There is No Playbook

A couple of weeks ago I met a friend for coffee. He has been trading for 30 plus years mainly in the European region. I asked him what he has been up to, he said the last 6 months he has been working as a consultant on a movie script about trading. He was very tight lipped so I told him about the screenplay I sketched 8yrs ago.

Anyone using my idea can send royalties to my Bitcoin address 1F1tAaz5x1HUXrCNLbtMDqcw6o5GNn4xqX

The movie is about a quant hedge fund manager who had spent 6yrs building a quantitative macro model with the most brilliant minds around. We will call him Jim. It didn’t take Jim long before he had $5 billion under management and was winning awards left right and centre. There was however a problem.

The problem Jim discovered was that despite the brilliant models the team had developed he had a bigger discovery than everyone in the company. Jim discovered that his “brilliant” macro model was nothing but a randomness machine built with the best intentions having fooled everyone including himself up until recently.

The plot goes into great detail about the fascinating discovery of randomness. Randomness is one of my favourite subjects and can serve as the springboard for many interesting letters in the future. However at this point Jim is faced with a tussle of human nature, and for this there is no playbook.

We now need to go back in time to the lesser known mathematician Jacob Bernoulli (1654 – 1705) of the famed Bernoulli family. But before we do so we first need to pay a debt to his nephew Daniel Bernoulli for his invaluable discoveries in probability theory. As behavioural economists we can lay the discovery of losses being more painful than gains squarely at his feet, where he introduced the idea of utility into the way we calculate probabilities. His profound idea presented in 1731 “The utility resulting from any small increase in wealth will be inversely proportionate to the quantity of goods previously possessed.” brilliantly introduces us to this fascinating asymmetry in probability that mathematicians such as Fermat and Pascal missed.

By the way I am drawing liberally from Peter Bernstein’s brilliant book, Against the Gods, the remarkable story of risk. Let us get back to Jacob.

Jacob wanted to understand why our understanding of probabilities broke down when working with sample data of real life situations. He felt that the uses of probability could be limited exclusively to games of chance. In order to make valid probability calculations you need all the relevant information and unless your model incorporates all the relevant data your models are likely to be “out”. Ok its time to make my point.

Just like Jim in the movie I never made, he has no playbook as to how to run his fund, so to central bankers have no playbook how to run their banks.

I regard myself as a fair student of economic history and it is my understanding that nobody has a clue how things will play out according to the current playbook. Why? Because they are making it up on the fly, buffeted from one crisis response to another. Of course it is all well packaged with the necessary mathematical rigour along with the poetic by current day soothsayers β€œit (government) can’t run out of dollars any more than a carpenter can run out of inches.”― Stephanie Kelton .

Be it Keynesian Aggregate Demand, Be it Friedman’s Monetarism or Be it the more exotic Modern Monetary Theory it is probabilistic theory based on incomplete information.

As Fischer Black is quoted as saying, “we either have information we need or else we have no need for information.”

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  1. avatar
    Albert says:

    πŸ˜‰ naanaa; ..Mike; you gotta create an NFT like generative art lol every time it gets sold you get a piece ..

    why am i smelling Jim Simmons here (‘xcept his models ,well .. Ray (Dalio) who?)

    Well, it breaks down ‘cos you can have all the battle plans ready but generals (‘t least should) adapt on the ground ..

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