The False Precision Black Hole

When I started at Commodities Corporation in 1979, we managed $100MM dollars. We had computers that sat on raised floors in climate controlled rooms. We were state of the art….and we still had 100 employees. Alas, fees were higher, but my point is that advancing data availability and data processing has been a boon to the investment industry.

But there has been an unmistakable downside to all this power and information, what my partner Roger has christened “false precision”. Everyone has lots of data and the power to manipulate it with ease. All questions can be answered with “hard numbers”. Risks can be fully calibrated (see previous post, A Note on Risk). Nowhere has this thinking reached more heroic levels of absurdity than at your Federal Reserve. From a Chairman Yellen speech, circa 2012:

Although simple rules provide a useful starting point in determining appropriate policy, they by no means deserve the “last word”–especially in current circumstances. An alternative approach, also illustrated in figure 10, is to compute an “optimal control” path for the federal funds rate using an economic model–FRB/US, in this case. Such a path is chosen to minimize the value of a specific “loss function” conditional on a baseline forecast of economic conditions. The loss function attempts to quantify the social costs resulting from deviations of inflation from the Committee’s longer-run goal and from deviations of unemployment from its longer-run normal rate. The solid green line with dots in figure 10 shows the “optimal control” path for the federal funds rate, again conditioned on the illustrative baseline outlook. This policy involves keeping the federal funds rate close to zero until late 2015, four quarters longer than the balanced-approach rule prescription and several years longer than the Taylor rule. Importantly, optimal control calls for a later lift-off date even though this benchmark–unlike the simple policy rules–implicitly takes full account of the additional stimulus to real activity and inflation being provided over time by the Federal Reserve’s other policy tool, the past and projected changes to the size and maturity of its securities holdings.

Lord have mercy! Can she really think this can work? Is there any Fed model that caught 2008, 1998, 1987, or any other market moving event? This is the event horizon of the false precision black hole. But don’t worry, just throw a bunch of junk mortgages in a bucket, stir, and voila – AAA. It’s all right here in this spreadsheet.

“Simple Enough To Be Good”

picassoI just read a great book – The Simplicity Cycle by Dan Ward. It articulates wonderfully a philosophy that underpins everything we do here at Mount Lucas, something that we feel is incredibly important for investors to understand, and that investors in general are moving away from. The book isn’t finance based at all, a quick and easy read. The basic premise is summed up with the quote below:

“…humans gravitate towards complexity, in our technologies and religions, our laws and relationships, because simplicity is so often inadequate to our needs. We require a certain degree of complexity in our lives, just as we require a certain number of calories each day. Accordingly, we add layers, gizmos, features, functions, connections and rules to the things we create in an attempt to make them more exciting, more effective, or otherwise better. This preference, too, becomes a problem when it spirals out of control and produces industrial-strength concentrations of complexity that surpass our needs by multiple orders of magnitude….Simplicity is great and important, to be sure, but let me say it again: simplicity is not the point. What is the point? In a word, goodness…Simplicity matters because it affects goodness, but it turns out the relationship between simplicity and goodness does not follow a straight line. This means an increase in one does not always correspond with an increase in the other. Sometimes making things simpler is indeed an improvement. Sometimes not. Life is tricky that way”

Continue reading