Math is Different

Outlook 15Recently I wrote a piece on financial services lies here at Above the Market. Lie #10 was “I don’t need help.” Here’s what I wrote about it.

American virologist David Baltimore, who won the Nobel Prize for Medicine in 1975 for his work on the genetic mechanisms of viruses, once told me that over the years (and especially while he was president of CalTech) he received many manuscripts claiming to have solved some great scientific problem. Most prominent scientists have drawers full of similar submissions, almost always from people who work alone and outside of the scientific community. Unfortunately, none of these offerings has done anything remotely close to what was claimed, and Dr. Baltimore offered some fascinating insight into why he thinks that’s so. At its best, he noted, good science (like good investing and good thinking) is a collaborative, community effort. On the other hand, “crackpots work alone.” Good collaboration among professionals and with good professionals by consumers improves investment outcomes, usually by a lot. A good professional can offer help with goals and plans, an Investment Policy Statement, asset allocation, risk management, behavioral management, protection from fraud (especially for seniors), and tax, estate and financial planning. We all need more help than we think.

A commenter calling himself (herself?) “pott” responded to that post as follows.

“Crackpots work alone” — a crackpot. Damn right, mister.

Continue reading

“It just feels better and safer to me”

FeelingsThe Sunday edition of The Los Angeles Times included a story about Bob Sears, an Orange County pediatrician who provides comfort to parents who doubt the efficacy of vaccinations for their children. Although he claims not to be an anti-vaxxer himself, about half of his patients forgo them entirely and he offers his own alternative and selective vaccination schedules to the others, which delay or eliminate a variety of immunizations that science strongly supports.

“We eliminated endemic measles in the U.S. in 2000. It’s now 2014 and we’re at 400 cases. Why?” Dr. Paul Offit, chief of infectious diseases at Children’s Hospital of Philadelphia, said in an interview in June (the number of cases has risen by another 50 percent since). “Because people listen to Bob Sears. And, frankly, I blame him far more than I do the Jenny McCarthys of this world. Because he’s a doctor. And he should know more.” As the Times reports, Sears and his ilk are having an impact. “California parents are choosing to forgo vaccinating their kindergarten-age children at twice the rate they did seven years ago, a fact public health experts said is contributing to the re-emergence of measles and could lead to outbreaks of other diseases.”

I was struck by the article’s concluding line, which was a quote from a mother anxious about vaccinations for her young children and apparently desperate for someone to tell her that delaying or avoiding them is okay. “It’s not really research-based,” she said. “It just feels better and safer to me.”

In life generally and in the investing world, avoiding the findings of careful research on account of “a feeling” is extremely dangerous business. We all tend to like to follow feelings, ideologies, herds and stories instead of good data. Doing so is in our nature. But if we want to maximize the likelihood of positive outcomes, we need to be data-driven at every level and all the time.

What Works

Science2On Saturday, within the context of discussing who the Fed’s next Chair might be, The New York Times asked What Is Economics Good For?  Interestingly, if unsurprisingly, the Times asserted that “the task of the Fed’s next leader will be more a matter of craft and wisdom than of science.” That’s largely because of a less than stellar track record on the part of economists (and by extension, investment managers):  “The trouble with economics is that it lacks the most important of science’s characteristics — a record of improvement in predictive range and accuracy.” As I have noted before, economists have exhibited an “all-too-frequent willingness to elevate a favored ideology ahead of the actual facts.” Indeed, for many economists it seems a point of pride. That they simultaneously tend toward an unwarranted triumphalism too (macroeconomics “has succeeded: Its central problem of depression prevention has been solved”) is both tragedy and delightful irony rolled into one astonishing package.

Per Rama Cont, whose background is in physics, a “hard” science: “When I first became interested in economics, I was surprised by the deductive, rather than inductive, approach of many economists.”  In science, practitioners are supposed to observe empirical data and then build a hypothesis to explain their observations. However, “many economic studies typically start with a theory and eventually attempt to fit the data to their model.”

Many (including analysts as disparate as Cullen Roche and Ben Schreckinger) go so far as to equate economics with religion.  Cullen, like Cont, would (wisely) have us start with stylized facts – as broadly understood and accepted – and work our models and theories from there.  That’s how science is supposed to work. But for economists, it’s often a process honored only in the breach. Continue reading

Think Like a Scientist

Yesterday I recommended that investors employ the scientific method even though investing is the last liberal art.  That may sound like a contradiction, but it isn’t.

scienceThe Oxford English Dictionary defines the scientific method as “a method or procedure that has characterized natural science since the 17th century, consisting in systematic observation, measurement, and experiment, and the formulation, testing, and modification of hypotheses.”  What it means is that we observe and investigate the world and build our knowledge base based upon what we learn and discover, but we check our work at every point and keep checking our work.  It is inherently experimental.  In order to be scientific, then, our inquiries and conclusions need to be based upon empirical, measurable evidence. 

Thus the scientific method can and should be applied to traditional science as well as to all types of inquiry and study — including investing. The great scientist Richard Feynman even applied such experimentation to hitting on women. To his surprise, he learned that he (at least) was more successful by being aloof than by being polite or by buying a woman he found attractive a drink. Continue reading

Hot Action Item

Five years ago my family and I were awakened early in the morning and forced to evacuate our home due to raging wildfires burning out of control near our home in Southern California and fanned by winds gusting to over 100 miles per hour (as shown right).  Unlike many of our neighbors, we had time to gather a few things before we escaped.  We left seriously doubting that we would return to find our home still standing.

After nearly a week we were allowed back into our neighborhood.  Fortunately, our home survived.  We suffered smoke damage and some damage to trees, but few other problems of note.  Many of our friends and neighbors were not nearly so lucky (see below). Just within our church community, 70 families lost their homes.  We live with “fire season” every year.  But the problems and the risks have grown consistently over the 17 years we have lived in San Diego and they will continue to grow, largely on account of climate change.

According to nearly all working scientists in the field and the various organizations representing America’s best scientists, climate change is a fact. It is very likely caused by the emission of greenhouse gases from human activities and poses significant risks for a range of human and natural systems. As these emissions continue to increase, further change and greater risks will ensue.  These risks include rising temperatures, extreme weather, and the problems caused or (more typically) exacerbated by them.  A helpful summary of the science of climate change is provided by the following video.

Without belaboring what is remarkably clear, temperatures are rising significantly.

Source: NASA

And sea level is rising and rising faster.

Source: NASA

With events like Hurricane Sandy crashing onto the East Coast recently becoming more and more common, it is exceedingly difficult to ignore the increased and intensifying storms, droughts, cold snaps, heat waves, wildfires and disease that inevitably follow from climate change and which are causing devastating damage and disaster-related losses, according to organizations like the National Oceanic and Atmospheric Administration and the Intergovernmental Panel on Climate Change.  It also means more agriculture-related problems and more variability in weather patterns.

If you don’t want to believe scientists directly, then believe the highly profit-motivated insurance industry, which has become the first major business sector to acknowledge the effects of climate change and to seek to deal with that risk in a systematic fashion.  Just two weeks before Sandy slammed onto the Jersey shore, German reinsurance giant Munich Re issued a report entitled Severe Weather in North America, in which it linked the risks of severe weather events to human-caused, or anthropogenic, climate change:  “In the long-term, anthropogenic climate change is believed to be a significant loss driver. […] It particularly affects formation of heatwaves, droughts, thunderstorms and — in the long run — tropical cyclone intensity.” Allianz actively lobbies for worldwide, binding carbon emission targets and has designed various insurance products to deal with climate change risk, such as catastrophe bonds and micro-insurance. Swiss Re also has a product line that is explicitly geared toward climate-change risks.

Or perhaps you’ll be influenced by the United States Navy, which is actively preparing for an ice-free Arctic Ocean.  Indeed, a major study commissioned by the Pentagon asserts that climate change is a greater threat to national security than terrorism. Even oil companies (see here, for example) acknowledge the facts of climate change and its human causes.

There is a dedicated group of climate change “skeptics” who insist either that climate change is a myth or that its risks are overstated.  Since causation is such a difficult matter to ascertain to everyone’s satisfaction (and especially to the asserted satisfaction of those whose financial status is threatened by climate change), there will be some kind of debate about this for the foreseeable future.  But no serious climate scientist believes that sea level will rise less than a meter this century unless we get off fossil fuels with great haste.  Many forecasts are much grimmer.  At least 20 port cities will be seriously exposed to coastal flooding risks in the coming decades including Mumbai, Calcutta, Ho Chi Minh City, Shanghai, Bangkok, Tokyo, Miami, Alexandria, and New York (as Hurricane Sandy demonstrated).

But even if the science were in dispute, when an activity raises threats of harm to human health or the environment, precautionary measures should be taken even if some cause and effect relationships are not fully established. In this context the proponent of a threatening activity, rather than the public, should bear the burden of persuasion.  If they cannot do so — by establishing that climate change is not a substantive risk — then we should act as if climate change is a major risk to our lives and health. This approach is particularly appropriate, as Nassim Taleb points out, because the extent of the threat and the risks are so high.  As Taleb explains, we should readily use a headache pill if it is deemed effective at a 95 percent confidence level but assiduously avoid such a pill if it is established that it is “not lethal” at a 95 percent confidence level.

The results of the presidential election and the impact of Hurricane Sandy suggest that there might finally be some traction toward dealing with climate change.  After a campaign devoid of its consideration, climate change was finally brought up by New York City Mayor Michael Bloomberg in his surprising last-minute endorsement of President Obama in the wake of Sandy. The President himself returned the issue to public light by speaking of it in his acceptance speech on election night:

“We want our children to live in an America that isn’t burdened by debt, that isn’t weakened by inequality, that isn’t threatened by the destructive power of a warming planet.”

Yet, to this point, little has been done.  Neither New York City nor New Jersey, which took the brunt of Hurricane Sandy’s force, have made climate change response a serious priority, perhaps because doing so would create further tax burdens on a population already economically stretched.  More cynically, while storm mitigation is largely a state and local expense, disaster clean-up garners major federal dollars.  Irrespective of the reasons, much needs to be done and almost nothing has been done.

But is there an investment play here?

The reality of climate change doesn’t mean that there’s a trade to be made. Jeremy Grantham (see here) addresses the issue directly: Global warming will be the most important investment issue for the foreseeable future. But how to make money around this issue in the next few years is not yet clear to me.”  I hesitate to disagree with Grantham because of the great respect I have for him, but disagree I do.

With the possible exception of the inverting demographic pyramid, I expect climate change to be the dominant investment challenge and opportunity of our time. But I don’t expect it to play out quickly. For most traders, an actionable item is one that can and should be undertaken right now and is expected to pay off essentially right away (not that there’s anything wrong with that).  But no matter how often I point out that lunch tomorrow is not a long-range plan, I don’t seem to get heard all that often on this point.  Yet I will not be deterred.  Today I offer an action item that will almost surely pay off in the longer term for those with the necessary patience based upon any reasonable interpretation of the available data.  The climate is changing and those changes will have to be dealt with sooner or later.

The denialists do not trouble me in the least.  As Bruce Chadwick puts it, “if your investment horizon is long enough and your position sizing is appropriate, you simply don’t argue with idiocy, you bet against it.”

Investment opportunities in this area fall into two general categories.  Climate mitigation focuses on reducing greenhouse gas emissions while climate change adaptation refers to actions taken to address the risks and opportunities associated with the physical effects of climate change such as changes to temperature, rainfall and ecosystems.

I remain unconvinced about the investment opportunities available with respect to mitigation. Since entrenched energy interests have a strong economic incentive to delay governmental initiatives towards climate mitigation, since climate denialists are likely to oppose such initiatives, and since it remains decidedly unclear which approaches will succeed (even assuming the “correct” approach(es) currently exist), Grantham’s uncertainty is well placed in this regard.  From an investment perspective, we can avoid arguing about the causes of climate change — which are fraught with political peril despite science that is clear — and simply put our money to work in companies that deal with the consequences of climate change while avoiding those entities and regions with the most to lose.

Thus the better investment opportunities exist in climate change adaptation.  Adaptation efforts include improved infrastructure design (Sandy clearly demonstrated the fragility of our energy infrastructure), more sustainable management of water and other natural resources, modified agricultural practices, and improved emergency responses to storms, floods, fires and heat waves.  Infrastructural improvements include sea-walls, dykes, tidal barriers, and detached breakwaters. But since these improvements may have unintended and damaging side effects, for example by displacing erosion and sedimentation, we might also consider “softer” accommodation options that involve restoring dunes or creating or restoring coastal wetlands, or continuing with indigenous approaches such as afforestation.

Other accommodation options include warning systems for extreme weather events as well as longer-term measures such as improving drainage systems by increasing pump capacity or using wider pipes. Of particular interest ought to be food technologies that are resistant to heat, drought and flooding.  Water needs provide opportunities in adaptation strategies for water conservation, storm water control and capture, resilience to water quality degradation, preparation for extreme weather events and diversification of water supply options.

Harsher and more wide-spread droughts will lead to a strain on communities and farmers that need fresh water. At the same time, rising sea levels will affect coastal regions, potentially leading to an increase of salt in ground water. So-called desalination technology has been a non-starter to this point; venture capitalists may want to re-think that. Other water recycling approaches are also promising. Further opportunities exist with respect to innovations in dealing with infectious diseases and pest control, weather forecasting technologies and more efficient irrigation systems.

Because the facts (and the science) are inexorable, society is going to have to adapt to higher temperatures and a rising sea level.  Obviously, it’s much cheaper to deal with climate change before a crisis hits than after a city has been flooded. But there is no reason to believe or expect that we will have the public policy sense to do so.  Moreover, green-energy technologies are still too speculative for the type of call I’m making here. The obvious investment priority is in adaptation technologies that will prepare and help us to deal with effects of climate change.

It is a highly speculative play.  It is a very long-term play.  But it is the right play.  Our atmosphere is getting warmer and that has inevitable consequences.  It is the most important hot action item of our time.

Easier Said Than Done – Reflections on the LA Times Festival of Books

I went to a number of panels featuring scientists at last week-end’s outstanding Los Angeles Times Festival of Books, and a major theme was clear throughout.  It was stated most directly by Timothy Ferris:  “I recommend a scientific approach to social issues.”  As a consequence, he expressly rejects the idea of beginning with ideology and recommends following the evidence wherever it leads.  Sean Carroll added a corollary – he is “an unrelenting empiricist.” This approach (to pretty much everything) was implicitly endorsed in remarks by other luminaries such as David Baltimore, Holly Tucker, Jennifer Ouellette, Cara Santa Maria and Leonard Mlodinow. Given that they are scientists, others whose remarks did not touch on this theme (such as Daniel Kahneman) would almost surely agree too.  As I have written many times (examples are here and here), I am sympathetic to – indeed, I am fully supportive of – such an approach to most things and to the investment world in particular.

That said, I am concerned about the implications of the arguments expressed, even though I hasten to add that I am not a scientist and that I may be seeing and hearing implications that were not intended or that simply do not exist.

My first concern relates to Hume’s recognition that no ethical or even evaluative conclusion may be validly inferred from a set of purely factual premises.  Accordingly, even though a given fact may preclude the accuracy of a given interpretation, no fact or set of facts can conclusively establish the truthfulness of a given interpretation.  Any interpretive scheme requires some presumed sentiment(s) or value(s) about which one must be persuaded.  

The scientists I saw over the week-end seemed to think that a scientific approach – which should lead to a much better understanding of the facts – would make crossing the is/ought divide easy. Some may even embrace scientism.  I remain skeptical.

Most fundamentally, scientism – the idea that science can answer every question – rejects dialogue.  It is the simple (simplistic) view that science provides all the answers and every other area and mode of inquiry needs to shut up and take instruction. I hasten to emphasize that well-supported messages from science are far too often foolishly ignored, especially here in the USA, where many seem to take a perverse pride in claiming to reject science in various guises all the while inconsistently accepting without quibble its many benefits (for example, those who reject evolution while giving nary a thought to taking prescription drugs, the creation and effectiveness of which are wholly dependent upon evolution).

Yet even those scientists who do not embrace scientism have their issues too. Fewer factual errors and erroneous claims will surely help any proposed analytical framework, perhaps a lot and across-the-board. But many scientists seem to assume that agreement on the facts will result in interpretive agreement as well.  Note this telling comment from David Baltimore concerning an interpretive conclusion about religion:  “Because I am myself unable to accept a religious explanation of anything, I wonder why others so readily do so.”  He seemingly cannot imagine anyone disagreeing with his conclusion. That sounds far more human than scientific to me.

Scientists also express far too much faith in their ability to analyze the evidence fairly and to make decisions rationally.  As Seneca famously expressed it, the belly will not listen to advice. Or, as I have noted before, information is cheap while meaning is expensive

We all like to think that we carefully gather and evaluate facts and data before coming to our conclusions and telling our stories.  But we don’t. 

Instead, we tend to suffer from confirmation bias and thus reach a conclusion first.  Only thereafter do we gather facts, but even so we tend to do so to support our pre-conceived conclusions.  We then take our selected “facts” (or thereafter examine any alleged new facts) and cram them into our desired narratives, because narratives are so crucial to how we make sense of reality. 

Keeping one’s analysis and interpretation of the facts reasonably objective – since, again, analysis and interpretation are required for data to be actionable – is really, really hard even in the best of circumstances – even for scientists and especially in areas that don’t allow for ready testing and analysis.  Indeed, the recent scandal of retractions in scientific journals due to fraud and just plain error suggest that even testable scientific endeavors are more prone to error than was previously thought.  Everybody has an ax to grind

Ironically, none of these behavioral biases would surprise Daniel Kahneman in the least, as his Festival presentation emphasized.  Moreover, as Margaret Wertheim pointed out, also at the Festival, we have an ongoing problem on account of the hubris of scientists (indeed – of just about everyone). As Tadas Viskanta points out in his fine new book, Abnormal Returns, investing is really hard and we are wildly overconfident about our ability to tame (or even understand) the markets.

I saw the general rubric favored by scientists acted out during the two panels on politics I attended.  Partisan blindness was evident on all sides as was lots of emotional heat.  To pick one easy example among many, Nancy Cohen claimed – without a shade of doubt or qualification – that the Tea Party movement was primarily about the standard goals of social conservatism despite being pointed toward good evidence showing that support for the Tea Party is not synonymous with support for the so-called “religious right” and that Tea Party support for smaller government far exceeded Tea Party support for conservative social policy.

The scientific method works via induction.  Thus scientific truth can rarely be demonstrated in a definitive fashion.  It must be inferred and remains constantly subject to revision and falsification.  But that is a principle that seems far too often to be honored only in the breach, even by scientists.  All of us (including scientists) can and should be passionate advocates for what we believe to be right, true and best even as we retain the humility to recognize that we just might be wrong. Stating confidence in expected outcomes via the scientific process is easy.  But I suspect that actually getting a good result is much tougher to accomplish.

Crackpots Work Alone

In conversation over the week-end at the Los Angeles Times Festival of Books, American virologist David Baltimore, who won the Nobel Prize for Medicine in 1975 for his work on the genetic mechanisms of viruses, commented that over the years (and especially while he was president of CalTech) he had received many manuscripts claiming to have solved some great scientific problem or to have overthrown the existing scientific paradigm to provide some grand theory of everything.  Most prominent scientists have drawers full of similar submissions, almost always from people who work alone and outside of the scientific community.

Unfortunately, none of these offerings has done anything remotely close to what was claimed, and Dr. Baltimore offered some fascinating insight into why he thinks that’s so.  At its best, he noted, good science is a collaborative, community effort. On the other hand, crackpots work alone.

I suspect that this idea is as true in our business as it is in science generally.  Working collaboratively and in community lessens the likelihood that our work will be fraught with the bias to which we are so prone and increases the likelihood that all analysis and any conclusions drawn therefrom will be questioned, checked and tested.

Of course, in this context “collaborative” must mean that there is a free and uninhibited exchange of ideas, viewpoints and conclusions.  It most decidedly is not a bunch of people agreeing vehemently with the boss or those with a seal of approval from the boss. In both the scientific and the investment process, principled, data-driven questioning and even disagreement should not only be tolerated, it needs to be encouraged.  Only then can some approximation of truth (or at least reality) be an expected outcome.

As Dr. Baltimore emphasized, “Science is about changing our understanding of something by investigating its behavior.” In this sense, investigating includes analysis, testing, reaching tentative conclusions and then repeating – perhaps again and again.  If what we think cannot be substantiated by data, evidence and experience, even after the most rigorous attempts to falsify it, we have no business claiming it to be true or investing as if it were true, no matter how intuitive, elegant or sales-worthy it may be.

Addendum:  This post came about out of a wonderful conversation with Tom Brakke, of the outstanding blog, The Research Puzzle, over lunch today.  Thanks, Tom.