Saturday, May 6, 2023

The Diff Links

  • A good mental exercise for CEOs is to periodically ask: if I were building a company that served the same customer need, would I rebuild the exact company I run today or would I build something totally different? There's usually some level of path-dependency in how companies eventually come to operate, which means that they need to get pruned from time to time. But occasionally the result of that pruning is to conclude that the business is actually in terminal decline and it needs to be demolished and rebuilt as quickly as possible. [The Diff]
  • Neal Stephenson's Baroque Cycle is up there with The Years of Lyndon Johnson in the pantheon of hefty multi-volume works that explore a storyline but really constitute a long meditation on more abstract historical forces. In the case of the Cycle, the big themes are the importance of the Enlightenment and the nature of money. The book toggles back and forth between a picaresque novel about piracy and an exploration of how finance and banking worked in the early 18th century. All of which is surprisingly modern—an important plot point revolves around what happens to the economy when a major bank's obligations are no longer seen as money-good. The book is technically historical fiction, and it does have a plot, but one of the main purposes of the fictional characters is to create an internally-consistent story that involves as many actual historical figures as possible from the time period. [The Diff]
  • There are two general ways to use factors. One is to run your entire portfolio based on them, i.e. to build a screening tool that gets you a list of companies that fit the factors you expect to perform well, or just that fit a bunch of the classic factors, and then to buy them. There are plenty of tools for doing exactly this. But a more interesting option is to use them as a backwards-looking tool: this page will give you factor exposure for specific stocks, or for an entire portfolio. It's useful to dump in things you own, or things you made or lost a lot on, just to see 1) which factors you tend to like, and 2) which factors like you back. There are some investors with a talent for digging through value stocks—which is basically a process of looking at fifty cheap companies to find the two or three that don't deserve to be that cheap. [The Diff]
  • The adaptive market hypothesis has several implications that differentiate it from the efficient market hypothesis: To the extent that a relation between risk and reward exists, it is unlikely to be stable over time. This relation is influenced by the relative sizes and preferences of populations and by institutional aspects. As these factors change, any risk/reward relation is likely to change as well. There are opportunities for arbitrage. Investment strategies—including quantitatively, fundamentally and technically based methods—will perform well in certain environments and poorly in others. An example is risk arbitrage, which has been unprofitable for some time after the decline in investment banking in 2001. As M&A activities increased, risk arbitrage regained its popularity. The primary objective is survival; profit and utility maximization are secondary. When a multiplicity of capabilities that work under different environmental conditions evolves, investment managers are less prone to become extinct after rapid changes. The key to survival is innovation: as the risk/reward relation varies, the better way of achieving a consistent level of expected returns is to adapt to changing market conditions. [Wiki]
  • Earlier, we defined a couple factors in terms of the bet that you’re making — momentum is the bet that investors under-discount recent good and bad news, for example, and value is a bet that investors underestimate the power of mean-reversion. What’s the bet behind passive? It’s simply the bet that the cost of adverse selection (buying something overpriced, or selling something underpriced) is smaller than the cost of active management. Phrased that way, of course it’s going to move in cycles: when passive has had better returns, more assets move to passive; when assets move into passive, the marginal buyer is less sensitive to valuation, so the cost of being wrong about valuation is lower. [The Diff]
  • Being a contrarian is a useful trait for someone who fundamentally makes a living from taking risk, but that’s only one part of the financial services industry. If your job is closer to asset-gathering, then being contrarian is a liability. It’s much, much easier to sell a product if people are already inclined to believe in it. And one source of persistent alpha is that the expected value from earning management fees on blind extrapolation from a trend is, for most people, higher than the expected performance fees from arduously raising money to bet against it. [The Diff]
  • Nielsen has been collecting and analyzing retail point-of-sale data for years. If you're selling candy, soft drinks, or detergent, you want real-time information on demand, not lagged information based on how retailers' orders change over time. And when there's a drop in demand, you want to know whether it's from a change in overall spending behavior or because of market share losses. [The Diff]

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