Zhou Xiaochuan - the central banker even quants should have known. But who will come next?

You have heard of Yellen (Fed), Draghi (ECB), Kuroda (BoJ), and Carney (BOE), but most cannot name any China central banker, yet the moves of this bank may be more important than the four when thinking about the future of world currency hegemony. Zhou Xiaochuan has been in the news just before the Chinese Congress with a strong appeal for financial reform. This is reform for further ascent of China as a major financial player. He has followed this path across his central banking career, but he is set to retire in January. 

On margin, his successor may be more important than other central bankers over the longer-run because he will determine whether there will further financial reforms and global financial integration. 

Any shift in policy will have strong global ramifications. For example, a slowdown in reforms and a move back to a cheaper yuan policy will impact both developed market and emerging markets. Just look at the yuan chart and match with commodity or dollar flows. The speed of reforms for flexibility will impact currency trading flows and thus impact all who are active in the FX markets. 

Many quants will argue that these musing on policy financial statecraft do not have an impact on traders because they don't trade the yuan and their interests are always short-term, yet a change in yuan policy or a switch in reform direction will spill-over to both commodity and financial markets. Structural changes do matter. Just look at the shifts in the yuan over Zhou's tenure.  

Structural policy changes lead to market divergences. They may not always impact prices immediately, but they will play pressure on teen directions. 

I don't need diversification - I got my 60/40 stock/bond blend! Think again

"Enough with this diversification talk, I've got my 60/40 and I am happy!" The 60/40 stock/bond portfolio mix has become a standard reference or benchmark for many investors, yet its performance versus a truly diversified portfolio is mixed. 

The diversified portfolio present above (high yield, TIPS, EM bonds, EM equities, REITs, and commodities equally weighted) is just one alternative diversifying mix of assets; nevertheless, the sample above shows that an equal weighted portfolio will do better than a 60/40 stock/bond mix (S&P 500/Barclays Agg) about 2/3rds of the time.  You could say that the positive opinion towards the 60/40 blend is a recency bias with it outperforming a diversified basket four of the last five years not including the partial 2017 year. 

The periods when there have been extended outperformance of the 60/40 blend relative to the diversified portfolio has been centered when there has been equity overvaluation in the US markets; mid-80's before the 1987 crash, late 90's before the tech bubble, and the more recent period when US stocks have seen significant gains in asset inflation. 

There are a number of ways to beat the simple 60/40 blend in the long-run. One, add diversifying assets from the list used in the graph above. However, the excess return was based on the fully diversified portfolio versus the 60/40 blend. Two, add hedge fund strategies that have diversification of assets along with diversification of style. This, for example, could be a portfolio of managed futures programs which already are globally diversified across a broad set of markets including equities, bonds, rates, currencies and commodities. Along with the asset class diversification, investors get strategy diversification that will often weight long and short positions by trends. The advantage of managed futures is that there is the opportunity for adding convexity or portfolio gamma.

The combination of a strong US stock market with a diversification from bonds has made for successful return to risk combination, but as we have seen, there are no guarantees that this combination will always do well. Further diversification will better manage risk but also allow for higher returns especially after periods of one-sided performance.

Richard Thaler - Nobel Prize winner - The economist who provides a foundation for rules-based managed futures

We congratulate Richard Thaler on winning this year's Nobel Prize in Economics. His relentless research on the failings of rational behavior in human decision-making has had a significant impact in finance and economics. His prolific work is the foundation for all of what we call behavioral economic and finance. Prior to Thaler, economist focused on Homo Economicus, the rational man that does not make mistakes or misjudgments. Thaler showed through test after test that we make mistakes and have biases. He did this albeit radical work not as an outsider to finance like Dan Kahneman but as a economist steeped in the neoclassical tradition. 

Through an ever-increasing set of tests and analysis, Thaler showed us that investors do have inherent biases. Being human means making mistakes. There is now a catalogue of behavioral mistakes that can affect rational choice and market behavior. His work links economics and psychology and pulls economics closer to other social sciences and away from any view that it is like a hard science. Economics cannot be stripped of its psychological roots. There have now been three economists that have focused on this part of economic behavior, Dan Kahneman, Bob Shiller, and now Richard Thaler. 

Why is this important to trend-following and quant trading? Thaler, with his work in the 80's, gave reason for why quant models could work. The behavioral finance revolution justifies the use of models to hard code good behavior. For example, we know that investors have a tendency to hold onto winner and sell losers.  The behavior evidence is strong. Models can be built to offset this bias. Behavioral finance suggests that errors are made with a tendency to react slowly when faced uncertain risks. Trend-following, attached to risk management rules, can offset some of those errors. 

More broadly, the behavioral finance revolution tells us that markets are not likely to be efficient, Prices may not move immediately to equilibrium given our cognitive biases. However, there is the potential for schemes to break through these behavior biases. Behavioral finance cannot tell us which models will make money or how to make money, but it does tell us that disciplined rules-based investing can protect investors and serve as a way to offset any bad behavior.

You don't need intelligence; you need "mindware" to be successful

"Mindware" has been coined by David Perkins, a cognitive scientist at Harvard University as the set of rules, data, procedures, and strategies that are used or retrieved from memory to think rationally and solve problems. It is our skill at thinking about probabilities and making scientific inferences. This skill is different than what is measured by IQ tests, yet it is closer to what we use the word intelligence.

Intelligence is more complex than what we see in IQ tests. Perkins will state that intelligent is the combination of power (raw intelligence or efficiency at using our brain) plus tactics and context. The context is our ability to place a problem in the right domain or use specific knowledge to solve a problem. We can do investment management better when we understand the mechanics of investment management. 

However, the tactics or our frames for thinking is what matters most. Better "software" is critical for using the hardware correctly. Similarly, better "mindware" or tactics such as reasoning skills or our ability to make inferences, measure probabilities, and use appropriate reasoning is essential for problem solving. 

The problem is that many thinkers are "cognitive misers" according to Keith Stanovich whose work can be summarized in, "Rational and Irrational Thought: The Thinking that IQ Tests Miss; Why smart people sometimes do dumb things". The cognitive miser will chose the thinking tactic that uses the least effort. This is what will get us into trouble. He has coined the term dysrationalia which is analogous to dyslexia. This is the equivalent of fast or system 1 thinking as described by Daniel Kahneman. It is fast thinking that will usually get us in trouble with complex problems. 

Due diligence, in a sense, is measuring not the intelligence but the mindware of a manager. It is not his brilliance at showing how intelligent he is with knowledge and facts, but what are the tactics he uses to solve investment problems. 

For the quant, it is not so much that he knows new statistical techniques, but that he knows how to use the right tools for the right problem and understands the context of the problem so as to use the right tools. For the discretionary manager, the tactics will be driven by his ability to use the right thinking for right problem. If a stock is viewed as undervalued by others, the manager is able to take a fresh perspective and truly determine whether value exists. 

Mindware for investment management may be acquired through experience. It may not be bestowed through a degree. The critical skill for due diligence is not being fooled by intelligence but discerning what it means to be smart.