Tuesday, August 31, 2010

Roger Clemens? Meet Bernie Madoff. An explanation...

With retired (for real this time, right Brett Favre?) pitcher Roger Clemens in Washington, DC this week to answer to perjury charges related to his alleged steroid use, the ongoing debate regarding steroid use in sports has once again come into the public spotlight.

The arguments on both sides have been well-documented (very well done here), but I was particularly drawn to one recent piece on NPR, in large part because it does a great job of summarizing my own feelings about performance-enhancing drugs (PEDs) in sports.
"Katherine from Larkspur, Calif." called into NPR's Talk of the Nation nearly three years ago. It was a few days after [Olympic track star Marion] Jones made her public admission [regarding PED use], and the topic for discussion was why athletes dope, and why they think they can get away with it.
The caller said that was missing the point.
"There is an untold story," she said, "about all the thousands ... who make a conscious decision, that are really great athletes doing the right thing, working really hard — and they just drop out because they're just not willing to do the things to your body and to go down that road."
In other words, athletes who don't just say no to drugs, but no to sport — athletes, it turns out, like that caller: Katherine Hamilton.
Ultimately, this is the insidious problem with steroids. It's not about the health risks, or that it encourages high school athletes to use similar PEDs--at least not directly. The problem is that where there are great rewards--and the rewards, both financial and otherwise, for athletic prowess have never been greater--there will always be those who attempt to cheat the system. If we allow those cheaters to prosper, then the viability of the entire enterprise is compromised. The more great athletes who quit out of despair, the closer sports in general come to being simply irrelevant. Nobody cares about sports that they consider (or fear) to be rigged, except as a side show--like professional wrestling or heavyweight boxing.

We simply cannot allow the greatest rewards to be accessible only to those who are willing to make the most questionable decisions. Therein lies the similarity between Roger Clemens and Bernie Madoff (or any number of other white-collar criminals). Both existed in arenas where great rewards were to be had, and both (allegedly, for now) cheated to rise to the top.

Being the great believer in meritocracy that I am, nothing offends me more than to see a supremely talented athlete--like the woman profiled in NPR--abandon her dreams because she sees no choice in a rigged game. A society that rewards (or at least, does not punish) the taking of shortcuts to their accomplishments will eventually find itself with no incentive to work hard or do things "the right way".

Clearly, our society is one that is rife with inconsistencies. We vilify those who use PEDs in sports, but we cannot watch a single sporting event on television without being bombarded with advertisements for antidepressants, male enhancement drugs, or cholesterol-lowering medicines. In many ways we have become a "quick-fix" society, but we shun these behaviors at the highest levels, or when they begin to offend our collective morals.

Eventually, we will need to address these inconsistencies, and find a way to return to being a society defined by true hard workers. Until then, focusing on figures like Clemens and Madoff--men who chase the highest rewards that our society can provide--will have to suffice. Hopefully, this is one area where "trickle-down" economics will indeed pay dividends.

[National Public Radio]

The many faces of market volatility

As an options trader, market volatility is a near-constant concern for me; understanding and responding to it defines much of my job on a daily basis. The dramatic spike in volatility in the last two years has meant that all investors, not just options traders like me, have become highly sensitive to developing trends in volatility.

It is my firm belief that anyone who chooses to be involved in this market (or any market) must understand the different faces of market volatility, so that they can better recognize the risks and rewards of their investment strategies.

I have pored through historical data on the S&P 500 Index (SPX), and summarized some of my findings below. My aim in this post is to describe, rather than to analyze--every investor has different risk tolerances, so the responses to this data are bound to be mixed. But I found many of these trends to be interesting, which is why I feel compelled to share the data. Enjoy.

Considering all of the data going back to 1957 (when the SPX in its current form was first published), I came away with three primary findings of relevance to today's investor.

1) Daily and weekly volatility have increased

This is hardly news to any investor. Some of the one-day (and one-week) moves recently have been downright scary, and these moves are a primary reason behind the massive outflows from equity funds in recent months. 

Both daily and weekly moves are increasing in magnitude (though the trend is far from smooth). The long-term average daily move in the SPX (since 1957) is 0.67%--the years 2008 to 2010 have seen average daily moves of 1.74%, 1.24%, and 0.91%, respectively. 2008 also saw an average weekly move of 3.18%, versus a long-term average of 1.56%. These are big, fast moves. 

2) Larger bull/bear market trends have remained essentially normal

Despite the significant increase in the velocity of the market, as evidenced by the first point, larger trend moves have been basically normal. If we consider anything greater than a 10% move to be a "trend", we see the following trending markets (top 5 of each type):

The 2007-2008 market sell-off, while the largest in magnitude since the SPX was first published, was not dramatically different in size or duration from previous bear markets. It was, of course, followed by a second bear market from January 2009 to March 2009 (27.4%), but this came after a significant bounce in the intervening months. You will also notice that the responding bounce off of March 2009 lows did not even register in the top 5 bull markets.

Bear markets, in general, tend to be fast. They are not, however, necessarily scary. The market sold off a total of 39.2% from May 2001 to July 2002 (with a couple of 20% rallies breaking it up along the way), but never once had a daily move greater than 5%. It was a perfectly normal, steady sell-off. Trend volatility and short-term volatility, as this example shows, do not necessarily track each other. BUT...

3) Fall 2008 was completely insane

There's simply no other way to say it. Since 1957, there have been a total of 38 trading days where the SPX has moved more than 5% (17 positive, 21 negative); 18 of those occurred between September and December of 2008 (7 positive, 11 negative). Furthermore, 3 of the 5 largest up days and 3 of the 5 largest down days since 1957 occurred in that same period. In short, 50 years of market movement were crammed into 3 months.
It is impossible to know yet whether the fall of 2008 is a one-time aberration or indicative of a new age in the financial markets. The months since have been more volatile on a daily and weekly basis than previous years, but not at a level unseen previously.

The fall of 2008 is still fresh in our memories, and time will tell if it is a warning sign for the next generation of investors. Many investors look at the "flash crash" of this May in tandem with that ugly fall, and draw conclusions that the market is irreparably broken. But "flash crashes" are not new, either.

Either way, the lesson of the last two years (I know, I said I wouldn't analyze, but I can't help myself) seems to be that while market velocity has increased, large-trend volatility has not. Now more than ever, the smart investor must look past the short-term and focus instead on longer-term trends.

[Yahoo! Finance]

Monday, August 30, 2010

Are we our own worst enemy?

Adm. Mike Mullen, chairman of the Joint Chiefs of Staff, made waves on Friday when he claimed that the national debt--not terrorism or the ongoing wars in Iraq and Afghanistan--posed the single greatest threat to our national security.
American taxpayers are going to pay an estimated $600 billion in interest on the national debt in 2012, Navy Adm. Mike Mullen told local leaders and university students [in Detroit].
“That’s one year’s worth of defense budget,” he noted, adding that the Pentagon is going to have to work to “cut the fat” from its overhead spending.
At first glance, Adm. Mullen's comments represent a new twist on an old theme. During the Bush administration, it was a common (if not overwhelming) concern that the dual conflicts in the Middle East were spreading our military too thin, leaving us vulnerable to a potential uprising in North Korea or Iran. Now the concern is that our wallets--rather than our troops--have been overtaxed, and that significant defense spending cuts are inevitable.

But the debate as to whether debt could be more dangerous than terrorism may have more far-ranging implications for American society. After the nation was knocked back on its heels by 9/11, the effect of the terrorist act was to steel our resolve, uniting us (at least initially) in a surge of patriotism. While we may have disagreed on the proper response to the attack, we were united in cause and principle.

But the failures of Bear Stearns and Lehman Brothers dealt a more significant blow to our collective psyche, giving rise to a wave of distrust in institutions and each other. Rather than uniting in response to the financial crisis, our nation has instead experienced fissures from one coast to the other, with the recession dividing us along economic, cultural, and even racial lines.

Empires rarely fall as a result of an external force; more commonly, they are torn apart by those willing to compromise (or at least lose sight of) the founding values that unite, for the benefit of various short-term interests. Regardless of our individual views on deficit spending and how best to solve the ills that recession has wrought, it should be clear from Adm. Mullen's comments that crises borne of internal factors can often be more dangerous and insidious than external shocks.

[Department of Defense]

Friday, August 27, 2010

Ow, my arm... I think it's broken

Since my move south to Virginia three years ago, the hard-luck Washington Nationals have become my adopted home baseball team. I even worked for them during the summer of 2008, and I've still got plenty of friends in their front office. So it was hard for me to read the news today that their star rookie pitcher, Stephen Strasburg, is likely to need Tommy John surgery to repair a torn ligament in his pitching arm.
That means only 12 games into his major league career, Strasburg, 22, is facing a 12-to-18-month recovery from the operation and perhaps another season to recover his form. Strasburg, the No. 1 pick in the 2009 draft, seemed headed for superstardom and now looks like a lot of young pitchers whose arms fail suddenly.
It's easy for many to draw a comparison between Stephen Strasburg and former Cubs pitcher Mark Prior, who entered the league in 2002 to equally hyperbolic praise after a similarly dominating collegiate career. Both will be viewed as cautionary tales of star pitchers asked by their teams to do too much, too soon.

But Strasburg's case is more troubling because the Nationals really did do everything right. After starting the season in the minor leagues, Strasburg made 11 starts for the Nationals before injuring his arm in the 12th. In those 11 starts, he never once threw 100 pitches, and averaged only 92.5, as well as being scratched from one start for precautionary reasons--a difficult decision for his team to make, given that attendance doubled in games he was scheduled to pitch.

Prior, on the other hand, is a case study in pitcher abuse. He made 19 starts as a 21-year old rookie in 2002, throwing an average of 106.5 pitches (15 percent more on average than Strasburg) and exceeding 115 pitches four times. The next year, new manager Dusty Baker allowed Prior to average a staggering 113.4 pitches over 30 starts, as well as making 3 more starts averaging 122.7 pitches in that year's playoffs. It was to nobody's surprise when Prior's clear overuse caught up with him, effectively ending his career after those two seasons.

For both pitchers, though, it is likely that the damage was done long before the pitchers ever made it to the professional level. While Little League Baseball places strict pitch limits on its players, high school and college coaches are rarely incentivized to look out for their young players' best interests; rather, it is to their benefit to ride unusually talented players as far as they will take them. In that regard, hall-of-fame outfielder Tony Gwynn, Strasburg's college coach at San Diego State, must shoulder some of the blame here. Even before the recent diagnosis of a torn ligament, Strasburg admitted to having pitched through similar pain throughout his collegiate career. If Gwynn knew this, and ignored it, the Nationals should be furious with him.

Either way, the lesson for big league ballclubs is, as always, "buyer beware". By the time a pitcher reaches the age of 21, it is increasingly likely that at least one coach along the way has abused his arm with little regard for his long-term health. The only way the Nationals could have known exactly how much abuse Strasburg's arm had taken was by asking him before they signed him--and with $15 million on the line, I sincerely doubt that they would have heard the whole truth at the negotiating table.

Hopefully Strasburg will beat the odds and ultimately recover to become the pitcher the Nationals hoped he would be when they signed him; if not, it's probably not the Nationals who will be to blame.

[New York Times]

Expectations are tricky things, Part Deux

After yesterday's failed rally following the better-than-expected/worse-than-expected jobless claims report, expectations are once again in the market spotlight this morning. The culprit this time? GDP.
The Commerce Department slashed its estimate for U.S. GDP growth in the second quarter from a 2.4 percent annual rate to 1.6 percent, confirming fears that economic growth has slowed to a crawl.
While the numbers were grim, they were expected to have been worse. The growth rate topped calculations by economists who had forecast that the earlier estimate would be almost halved to an annualized rate of 1.4 percent.
When the Commerce Department released its initial GDP estimate in July, expectations were for 2.5% growth. Which means that we've got--for the second time in as many days--a "better than expected, but worse than originally expected" economic data release.

The market's response? Remarkably similar to yesterday. An immediate rally after the release, which was unable to push higher and eventually reversed course into a sell-off.

It will be interesting to see how this plays out going forward. Beating downwardly revised expectations no longer appears to be sufficient impetus to move the market higher. What will happen if we start to miss our downwardly revised expectations? How far down will we revise our expectations?

This market is searching desperately for direction, but right now it, like most of us, simply doesn't know what to expect. Until we do know what to expect, we're likely in for a weird, bumpy ride.

[The Washington Post]

Thursday, August 26, 2010

How much does speech reveal about our beliefs?

I ran across an interesting blog post this morning from Barry Ritholtz, a market strategist whose blog (The Big Picture, which I link to on the right panel of this blog) is a consistently solid source for non-mainstream market insights. He noticed that there were significant differences in the way market action (specifically, the bond market) was being described within the investment community:
Consider the following overheard phrases, each of which come from traders, fund managers, and strategists:
The first two reflect a certain belief in the rationality of markets: “Bonds are pricing in a deflationary outcome” is how one strategist described it. Another...said that “the fixed income market is discounting a double dip.”
But a fund manager described it quite differently, relying on language of sentiment: “Traders fear an economic slowdown.
The actual language used suggest clear theoretical underpinnings:  The first two speakers are likely adherents of the efficient market hypothesis. They consider market action to reflect the collective knowledge of all participants...The second is a behavioral economics approach.
Barry is dead on. The words we choose--not necessarily what we say, but how we say it--can be incredibly revealing as to the assumptions and beliefs that we operate under. His post reminded me of a Wall Street Journal article from last month, which examined the linkages between language and culture:
Take "Humpty Dumpty sat on a..." Even this snippet of a nursery rhyme reveals how much languages can differ from one another. In English, we have to mark the verb for tense; in this case, we say "sat" rather than "sit." In Indonesian you need not (in fact, you can't) change the verb to mark tense. 

In Russian, you would have to mark tense and also gender, changing the verb if Mrs. Dumpty did the sitting. You would also have to decide if the sitting event was completed or not. If our ovoid hero sat on the wall for the entire time he was meant to, it would be a different form of the verb than if, say, he had a great fall. 

In Turkish, you would have to include in the verb how you acquired this information. For example, if you saw the chubby fellow on the wall with your own eyes, you'd use one form of the verb, but if you had simply read or heard about it, you'd use a different form.
 The Journal article went further:
For example, in Pormpuraaw, a remote Aboriginal community in Australia, the indigenous languages don't use terms like "left" and "right." Instead, everything is talked about in terms of absolute cardinal directions (north, south, east, west), which means you say things like, "There's an ant on your southwest leg." To say hello in Pormpuraaw, one asks, "Where are you going?", and an appropriate response might be, "A long way to the south-southwest. How about you?" If you don't know which way is which, you literally can't get past hello.
I found this to be fascinating. The Pormpuraawans, it turns out, have an incredible gift for sense of direction. Without being told, they know at all times which direction they are facing, without need for a compass. This focus impacts much of the way they view the world, including such seemingly unrelated topics as the passage of time. (If you have time, read the whole Journal article, linked to below. It really is interesting.)

The lingering question is whether the language itself is to credit for the Pormpuraawans' sense of direction, or if the language evolved to reflect their lifestyle. Do we consciously decide the way we speak based on our beliefs? Or does our native language shape those beliefs without us even realizing it?

Either way, as any relocated northerner who's been mocked for using the word "wicked" in Virginia (who, me?) would know, we can give away a lot of information about ourselves without realizing it, simply by the words we choose. It can also help us to understand others, and where they might be coming from.

[The Big Picture] 
[Wall Street Journal] 

Expectations are tricky things

Last Thursday, the market was sent tumbling after the Labor Department's weekly jobless claims report came out worse than expected, with 500,000 Americans filing for first-time jobless benefits versus analyst expectations of 480k.

Following historically bad home sales data--both for existing homes and new homes--early this week, analysts revised their expectations for jobless claims, with a consensus of 495k instead of 480k for this morning's report. The actual number beat expectations with 473k initial claims, immediately sending the market higher (please ignore the fact that the rally seems to be failing; it's the initial response that I'm focusing on).

This market bounce came despite the fact that the number fell in line with last week's estimates, and that the two-week total of 973k came out to average greater than the original 480k per week expectation. In fact, with this morning's data, the 4-week moving average for jobless claims has now reached its highest point since November 2009.

We often find ourselves in strange places when we revise--or don't revise--our expectations. As a lifelong Red Sox fan, I (like most Sox fans) find myself disappointed by this season, despite the fact that the team's basic performance--on pace for 92 wins--would have been considered a great success in any year before 2004's famous drought-busting championship. Texas Rangers fans, meanwhile, are likely ecstatic about their team's first-place season so far, despite currently having a worse record than the Red Sox.

As individuals, we are typically very quick to raise our expectations, but very stubborn about revising them downward. The market tends to behave in much the same way, which is what makes the last week's market action so compelling. I have rarely seen a market that is more unsure and inconsistent in its determination of what separates "good news" from "bad news".When we don't know what to expect, it's hard to determine whether or not we should be excited.

In general, I think it would be wise for us all to beware of runaway expectations. Following a once-in-a-lifetime tech boom and an unprecedented housing bubble, many of us became accustomed to an incredible level of consumption and economic growth. As we try to muddle through the recession, we shouldn't expect to return to our previous level, or really anywhere close to it--at least not quickly. If we expect that, we'll probably find ourselves like me, a disappointed Red Sox fan desperate for football to start up. Believe me, you don't want to be like me.

[Calculated Risk]

Wednesday, August 25, 2010


Another day, another tournament, another golf rant... hopefully this won't become a trend.

Three years ago, the PGA Tour introduced the FedEx Cup, its annual NASCAR-like year-end playoff for the title, with a $10 million ultimate payout for the champion. It's struggled to gain traction and popularity, and this isn't going to help:
[Jim] Furyk overslept Wednesday after his cell phone alarm clock lost power overnight, causing him to be late for his pro-am tee time in The Barclays. That left PGA Tour officials no choice but to disqualify him from the first of four FedEx Cup playoff events.
A two-time winner on tour this year, Furyk is No. 3 in the standings as the race for the $10 million prize gets under way at Ridgewood Country Club without him.
I completely disagree that PGA Tour officials had "no choice but to disqualify him". Pro-ams aren't part of the tournament, they're a promotional tool that the PGA likes, and they created this disqualification policy in 2004 because too many players were skipping the pro-ams for specious reasons. Fair enough.

But to disqualify one of the best players on tour from one of the season's most important tournaments on a technicality (made worse by the fact that Furyk didn't MISS the whole pro-am, he was simply late, by about 15 minutes, realistically missing one hole) is simply bad business.

I'm consistently baffled by people and companies who insist on hiding behind policies. Firm "policies" remove judgment from business, and they are often the last resort of the intellectually lazy. Countless times, I have found myself in long arguments with customer service reps from cable companies, cell phone companies, airlines, you name it, that dead-end into "I'm sorry, sir, but that's our policy".

Well if the policy sucks, and it isn't working, you need to change it. This policy isn't working, PGA. By disqualifying Furyk, you've sent a clear message to your fans that protecting the pro-am is more important than protecting the competitive viability of the FedEx Cup. Not exactly a ringing endorsement of your fledgling playoff system, is it guys?


The fallacy of "productivity gains" in a recession

As the nation's economic recovery has struggled to gain traction, the monthly employment reports produced by the U.S. Department of Labor have been closely watched in the investment community and beyond. With the unemployment rate remaining stubbornly high, most Americans have become suspicious of the viability of another "jobless recovery".

Those who promote the concept of the so-called "jobless recovery" point frequently at improving labor productivity as a potential driver of economic growth. As the Los Angeles Times notes,
Productivity, defined as real output divided by hours worked, is one of the most important — but elusive — economic data points. Productivity gains, if the benefits are shared, can hold the key to better living standards, higher wages, increased profits and low inflation.
Simply put, real economic growth and high unemployment cannot coexist, unless those still employed are producing at a higher rate than they previously did. Good news!, say the "jobless recovery" talking heads. Even as our unemployment rate climbed above 10%, worker productivity was steadily increasing.

Businesses, forced by the recession to take a hard look at their business practices to cut costs, "got lean". Laying off supposedly unproductive workers, they were amazed to find that they were able to produce the same (or more) output with fewer workers. Fantastic! Maybe our businesses were all just massively inefficient all along, and it took a recession to get them to realize it.

The problem is, these productivity gains were fleeting. Already in the second quarter, worker productivity--as measured by the Labor Department--began to decline. Why is that? Simple. Over the long run, the only thing that can reliably increase worker productivity is improved technology--something, anything (say, a computer instead of a typewriter or a lawn mower instead of a scythe) that allows a worker to do more in less time. (Yes, there can be frictional exceptions when individual businesses are indeed inefficient and have truly unproductive workers on their rolls, but these rarely translate to the macro picture as would be displayed in Labor Department reports).

In this recession, no technological magic bullet has materialized to create these productivity gains (please, don't e-mail me and argue that the iPhone increases worker productivity). So what explains them?

Anecdotal evidence indicates that the answer may be largely psychological. When massive layoffs are occurring nationwide, workers naturally fear for their jobs, especially if coworkers have already lost their jobs. In the short run, these workers will be willing to work harder, doing the job of 1.5 or 2 employees to ensure that they, too, aren't sent to the unemployment line.

Initially, this dynamic creates productivity gains, which many companies mistakenly assume are sustainable. But eventually, this type of worker exertion leads to exhaustion, and ultimately a decline in worker morale. Whip a horse enough, and the horse gives up.

Two friends of mine here in Charlottesville have recently reached this point of exhaustion, and are now on the verge of quitting their jobs. Their respective companies will soon be scrambling, trying to replace productive workers and train them on the fly. It will be exceedingly difficult for these companies to hire and quickly train new hires to do the work of 1.5 employees that my friends were previously doing. After all, who's going to train them? All of the remaining employees are already overworked as it is.

Companies who make this mistake will suffer significantly in the coming months, and will find themselves in a strategically weak position if (and when) the economy does begin to recover. Overwork your employees, and you'll only hurt yourself in the long run.

[Los Angeles Times]

Tuesday, August 24, 2010

Wake up, USGA

If you don't like or care about golf, please ignore my following rant...

As an avid golfer and former competitive golfer, I follow the annual US Amateur Championship (run by the USGA) very closely. The tournament field is always a great mix of future professionals on the way up and moonlighting 50-year old accountants with a dream, which makes for an intriguing dynamic. But this year, I've already come across something that piques my anger at the USGA. In yesterday's first round of stroke play,
Members of four groups – a combined 12 golfers – were assessed one-stroke penalties for failing to meet the pace-of-play standard at hole checkpoints through their round.
“That’s not necessarily abnormal for the U.S. Amateur,” said Mike Davis, the USGA’s senior director of rules and competition.
That's all well and good; I understand the reasons for pace of play guidelines. I'm a baseball fan and former player, and I think that baseball would do well to take a page out of the USGA's playbook here. But that's not what upset me.
At the first checkpoint, the group was one minute behind and received a warning. At the second checkpoint – the ninth hole – the players lagged behind three minutes, and were given the penalty.
Really? Three minutes over nine holes gets you a penalty? This wouldn't be so egregious if not for the details. First of all, USGA rules dictate that penalties are assessed to all players in the offending group, no questions asked. This alone is a problem. I've played plenty of recreational and competitive golf, and I know that some players are simply slow. There's not much you can do if a member of your group is playing slowly--he's not your teammate, he's your competitor. You can't grab the club and hit the ball for him.

This is compounded by the course in question, and the way that the USGA insists on setting it up. Chambers Bay is a beautiful course in Tacoma, WA. Thanks to a good friend of mine, I had the opportunity to play there earlier this spring. It's long, difficult, and very hilly. Bring on the USGA, who has the course playing to an unheard of distance of 7,700 yards, with long rough and fast greens, and slow play shouldn't be surprising. A whopping 94 of the 311 players to tee off yesterday shot 80 or above. Of those, 6 shot over 90, with 2 unfortunate guys carding 95s.

I'm sorry, but you can't trick out a course to a ridiculous degree (remember, USGA, these guys are AMATEURS), then penalize a whole group because one guy shot 92 or 93 and dragged the whole group down. That's not the point of pace of play guidelines. Players are being penalized for something that the USGA created, and that's patently unfair.

The concept of penalizing many for the sins of a few (or one) is one that continues to make me scratch my head. What's next? Forcing millions of taxpayers to subsidize a few over-leveraged people who are underwater on their mortgages? Oh, crap.

[The News Tribune]

On insurance and flat tires

This morning, as I was climbing back into my car with my wife Meggie following our 4-mile run, I spotted a large nail sticking out of the sidewall of one of my tires--brand new tires I'd bought barely a month ago. Not just in the tread, but in the sidewall, making patching impossible and replacement mandatory. Great.

As I drove home, Meggie called the tire shop to set up an appointment. It was then that I realized that I'd had the amazing foresight to buy the Tire Protection Plan when I'd bought my tires. $70 extra on $700 tires gave me free replacement for the life of the tires, if something like a nail in the sidewall came along. Hooray! All is well.

The trader in me had to laugh. In fact, he's still laughing. Hysterically. For years now in the options markets, I've made a living by selling insurance (in the guise of option volatility) to investors who overvalue it. It's good business, provided you are well-trained in the art (note: not science) of risk management. The fact is, especially in times of great uncertainty, investors and consumers unconsciously place incredibly high values on insuring against unpalatable outcomes. Following the schizophrenic markets lately, all manner of talking heads--including men whom I respect greatly, like Nassim Taleb--are advising investors to "protect their tail risk", and buy insurance. This, even when the cost of doing so has nearly doubled (at one point, it had in fact tripled) in just four months. Frankly, it's madness.

It is rare for the average individual or investor to do even basic expected value math (Expected loss = Probability of loss x Amount of potential loss) to determine what price they should be willing to pay for insurance. Insurance companies know this, and profit massively from it.

Why, then, do people do this? Well, for the same reason that I'm an incredibly happy man this morning, that's why. As you might expect, I almost never buy the protection plans pitched by car rental companies, appliance salesman, tire shops, or (my personal favorite because of their incredibly absurd premiums on low-value goods) Best Buy. I'm frequently arguing with Meggie (your typical risk-averse consumer) about why she shouldn't spend money on various insurance products (life insurance happens to come up frequently). I'm still not really sure why I bought the Tire Protection Plan this time around. But I do now better understand why many people do.

Frankly, it's biological--or, at least, psychological. We as humans are hard-wired for "loss aversion". While it may seem counter-intuitive, losing $100 causes us more pain than gaining $100 yields pleasure. It's bizarre, but it's true. Therefore, avoiding a $100 loss (or a $150 loss in the case of my flat tire) is actually more exciting than stumbling into a $100 gain. Yes, you heard right. I'm happier this morning than I would be if I'd come back to my car and seen a 100 dollar bill sticking out of my tire.

Yes, there are of course other valid reasons to buy insurance (if, for example, the magnitude of the potential loss is so great that you won't have enough cash to cover it, then you may have no choice but to buy insurance), but this mental accounting trick explains a great portion of why people OVERvalue insurance. Does this all mean that I'm going to start buying the protection plans more frequently? Good Lord, no. As I say often to people, they build big buildings in Las Vegas because of thinking like that. But it certainly makes me understand why many people do.

(If you're a real nerd like me and want to read more on this topic, check out Richard Thaler's "Mental Accounting Matters" here: http://www.som.yale.edu/faculty/keith.chen/negot.%20papers/Thaler_MentalAccounting99.pdf. It's a real page-turner.) 

Welcome to my blog

Welcome to The Crimson Cavalier, your new source for insights on finance, current events, sports, and whatever comes across my radar screen and seems noteworthy or interesting. For those who don't know me, the "Crimson Cavalier" moniker refers to my two alma maters--Harvard (undergrad) and the University of Virginia (MBA). Yes, I know that it's also the name of an obscure Marvel comics character of French descent. I'm completely okay with this. 

I live now in Charlottesville, VA, home of UVA and the Cavaliers. I've gotten here by somewhat roundabout means, via Boston (my hometown), Chicago, and New York. 

My background (and current career) is as an index options trader--formerly on the floor of the American Stock Exchange, and currently from my home office. I am an avid golfer, a former baseball player, and have recently taken up distance running (I ran the 2010 Boston Marathon, my first marathon). I love to cook (especially Mexican food), and I love to travel. All of these passions will become evident in my postings to this blog. 

Hopefully, you'll enjoy my blog, and you won't think I'm too full of s**t (which I am), or too all over the map with my musings (which I tend to be as well). Happy reading.