to hinder the powerful force that is mathematics.

Learning Risk and Behavioral Economics with the Santa Fe Institute

This week I had the privilege to attend the Sante Fe Institute’s conference in conjunction with Morgan Stanley entitled Risk: The Human Factor.  There was quite the lineup of speakers, on topics ranging from Federal Reserve policy to prospect theory to fMRI’s of the brain’s mechanics behind prediction.  The topics flowed together nicely and I believe helped cohesively construct an important lesson—rules-based systems are an outstanding, albeit imperfect way for people and institutions alike to increase the capacity for successful prediction and controlling risk.  In the past on this blog, I have spoken about the essence of financial markets as a means through which to raise capital.  However, in many key respects, financial markets have become a living being in their own right, and as presently orchestrated are vehicles where humans engage in continuous prediction and risk management, thus making the lessons learned from the SFI speakers amazingly important ones.

This notion of financial markets as living beings in SFI’s parlance can be described as a “complex adaptive system” and is precisely what SFI is geared towards learning about.  While financial markets (and human beings) are complex adaptive systems, SFI is a multi-disciplinary organization that seeks to understand such systems in many contexts, including financial markets, but also in biology, anthropology, social structures, genetics, chemistry, drug discovery and all else where the concepts can be applied. 

To highlight the multi-disciplinary nature of the event, John Rundle, one of the co-organizers of the event and a physics professor at the University of California Davis, with a special background in earthquake simulation and prediction introduced the theme for the day. Dr. Rundle presented results for his trading strategy founded upon his theories for earthquake prediction.   The strategy was built upon asking the following question: can models for market risk be constructed that implicitly or explicitly account for human risk?  Seems like things are off to a great start.

Some of the coolest, most interesting moments came during the Q&A sessions, where this year’s presenters, some past presenters, and many brilliant minds from finance including Michael Mauboussin, Bill Miller and Marty Whitman had the opportunity to engage each other on their theses, refining and expounding upon each other’s ideas.  Sitting in the room and absorbing conversations like John Rundle speaking with Ed Thorp during an intermission about their own risk management perspectives and how to maximize the Kelly Criterion in investments was a surreal experience that I sadly cannot impart in this blog post, but I hope to channel the spirit in sharing some of the important ideas I learned. Further, I'd like to invite any of you readers out there to add your own thoughts in the comments below. 

Let’s start with the first presentation and walk through the day together.  In each subsection, I will give the presenter and their lecture title, followed by some notes from the lecture that I felt were relevant to my practical needs (this is not meant to be a thorough overview of each and all presentations).  I will type up my notes from Ed Thorp’s presentation in its own blog post, for there seemed to be considerable interest from fellow Twitterers on that one lecture in particular.

David Laibson, Harvard University

  Can We Control Ourselves?

Does society have the capacity to prepare for demographic change?  Experiments consistently show that people want the right thing, particularly when the question is presented as one of future choice.  However, when faced with the very same choice in the present, we fail to make the right decision; the very same decision we would make for longer-term planning purposes.   There is a behavioral reason for this: we want the right thing, but right now gets the full brunt of the emotional psychological weight, while planning is not nearly as influenced by the emotional element.  As a result, humans have a knack for making terrific plans, with no follow-through.

There is a neural foundation for this, as we have 2 systems (this is derivative of the idea presented in Daniel Kahneman’s Thinking Fast, and Slow). 

• The planning and focused system
• The dopamine reward system based on immediate satisfaction

How can we help people follow-through on their goals in planning as it pertains to saving for retirement?

• We can change the system from opt-in to auto-enroll, also known as the Nudge. Nudge is based on an idea presented by behavioral economists, Richard Thaler and Cass Sunstein in the book Nudge: Improving Decisions about Health, Wealth, and Happiness.
• We can use what’s called “active choice” and punish inaction, such that people must call and make a decision about their savings, rather than delaying it.
• Make enrollment quicker by taking away the 30 minute paperwork barrier.

Which is most effective:

• 40% participate with opt-in
• 50% participate with an easier process
• 70% enroll with active choice
• 90% participate with a nudge

To that end, we were presented with information that showed people recognize self-control problems and opt for less liquid savings options if given the choice, EVEN IF the returns are exactly the same.  That is, people acknowledge their inability to control the itch to break their well-made plans.

Vincent Reinhart, Managing Director and Chief U.S. Economist at Morgan Stanley

FED Behavior and Its Implications

1. Our paradigm for monetary policy:
   1. We have an expectation for the path of the economy and the Fed sets policy to meet that expectation
   2. The difference in policy over 2 successive actions follows a random walk. You can only acquire so much new information about the economy over the course of six weeks, making decisions based primarily on prior knowledge.
   3. The puzzle of persistence:
      1. Despite the random walk on decision-making, a chart of the Fed Funds Rate doesn’t actually follow a random walk.  It is a persistent path, whereby if the interest rate went down the prior month, it is more likely to go down again in the present month.
      2. The source of persistence:
         1. If there is persistence, and policies are predictable, then there should be ways to generate returns off of it.  Prices then would be drive to a fundamental value by arbitrage.  However, in central banking there is no arbitrage opportunity, because the mechanisms are confined to just the Fed and commercial banks, with no open market participation.
         2. While many talk about recent actions being “unprecedented” this is unequivocally not true.  These actions are very consistent with central bank behavior—QE and its ilk are balance sheet actions. 
            1. Previously the Fed had a larger balance sheet as a % of GDP in the mid-1940s.
2. Policy decisions are made by committees:
   1. Larger committees lead to less variance
   2. The right model to think about this is the committee as a jury, not a sample of policy options. The committees deliberate and take the best argument.
   3. There is an hierarchy of status in the Fed, including titles and media-friendliness that lead to greater degrees of influence from some members, over others.  This leads to the perfect setting for herding outcomes.
   4. Thus the random walk fails.
   5. Why have we not had a strong bounce-back from this recession?
      1. Milton Friedman talks of “plucking on a string” whereby a big drop should lead to a big bounce.
         1. There are serious problems with this analogy:
            1. An equal percent decline, and rise will not get you back to your starting point. (1-x) * (1+x)=1-x²
            2. In a “pluck” in physics it never gets you back to your starting point, as there is a transfer of energy in the transition from down to up.
            3. The observation that recessions should work like a plucked string were misguided, since they focused on a small sample size ONLY covering 1946-1983, looking neither at the prior 100 years, or updating for the past 30 years.
3. After severe financial crisis, recoveries are consistently very poor.
4. What is the best paradigm for decision-making?
   1. Rules consistently do better than discretion.
   2. From June to December that conversation has started to change, and QE3 is far more analogous to a rules-based system. However, we don’t yet have enough information on when or how the rules will end.

I had the opportunity to ask a question, so I asked whether NGDP targeting would be such an optimal rules-based system, and if QE3 was something akin to NGDP.  Reinhart answered that while QE3 does get us closer to a rules-based system it is not like NGDP.  He further asserted that he wouldn’t necessarily be in favor of NGDP targeting, and that a system of NGDP targeting would be an implicit, under-the-radar way for the Fed to let the market know it will slacken on the inflation coefficient of its dual mandate.

Philip Tetlock, University of Pennsylvania

The IARPA Forecasting Tournament: How Good (Bad) Can Expert Political Judgment Become Under Favorable (Unfavorable) Conditions?

In the 1980s, the government funded a study looking into how well experts predict global events, called the IARPA Forecasting Tournament.  Today, this experiment is being recreated, with a focus on forecasting global events of interest to the US government.  The experiment uses the Brier Score, first developed for weather forecasters, in order to gauge accuracy.  The best Brier score is 0, a dart-throwing chimp registers a 0.5 and the worst possible score is 2.

Types of prediction ceilings:

• Perfectly predictable events (100% ability to predict)
• Partly predictable events
• Perfectly unpredictable

In the first year of the tournament, the average score in the baseline was 0.37, better than the chimp, but not quite perfect.  The best algorithms score 0.17 and sit 0.29 units away from the truth.

In the top performing groups of participants had the following traits in common (note: collaboration was welcomed and fostered by the moderators).  I’m injecting my opinion here, but I find these to be very important goals for any organization in attempting to participate in an arena where prediction is important (in this case, for investors the lessons can be particularly apt).

1. The best participants
2. Collaboration whereby people actually work together and deliberate about their predictions.
3. A training in probabilistic reasoning a la Kahneman’s ideas in Thinking, Fast and Slow
4. Combine the training and teamwork
5. Elitist aggregation methods whereby more weight is added to the best predictors/experts in certain areas when combining predictions to make one uniform “best” effort at prediction.

Two lessons/observations:

• Teams and algorithms consistently outperform individuals.
• Forecasters consistently tend to over-predict change.

Elke Weber, Columbia University

Individual and Cultural Differences in Perceptions of Risk

In finance we think of risk as volatility. Culturally however, risk is a parameter, not a model.  Risk is therefore subjective and intuitive on an individual level.  Further, when faced with extreme outcomes, emotion becomes an increasingly more powerful force on perceptions of risk.  It is the perceptions of risk that drive behavior, and these perceptions exist on a relative, not absolute scale. Humans are biologically wired to that end.

Weber’s Law (not Elke Weber, an earlier Weber): the differences in the magnitude required to perceive two stimuli is proportional to the starting point. i.e. all differences are measured by a relating the new position to the original.

Familiarity actually works to reduce perceptions of risk, but not risk itself. Experts in a certain field tend to underestimate risks due to familiarity.  Return expectations and perceived riskiness predict choice, NOT the expectation of volatility (i.e. risk is perceived on a relative scale, not through the formulaic calculation of volatility).

Cultural differences—Shanghai vs. US MBA students:

• The collectivist nature of Chinese culture mitigates the damaging effects of risk gone awry. This is called the “cushion hypothesis.”  As a result, Chinese MBA students tend to be more risk-seeking.
  • Families in China tend to help their members far more than in the US when it comes to transferables (people help mitigate the risk of a money-based decision gone wrong, but cannot do so on risky health decisions).
  • Risk was consistently based on relative perceptions of risk within the context of the safety net.

In the Animal Kingdom, the most base way to perceive risk is through experience.  Small probability events tend to be underweighted by experience, but overweighted by perception.

• When small probability events hit, the recency bias makes people overweight the chances it will happen again.
• Experience metrics tend to be more volatile in how they perceive risk.
• Studies show that crisis (like the Great Depression) do have an enduring impact on how risk is perceived.

I had the opportunity to ask Dr. Weber a question. I asked her about the point that familiarity tends to lead people to overlook risk, and how that can be reconciled with the value investing concept of sticking to a core competency? If through focusing on a core competency, rather than mitigating risk, investors were increasing it.  Dr. Weber rightly observed that focusing on a core competency does have some distinctions with familiarity in that the idea is to work in areas where one has the most skill, but that there could very well be such a connection. In fact, she thought my question to be “very interesting” and worth further observation.

Nicholas Barberis, Yale University

Prospect Theory Applications in Finance

Can we do better in financial markets replacing expected utility with prospect theory?

Some core elements of prospect theory in finance:

1. People care about gains and losses, not absolute levels of performance
2. People are more sensitive to losses than gains
3. People weight probabilities in a non-linear way (i.e. they overweight low probability, underweight high probability). 

There is little support for beta as a predictor of returns.  Prospect theory instead focuses on the idea that a security’s (or indices) own skewness will be priced based on the scale of the left or right tail. 

• In positively skewed stocks people tend to overweight small chances of big success, and thus get low returns as a result (and vice versa). 
• As a result, big right skewness should have a low average return and this is proven in IPOs, out of the money options, distress stocks and volatile stocks.
• Probability weighting in prospect theory is a better predictor of returns.
• If people are loss averse, as prospect theory holds, the equity premium will be higher.
• Overall, the market is negatively skewed, thus probability weighting produces a higher equity risk premium overall.

The Disposition Effect – people sell stocks that have gone up far quicker than stocks that have gone down.

• Do people get pleasure/pain from realizing gains/losses? i.e. realization utility. The model predicts that:
  • There is greater turnover in bull markets as a result.
  • There is a greater propensity for selling above historical level of highs.
  • There is a preference for volatile stocks.
  • Momentum is also preferred.

Gregory Berns, Emory University

When Brains are Better than People: Using fMRI to Predict Markets

Dr. Berns started with a history of using blood pressure in order to ascertain where/how/why certain stimuli impact the brain.  Today we can use fMRI in order to clearly see ventricular activity and this provides a nice window into how the brain works.  Blood flow to regions of the brain change based on which part of the brain is active/engaged at any given point in time.  Animals in the wild that are most adept at prediction can survive far better in changing environments than those who cannot.

Contrary to conventional wisdom, dopamine is not directly correlated to pleasure. Dopamine in fact is correlated to the anticipation (i.e. the delta) of pleasure.  It is the changes in dopamine levels which lead to decisions.  Dr. Berns showed a fascinating slide using the corking and drinking of a fine wine to illustrate this point.  It is in the moment of opening the bottle of wine that people experience the dopamine release, rather than during the pouring of the glass or taking the first sip.

Dr. Barberis had mentioned fMRI and its application to measuring the disposition effect and here Dr. Berns confirmed and illustrated.  There are three explanations for why the disposition effect happens:

1. People’s risk preference
2. The realization utility (i.e. people like realizing gains, loathe realizing losses)
3. Mean reversion

Using fMRI, we can see that there are different approaches to the disposition effect depending on how and where the brain reacts (note: boy do I wish I had these slides, because the images are amazing in highlighting the effects).  People tend to fall into 2 camps—those who are influenced by the disposition effect, and those who are not.  fMRI shows that in those who ARE influenced by the effect, the blood flow is most active in the stem of the brain, the area where dopamine is released.  In those who are NOT impacted by the disposition effect, there is brain activity in a much broader portion of the cerebrum (the bigger part of the brain).

This effect was studied using fMRI in 2 contexts involved in understanding prediction.

• Music: people were given fMRI while many songs were played, analyzing where in fact the brain was triggered. Only years later, when one of the obscure songs became a hit did Dr. Berns check his data and it showed that this hit song actually did in fact induce a higher degree of activity in the brain. Brain data correlated more with the likeability of success.
• Markets: MBA students were given fMRI while simulating the ownership of stocks into earnings. Their reactions were tested for beats or misses.  The tests were demonstrative of the fact that negative surprises hurt far more than positive ones feel good.  This could be a major explanatory force behind the disposition effect.  

Please note: I apologize for any formatting errors. This post was drafted in Word and did not transfer very cleanly at all into the Squarespace format. In the interest of sharing the ideas in a timely mannger, I will go ahead and publish before I have the chance to clean up all the spacing, tabbing, etc.  Please enjoy the content and try to look past the messy spacing.

The Answer to the Eurozone Crisis was Written in 1787

When I last focused on the EU in this blog, I took a look at why Italy doesn't worry me too much.  I omitted Spain from this analysis purposely, because what placated me with regard to Italy just did not exist in Spain despite Spain's lower overall stated sovereign debt-to-GDP ratio.  Since that time, the Eurozone had calmed down, but during my blogging hiatus things once again flared up.  Now, I think it's time to take a much deeper look at the EU and what it all means, because this has become far bigger than an economic question.  More specifically, I am firmly in the camp that sees the Eurozone crisis as a constitutional crisis, not an economic one.  

Since World War II, the European Continent has moved towards a unified economy, without unifying any of the institutions necessary to manage and enforce a centralized currency.  As a political philosophy guy, this is seriously fascinating stuff, as we are witnessing history in the making, while as an investor it's skewed to the scary side of things.  The uncertainty is great, however, for you history buffs out there, the clearest parallel to Europe's present predicament is the United States under the Articles of Confederation.  

As a refresher, the Articles of Confederation governed the United States in the time period between the American Revolution and the Constitution, where States existed as de facto sovereigns and no strong centralized power existed.  In response to growing economic and political failures, and rising social tensions, the leading intellectuals and political figures in young America gathered in Philadelphia to "form a more perfect Union."

Unfortunately, and contrary to the linear path with which history is narrated, the Constitution was not instantly greeted with excitement and acceptance.  As a result, the Founding Fathers had to go to great lengths to ensure its passage, especially in the "core" states of New York and Virginia.  Alexander Hamilton was a particularly important architect of our form of American Federalism and was a key emissary for the State of New York (in fact, he was the only New Yorker to sign the document).  To help get New Yorkers and Virginians to vote "yay" for the Constitution, Hamilton and James Madison wrote what are now known as The Federalist Papers under the pseudonym "Publius."  It's amazing how relevant these papers remain today.  

To be clear, I did not originally conceive of this idea of the EU as the pre-Constitutional US.  I first encountered the parallel in some of Bridgewater's excellent economic research available on the WWW.  Instantly the parallel resonated with me, and as a result, I started re-reading some of the relevant American History.  No one document struck me as more important today than Federalist #15.  It's as if Alexander Hamilton wrote each and every word directed at the powers that be in the EU today. 

Hamilton so adeptly incorporates the political, economic and ultimately the human emotional element into constructing a deeper understanding of the failures of a weak, centralized confederacy of interests.  Interestingly, Hamilton briefly gets into the history of failed attempts at confederation in Europe and their collapse at the hands of individual constituency interests.  Ultimately, he makes it abundantly clear why no sovereign interests can unite without unified institutions that have real powers of enforcement.

Below are a few excerpts from  Federalist Paper #15, entitled "The Insufficiency of the Present Confederation to Preserve the Union" but I urge all interested parties to read the whole thing:

In pursuance of the plan which I have laid down for the discussion of the subject, the point next in order to be examined is the "insufficiency of the present Confederation to the preservation of the Union." It may perhaps be asked what need there is of reasoning or proof to illustrate a position which is not either controverted or doubted, to which the understandings and feelings of all classes of men assent, and which in substance is admitted by the opponents as well as by the friends of the new Constitution. It must in truth be acknowledged that, however these may differ in other respects, they in general appear to harmonize in this sentiment, at least, that there are material imperfections in our national system, and that something is necessary to be done to rescue us from impending anarchy. The facts that support this opinion are no longer objects of speculation. They have forced themselves upon the sensibility of the people at large, and have at length extorted from those, whose mistaken policy has had the principal share in precipitating the extremity at which we are arrived, a reluctant confession of the reality of those defects in the scheme of our federal government, which have been long pointed out and regretted by the intelligent friends of the Union.

...

It is true, as has been before observed that facts, too stubborn to be resisted, have produced a species of general assent to the abstract proposition that there exist material defects in our national system; but the usefulness of the concession, on the part of the old adversaries of federal measures, is destroyed by a strenuous opposition to a remedy, upon the only principles that can give it a chance of success. While they admit that the government of the United States is destitute of energy, they contend against conferring upon it those powers which are requisite to supply that energy. They seem still to aim at things repugnant and irreconcilable; at an augmentation of federal authority, without a diminution of State authority; at sovereignty in the Union, and complete independence in the members. 

...

There is nothing absurd or impracticable in the idea of a league or alliance between independent nations for certain defined purposes precisely stated in a treaty regulating all the details of time, place, circumstance, and quantity; leaving nothing to future discretion; and depending for its execution on the good faith of the parties. Compacts of this kind exist among all civilized nations, subject to the usual vicissitudes of peace and war, of observance and non-observance, as the interests or passions of the contracting powers dictate. In the early part of the present century there was an epidemical rage in Europe for this species of compacts, from which the politicians of the times fondly hoped for benefits which were never realized. With a view to establishing the equilibrium of power and the peace of that part of the world, all the resources of negotiation were exhausted, and triple and quadruple alliances were formed; but they were scarcely formed before they were broken, giving an instructive but afflicting lesson to mankind, how little dependence is to be placed on treaties which have no other sanction than the obligations of good faith, and which oppose general considerations of peace and justice to the impulse of any immediate interest or passion.

...

Government implies the power of making laws. It is essential to the idea of a law, that it be attended with a sanction; or, in other words, a penalty or punishment for disobedience. If there be no penalty annexed to disobedience, the resolutions or commands which pretend to be laws will, in fact, amount to nothing more than advice or recommendation. This penalty, whatever it may be, can only be inflicted in two ways: by the agency of the courts and ministers of justice, or by military force; by the COERCION of the magistracy, or by the COERCION of arms. The first kind can evidently apply only to men; the last kind must of necessity, be employed against bodies politic, or communities, or States. 

...

There was a time when we were told that breaches, by the States, of the regulations of the federal authority were not to be expected; that a sense of common interest would preside over the conduct of the respective members, and would beget a full compliance with all the constitutional requisitions of the Union. This language, at the present day, would appear as wild as a great part of what we now hear from the same quarter will be thought, when we shall have received further lessons from that best oracle of wisdom, experience. It at all times betrayed an ignorance of the true springs by which human conduct is actuated, and belied the original inducements to the establishment of civil power. Why has government been instituted at all? Because the passions of men will not conform to the dictates of reason and justice, without constraint. 

...

From this spirit it happens, that in every political association which is formed upon the principle of uniting in a common interest a number of lesser sovereignties, there will be found a kind of eccentric tendency in the subordinate or inferior orbs, by the operation of which there will be a perpetual effort in each to fly off from the common centre. This tendency is not difficult to be accounted for. It has its origin in the love of power. Power controlled or abridged is almost always the rival and enemy of that power by which it is controlled or abridged. This simple proposition will teach us how little reason there is to expect, that the persons intrusted with the administration of the affairs of the particular members of a confederacy will at all times be ready, with perfect good-humor, and an unbiased regard to the public weal, to execute the resolutions or decrees of the general authority. The reverse of this results from the constitution of human nature.

...

All this will be done; and in a spirit of interested and suspicious scrutiny, without that knowledge of national circumstances and reasons of state, which is essential to a right judgment, and with that strong predilection in favor of local objects, which can hardly fail to mislead the decision. The same process must be repeated in every member of which the body is constituted; and the execution of the plans, framed by the councils of the whole, will always fluctuate on the discretion of the ill-informed and prejudiced opinion of every part. 

...

In our case, the concurrence of thirteen distinct sovereign wills is requisite, under the Confederation, to the complete execution of every important measure that proceeds from the Union. It has happened as was to have been foreseen. The measures of the Union have not been executed; the delinquencies of the States have, step by step, matured themselves to an extreme, which has, at length, arrested all the wheels of the national government, and brought them to an awful stand.

...

Why should we do more in proportion than those who are embarked with us in the same political voyage? Why should we consent to bear more than our proper share of the common burden? These were suggestions which human selfishness could not withstand, and which even speculative men, who looked forward to remote consequences, could not, without hesitation, combat. Each State, yielding to the persuasive voice of immediate interest or convenience, has successively withdrawn its support, till the frail and tottering edifice seems ready to fall upon our heads, and to crush us beneath its ruins.

I'm back!

First let me apologize for my one month posting hiatus.  On June 2nd, I took the Level I CFA exam and had been spending the entirety of my blogging time allocation on studying.  While the CFA Designation is not something I "need" for what I do, I strongly believe in what the CFA Institute stands for and does to enhance the integrity of capital markets and further, I have always felt a chip on my shoulder coming from a background in political science, philosophy and law into investing.  As such, the effort to earn the CFA designation for me is an expression of my commitment to my career path and to the ethical standards I ultimately aim to uphold.  

While on my path to prepare for the CFA Exam, markets hit the skids and global macroeconomic events jumped into mainstream headlines.  Considering many of these events lie at the heart of the social sciences--that intersection between sociology, politics and economics--I am eager to get some of my thoughts clearly spelled out.  Without further ado, I will start slowly but surely laying out my beliefs and opinions on the nature of the crisis and the road map to putting a light at the end of this seemingly never-ending tunnel.  

Links for Thought -- April 27, 2012

Pixar Story Rules (The Pixar Touch, h/t to Ritholtz) -- This is a great list of the "rules" that shape Pixar's stories.  No matter what our age, we all know (and I'm sure love) the great stories from Steve Job's computer animation studio.  While these rules are about how to structure a great animated film, they are deeper life lessons with broader implications.  Definitely worth a read.

Logical Fallacies Poster (Boing Boing) -- Ah remember the good 'ole days as a philosophy major in college memorizing the long list of all the fallacies.  Each day as I peruse the financial news, I'm pretty sure I encounter at least a handful.  Slippery slopes, strawmans and appeals to emotion are RAMPANT throughout today's 24-hour news cycle.  Which others do you see regularly?

Lonesome Dove (Free Exchange) -- The Economist's economics blog looks at Ben Bernanke's maneuvering and posturing through the financial crisis.  In particular, this post looks at how Bernanke has positioned himself between those like Paul Krugman saying the academic Bernanke would do more to fend off deflation, and the inflationistas who at every step of the way insist that hyperinflation is right around the corner.  This is a must read for those interested in macroeconomics.

Don't Cripple Innovation for the Sake of this Quarter's Numbers (Harvard Business Review) -- This article touches on a point I will get back to time and again.  Companies need to manage their business to maximize the long-term value, and not for meeting quarterly numbers.  Too often we see companies doing precisely the wrong thing.  Many of today's managerial challenges on this end are driven by increasingly fickle shareholders looking to make a quick buck on a trade, rather than building wealth through long-term investment.  The tide does seem to be shifting though.

Bullish Sentiment At Lowest Level Since Last September (Pragmatic Capitalism) -- I usually try to focus on pieces that are not pegged in time, but this I just found so damn interesting.  Right now as the market sits within spitting distance of multi-year highs, investor sentiment is much nearer levels consistent with a bottom.  This is a pretty consistent contrarian indicator, where the preponderance of market participants tend to be wrong.  It's also a great counterpoint to those talking heads who keep speaking of excessive bullishness.

People are Figuring Out Austerity is Stupid (Ritholtz) -- It's about freaking time! Austerity has never worked throughout history and it sure as hell won't work now.  Don't be fooled by all the appeals to emotion and slippery slopes (go check out those logical fallacies from above).  The austerity argument is stooped in moralism far more than sound economics, and in reality the morality is all wrong anyway.  There is a sound empirical explanation for why austerity not only doesn't work, but is also in fact counterproductive and a force which increases (not decreases) an aggregate debt burden.  It's all about thinking of things in terms of their relative levels (i.e. debt to GDP) instead of gross levels.

David Wright: Greatest Met Ever? (Fangraphs) -- Well just 3 years ago I think every Mets fan would've agreed Wright had a clear shot at being the greatest Met ever.  Today many would beg to differ.  Reality, as it often does, lies somewhere in the middle.  He had some all-time great Mets years, with a couple of injury riddled ones we'd rather forget.  Looks like things are getting back to normal though for D. Wright.  The most shocking surprise from the Fangraphs analysis is that Edgardo Alfonzo is way higher than I thought he'd be statistically speaking.  I was a HUGE fan back in the day.

Typically I leave off with a great nature shot, but today I will again diverge and end with the 3 best photos I took at today's flyby from the Enterprise Space Shuttle.  What a cool site that was flying first up the Hudson from downtown, and then back towards the city, past the Hudson cliffs and over the George Washington Bridge.  While the space shuttle is old and headed for retirement, I still couldn't help but laugh at the contrast with my recent post on New York City pre-concrete junge.  Just an awesome site to see!