The Rogers Diffusion Curve and Finance

The Rogers Diffusion Curve for innovation has been used as a clear description for how new ideas and products permeate through the economy. Innovation is communicated through time in a regular process through a different set of users from innovators, early adopters, early majority, late majority, and finally laggards. The bell-shaped curve translates to a logistic function which shows the speed of adaptation for any innovation. Diffusion or the evolution of ideas and technology may have different speeds, but it always follows this same narrative.

Without going into all the details of the diffusion curve and how it will differ across technologies and products, we can easily say that there is a diffusion of ideas within finance and investing. 

We can think about this diffusion on two levels for finance and investing. There is the diffusion of ideas in finance like the CAPM or optimization which is the acceptance and use of new research ideas. There is also the diffusion of news, ideas, themes, and valuation through the market. 

News can follow the diffusion curve as early adaptors of new information or valuation put on trades which are then followed by others. A news announcement can have early adopters then followed by the majority and finally laggards. Themes can develop across markets with first some early adaptors and then the majority.  New ideas and different valuations can also follow a diffusion curve until the laggards join and there is then a new idea. Every idea, very piece of news, and every theme has a life cycle and the job of most traders and portfolio managers is the find out how to join the diffusion curve early. 

Even trend-followers follow the diffusion curve. they may not be innovators or early adaptors but there is the hope that the trend can be found before the peak between the early and late majority. Part of what makes an effective trend model is being able to be early in the diffusion curve and exiting before all the laggards join the market. 

Chronological snobbery in economics and finance

 

C. S. Lewis defines chronological snobbery as “the uncritical acceptance of the intellectual climate of our own age and the assumption that whatever has gone out of date is on that count discredited.”

This can be applied to current economic and finance research. Without a doubt our knowledge of the economy and finance has advanced over the last decade, but it is less clear that we know how to properly discount our current knowledge relative to what is known from the past. Current thinking about monetary policy and our wisdom about how to make policy choices may be worse today than twenty years ago. Current modeling techniques such as ML may seem to have an advantage versus older techniques; however, the benefit after empirical testing may be limited.

A conservative approach to economics or investing does not mean clinging to old ideas as always being better. It does mean that new theories and approaches should be viewed with healthy skepticism - "please tell me your new ideas and then let's determine whether they are truly better." The conceit of today may lead to ruin tomorrow, so always be careful with following the research fashion of the day.

The clouds over the economy - disruptors

What causes a recession? One darn thing after another. Any one of the following shocks may not be enough to cause a recession, but when combined there is enough disequilibrium to create business mistakes that lead to production slowdowns, inventory builds, slower hiring, and less consumer confidence.  

•  UAW strike - This strike can last given the wide disparity between parties. If it spills over to other suppliers, it will start to be an economic drag.
• A government shutdown - We have seen this before, but that does not mean there aren't risks. There was just an averted shutdown in June after which the Treasury issued well over one trillion dollars of new debt, so we are back in the same situation.
• The oil price shock - Production has been cut by Russia and Saudi Arabia and prices are unlikely to reverse in the near-term. With prices now solidly in the $90's, gasoline prices are higher, heating oil is higher, and there is new fuel for higher inflation.
• Student loan debt - The day is coming that payments will be due, and the cost will hit marginal households. Many households increased consumer debt during the student loan moratorium so new payments will reduce spending power for households that have a higher marginal propensity to consume.

Disruptions lead to new trends which offer opportunities, but the transitions are usually costly for investors. 

The "impossible" triangle for managed futures (or any hedge fund)

The 'impossible" triangle is the combination of diversification (low correlation with an equity benchmark), stable positive return, and "crisis alpha" or positive excess gains in the face of sustained equity decline. Can it be achieved? You can usually only achieve two of the three. It may not be impossible, but it is hard to get all three. It. can just be what is your tolerance to give-up on one of the three.

Diversification can be achieved through trading different assets long and short from the main target or benchmark asset. If you want diversification from equities, trade commodities, currencies, and fixed income. Trade both long and short as well and you will achieve a low correlation with equities. The diversification will pull down returns during a strong equity bull market yet serve an investor well in a bear market. The diversification will cancel some of the more extreme returns, but there is a likely gain in Sharpe ratio.  

If you want to have stable returns in all environments, you will have to trade a combination of styles to ensure that no one style will drive returns negative. Diversification of styles will smooth returns and help with diversification; however, there will be less convexity or excess returns at extremes.

If you want crisis alpha or positive convexity, you must have a high concentration of risk in trend-following; however, by doing this you will likely have lower returns during periods of stable markets. Hence, the convexity is only achieved through giving up the more stable returns. 

So, an investor is going to have to focus on two at the expense of the third. The question is what you can live with or what is more important for your overall portfolio. This is the personal choice that must be made by investors.