Define market (in)efficiency: the Euro

Euro/USD prices: An anomalous move? Source: thinkorswim by TDAmeritrade

The Efficient Market Hypothesis is a well-known, well-respected theory.  It’s frequently cited by folks in the economic & financial space to justify very conventional, buy-and-hold investment products.  Particularly in the stronger forms of EMH, all publicly available information is immediately reflected in asset prices.

I’ve written before about the impact of ‘known unknowns’ versus ‘unknown unknowns’ in financial markets.  The recent crash in the Euro strikes me as an interesting case study:

• Why is the Euro crashing?  In a term, policy divergence.  The European Central Bank is providing quantitative easing to the Euro-area, which means (all other things equal) higher money supply and a cheaper currency.  In contrast, the Federal Reserve is gradually pulling back from their quantitative easing (i.e. letting their purchased bonds run-off), and thinking about raising interest rates this summer.  Both these actions should mean a stronger US Dollar.
• Why such a prolonged slide?  This is where I think the markets are interesting.  In an informationally-efficient world, I would have expected a big move at the onset of European QE, with not much happening thereafter (perhaps some oscillation around a new equilibrium level).  Instead, we’re being treated to a managed futures manager’s dream scenario: a fairly steady downward trend, without many pull-backs.
• Perhaps behaviour economics can answer?  An explanation could be found in the inefficiencies considered by behavioural economics.  Among the possibilities:
  • Discrete decision points: perhaps each business/investor considers the QE announcement at different intervals, and thus make moves in sequence.
  • Loss aversion/disposition effect: folks long Euros have been holding on, while losses pile up.  Over time, they accept their painful losses at different points based upon relative aversion.

In sum: efficient markets shouldn’t really show these kind of smooth trends.  But the trends exist all the same.  Hence it’s worthwhile considering momentum as a viable investment strategy.

Financial literacy and UK pension changes

The money is mine!! Source: Google images

A quick one today, versus yesterday’s rant.

There was another Dispatches episode recently discussing April 2015 changes to UK pensions policy.  For those unaware, until now UK pensioners were forced to purchase annuities with their savings (aside from a 25% lump sum, which could be taken as cash). As of April, this is no longer required: folks can use their funds as they like.

On the face of it, there seems to be no issue here.  I mean, we’re all about freedom, particularly when it comes to hard-earned savings, right?  Well… my concern here is about timing: it’s like the government just said “we know you had saved in expectation of this happening, but instead it will be that…now go!”  There was little prep time for folks to learn how to manage their own pension savings.

I may be making a mountain out of a mole hill, but the stories in the Dispatches episode, in conjunction with surveys of financial literacy such as this one give me reason for pause.  There will inevitably be several folks (such as those interviewed in the show) who decide to blow a significant portion of their now-liquid savings on new cars and such; their financial future will need to be picked up by additional state pension benefits, paid for by younger generations.  I’ve written at length about my feelings of the latter.

So what’s the solution?  To be honest, I’m torn: my libertarian side says the government had no business forcing the purchase of annuities, so this is an unambiguously good thing; my paternalist (and perhaps more realist and cynical) side thinks this will almost certainly increase the need for state pension benefits, and associated taxation.  Hum.

In sum: if you know of someone benefitting from the rule changes, please encourage him/her to seek financial advice.  Thankfully the UK government has set up the Money Advice Service…I really hope it gets used.

Who to trust: the machine, or me?

Who’s smarter – computer or user? Source: Google Images.

I suppose it’s a common refrain among newer systematic traders (i.e. those who prefer to have a programmed computer trade on their behalf): when is it OK to override the system I created?

This is particularly on my mind this week, as the volatility of global markets in the first few trading days of 2015 has been a mix of good and bad for my trading system:

• The good: higher volatility, combined with strong trends (I’m looking at you, oil and euro) has meant several winning positions for my relatively simple momentum system.
• The bad: despite some decent trends, there have been pretty good reactions/whipsaws in other markets (including equities and bonds).

So here’s my thought process, in the heat of battle, as it were:

• Rational side: I’ve created a robust system, without fiddling too much with parameters (learning lessons from others).  It works in backtest, and has worked since live trading.  Just keep away from it.
• Emotional side: I was up $xx in my S&P position, but am now up 75% of $xx.  The trend *looks* like it’s reversing.  Better to get out now, rather than await the inevitable close by the system.
• Result: A few good discretionary closes, saving a decent chunk of accumulated gains/avoiding loss.  Set against that, a few other discretionary closes led to a bad outcome – fear of missing out.
  • Say I closed a trade in oil, just to see the price continue its downward trajectory.
  • The system wanted to stay short, but I exited early.
  • I get mad at my decision, so get back short at a lower price.
  • The oil price finally does reverse, vindicating my earlier decision to close out early.  But now I’m stuck with a position (that the system still wants, btw) that I don’t want.
  • I close this second, losing trade, again mad at myself for the whole scenario.
  • Overall, these losses offset a decent chunk of the profits saved by discretionary exits.

What to do.  I guess it’s back to work on my system’s exit logic – hopefully my idea for closing out earlier doesn’t completely screw up the system’s profitability.  Regardless, I’ll learn more.

Quick note to self about the portfolio: mental accounting bias

In a word: fungibility.  Many folks are fans of compartmentalising their portfolios: this amount for housing; this amount for retirement; this amount for kids schooling.  There’s a behavioural investment bias associated with this, called mental accounting.  If memory serves me correctly, the CFA curriculum has a somewhat hand-wavy approach to this bias:

1. Mental accounting is suboptimal.  The portfolio is all fungible; money is money.  Creating silos can inhibit portfolio return, because it’s possible that more assets are kept in safer or less diversified holdings than if the portfolio was considered as a whole.  So CFA-designated financial advisors: don’t silo your clients’ portfolios.
2. But…. most people have real difficulty thinking of his/her portfolio as a whole.  It can be scary to think about (say) the kids’ college money being put into risky investments better left for long-duration retirement funds.  In order to sate clients’ needs to ‘see’ certain silos within their portfolios, the financial advisor might relent to this approach.

I think a big area of discussion related to this concept is ‘the emergency fund’ of cash.  Suppose the following, silly example:

• Single person, aged 35, with annual living expenses of $25,000 p.a.
• Has a job earning $50,000 p.a., so is saving a fair chunk.
• Due to lottery winnings/inheritance/previous stock options/etc., the person has a $1,000,000 portfolio.
• Conventional emergency fund thinking: stash away 3-6 months of living expenses (e.g. $7-12,000) in cash at all times.
• Total portfolio thinking: keep only necessary liquidity in cash (maybe $2,000, say).  Remainder is put in a portfolio of various assets, with a total return objective.  If bad times happen job-wise, liquidate some of the portfolio.

Which do you feel is better for this person?  What about your own situation?  Hmm…