Tag Archives: investing

Are markets underestimating climate risk?

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This sprawling Naked Capitalism article says yes, basically because investors don’t consider the long term. But if it were really true that most investors are not aware or not correctly valuing the risk, a small minority of investors should in theory be able to make money on that and bring markets back into equilibrium. Maybe the “long term” is just too long for mortal human investors to consider? But corporations and other institutions like pension funds are not mortal humans. Fossil fuel companies could try to exploit these opportunities to hedge their bets while they continue to cast doubt on the science and technology needed to get out of the mess.

How would an investor exploit other investors’ underestimation of climate risk, if this actually exists? Short-sell companies insuring homes, businesses, and lives in coastal and fire-prone areas? Buy construction and engineering companies that will get our tax money to clean up after disasters? Military and security contractors who build walls and detention camps (a morbid thought, but mass migration driven by climate panic seems likely to hit us at some point). Clean energy? Nuclear energy? It’s hard to guess and time these things – basically comes down to luck, and there are always going to be people with deeper pockets and political influence to keep us small-time investors from getting ahead. Diversifying across asset classes and internationally, and not having all our savings tied up in our houses, still seem like the best options for us little people.

an agent-based stock market simulator

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This agent-based stock market simulator, which was originally programmed in NetLogo and later moved to R, captures the behavior of the market in a statistical sense. Which is to say, it shows how multiple traders following logical strategies can add up to a whole lot of randomness and unpredictability. Also known as autoregressive conditional heteroscedasticity and/or generalized autoregressive conditional heteroscedasticity, if I remember my statistics class correctly. But the article does not go into that.

stock market returns as simulated by an agent-based model

Pension funds should never rely on correlation

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Pension funds should not rely on correlations between mean annual return and variance in annual return when deciding how much stocks and bonds to own, according to this article on which Nassim Nicholas Taleb (the Black Swan guy) is the second author. To paraphrase/oversimplify my understanding of the article greatly, the main arguments are that (1) data from the past is not a perfect predictor of the future, and (2) short term volatility is not a good measure of the risk of achieving a long term goal.

In engineering, I hear #1 all the time from people – why don’t we rely on data instead of “modeling” when trying to predict the future? Of course we do both – try to understand the underlying structure of the system we are dealing with, then use data from the past to try to confirm that we got it right, at least for the conditions that prevailed when the data were collected (and assuming the data themselves are reasonably accurate or at least any measurement error is not biased one way or the other), and then use the resulting model of the system to try to predict the future. Conditions in the future may be different than conditions in the past, and that is why we don’t “just rely on data”. If external conditions are different but the underlying structure of the system doesn’t change (much), we can come up with reasonable predictions of the future. The only true test of whether the prediction is right comes from data which will be collected in the future, but is not available today when a decision has to be made. A lot of decisions are really just playing the odds about what might work in the most likely future, or what might work across several different possible futures that collectively are very likely (a “robust” decision). The decision that is best for the single most likely condition and a group of very likely conditions may not be the same one – now you are a gambler trying to decide whether you go for the biggest possible payoff while accepting a larger chance of a loss, or whether you want to maximize your chances of a positive payoff while giving up your shot at a really big payoff. You would think the pension fund would go for the latter.

#2 makes sense to me. Variability in annual returns doesn’t matter much if you are 25 and investing money you plan to need at 65. A pension fund is a little different, because it is essentially immortal but has obligations it has to meet each year.

In the case of investment returns, the approach seems to be almost purely “data-driven” with no real understanding of the underlying system, and this leads to an existential crisis when people try to figure out what asset allocation advice to stake their future on. We understand the real economy to some extent, we think, but we don’t really seem to confidently understand how the real economy and the financial economy are related, especially over shorter time frames. So we are reduced to just describing the data, which might lead to some insights about the system but has limited predictive value. Still, examining the evidence before making a decision seems like a good idea to me. What is the alternative – guessing, wishing, praying?

margin calls

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I don’t pay too much attention to stock market commentary, but another warning light on the economic dash might be that margin calls appear to have spiked. You ignore most of those warning lights most of the time, but sometimes they mean something, and if there are more of them over time and they are all flashing at once you might want to do something about it. Margin calls mean investors who have borrowed money from their brokers to buy stocks are being told by the brokers they have to pay the loans back, which forces them to sell some of what they have. It suggests the brokers are nervous the market might fall. If it actually starts to fall, this can accelerate the fall because people are then forced to sell when they don’t want to and everybody else is selling. And margin calls are just the visible tip of a debt iceberg, most of which lies unseen beneath the surface. This blog is called Wolf Street.

the Black-Scholes equation

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This 2012 article from the Guardian goes into some detail on the Black-Scholes equation for pricing options, which bears some responsibility for the 2007-2008 financial crisis. It was cooked up by geniuses to spread risk, but misapplied by idiots to actually create risk. What are the geniuses cooking up now for the idiots to misapply next?

S&P green rating

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Standard and Poor’s is coming out with a new rating system for the green-ness of bonds.

Our proposed Green Bond Evaluation methodology looks beyond the governance and management of a bond by providing an analysis and estimate of the environmental impact of the projects or initiatives financed by the bond’s proceeds over its lifetime relative to a local baseline. This would be in addition to assessing the governance and transparency surrounding the bond. When evaluating environmental impact, the methodology would consider both climate change mitigation and adaptation projects.

Mitigation projects focus on efforts to reduce or prevent the emission of greenhouse gases, ranging from upgrades to conventional generation projects to new renewable energy and energy efficiency initiatives. Adaptation projects aim to take practical steps toward reducing the exposure to and managing the impact of natural catastrophes, such as building the resilience of communities and critical infrastructure against an increased risk of extreme weather events due to climate change.

The output of the Green Bond Evaluation would include at least three scores (a Transparency score, a Governance score and a Mitigation score and/or Adaptation score, as relevant…

An interesting question is whether the idea is that investors would expect to make more on a green investment, or whether some investors would be willing to settle for less in exchange for the satisfaction of having a positive impact. Borrowers would have a financial incentive to be good if doing so meant a lower interest rate, which kind of supports the latter possibility. Exactly why the rating agency itself is motivated to do this was unclear to me. But after digging into the paper a little, it looks like governments and companies will have an incentive to show that they are complying with the Paris agreement, so that may be part of what is driving this.

stupid advice for 20 year olds

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Here is some really stupid advice for 20-somethings, making the rounds as a viral email apparently:

People who are saving in their 20s are people who don’t set their sights high. They’ve already dropped out of the game and settled for the minor leagues.

Your 20s are not the time to save; they’re the time to gamble. $200 a month isn’t going to make the dent that a $60,000 pay raise will after spending all those nights out networking.

When you’re 40, you’re not going to look back on your 20s and be grateful for the few thousand you saved. You’re going to be full of regret.

You’ll regret the experiences you didn’t take, the people you didn’t meet and the fun you didn’t have because you were too worried about a future that came and went.

Well, I just turned 40, so let me think back to my 20s. I was a particularly clueless 20-something in many ways, but somehow I built a career, saved some money, and had a lot of fun too. There were big expenses and small expenses. The big expenses were housing and transportation. I controlled the big expenses by living in small, cheap places and having a small, cheap car (and later, no car). That left me plenty of money to save, and plenty of pocket change to have a little fun. I am glad I had fun – I have no regrets, other than maybe having a little too much fun and getting behind the wheel once or twice when I shouldn’t have. I certainly don’t regret the “few thousand” I saved back then, which gives me and my family some piece of mind 20 years later. So that’s the advice I would give 20-somethings, if they ever thought they needed my advice – pick a profession, build a career, save, live in a small place, go car-free if you can, make some friends and have some fun. When you turn 40 you will like where you are.