The Federal Reserve: Love it or Hate it

[ianlippert]

[ QUOTE ]
business cycles come from an inability to manage perfectly. when demand has been higher than previous periods, we order more (typically far more) on the assumption that the next period will have more of the same. it takes a realization of the decreased demand to reduce orders for the next period (again by too much). humans over-react and no matter what you do (as has been studied in oprations research), that extrapolation is unavoidable and thus business cycles will always be around regardless of whether we have a fed or not.


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I dont really see how this is irrational, mabey more just bad management. And of course there will be small cycles in particular industries, but how can you have an entire economy collapse from individual industries?

Your example works much the same way as my stock market example. If you dont take into account future demand and I do, I make a profit and you go out of business. Considering the level of competition in most industries I find it very unlikely that there will be much mismanagement from year to year among competant capitalists.

[DcifrThs]

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[ QUOTE ]
business cycles come from an inability to manage perfectly. when demand has been higher than previous periods, we order more (typically far more) on the assumption that the next period will have more of the same. it takes a realization of the decreased demand to reduce orders for the next period (again by too much). humans over-react and no matter what you do (as has been studied in oprations research), that extrapolation is unavoidable and thus business cycles will always be around regardless of whether we have a fed or not.


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I dont really see how this is irrational, mabey more just bad management. And of course there will be small cycles in particular industries, but how can you have an entire economy collapse from individual industries?

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you are taking it literally. i'm using it as an example as to how "bad management" is actually irrational. for exmaple, why is it that the average mutual fund investor does FAR worse over time than the average mutual fund even controlling for dollar weighting?

because of the above extrapolative fallacy. people move money into mutual funds that have recently performed well in the past and out of mutual funds that have recently performed poorly (thus extrapolating that their performance will continue). people would do better if they just left their money in the fund.

that is irrational. i.e. not learning from past experiences. continuing to make the same mistake again...

[ QUOTE ]
Your example works much the same way as my stock market example. If you dont take into account future demand and I do, I make a profit and you go out of business. Considering the level of competition in most industries I find it very unlikely that there will be much mismanagement from year to year among competant capitalists.

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then you'd be wrong. people (read : every single compnay, even walmart) have a horrible time matching supply and demand. they oversupply and then they under order, then they over order, then they oversupply, quarter after quarter, year after year.

the supply thing is just an example though. i mean to use it to talk about investments individuals make (when the stock market is climbing, everybodypiles in expecting that run to continue etc.) on the margin and how that plays out over time. an unmanaged economy would let those trends go until a more massive bust hits (or a more massive boom occurrs)

Barron

[ianlippert]

[ QUOTE ]
that is irrational. i.e. not learning from past experiences. continuing to make the same mistake again...



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But isnt the whole point of the free market that it weeds out bad capitalists? Even if everyone is acting irrational, those capitalists that act the most rational (even if its by accident) will rise to the top. Its like evolution, there is no 'rational' direction mutation takes but the constraints of the environment always produce extremely efficient animals with very 'rational' survival mechanisms.

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the supply thing is just an example though. i mean to use it to talk about investments individuals make (when the stock market is climbing, everybodypiles in expecting that run to continue etc.) on the margin and how that plays out over time. an unmanaged economy would let those trends go until a more massive bust hits (or a more massive boom occurrs)


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This is what I originally thought you meant but then you said it wasnt. The austrian arguement is that the liquidity that gets pumped into the economy causes investors to act irrationally because it makes them miscalculate the value of stocks. But this isnt irrational given the individuals immediate information on the availability of credit. If the stock market were truly free from government regulation the true market values of stocks would be achieved a lot faster.

Another arguement I've heard is that programs like RRSPs provide tax incentives for individuals to put their money into mutual funds that wouldnt otherwise be there. In a true free market there would be no taxes and no fake incentives to invest in the stock market. I think the problem is that there is just way too much money in the market. This allows investors to take risks that they otherwise wouldnt take with other peoples money. There is less of a feedback mechanism to weed out 'irrational' behaviour than there would be in a free market.

[adios]

[ QUOTE ]
This is what I originally thought you meant but then you said it wasnt. The austrian arguement is that the liquidity that gets pumped into the economy causes investors to act irrationally because it makes them miscalculate the value of stocks. But this isnt irrational given the individuals immediate information on the availability of credit. If the stock market were truly free from government regulation the true market values of stocks would be achieved a lot faster

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You realize that U.S. stock market returns in the aggregate since say 1926 are mucho higher than what financial theory would predict them to be. This is what I don't understand about all the criticism regarding investors getting bilked because of actions by the Fed. Investors have been overly compensated for the risk inherent in owning stocks not under compensated for the risk. I use 1926 because that's generally the date people use since that's when the S&P 500 was initiated. The S&P 500 is a proxy for the overall valuation of the market. The disparity between actual returns from the stock market (ex post returns) and what financial theory states they should be is commonly refereed to as the equity risk premium puzzle or paradox. Search google for more info if interested. Dr. Bradford Cornell, UCLA professor, wrote an excellent and higly readable book about the equity risk premium which includes a discussion of the equity risk premium puzzle.

Cliff Notes: Investors have been overly compensated for the risk of owning stocks not under compensated.

[Copernicus]

[ QUOTE ]
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This is what I originally thought you meant but then you said it wasnt. The austrian arguement is that the liquidity that gets pumped into the economy causes investors to act irrationally because it makes them miscalculate the value of stocks. But this isnt irrational given the individuals immediate information on the availability of credit. If the stock market were truly free from government regulation the true market values of stocks would be achieved a lot faster

[/ QUOTE ]

You realize that U.S. stock market returns in the aggregate since say 1926 are mucho higher than what financial theory would predict them to be. This is what I don't understand about all the criticism regarding investors getting bilked because of actions by the Fed. Investors have been overly compensated for the risk inherent in owning stocks not under compensated for the risk. I use 1926 because that's generally the date people use since that's when the S&P 500 was initiated. The S&P 500 is a proxy for the overall valuation of the market. The disparity between actual returns from the stock market (ex post returns) and what financial theory states they should be is commonly refereed to as the equity risk premium puzzle or paradox. Search google for more info if interested. Dr. Bradford Cornell, UCLA professor, wrote an excellent and higly readable book about the equity risk premium which includes a discussion of the equity risk premium puzzle.

Cliff Notes: Investors have been overly compensated for the risk of owning stocks not under compensated.

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This kind of modeling goes well beyond what we use regularly, though one of my client's large investment managers brought it up at dinner a couple of months ago. Apparently Yakov Ben-Haim has proposed a "solution" to the paradox that is consistent with the actual risk premium. His "cocktail party" synopsis raised my interest in the context of poker, since it is centered around decision making under uncertainty. The little reading I did after that kinda killed my interest, since the solutions are non-probabilistic.

[DcifrThs]

[ QUOTE ]
[ QUOTE ]
This is what I originally thought you meant but then you said it wasnt. The austrian arguement is that the liquidity that gets pumped into the economy causes investors to act irrationally because it makes them miscalculate the value of stocks. But this isnt irrational given the individuals immediate information on the availability of credit. If the stock market were truly free from government regulation the true market values of stocks would be achieved a lot faster

[/ QUOTE ]

You realize that U.S. stock market returns in the aggregate since say 1926 are mucho higher than what financial theory would predict them to be. This is what I don't understand about all the criticism regarding investors getting bilked because of actions by the Fed. Investors have been overly compensated for the risk inherent in owning stocks not under compensated for the risk. I use 1926 because that's generally the date people use since that's when the S&P 500 was initiated. The S&P 500 is a proxy for the overall valuation of the market. The disparity between actual returns from the stock market (ex post returns) and what financial theory states they should be is commonly refereed to as the equity risk premium puzzle or paradox. Search google for more info if interested. Dr. Bradford Cornell, UCLA professor, wrote an excellent and higly readable book about the equity risk premium which includes a discussion of the equity risk premium puzzle.

Cliff Notes: Investors have been overly compensated for the risk of owning stocks not under compensated.

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yup. there is one theory about a "fix" to the puzzle that i agree with put forth by a solid economist, Thaler.

he says that the premium matches what you'd expect if you assume investors are often short sighted and have a time horizon shorter than logically correct for long term investors AND are highly averse to losses vs. gaines (prospect theory proves this last point). if you assume a portfolio evaluation horizon of 1 year and a 2x loss aversion, the equity risk premium is what you'd get (i.e. about 6%).

this theory isn't widely accepted but i think it matches what i'd imagine investors in aggregate to be like (i.e. not theoretically correct and very loss averse relative to gains).

other theories about the risk premium puzzle just make assumptions about investors that i highly disagree with and in practice don't match participant action.

Barron

[DcifrThs]

[ QUOTE ]
[ QUOTE ]
business cycles come from an inability to manage perfectly. when demand has been higher than previous periods, we order more (typically far more) on the assumption that the next period will have more of the same. it takes a realization of the decreased demand to reduce orders for the next period (again by too much). humans over-react and no matter what you do (as has been studied in oprations research), that extrapolation is unavoidable and thus business cycles will always be around regardless of whether we have a fed or not.


[/ QUOTE ]

I dont really see how this is irrational, mabey more just bad management. And of course there will be small cycles in particular industries, but how can you have an entire economy collapse from individual industries?

Your example works much the same way as my stock market example. If you dont take into account future demand and I do, I make a profit and you go out of business. Considering the level of competition in most industries I find it very unlikely that there will be much mismanagement from year to year among competant capitalists.

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this point i made earlier is wrong. i'd like to redefine it.

humanity making decisions under uncertainty is what causes business cycles. not my "irrationality" comment earlier. that was a mistaken catagorization imo.

Barron

[Copernicus]

There seems to be a basic misunderstanding in this thread of what "risk" is in investment terms. Risk is volatility, not the more general notion of "safety of principal". The risk free rate of return is what an investor would demand IF there was no volatility in those returns. Loss of prinicpal can be the result of volatility if you need to liquidate when the value of the investment is down, but most actual loss of principal comes from mispricing the asset in the first place.

There is no totally non-volatile asset, but 3 month Treasuries are so short term that for all practical purposes an investor can hold them to maturity which does eliminate volatility. Treasuries arent "risk free" (in investment terms) simply because the US government isnt going to default on them, and they dont bear "risk" simply because of some small but finite possibility that the government might default.

If you look at most financial models that are driven by risk free returns, rather than inflation, short term Treasuries are assumed to have standard deviation...ie they are not assumed to be "risk free"

[DcifrThs]

[ QUOTE ]
There seems to be a basic misunderstanding in this thread of what "risk" is in investment terms. Risk is volatility, not the more general notion of "safety of principal". The risk free rate of return is what an investor would demand IF there was no volatility in those returns. Loss of prinicpal can be the result of volatility if you need to liquidate when the value of the investment is down, but most actual loss of principal comes from mispricing the asset in the first place.

There is no totally non-volatile asset, but 3 month Treasuries are so short term that for all practical purposes an investor can hold them to maturity which does eliminate volatility. Treasuries arent "risk free" (in investment terms) simply because the US government isnt going to default on them, and they dont bear "risk" simply because of some small but finite possibility that the government might default.

If you look at most financial models that are driven by risk free returns, rather than inflation, short term Treasuries are assumed to have standard deviation...ie they are not assumed to be "risk free"

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how do you calculate excess returns?

see one of my points? you can't construct a portfolio without assuming a risk free rate of return in the form of the "guaranteed" return you'd get on 3mo tbills (or 1 mo repo rate). you need the excess return streams to assess the volatility of other positions....the volatility of other positions relative to that of some risk free return you could earn in each period.

even US 10yrs are subject to this (i.e. when looking at the excess return, you subtract out the "risk free" rate of return).

To take your post one step further, all securities (including 10yrs) give Total Return.

total return can be broken down into all of its constituent parts. TR(US10yr)=price change + coupon

so there's price and coupon returns. since price of the 10yr responds to changes in long term inflation expectations and yield curve shifts (and moves), the price risk is significant. duration of 10yrs is about 7.5yrs so a 1bp change in yield leads to about .075% change in price.

default risk would be factored into the coupon payment. if you believe in fairly efficient markets, it already (or mostly already) is.

Barron

[DcifrThs]

Just to correct something i said:

Total return=Price change + Coupon + risk free rate

Excess return= Total return-risk free rate.

so the Excess return=price change + coupon. to get the excess return, you need the risk free rate.

More generally, Total Return= XR + cash

where XR is the excess return of whatever you are looking at and cash is colloquial for the risk free rate.

Barron