It’s Not About the Nail

epsilon-theory-its-not-about-the-nail-march-31-2015-yoda

Do, or do not. There is no try.”

– Yoda, “Star Wars: Episode V – The Empire Strikes Back” (1980)

I see it all perfectly; there are two possible situations – one can either do this or that. My honest opinion and my friendly advice is this: do it or do not do it – you will regret both.
Soren Kierkegaard, “Either/Or: A Fragment of Life” (1843)

The only victories which leave no regret are those which are gained over ignorance.
Napoleon Bonaparte (1769 – 1821)

Maybe all one can do is hope to end up with the right regrets.
Arthur Miller, “The Ride Down Mt. Morgan” (1991)

Of all the words of mice and men, the saddest are, “It might have been.”
Kurt Vonnegut, “Cat’s Cradle” (1963)

One can’t reason away regret – it’s a bit like falling in love, fall into regret.
Graham Greene, “The Human Factor” (1978)

epsilon-theory-its-not-about-the-nail-march-31-2015-cash.jpg

I bet there’s rich folks eatin’

In a fancy dining car.

They’re probably drinkin’ coffee

And smokin’ big cigars.

Well I know I had it comin’.

I know I can’t be free.

But those people keep-a-movin’

And that’s what tortures me.

– Johnny Cash, “Folsom Prison Blues” (1955)

epsilon-theory-its-not-about-the-nail-march-31-2015-paul-anka

Regrets…I’ve had a few.

But then again, too few to mention.

– Paul Anka, Frank Sinatra “My Way” (1969)

The Moving Finger writes; and, having writ,
Moves on: nor all thy Piety nor Wit
Shall lure it back to cancel half a Line,
Nor all thy Tears wash out a Word of it.
Omar Khayyam, “Rubaiyat” (1048 – 1141)

You can tell it any way you want but that’s the way it is. I should of done it and I didn’t. And some part of me has never quit wishin’ I could go back. And I can’t. I didn’t know you could steal your own life. And I didn’t know that it would bring you no more benefit than about anything else you might steal. I think I done the best with it I knew how but it still wasn’t mine. It never has been.”
Cormac McCarthy, “No Country for Old Men” (2005)

Jesse: Yeah, right, well, great. So listen, so here’s the deal. This is what we should do. You should get off the train with me here in Vienna, and come check out the capital.
Celine: What?
Jesse: Come on. It’ll be fun. Come on.
Celine: What would we do?
Jesse: Umm, I don’t know. All I know is I have to catch an Austrian Airlines flight tomorrow morning at 9:30 and I don’t really have enough money for a hotel, so I was just going to walk around, and it would be a lot more fun if you came with me. And if I turn out to be some kind of psycho, you know, you just get on the next train.

Alright, alright. Think of it like this: jump ahead, ten, twenty years, okay, and you’re married. Only your marriage doesn’t have that same energy that it used to have, y’know. You start to blame your husband. You start to think about all those guys you’ve met in your life and what might have happened if you’d picked up with one of them, right? Well, I’m one of those guys. That’s me, y’know, so think of this as time travel, from then, to now, to find out what you’re missing out on. See, what this really could be is a gigantic favor to both you and your future husband to find out that you’re not missing out on anything. I’m just as big a loser as he is, totally unmotivated, totally boring, and, uh, you made the right choice, and you’re really happy.

Celine: Let me get my bag.

Richard Linklater, “Before Sunrise” (1995)

For it falls out
That what we have we prize not to the worth
Whiles we enjoy it, but being lacked and lost,
Why, then we rack the value, then we find
The virtue that possession would not show us
While it was ours.
William Shakespeare, “Much Ado About Nothing” (1612)

When to the sessions of sweet silent thought
I summon up remembrance of things past,
I sigh the lack of many a thing I sought,
And with old woes new wail my dear time’s waste:
William Shakespeare, “Sonnet 30” (1609)

epsilon-theory-its-not-about-the-nail-march-31-2015-nirvana

No, I don’t have a gun.

– Nirvana, “Come As You Are” (1992)

I spend a lot of my time speaking with investors and financial advisors of all stripes and sizes, and here’s what I’m hearing, loud and clear. There’s a massive disconnect between advisors and investors today, and it’s reflected in both declining investment activity as well as a general fatigue with the advisor-investor conversation. I mean “advisor-investor conversation” in the broadest possible context, a context that should be recognizable to everyone reading this note. It’s the conversation of a financial advisor with an individual investor client. It’s the conversation of a consultant with an institutional investor client. It’s the conversation of a CIO with a Board of Directors. It’s the conversation of many of us with ourselves. The wariness and weariness associated with this conversation runs in both directions, by the way.

Advisors continue to preach the faith of diversification, and investors continue to genuflect in its general direction. But the sermon isn’t connecting. Investors continue to express their nervousness with the market and dissatisfaction with their portfolio performance, and advisors continue to nod their heads and say they understand. It reminds me of Jason Headley’s brilliant short film, “It’s Not About the Nail”, with the advisor reprising Headley’s role. Yes, the advisor is listening. But most find it impossible to get past what they believe is the obvious answer to the obvious problem. Got a headache? Take the nail out of your head. Nervous about the market? Diversify your portfolio. But there are headaches and then there are headaches. There is nervousness and then there is nervousness. It’s not about the nail, and the sooner advisors realize this, the sooner they will find a way to reconnect with their clients. Even if it’s just a conversation with yourself.

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Investors aren’t asking for diversification, which isn’t that surprising after 6 years of a bull market. Investors never ask for diversification after 6 years of a bull market. They only ask for it after the Fall, as a door-closing exercise when the horse has already left the burning barn. What’s surprising is that investors are asking for de-risking, similar in some respects to diversification but different in crucial ways. What’s surprising is that investors are asking for de-risking rather than re-risking, which is what you’d typically expect at this stage of such a powerful bull market.

Investors are asking for de-risking because this is the most mistrusted bull market in recorded history, a market that seemingly everyone wants to fade rather than press. Why? Because no one thinks this market is real. Everyone believes that it’s a by-product of outrageously extraordinary monetary policy actions rather than the by-product of fundamental economic growth and productivity, and what the Fed giveth … the Fed can taketh away.

This is a big problem for the Fed, as their efforts to force greater risk-taking in markets through LSAP and QE (and thus more productive risk-taking, or at least inflation, in the real economy) have failed to take hold in investor hearts and minds. Yes, we’re fully invested, but only because we have to be. To paraphrase the old saying about beauty, risk-taking is only skin deep for today’s investor, but risk-aversion goes clear to the bone.

It’s also the root of our current advisor-investor malaise. De-risking a bull market is a very different animal than de-risking a bear market. And neither is the same as diversification.

Let’s take that second point first.

Here’s a simple representation of what diversification looks like, from a risk/reward perspective.

epsilon-theory-its-not-about-the-nail-march-31-2015-historical-risk-rewardFor illustrative purposes only.

The gold ball is whatever your portfolio looks like today from a historical risk/reward perspective, and the goal of diversification is to move your portfolio up and to the left of the risk/reward trade-off line that runs diagonally through the current portfolio position. Diversification is all about increasing the risk/reward balance, about getting more reward per unit of risk in your portfolio, and the goodness or poorness of your diversification effort is defined by how far you move your portfolio away from that diagonal line. In fact, as the graph below shows, each of the Good Diversification outcomes are equally good from a risk/reward balance perspective because they are equally distant from the original risk/reward balance line, and vice versa for the Poor Diversification outcomes.

epsilon-theory-its-not-about-the-nail-march-31-2015-historical-risk-reward-2

For illustrative purposes only.

Diversification does NOT mean getting more reward out of your portfolio per se, which means that some Poor Diversification changes to your portfolio will outperform some Good Diversification changes to your portfolio over time (albeit with a much bumpier ride).

epsilon-theory-its-not-about-the-nail-march-31-2015-historical-risk-reward-3

For illustrative purposes only.

It’s an absolute myth to say that any well-diversified portfolio will outperform all poorly diversified portfolios over time. But it’s an absolute truth to say that any well-diversified portfolio will outperform all poorly diversified portfolios over time on a risk-adjusted basis. If an investor is thinking predominantly in terms of risk and reward, then greater diversification is the slam-dunk portfolio recommendation. This is the central insight of Harry Markowitz and his modern portfolio theory contemporaries, and I’m sure I don’t need to belabor that for anyone reading this note.

The problem is that investors are not only risk/reward maximizers, they are also regret minimizers (see Epsilon Theory notes “Why Take a Chance” and “The Koan of Donald Rumsfeld” for more, or read anything by Daniel Kahneman). The meaning of “risk” must be understood as not only as the other side of the reward coin, but also as the co-pilot of behavioral regret. That’s a mixed metaphor, and it’s intentional. The human animal holds two very different meanings for risk in its brain simultaneously. One notion of risk, as part and parcel of expected investment returns and the path those returns are likely to take, is captured well by the concept of volatility and the toolkit of modern economic theory. The other, as part and parcel of the psychological utility associated with both realized and foregone investment returns, is captured well by the concepts of evolutionary biology and the toolkit of modern game theory.

The problem is that diversification can only be understood as an exercise in risk/reward maximization, has next to nothing to say about regret minimization, and thus fails to connect with investors who are consumed by concerns of regret minimization. This fundamental miscommunication is almost always present in any advisor-investor conversation, but it is particularly pernicious during periods of global debt deleveraging as we saw in the 1870’s, the 1930’s, and today. Why? Because the political consequences of that deleveraging create investment uncertainty in the technical, game theoretic sense, an uncertainty which is reflected in reduced investor confidence in the efficacy of fundamental market and macroeconomic factors to drive market outcomes. In other words, the rules of the investment game change when politicians attempt to maintain the status quo – i.e., their power – when caught in the hurricane of a global debt crisis. That’s what happened in the 1870’s. That’s what happened in the 1930’s. And it’s darn sure happening today. We all feel it. We all feel like we’ve entered some Brave New World where the old market moorings make little sense, and that’s what’s driving the acute anxiety expressed today by investors both large and small. Recommending old-school diversification techniques as a cure-all for this psychological pain isn’t necessarily wrong. It probably won’t do any harm. But it’s not doing anyone much good, either. It’s not about the nail.

On the other hand, the concept of de-risking has a lot of meaning within the context of regret minimization, which makes it a good framework for exploring a more psychologically satisfactory set of portfolio allocation recommendations. But to develop that framework, we need to ask what drives investment regret. And just as we talk about different notions of volatility-based portfolio constructions under different market regimes, so do we need to talk about different notions of regret-based portfolio constructions under different market regimes.

Okay, that last paragraph was a bit of a mouthful. Let me skip the academic-ese and get straight to the point. In a bear market, regret minimization is driven by existential concerns. In a bull market, regret minimization is driven by peer comparisons.

In a bear market your primary regret – the thing you must avoid at all costs – is ruin, and that provokes a very direct, very physical reaction. You can’t sleep. And that’s why Rule #1 of de-risking in a bear market is so simple: sell until you can sleep at night. Go to cash. Here’s what de-risking in a bear market looks like, as drawn in risk/reward space.

epsilon-theory-its-not-about-the-nail-march-31-2015-historical-risk-reward-4

For illustrative purposes only.

Again, the gold ball is whatever your portfolio looks like today from a historical risk/reward perspective. De-risking means moving your portfolio to the left, i.e. a lower degree of risk. The question is how much reward you are forced to sacrifice for that move to the left. Perfect De-Risking sacrifices zero performance. Good luck with that if you are reducing your gross exposure. Average De-Risking is typically accomplished by selling down your portfolio in a pro rata fashion across all of your holdings, and that’s a simple, effective strategy. Good De-Risking and Poor De-Risking are the result of active choices in selling down some portion of your portfolio more than another portion of your portfolio, or – if you don’t want to go to cash – replacing something in your portfolio that’s relatively volatile with something that’s relatively less volatile.

In a bull market, on the other hand, your primary regret is looking or feeling stupid, and that provokes a very conflicted, very psychological reaction. You want to de-risk because you don’t understand this market, and you’re scared of what will happen when the policy ground shifts. But you’re equally scared of being tagged with the worst possible insults you can suffer in our business: “you’re a panicker” … “you missed the greatest bull market of this or any other generation”. Again, maybe this is a conversation you’re having with yourself (frankly, that’s the most difficult and conflicted conversation most of us will ever have). And so you do nothing. You avoid making a decision, which means you also avoid the advisor-investor conversation. Ultimately everyone, advisor and investor alike, looks to blame someone else for their own feelings of unease. No one’s happy, even as the good times roll.

So what’s to be done? Is it possible to both de-risk a portfolio and satisfy the regret minimization calculus of a bull market?

Through the lens of regret minimization, here’s what de-risking in a bull market looks like, again as depicted in risk/reward space:

epsilon-theory-its-not-about-the-nail-march-31-2015-historical-risk-reward-5

For illustrative purposes only.

Essentially you’ve taken all of the bear market de-risking arrows and moved them 45 degrees clockwise. What would be Perfect De-Risking in a bear market is only perceived as average in a bull market, and many outcomes that would be considered Good Diversification in pure risk/reward terms are seen as Poor De-Risking. I submit that this latter condition, what I’ve marked with an asterisk in the graph above, is exactly what poisons so many advisor-investor conversations today. It’s a portfolio adjustment that’s up and to the left from the diagonal risk/reward balance line, so you’re getting better risk-adjusted returns and Good Diversification – but it’s utterly disappointing in a bull market as peer comparison regret minimization takes hold. It doesn’t even serve as a Good De-Risking outcome as it would in a bear market.

Now here’s the good news. There are diversification outcomes that overlap with the bull market Good De-Risking outcomes, as shown in the graph below. In fact, it’s ONLY diversification strategies that can get you into the bull market Good De-Risking area. That is, typical de-risking strategies look to cut exposure, not replace it with equivalent but uncorrelated exposure as diversification strategies do, and you’re highly unlikely to improve the reward profile of your portfolio (moving up vertically from the horizontal line going through the gold ball) by reducing gross exposure. The trick to satisfying investors in a bull market is to increase reward AND reduce volatility. I never said this was easy.

epsilon-theory-its-not-about-the-nail-march-31-2015-historical-risk-reward-6

For illustrative purposes only.

The question is … what diversification strategies can move your portfolio into this promised land? Also (as if this weren’t a challenging enough task already), what diversification strategies can work quickly enough to satisfy a de-risking calculus? Diversification can take a long time to prove itself, and that’s rarely acceptable to investors who are seeking the immediate portfolio impact of de-risking, whether it’s the bear market or bull market variety.

What we need are diversification strategies that can act quickly. More to the point, we need strategies that can react quickly, all while maintaining a full head of steam with their gross exposure to non-correlated or negatively-correlated return streams. This is at the heart of what I’ve been calling Adaptive Investing.

Epsilon Theory isn’t the right venue to make specific investment recommendations. But I’ll make three general points.

First, I’d suggest looking at strategies that can go short. If you’re de-risking a bull market, you need to make money when you’re right, not just lose less money. Losing less money pays off over the long haul, but the long haul is problematic from a regret-based perspective, which tends to be quite path-sensitive. Short positions are, by definition, negatively correlated to the thing that they’re short. They have a lot more oomph than the non-correlated or weakly-correlated exposures that are at the heart of most old-school diversification strategies, and that’s really powerful in this framework. Of course, you’ve got to be right about your shorts for this to work, which is why I’m suggesting a look at strategies that CAN go short as an adaptation to changing circumstances, not necessarily strategies that ARE short as a matter of habit or requirement.

Second, and relatedly, I’d suggest looking at trend-following strategies, which keep you in assets that are working and get you out of assets that aren’t (or better yet, allow you to go short the assets that aren’t working). Trend-following strategies are inherently behaviorally-based, which is near and dear to the Epsilon Theory heart, and more importantly they embody the profound agnosticism that I think is absolutely critical to maintain when uncertainty rules the day and fundamental “rules” change on political whim. Trend-following strategies are driven by the maxim that the market is always right, and that’s never been more true – or more difficult to remember – than here in the Golden Age of the Central Banker.

Third, these graphs of portfolio adjustments in risk/reward space are not hypothetical exercises. Take the historical risk/reward of your current portfolio, or some portion of that portfolio such as the real assets allocation, and just see what the impact of including one or more liquid alternative strategies would be over the past few years. Check out what the impact on your portfolio would be since the Fed and the ECB embarked on divergent monetary policy courses late last summer, creating an entirely different macroeconomic regimeSeriously, it’s not a difficult exercise, and I think you’ll be surprised at what, for example, a relatively small trend-following allocation can do to de-risk a portfolio while still preserving the regret-based logic of managing a portfolio in a bull market. For both advisors and investors, this is the time to engage in a conversation about de-risking and diversification, properly understood as creatures of regret minimization as well as risk/reward maximization, rather than to avoid the conversation. As the old saying goes, risk happens fast. Well … so does regret. 

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Troy Will Burn – the Big Deal about Big Data

epsilon-theory-troy-will-burn-the-big-deal-about-big-data-march-16-2015-jeb-bush

For the life of me, I don’t understand the debate [over the NSA metadata program].

– Jeb Bush, February 18, 2015

The Central Intelligence Agency played a crucial role in helping the Justice Department develop technology that scans data from thousands of US cellphones at a time, part of a secret high-tech alliance between the spy agency and domestic law enforcement, according to people familiar with the work. 

The Wallstreet Journal front page story, March 10, 2015

Athena:  You wish to be called righteous rather than act right.

Aeschylus, “The Oresteia” (458 BC)

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Point72 Asset Management, the successor to Cohen’s hedge fund SAC Capital Advisors, has hired about 30 employees since the start of last year to build computer models that collect publicly available data and analyze it for patterns, according to two people with knowledge of the matter.
Cohen, whose SAC Capital shut down last year and paid a record fine to settle charges of insider trading, joins Ray Dalio’s Bridgewater Associates in pushing into computer-driven investing, an area dominated by a handful of big firms such as the $25 billion Renaissance Technologies and the $24 billion Two Sigma. The money managers are seeking to take advantage of advances in computing power and data availability to analyze large amounts of information.

Bloomberg, March 10, 2015

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Cassandra:  Have I missed the mark, or, like true archer, do I strike my quarry? Or am I prophet of lies, a babbler from door to door?

– Aeschylus, “The Oresteia” (BC)

I know, I know … I’m a broken record and a Cassandra, with 2 successive notes on Big Data. But I don’t care. This is a much larger structural risk for markets and investors than HFT and the whole Flash Boys brouhaha, it’s just totally under the radar and hasn’t surfaced yet. And unfortunately, just as I think Jeb Bush speaks for most Americans – Democrat and Republican alike – when he says that he doesn’t get what all the fuss is about when it comes to metadata collection and Big Data technologies, so do I think that most investors – institutional and individual alike – are blithely unaware of how their market identities can be stolen and their market behaviors influenced, all in plain sight. 

Jeb Bush should know better. I think he probably does. Investors may not know better yet, but they will soon, one way or another. As you read this note, a small group of hedge fund managers are doing to you exactly what the NSA is doing to “terrorists”.

Today a handful of governments use Big Data to identify individual behavioral patterns so that certain individuals can be killed. Today a handful of hedge funds use Big Data to identify investor behavioral patterns so that certain investors can be crushed. Today Big Data is primarily an instrument of social information gathering, with a powerful but punctuated impact on those individuals on the receiving end of a drone strike or a targeted trade.

Tomorrow a handful of governments will influence aggregate political behaviors by triggering small communications that Big Data tells them will be voluntarily magnified by individual citizens, snowballing into outsized, long-lasting, and untraceable “popular” actions. Tomorrow a handful of hedge funds will influence aggregate market behaviors by triggering small trades that Big Data tells them will be voluntarily magnified by individual traders, snowballing into outsized, long-lasting, and untraceable “market” actions. Tomorrow Big Data will be primarily an instrument of social control, with a powerful and ubiquitous impact on all citizens and all investors.

Q: How can I protect myself?
A: You can’t.

But WE can protect ourselves, to some extent at least, by working together to raise voter and investor awareness of the risk and pressing for regulatory reform to shield our behavioral data from commercial use AND bureaucratic collection. I’ll leave the voter awareness piece to others, and use Epsilon Theory to focus on investor awareness.

Trust me, I know how this sounds, to write to an audience of free market-oriented investors and call for stronger regulatory intervention to prevent the collection or sale of “anonymous” investment data. And if you think that any mutually agreed upon transaction should be allowed, no matter how large the gulf in knowledge between the buyer and seller … if you would buy an original Honus Wagner baseball card from a 10-year old kid for a quarter, telling him that you were doing him a favor to pay him that much for such a ratty card … then I’m never going to convince you of the merits of my argument. If that’s you, then I’m sure Stevie Cohen sends his best regards from the Grand Duchy of Fairfield County. But if you believe, as Adam Smith did, that it is government’s appropriate role to prevent transactions that are massively lop-sided from an informational perspective and that directly subvert the small-l liberal institutions of free elections and free markets, then I think you will find this a proposal worth considering.

It’s by no means a perfect solution, but I like more than I dislike about the way our personal medical data is protected through HIPAA. As an initial step, I’d like to see federal financial data legislation equivalent to HIPAA, where both private AND public sector use of our investment history, no matter how scrubbed or “anonymized”, is prohibited. 

Such a law would cause a lot of pain. For-profit exchanges, all of which have transformed themselves from trading venues into “data companies”, would no longer be able to sell disaggregated transaction data. Mega-asset managers would no longer be able to sell anonymized client portfolio data. Ubiquitous financial information companies that may or may not share a name with a former mayor of New York would be subject to a regulatory scrutiny that is sorely lacking today.

Yes, a lot of pain. But it’s a fraction of the pain we will ALL feel if for-profit exchanges, mega-asset managers, and ubiquitous financial information companies are allowed to continue producing weapons-grade plutonium for the handful of hedge funds that are building their instruments of market control.

Unfortunately, like Cassandra, I’m predicting future pain, and that’s rarely successful as a goad to current action. To quote Aeschylus once more:

Nothing forces us to know
What we do not want to know
Except pain.

I don’t think we investors have suffered enough … yet … to force us to accept the unwanted knowledge we need to spark effective collective action. Instead, I can just hear the apologists, the lobbyists, and the bought-and-paid-for spouting the Big Lie when it comes to Big Data: “But it’s anonymous data we’re talking about, so you have nothing to worry about.”

I hope I’m wrong, but I’m not optimistic.

Pessimism and hope may seem to be odd bedfellows, but for 2,500 years that’s been the best prescription for dealing with a tragic world, where external forces threaten at every turn to sweep us off our moorings. I’ve used a lot of quotes this week from Aeschylus because, as the inventor of tragedy as an art form, he was the guy who first proposed that bittersweet tonic.
Aeschylus had an interesting life and an interesting death. As the story goes, in middle age a fortune teller warned him he would be killed by something dropped on his head. From then on, Aeschylus famously stayed out of cities, where someone might accidentally knock a chamber pot or some such out from an open window. Sure enough, though, in the best tradition of the inescapable-destiny trope that Aeschylus helped invent, he was killed outside a Sicilian town when an eagle mistook his bald head for a rock and dropped a turtle on it. As I recall, there was a CSI episode that used this as a plot device to resolve an inexplicable death in the desert outside of Las Vegas … my estimation of the show runners went up immensely when they showed their surprising knowledge of classical history!

epsilon-theory-troy-will-burn-the-big-deal-about-big-data-march-16-2015-aeschylus

But it’s his life that I want to commemorate here. You see, first and foremost Aeschylus was a patriot. He fought the Persians at Marathon, Salamis, and Plataea, where he was recognized for bravery in all three battles. His epitaph says nothing about being a playwright, only about being a soldier. One of his two brothers was killed at Marathon, the other lost his hand at Salamis. Aeschylus himself bore terrible scars from the victory at Marathon. We know that he had these scars because he showed them to the jury when he was put on trial for treason after supposedly revealing some of the Eleusinian Mysteries – essentially state secrets – in one of his plays. Fortunately for the world, Aeschylus was acquitted, and Athens went on to experience a golden age that inspires us still.

Aeschylus argued that you can question your government’s policy on secrecy without being a traitor, that he was in fact still a patriot – perhaps even more of a patriot – for the tragedies he wrote. I’d hope that we can be as wise today as that Athenian jury was more than 2,500 years ago. I’d hope that we can question both our government’s policy and our private sector’s policy on behavioral data collection without being accused of treason or (worse in some investor circles) socialism. I’d hope. But I’m not optimistic.

So here’s Plan B, a plan for a crowd-sourcing world.

If we can’t cut off the supply of plutonium for these weapons of mass market destruction, then we can at least provide the blueprints for the Bomb so that anyone can build one. Or, better yet, we can build a collective early warning system, an open-source Bomb detector … a Big Data market intelligence available to everyone. It’s not an instrument of social control and it’s not a spoofer; the former is the enemy and the latter is really, really expensive. It’s a collection of highly sensitive risk antennae, sensitive enough to identify the likelihood of otherwise untraceable market manipulation in real time.

epsilon-theory-troy-will-burn-the-big-deal-about-big-data-march-16-2015-manipulation

Recursive inference engine [A] comprised of thousands of “bots” (static data models) executes small trades to test market reaction to different stimuli. Game/learning implementation [B] serves as dynamic data model to recognize and calculate arbitrage likelihood functions. Analytics platform [C] operating within real-time database architecture governs [A] and [B].

This is a basic schematic for what I think could function as a rudimentary Big Data market intelligence. When I sketched this out 4 years ago I pegged the hardware cost at close to $5 million; today I figure it’s closer to $1 million. Host it somewhere like my friend Gary King’s Institute for Quantitative Social Science and the total cost, both to build and maintain, becomes very manageable. What’s costly is the time required to program the system, but there’s no shortage of Big Data wizards coming out of Harvard, MIT, Stanford, etc. every year.

Yes, I know that this schematic will be gobbledygook to almost all of my readers, and the few readers who are immersed in this stuff will undoubtedly find it overly simplistic. But it’s a start on Plan B. It’s a start on demystifying the powerful non-human intelligences that will soon be used … I suspect are already being used … by all-too-human institutions to shape our political and commercial behavior in pervasive and unwanted ways. And yes, I know that this is what all-too-human institutions have always done to the madding crowd. But what’s different today is the scale and scope of what’s possible. Big Data non-human intelligences ARE the Singularity, and they are coming soon to a stock market near you. I’d like to starve them out with legislation establishing a financial data equivalent to HIPAA (Plan A), or failing that enlist one of their own to share the information as widely as possible and thus diffuse their market impact (Plan B). But if we do nothing, then the Stevie Cohens of the world are going to conquer our capital markets just as surely as Agamemnon sacked Troy. That’s my prediction.

I don’t really know what to expect by putting these ideas out there on Epsilon Theory, and I’m really curious to see the reaction this note will get. Support for Plan A? Enthusiasm for Plan B? Both? I hope it’s both. But I’m not optimistic. I fear that like Cassandra, my blessing is to see the future clearly and my curse is that no one believes me.

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Epsilon Theory Mailbag: Bitcoin and Big Data

One of the best parts of authoring Epsilon Theory is the correspondence I get from readers. For the past few months, however, I’ve been frustrated by my inability to respond to every writer with the same attention and thoughtfulness evidenced by their emails. Between my day job and the effort each Epsilon Theory note requires, I’ve run out of hours in the day to respond to the geometrically increasing volume of emails I receive. Having a public comments page on the website isn’t a solution for a number of reasons – some of my correspondents don’t want to be public, I still wouldn’t have time to respond to the comments, an anonymous comments page tends to become a cesspool, and the regulatory burden this would place on Salient is not insignificant – so I’ve decided to start an irregular mailbag column. For the most part I’ll be aggregating common comments and questions with a few recent news articles, and I won’t reprint anyone’s private email communication without asking permission first. Along the way I’ll try to work in some of the more insulting comments published on the public/anonymous comments pages of ZeroHedge, Seeking Alpha, and Forbes Online, as well as some lovely Tweets … it’s important to keep a sense of humor about this stuff!

For this initial effort I’ll focus on reader comments to “The Effete Rebellion of Bitcoin” and “First Known When Lost”, two recent notes that sparked more than their fair share of responses. 

You, sir, are using glib, provocative, and insulting descriptions to pull in readers, then doing a bait & switch.

Elizabeth VH

Well…yeah.

If bitcion is just a fad, what do you consider the Internet?

@PerianneDC

Not very smart. Surprised Forbes published him. Spouting bs before enlightenment is a common trait of effete snobs.

@jmwnuk

These were fairly typical comments from the Twitterverse. As someone who has been called the a-word, the b-word, the c-word (yes, the c-word), the d-word, the f-word, and the s-word on the mean streets of ZeroHedge, I find Twitter haters to be almost charming in their child-like Peewee Herman-ish insults. For the record, I suspect the Interwebs are here to stay. And, dude … I know you are, but what am I?

You’re an idiot. Ever heard of 2-factor authentication?
many anonymous comments, surprisingly few emails

I love 2-factor authentication. I love anything that allows me to keep the same password for more than a few months and avoid the “security theatre” that so many enterprises portray by requiring me to change a password for absolutely no reason other than that it looks like they’re actively defending my security.

Banks love 2-factor authentication, too. Why? Because it provides a significant security upgrade for the online account transfers that federally regulated banks are required to offer per the Electronic Fund Transfer Act of 1978. Yes, 1978. The same year that TCP/IP was invented. Jimmy Carter vintage legislation for an Internet that wasn’t even a twinkle in Al Gore’s eye and a retail banking world where ATM’s were novelties. Banks aren’t rolling out 2-factor authentication protocols in 2015 because it’s a convenience for you. They’re rolling it out because it’s good for them, because it helps limit (but by no means eliminate) the losses they suffer from the online transaction liabilities imposed by Reg E of the 1978 Act. It’s exactly like a credit card issuer shutting down your card when you go on vacation. In no way is this “for your protection”; it’s all about limiting their liability for charges made on a stolen card. And even with the enhanced security of 2-factor authentication, notice how the transaction size of all online transfers is limited to an amount that the federally mandated blanket bond will cover. Take away that federally mandated insurance backstop and federally mandated online transaction liability and you’ve got Bitcoin – a Hobbesian environment where security and risk management is entirely on you, and where in a very real way life is “a war of all against all”. Yes, it’s invigorating and refreshing to be occasionally free of Leviathan and its mandates on this and mandates on that. But only in small doses, thank you very much. Sorry, but I’ve read Thomas Hobbes and seen “Jeremiah Johnson” too many times to be more than a tourist when it comes to modern crypto-anarchy.

Speaking of Leviathan … one-time 2-factor authentication requires a delivery device or token, and on a mass scale that means text messages over smart phones. Does anyone in his or her right mind believe that a cryptography system that generates a second key and texts it to you on your registered cellphone is unhackable or untraceable by any number of national security services? Really? Read this if you do.

You’re an idiot. Ever heard of multiple private key systems?
– many anonymous comments, surprisingly few emails

I love multiple private key systems. I appreciate them in the same way that I appreciate an intricate clock. I appreciate them in the same way that I appreciate the medieval voting system to elect a Venetian Doge. Wait … what? For more than 500 years, from 1268 – 1797, the Supreme Leader of The Most Serene Republic of Venice was elected for a life-time term by means of a highly complex ten-step process, where groups of electors were alternately randomly selected by lot and then directly selected by the votes of those selected by lot, over and over again for 5 of these dual rounds. The process was designed to prevent any single faction from corrupting the election through bribery or by “packing the court”, and … it worked. Venice maintained a stable oligarchy for hundreds of years, an unbelievably difficult feat in any age (for a fascinating analysis of the Doge electoral system and its implications for security protocols, see this paper by two HP scientists).

But it worked at a cost. Direct costs, opportunity costs, complexity costs … you name it, stability and elegance do not come cheap. There is an unavoidable and linear (or worse) relationship between security and cost. Or rather, the cost of breaking the security of a system does not increase faster than the cost of advancing the security of that system, whether you’re talking about multiple keys or longer passwords or extra voting/lottery election rounds. There is no such thing as a free lunch, particularly when it comes to information entropy, which is what we’re really talking about here.

The problem is that the cost of complexity in Bitcoin’s case is only manageable in a commercial sense if you inject third party service providers into the mix. Now there’s a long history of successfully injecting such third parties into financial transactions. In fact, no large property or securities cash transaction occurs today without a government-regulated escrow agent playing the central role of validating the underlying transaction. If I buy a house or 100 shares of Apple, my money isn’t released to the seller until a government-certified and insured intermediary makes sure that I have clear possession of that property or block of securities. Why is this a good thing? Because if something goes wrong with the underlying transaction … if all is not as advertised with the property or securities I am purchasing … I have recourse. Ultimately, I have a government and a government’s self-interest and a government’s guns on my side. None of this exists in the Bitcoin ecosystem, and any entity that holds itself out as an escrow agent or transaction validator does so without a smidgen of government support beyond what’s available to the local laundromat. Would I take a non-regulated escrow agent at their word if I’m buying a skim latte or a snappy new suit of clothes? Sure, why not. No biggie if the deal falls through, and at least I’ll have an interesting story to tell. Would I take a non-regulated escrow agent at their word if I’m buying a house? No way.

I know that no one in Bitcoin-world likes to think about Mt. Gox, and I know it was a flawed animal … a complete outlier from all of the brilliantly conceptualized and elegantly implemented Bitcoin and blockchain service providers that got their VC money and set up shop over the past 18 months. I’m not arguing otherwise. My point is simply this: once a Bitcoin service provider gets big enough … once there are a couple of hundred million dollars sloshing through your system … you’re going to be robbed. I don’t care how smart you are or how much you trust your employees and your systems, you’re going to be robbed. Now maybe you can find private insurance against the small stuff. But public insurance – which is the only thing that works in a big crack-up and has been part and parcel of the mainstream banking world for 80 years – is not available to you. There’s not a government in the world that really cares whether a Bitcoin service provider in its jurisdiction lives or dies, and that’s a problem. I want my bank and, by extension, my bank account backstopped by infinite lawyers, guns, and money (to quote the late, great Warren Zevon). And that’s what modern governments provide – infinite lawyers, guns, and money. The Venetian electoral system worked for 500 years not only because it was elegant and smart, but also because Venice had the largest navy and the biggest Treasury in the Western world over that span. That’s systemic security, and that’s what I want underpinning my elegant and smart financial service applications.

Bitcoin might have its flaws, but banks worldwide already allow direct trade – directly from bank account to bank account: http://cointelegraph.com/news/113537/german-bank-unveils-insured-express-bitcoin-buying-moves-into-us-market
– Monic DG

Am I surprised that an online-only German micro-bank (200m euros in deposits as of 12/31/13) is trying to gain publicity by claiming that Bitcoin transactions and deposits are now linked to insured accounts in euros or dollars? Of course not. But even here dig just one inch below the surface claims and you see that Fidor Bank is linking Bitcoins to an ordinary cash account in the same way that Bank of America might link your insured cash account with a personal check you want to deposit or a registered security you want to sell. I mean … if you give a bank 3+ days for the transaction to clear, you can get pretty much anything deposited to a cash account, but that’s a far cry from saying that depositing a personal check is the same thing as depositing cash, particularly if the personal check is for anything more than a trivial amount.

You mention Silk Road in passing. Have you read the Wired transcripts of the Dread Pirate Roberts trial?
– Bill E.

Wow. Everyone who doubts that Bitcoin is inextricably entwined with illegal activity, and not always of the victimless sort, should read the transcripts of the phone conversations between Silk Road founder Ross Ulbricht (aka Dread Pirate Roberts) and a senior manager for a regional Hell’s Angels franchise (aka Redandwhite), presented at Ulbricht’s federal trial. My conclusions:

  1. If there aren’t 20 screenplays making the rounds in Hollywood based on this transcript, I will eat the accumulated print outs of every Epsilon Theory note to date.
  2. Every company is a technology company today. Even the Hell’s Angels.
  3. Redandwhite would be a successful businessman in any century and any profession.
  4. As always, life imitates art. Hyman Roth: “I’m going in to take a nap. When I wake, if the money’s on the table, I’ll know I have a partner. If it isn’t, I’ll know I don’t.” Redandwhite: “I will check the computer in about 10 hours, and if I see that you want to go ahead with this and the payment has been sent, we’ll do it today.” [hat-tip to Todd C.]
  5. The murders-for-hire here are made possible by Bitcoin. Period. You think Ulbricht would be wiring cash or taking suitcases full of small bills to Vancouver? Please.

Bitcoin (or, if Bitcoin fails, some replacement cryptocurrency) represents a reversal in the rule/permission cycle, applied to ownership, in a similar way that the Internet as a whole represented a reversal in the rule/permission cycle applied to communication.

What I mean is: Neither the Internet (or any application of it, like email) fundamentally challenges the existence of certain legal rules. It *does* however fundamentally change the order in which you can proceed to do certain things: before the Internet, you needed to ask for permission more often than not (for example, to publish something), at which point a “rule check” took place.

The Internet reversed this process: the rules still exist, and you can still be prosecuted for breaking them, but the *first* step is your decision if you want to do something that could potentially break those rules or not: you can post whatever you want, on a number of places. Whether it’s legal or not is a different thing, but that check occurs *after the fact* of you posting it.

This is where Bitcoin comes in. A distributed, tamper-proof (by our best knowledge on the matter) way to register and transfer ownership rights nearly instantaneously, over arbitrary distances *without* the need to ask any authority for permission to do so, is a major step.

– Wouter D.

This is a very smart observation. Wish I had thought of it. The Internet is indeed a Great Leveler, a force for disintermediation that rivals the printing press, and no social practice – including the social practice of Money – is immune to that force. Thanks, Wouter.

Moving on to Big Data …

Big data is like teenage sex: everyone talks about it, nobody really knows how to do it, everyone thinks everyone else is doing it, so everyone claims they are doing it.
Speedy W.

Me and my team at work use big data all the time and I can tell you first hand it’s almost useless. SaaS and Cloud Computing were wearing thin so big data was needed to continue Silicon Valley’s only real talent: separating fools from their money.
“TS”

There’s no doubt that “Big Data” has become a marketing catchphrase, much like “The Cloud”. But my guess is that TS “and his team” are using Big Data in approximately the same way that free online speed-up-my-PC services are using advanced network security algorithms. Look … we kill people with drones every day on the basis of Big Data. You think we’ve got handsome NCIS agents prowling the outskirts of Sana’a calling in air strikes on the bad guys? No, we’ve got terrestrial and low-orbit devices picking up a cell phone signal that our NSA Big Data Machine tells us is highly likely to be associated with a high value target, and then we send in a drone to go blow up whoever is holding the cellphone. Now say what you will about the morality of all this (my view: the NSA gives new meaning to what Hannah Arendt once called, in reference to Adolf Eichmann, “the banality of evil”), but don’t tell me that the NSA is incompetent or doesn’t know what it’s doing. Big Data works.

Not sure I understand. “to identify the unique individual purchasing patterns of 90% of the people involved”… it doesn’t say it identifies the people involved. It’s a collection of purchasing patterns that belong to who knows.
“AF”

Sigh! Yet another article that starts with point A and leaps to point Doom. That algorithm doesn’t identify the individual, all it does is look at the data and posit which transactions are likely to have been carried out by the same individual.
“R”

These comments illustrate a very common misconception about Big Data and the collection of “anonymous data”, a misconception that is (surprise!) intentionally spread by the collectors of that data. For most Big Data purposes, nothing is gained by going the last mile to connect a specific name to a specific set of behaviors. To continue with the NSA example above, if I want to kill everyone in Yemen who has placed a cellphone call to a set of people who, in their aggregate behaviors, score high on some security threat matrix, then it would just slow me down to learn individual names. I’m going to kill whoever is holding that cellphone, regardless of what his name is. Or if you prefer a feel-good example, if I want to advertise my new movie to everyone who tweeted to a set of people who, in their aggregate behaviors, score high on some movie affinity matrix, then it would similarly just slow me down to learn individual names. But just because it’s usually inefficient to infer a specific identity from the data doesn’t mean it’s not possible. Actually, it’s child’s play, and for those rare applications that require specific identities you don’t stand a chance.

Ray Dalio’s $165 billion Bridgewater Associates will start a new, artificial-intelligence unit next month with about half a dozen people, according to a person with knowledge of the matter. The team will report to David Ferrucci, who joined Bridgewater at the end of 2012 after leading the International Business Machines Corp. engineers that developed Watson, the computer that beat human players on the television quiz show “Jeopardy!” 

The unit will create trading algorithms that make predictions based on historical data and statistical probabilities, said the person, who asked not to be identified because the information is private. The programs will learn as markets change and adapt to new information, as opposed to those that follow static instructions. 

Quantitative investment firms including $24 billion Two Sigma Investments and $25 billion Renaissance Technologies are increasingly hiring programmers and engineers to expand their artificial-intelligence staffs.
Kelly Bit, “Bridgewater Is Said to Start Artificial-Intelligence Team“, Bloomberg, Feb. 26, 2015

First, calling this “artificial intelligence” is a misnomer. There’s nothing artificial about it. It’s a non-human intelligence, but no less natural than our own. I dislike the term “artificial intelligence” because it implies that these systems are some sort of mimicry of the human brain, just on a larger, faster, more god-like scale. If you get nothing else out of what I’ve written on this subject (here and here), it’s this: the inductive simultaneity of a powerful non-human intelligence is sui generis. It sees the world in an entirely different way than a human intelligence can, and in the right hands it is magic.

Second, everything I said above about “don’t tell me that the NSA is incompetent or doesn’t know what it’s doing” … well, multiply that sentiment 10x when it comes to Bridgewater, Two Sigma, and Renaissance (and Citadel, and Fortress, and a dozen other firms I could name). What’s possible here is not only an accurate crystal ball for short-term market forecasts, but – even more profitably – the knowledge of what small market actions can trigger much larger market moves. Think of Ray Dalio standing on top of a giant mountain and rolling tiny snowballs down at you that get larger and larger as they pick up more snow. All completely legal. All completely above board. And all completely devastating. It’s something that I’ve been working on for the past 4+ years, and I’m absolutely convinced it’s possible. Within 20 years I don’t think we will recognize public capital markets. They’re going to be transformed by this technology into something else … a casino? a utility? … I have no idea where this goes. But it’s going somewhere that will disrupt the current investment patterns and portfolios of trillions of dollars of capital. Good times.

And on that happy note I’ll close this mailbag. Keep those cards and letters coming!

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