Broken Symmetry

How to Improve Investing Outcomes

From Alice Schroeder:

Rail traffic patterns are a window on commodity, wholesale, consumer, and international trade flows. Buffett is adding this kaleidoscope to what his other CEOs tell him about the "reset of the consumer" to a lower level of spending. They feed him data from Berkshire's portfolio of companies—sales of building materials, jewelry, furniture, real estate, credit, fractional jets, vacuum cleaners, fabricated steel, newspaper ad lineage, and other products and services. He may now command as much information about the state of the U.S. economy as anyone, including the Federal Reserve—and probably gets his faster.

See my review of her biography of Buffett here.

But will it last?

From the CFO blog:

S&P banking analyst Vandana Sharma pointed out that commercial and industrial loan portfolios were one of the brighter spots for banks in the fourth quarter of 2009, with noncurrent loans declining 7%. It was the first drop in NCLs in three years, Sharma noted. Then, Martin Fridson of Fridson Investment Advisors, bond investor extraordinaire, plainly started (sans any irony) that there was no reason to expect companies' credit situations not to improve.

Forecasters predict corporate defaults will drop to as low as 4% by year-end, after hitting the mid-teens last year. But even with loads of defaults in 2009, loan investors have had decent recoveries on defaulted borrowers, the panelists said, so the financial crisis "will not break the investment thesis for bank loans," said Scott Page, vice president of Eaton Vance.

Stimulus runs out at the end of Q2.

What is a democracy?

From Gus diZerega:

To put this point in terms of systems theory, democracies are spontaneous orders that are in continual flux. That are variously enlarging and shrinking their boundaries by means of widespread consent rather than conquest, and are similarly acquiring and devolving decision making authority from other democratic bodies of which they are constituted. The image of stability and permanency that we associate with states is evidence of a breakdown in democratic processes. The organizations within a spontaneous order always have a tendency to seek to freeze adaptive processes at points where their dominance can be assured.

How do you turn R&D into jobs?

From remarks today by Secretary Locke:

How do universities using federal R&D dollars balance the sometimes competing demands of:

• The pursuit of knowledge for its own sake; and
• Focusing on discoveries that have real potential to spawn new industries, new businesses and new jobs.

What is the best way to integrate universities into broader regional strategies for economic development?

And finally, how do we make it easier to connect entrepreneurs and other business builders with ideas coming out of university research labs?

Our romantic ideal of the university professor as distinterested gadfly -- as Socrates in spectacles -- must give way to a new ideal of ideas in action -- of the university professor as intellectual entrepreneur -- as Feynman at NASA.

Incentives Matter... Especially to Bankers

From the Economist:

What has disturbed me is the resistance of some within the financial sector to innovations which would improve the ability of the financial sector to perform its core functions. For instance, modern technology allows the creation of an efficient electronics payments mechanism, where the transfer of funds, say, from a customer's account to the retailer's would cost at most pennies. Yet in most countries, the fees can be orders of magnitude greater. As a member of President Clinton's Council of Economic Advisers, I saw the resistance to the introduction of inflation-indexed bonds that protect individuals' savings for their retirement from the uncertainties of inflation decades later. The financial sector's complaint was that individuals just bought and held these securities; for the retirees, who wanted to minimise transactions costs, that was good; for the financial sector, that wanted to maximise transactions costs, it was not. There are mortgage products (such as those prevalent in Denmark) which would have helped ordinary families manage the risk associated with their most important asset, their home. But in few countries have they been introduced; in many countries, the financial sector has resisted their introduction.

Via PE Hub

Surowiecki on What's Wrong with Venture Capital?

Don't miss his piece:

But it won't be enough for VCs simply to change what they invest in and where they invest. The real problem is not complex: there's too much venture capital, and there are too many venture capitalists, for the industry to be really profitable. The industry as a whole now has about $200 billion under management, more than twice what it did in 1998, and venture funds invested $20 billion to $30 billion a year for most of the past decade. And on the level of individual funds, huge amounts of capital combined with falling startup costs have, in Anderson's words, made funds "muscle bound": a $500 million fund can't make too many small investments, even if that's what would make economic sense, because the partners don't have the time to supervise hundreds of companies. (This is one reason, along with the desire to limit risk, that many VCs have started to wait until later rounds to invest.) In the absence of another bubble, there's no way for new companies to generate profits big enough to provide a reasonable return on $20 billion to $30 billion a year. Kedrosky, for one, argues that for the industry to consistently generate competitive returns, annual investment and money under management need to fall by more than half. And while Wilson describes himself as "very optimistic" about the coming decade, he says that the industry "needs to return to the size and shape it was in the late '80s and early '90s."

Via PE Hub

Too bad Surowiecki didn't elaborate on possible ways to increase the diversity in strategies among VC funds.

Munger's Tale

Told in Slate:

But even a country as cautious, sound, and generous as Basicland could come to ruin if it failed to address the dangers that can be caused by the ordinary accidents of life. These dangers were significant by 2012, when the extreme prosperity of Basicland had created a peculiar outcome: As their affluence and leisure time grew, Basicland's citizens more and more whiled away their time in the excitement of casino gambling. Most casino revenue now came from bets on security prices under a system used in the 1920s in the United States and called "the bucket shop system."

The winnings of the casinos eventually amounted to 25 percent of Basicland's GDP, while 22 percent of all employee earnings in Basicland were paid to persons employed by the casinos (many of whom were engineers needed elsewhere). So much time was spent at casinos that it amounted to an average of five hours per day for every citizen of Basicland, including newborn babies and the comatose elderly. Many of the gamblers were highly talented engineers attracted partly by casino poker but mostly by bets available in the bucket shop systems, with the bets now called "financial derivatives."

Via Reflections in Value Investing.

What's next for Larry Ellison?

Sailing is so last week:

"We've already beaten IBM in software, now ... we will beat IBM in hardware," Ellison boasted last fall at a gathering in Silicon Valley. "That is our goal."

As it integrates its new hardware business, Oracle's pitch is pretty straightforward. Corporations pay billions of dollars to companies such as IBM to hire consultants who stitch together disparate servers, software applications, databases and other IT infrastructure, all of it more often than not bought from various vendors. Why not create an offering that is designed to work together from the get-go, eliminating the need for IT services altogether?

"You can do a better job by having all the pieces designed by a team of engineers that talk to each other," Ellison said when the deal closed.

Myhrvold on Invention Capital

From HBR:

Outside the pharmaceutical and biotech industries, few companies consider inventing, or producing patented intellectual property, to be their primary mission. Corporate R&D has become mostly “D”: the development of products. Hardly any large corporations have “inventing” as a job category—even though it requires a different mind-set, has different goals, and must be managed differently than research and development positions. At universities and government agencies that fund academic research, patents typically don’t enter into tenure or grant decisions. Published research is rewarded, but invention usually is not. Indeed, these organizations primarily fund blue-sky programs aimed at expanding scientific knowledge. That’s a worthy thing to do. But it’s quite different from invention, which applies scientific knowledge in novel ways to create something useful, something that has economic value.

Via Zura. I have more to say about Menand's arguments in The Marketplace of Ideas, Myhrvold's "invention capital," and Kauffman's proposal for "free agents." But I'm buried in "discovery" -- a classic legal misnomer.

"Macroeconomic Resilience"

That's the title of a new anonymous blog.

Check out the categories, which include "complex adaptive systems," and "system dynamics".

I like what I'm reading so far. If the quality continues, then the blogger will not stay anonymous for long.

Sherrington on Complexity in Economics

From the Royal Society:

The real world of finance and economics is significantly more complicated than the simplistic MG. However, (i) already one sees several conceptually important aspects that are likely to extend to reality; one is the inadequacy of the doctrine of ‘rational expectations’ in which it is assumed that, given the same information, every agent will make the same deduction and achieve equilibrium —- it has already been pointed out that, even for the MG, there is no representative agent, but only a representative stochastic ensemble —- and another is clear from the recognition that, even if agents could change their strategies, there is no optimal solution in which all have the same strategy, as, by definition, not everyone can be in the minority, (ii) the model could be extended in increments of ‘reality’ or complication, for example, including the accumulation and expenditure/gambling of varying degrees of capital, the effects of market impact, allowing for producers, who must both buy and sell in order to carry out their business, and for consumers,16 or involving limitorder-book bidding, settling and price movement, (iii) the inclusion of some of these effects will result in there never being any ‘equilibrium’, although there might be periods of relative stochastic quasi-steady state, albeit probably also punctuated by catastrophic crises, (iv) many of the drivers of cooperation involve information with no spatial-range restriction, thereby justifying meanfield theory treatment as a good approximation, and (v) one could investigate the introduction of global ‘friction’ and ‘bias’ mechanisms, as, for example, through the imposition of trading taxes and/or other political and legal constraints and incentives.

Indeed, one can imagine many other social-science problems involving many individuals, often grouped into intermediate local, political or national groups, where the interest is in collective behaviour under the influence of both heterogeneous inherent/cultural inclinations and national and international laws. Clearly, anticipated reactions to variation of the laws are of crucial importance in trying to anticipate the resultant ‘health’ of the whole. Minimal models and their incremental complication play an important role in separating the essential from the peripheral, in anticipating the likelihood of catrastrophes and trying to devise ‘dampers’ to avoid or minimize them. Disorder, in the guise of different inherited and culturally nurtured inclinations, such as risk aversion, honesty and emotionality, as well as mental and physical abilities, is part of the natural make-up of individuals, while frustration is a feature of their collective coexistence requiring a degree of compromise to better the whole.

Read the whole thing. See earlier post on applications of the Ising Model to Keynes.

Via Stefan at the Backreaction blog.

Compound Interest and the Binomial Theorem

A book I'm working through is J.C. Stillwell's history of mathematics. This was the happy result of a recommendation in Needham's Visual Complex Analysis -- also a worthwhile read.

Stillwell spends a bit of time on the history of the binomial theorem, which gives the expansion for a polynomial of arbitrary degree:

The coefficients of the expansion are equivalent to the number of combinations of k elements taken from a set of n elements:

These coefficients have a use in probability theory, which is probably the more familiar to most people -- namely, that the probability of getting k successes in n binary trials (e.g., coin flips) is the coefficient divided by the total number of possibilities (2^n for coin flips). They can also be calculated using Pascal's Triangle:

The binomial expansion is sometimes expressed in a simplified formula, in which y is set equal to 1, so that the equation reduces to:

The relationship between the binomial theorem and probability theory is of interest because the same formula turns up in a pretty important place in finance -- namely, in the formula for compound interest:

Here, the binomial expansion is multiplied by a fixed coefficient equal to the principal (or "present value") PV. The total expected value of the sequence of interest payments is simply the binomial expansion, with interest i as the variable x.

Curiously, one does not often see cash-flows expanded through the binomial theorem. Rather, the tendency is for each of the n payments to multiplied out. But that's of course equivalent to mutiplying the present value PV times the binomial expansion of interest payments.

What interpretation should be attached to the fact that compound interest is a binomial expansion? Here are a few observations:

• Ignore the Distant Future: The present value of compounded interest is a polynomial expansion in powers of interest; because interest < 1, the lower-order terms dominate the expansion.
• Don't Ignore the Near Future: Some higher-order terms in the expansion -- the ones that fall in the middle of Pascal's Trial -- have coefficients large enough to make up for the fact that interest rates < 1 are being multiplied. In other words, the base of the pyramid of compound interest is built of lots of combinations of principal and interest payments that occur in the immediate and near-future.
• You Can't Do Better than e: So long as your future value derives exclusively from organic growth in your present value -- i.e., no external infusions of cash -- there is no way to make the future value grow faster than exponential (sorry, Kurzweil).

The last is a consequence of the fact that as compounding occurs more and more frequently over the period in which payments are made, future value nonetheless approaches a finite limit:

Thus, if compound interest is like a binomial expansion in powers of interest, then continuously compounded interest is an exponential function of interest.

A final thought to ponder: Why do we calculate future value with this formula? In many cases, the answer is obvious -- because that's how we agree payments will be made by a borrower.

In other cases, however, that answer is less obviously satisfactory, and may even be incorrect. We can use the binomial expansion as an approximation for future value when there is some predictable process of growth occuring. But when growth occurs at different rates, or when compounding cannot be carried out efficiently, some other approximation for future value is necessary. The use of the binomial expansion as a crutch may be positively misleading.

Is Intellectual Arrogance the Reason Why Accounting Rules Have No Theory?

More from Menand's The Marketplace of Ideas:

Accounting is a trade, but the history of accounting is a subject of disinterested history -- a liberal art. And the accountant who knows something about the history of accounting will be a better accountant. That knowledge pays off in the marketplace. Similarly, future lawyers benefit from learning about the philosophical aspects of the law, just as literature majors learn more about poetry by writing poems.

Judge Posner makes a similar point about legal education in The Problematics of Jurisprudence. The context in Menand suggests that accounting may indeed have been neglected as a subject of liberal inquiry (i.e., as a subject of disinterested literary, historical, and/or scientific theory) because of its rep as a trade.

My personal experience suggests this to be an accurate depiction of how accountants are educated. They were even more parochial in their interests and education than the physics and chemistry majors I rubbed elbows with as an undergrad and grad student.

Could this be part of the explanation for the repeated failures of our financial system? Many earlier posts on this blog have addressed the serious weaknesses of financial accounting theory as a basis for measuring and managing our finanical system. But others see the problems, as Northwestern, Chicago, and Stanford Law Schools have begun teaching accounting theory to their students, at least through electives.

It's the unsexy, quotidien words that carry the heavy baggage in language -- a lesson learned early by every patent litigator. Similarly, its the unsexy, quotidien rules of accounting that move the cash-flows that represent the very life blood of our economy.

Click the accounting category at right for earlier posts. A fascinating historical fact, which I believe is not without larger significance, is that both a patent system and double-entry bookeeping were adopted around the same time in Venice in the 15th Century.

From The Marketplace of Ideas by Louis Menand

I will almost certainly have more to say about this book, which represents extraordinary vision. The conceptual scheme fits very well within the ontology of systems theory -- "knowledge" is an evolving system of neural networks, social networks, and the phsyical objects used to mediate communication among them.

For now, try on for size this quote from the introduction:

In 1908, the Cambridge classicist F. M. Cornford, in his satirical guide for young academics, Microcosmographia Academica, advised that the basic rule of faculty governance is, "Nothing should ever be done for the first time."

Alexander Hamilton on Our Interconnectedness

Although Phil Weiser spoke eloquently, I thought it worth pointing out that the conception of society as a system of interconnected networks has venerable historical antecedents. Consider what Ron Chernow has to say of Alexander Hamilton's address to the the Annapolis Convention of 1786, which led directly to the Constitutional Convention:

The Annapolis address, with its conception of the political system as a finely crafted mechanism, composed of subtly interrelated parts, had a distinctly Hamiltonian ring. It reflected the penchant of systemic solutions, his sense fo the fine interconnectedness of things.

Here's an excerpt of the address to which Chernow seems to refer:

If in expressing this wish, or intimating any further sentiment, your commissioners should seem to exceed the strict bounds of their appointment, they entertain a full confidence that a conduct dictated by an anxiety for the welfare of the United States will not fail to receive a favorable construction. In this persuasion, your commissioners submit an opinion that the idea of extending the powers of their deputies to other subjects than those of commerce, which had been adopted by the State of New Jersey, was an improvement on the original plan, and will deserve to be incorporated into that of a future convention. They are the more naturally led to this conclusion, as, in the course of their reflections on the subject, they have been induced to think that the power of regulating trade is of such comprehensive extent, and will enter so far into the general system of the Federal Government, that to give it efficacy, and to obviate questions and doubts concerning its precise nature and limits, may require a correspondent adjustment of other parts of the Federal system. That there are important defects in the system of the Federal Government is acknowledged by the acts of all those States which have concurred in the present meeting; that the defects upon a closer examination may be found greater and more numerous than even these acts imply, is at least so far probable, from the embarrassments which characterize the present state of our national affairs, foreign and domestic, as may reasonably be supposed to merit a deliberate and candid discussion in some mode which will unite the sentiments and councils of all the States.

You're in good company, Mr. Weiser.

2010 Inductees to the IP Hall of Fame

IAM has announced the 2010 inductees to the IP Hall of Fame. This institution, which began in 2006, is very welcome by those of us who believe, like Lincoln, that the IP system marks a unique new stage in the progress of civilization.

This is also a special year for a colleague at my law firm, Henry Blanco White. Henry's father Thomas was posthumously inducted into the hall of fame this year. Congrats to Henry and his family, and to all of the inductees. They are an inspiration to many of us in the field.

Phil Weiser on the Topology of Innovation Networks

From a speech by Deputy Assistant AG to the Antitrust Division Phil Weiser on 31 January 2010:

One fascinating dynamic in today's entrepreneurial economy is that the world is simultaneously more locally driven and more interlinked. It is more local because clusters of business start-up and expansion activity can create local symbiotic relationships that fuel further growth and innovation; it is more interlinked because ongoing technological development and races to innovate have created internationally interconnected networks for product development, production, and distribution. A key challenge, recognized and engaged by the Obama Administration's Strategy for American Innovation is understanding how best to balance these local and global forces. For countries, it creates an awkward dynamic insofar as modern economic forces are making both local geography and global connections more important. Thus, to be economically successful, countries must both support local economic clusters to spur entrepreneurship and innovation as well as participate and compete in global markets.

I like almost everything Weiser has to say here, although he is as optimistic about the accuracy of antitrust regulation as you would expect for a government agent. To take the Microsoft case, for example, I have previously blogged that the best result might have been for Microsoft to license in browser technology from Netscape.

Weiser's ultimate suggestion is an excellent one. The government would do well to leverage the comparative advantage of private institutions, such as standards-making bodies, in balancing exclusivity and access in order to achieve the right balance between competition and innovation. See here for a few additional thoughts along these lines.

Weiser and I also share the view that natural monopolies ought to be subject to compulsory licensing -- a fact I discovered on reading a post he did on SSOs for the Truth on the Market blog a few months ago. Where we may disagree more is over the question of who and how natural monopolies are to be identified.