Jerome Brunner - Logic and narrative go together

 

Jerome Brunner, one of the towering figures in psychology and cognitive learning, developed a simple cognitive theory through framing experience into two models, propositional and narrative. Propositional thinking focuses on logic and formality, while narrative is based on storytelling. Narrative is emotional and needs to be personally convincing. It is the narrative that holds the propositional logic together as a useful tool. Simply put, we cannot develop theory and logic in a vacuum; instead, we use narrative as a tool to support our thinking or convey it through stories. The narrative provides an emotional connection.

We can use that framework to think about how stories are conveyed on Wall Street. Nothing is done by reviewing model results. No talking head refers to a model. The models are condensed into a concise story or narrative. The narrative can provide a connection that is absent from a model. 

Perhaps an extreme, but Fed independence is not presented as a formal problem in time inconsistency, but as a fight for control over a policy lever. The acquisition of a firm is not described in numerical terms, although a price is associated with the purchase. There is a discussion of strategic advantage and how the whole will be greater than the sum of the parts. 

See also:

Narrative and investing - Follow the facts

Financial globalization is determined by state actors

 

State and the Reemergence of Global Finance: From Bretton Woods to the 1990s by Eric Helleiner is a fascinating book on the politics of international plumbing. As a macro person, I focus on models and price relationships, rather than regulation or international relationships across countries. This book highlights the significant impact of global policy choices by states on markets. This should be viewed as obvious, but we often focus on innovation and market forces as the drivers of change; however, it is frequently the will of the state that is the major contributing factor. Financial globalization was not an organic change to the international order but was orchestrated through the policies and dictates of state players. This was a different perspective that I did not fully appreciate. 

Clearly, the world is being reset with respect to trade through tariff policies; however, we cannot forget that the world can also change through policies that impact capital markets and flows. Capital markets may have a greater impact on inter-country dynamics. While we have not seen capital flow policies change directly, the talk for a weaker dollar is clearly having an impact on flows. The sanctions placed on countries also have a flow constraint. We have not changed policies on capital controls, but the weakening of international organizations has spillover effects on capital flows. Financial globalization or deglobalization is in the hands of policymakers, and should be given more attention by all in finance.

Return stacking - an easy approach for return enhancements

 

Return stacking is not hedging. Return stacking is not a solution to higher returns. Return stacking is a means of efficiently using capital through mixing core assets with the benefits from futures margin structures. It is a variation on portable alpha strategies, or portable beta by another name. An investor gets capital efficiency through gaining exposure in futures for a core asset. The unlocked capital can then be used to buy another asset. See "Return Stacking &Portable Alpha: An Investor's Guide".

The core approach can allow capital to be used to create a better return-to-risk trade-off efficiently. Of course, the choice of the stack will determine the return-to-risk. The foundation of this work is based on choosing assets in the stack that are uncorrelated.

Private equity payoffs - Set of options

 

The return profile for private equity is one of the critical investment issues for many institutional investors. This will also become a crucial issue for retail investors if many of the large PE firms have it their way. We need to go back to basics and look at the pay-off structure for private equity, and the graph below provides valuable insight. This chart is from the new paper "Analytic Valuation of Private Equity Investments". 

Notice that four distinct pay-offs form a real option. If you cannot pay the borrowing costs, the investor makes nothing. Once the costs are covered, the investors make money until the invested capital is returned, and the GP then receives his fees. Afterward, the investor receives the excess. You have to clear hurdles to receive the next set of cash flows. There are failures which impact this pay-off, and the investments are illiquid and take, on average, 5-7 years to return capital. This is a long-term option on the quality of management to provide a return above the cost of capital.