On 2008-03-20 13:45:30 -0700, dapperdobbs <GeorgeCFL[at]hotmail.com> said:

- quote -

It is interesting that diversification among different assets is
usually practiced by people with a whole lot of money to invest, but is
not so often recommended to small investors. For example, where I live
there are many large apartment buildings, office towers, high-end
condos, etc. owned by wealthy offshore investors. I wonder what a Hong
Kong billionaire with real estate holdings would say if someone
suggested he get out of real estate and put everything into mutual
funds. Or if someone told a Saudi Prince, "Take out a home equity loan
on your palace and put the money into this great limited partnership."

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On Mar 19, 2:17*pm, Tad Borek <bore...[at]pacbell.net> wrote:
- quote -

Such events do occur, so such a statement can be true. What you are
really objecting to is the second statement (below), I think.

- quote -

Compared to what? Financial time series are go back further and have
less estimation error than the data used in most other social
sciences.

- quote -

As a prominent statistician has said, "all models are wrong, some
models are useful". A financial planner who wants to simulate the
probability that a client will not run out of money in retirement must
have a distribution of stock returns to draw from, for example, annual
returns normally distributed with a mean of 10% and a standard
deviation of 18%. If he samples from historical annual returns over
the last 80 years instead of assuming normality, there is still an
implicit return distribution.
What is the alternative to some kind of model?

Shifting to Elle's message, mathematicians or "quants" are needed on
Wall Street and in banks to determine interest rates on fixed rate and
adjustable mortgages that still leave the lender a profit margin.
Mortgages have considerable optionality, including the
(1) ability of the borrower to prepay when rates fall
(2) cap on interest rates often found on adjustable mortgages
(3) ability of the borrower to walk away when "underwater", especially
in non-recourse states such as California.

These options of the borrower make mortgage loans less attractive to
the lender than investing a non-callable Treasury bond, and valuing
them takes a quant. I think quants misvalued option (3), because that
option rises in value when house prices fall nationwide.

Since models of mortgages will have uncertain inputs, highly leveraged
structures of mortage-backed securities will be risky.
I think the lesson of the mortgage crisis is not to avoid mathematical
modeling but to limit leverage and ensure that modelers periodically
examine their assumptions.

Ideally, there would be software to help borrowers determine what is
the best loan for them, based on features in the checklist at
http://www.federalreserve.gov/pubs/a...st_english.htm . For
example, if one ARM has a floating rate of 2% above LIBOR with a cap
10%, and another has a floating rate of 3% above LIBOR but a cap of
7%, a mathematical model is needed to determine which loan is better.
The mortgage calculators I have seen are simplistic and do not make
such comparisons.

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Thanks for your reply. Your point about diversification among asset
classes is well taken - the neglect of that was a fatal flaw in LTCM's
blow up.

Augustine (on this thread) brought up a couple of good point that I
think apply to the "derivatives" models. He refers to what have been
called "fat tails" of the standard bell curve (the 'snake oil':-).

Have you (or has anyone here) read anything about the specifics of any
"derivatives risk model" that would give specific insight into their
construction?


On Mar 20, 11:50*am, Don <dwz...[at]telus.net> wrote:
[trim]
- quote -


======================================= MODERATOR'S COMMENT:
While interesting, this thread is getting beyond the mandate of this newsgroup which is general financial planning. Posters who respond to this thread are requested to keep that in mind.

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On 2008-03-20 02:14:42 -0700, dapperdobbs <GeorgeCFL[at]hotmail.com> said:

- quote -

True. Mathematical models for making predictions about the future have
to assert something like "If a, b, c, ... are present, then the
probability that x will happen is such-and-such." This may work for a
while and lead to some accurate predictions, but almost always some
further conditions not taken into consideration (d or e) will come
along and make the model useless. This is especially likely to happen
in long-term financial predictions, because so many unexpected
variables can enter the picture as governments change, new things are
invented, wars occur, etc.

The same principle applies not only to detailed mathematical models,
but also to a lot of generally accepted wisdom such as "stocks return
more in the long run than real estate," or "banks are secure," or
"government bonds are safe," and so on. That is a reason I would argue
that diversification among asset classes is just as important, if not
more important, as diversification among stocks.

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"dapperdobbs" <GeorgeCFL[at]hotmail.com> wrote
- quote -

Well sure. :-) I absolutely agree with your point that
leveraging has aggravated the problem "greatly." Though I
put the last word in quotation marks because it is hard to
say anything with precision here, regarding the precise
effects of the leveraging, and relative to the period around
1991, and just as the August 07 Fidelity report that you
cited points out.

The magnitudes of which you (and Fidelity's paper, etc.)
speak and other reports have me worried that this could be a
mother of a recession. Hopefully I will be eating my words
within a year. Whence I hope younger folks here and myself
will have under our belts one more period of serious market
correction to temper our thoughts on long term investing.

I do like that my IRA's reinvested dividends pick up more
shares at bargain prices.

- quote -


I think there's also a nasty myth going around, promoted by
our government among others, that owning a home should be
everyone's goal. As has been much discussed here, renting is
often the better financial choice. Renting does not
necessarily mean having less square feet.

Still, I put a lot of blame on those calling themselves
"mathematicians" who participate in the financial industry.
Unfortunately I suspect too often they do so thinking they
can get rich quick through manipulation of numbers, when
studies attest otherwise.

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You're drifting over to my point of view! I see you!:-)

I'm still waiting for you to say "30 to 1 leverage on those credit
derivatives!" C'mon ... I know you can say it!:-) Try it once where
nobody can hear you! It won't hurt!

I do not disagree with you on what you wrote below - a bubble tends to
catch an awful lot of people up in it's frenzy. There were loans made
to those who could not, it turns out, afford them. No doubt some were
really hurt by it - a young married couple, afraid to miss out on ever
owning a home, and a lender believing house prices would only go
higher bending over backwards to get them in. That makes me sad and
angry - I'm not sure at whom - but basically it's at those who were in
the housing market only seeking windfall profits.

On Mar 19, 4:45*pm, "Elle" <honda.lion...[at]spamnocox.net> wrote:
[trim]
- quote -

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On Mar 19, 3:14*pm, Don <dwz...[at]telus.net> wrote:
- quote -

Isn't what you wrote above the mathematics of probability?
****
Isn't what you wrote below analysis of cause and effect?

- quote -

I'm not trying to be facetious or lay "traps" here - I really would
like to clarify this.

I see the probabilities as a mathematical game not unlike roulette.
I see analysis as absolutely critical to financial planning and
investment.

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One usually resorts to a model when it's about something new and not
well understood. Eventually, as data becomes available, the model
accuracy can be verified, but not before.

How someone claims a probability of hundreds of years for a model
that's months old is beyond me.

Or perhaps it's just snake-oil tactics, when the error margin for the
stated probability is larger than itself. For instance, the
probability for this to happen is 100 years, give or take 200
years. :-)

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"dapperdobbs" <GeorgeCFL[at]hotmail.com> wrote
- quote -

No doubt.

- quote -

I continue to believe it was a group effort in greed, from
little guy who did not have enough for a down payment yet
bought anyway; to flip-pers with their ridiculous get-rich
quick schemes; to those who sold credit derivatives without
understanding the underlying risk; to banking practices that
did not reveal the extent of exposure to subprime mortgages.
"Only sell what you understand, and if you have to wave your
hands to explain it to an investor, you shouldn't be selling
it to him/her." Toss in a government that maybe should have
done something to regulate lending standards as it lowered
interest rates.

I am not someone who like the concept of "dispersion of
blame," but here it seems at least a bit appropriate.

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"Tad Borek" <borekfm[at]pacbell.net> wrote
- quote -

Right, and as I am sure you know but to clarify (IMO), even
application of the phrase "25-year event" to the field of
finance is dubious.

The shortness and lumpiness (as you put it) all by
themselves should be a red flag for anyone who is presented
with models allegedly predicting market behavior using
complicated statistical mathematics.

I am not sure how Volcker is viewed historically, but he
seems like an economist smart enough not to miss the forest
for the trees. Back to that theme of Sgt. Sausage's and
occasionally Skip Weldon's: It seems it's learning by
experience, tempered especially by living through all kind
of markets, that has great value when planning for the long
term. It's the older folks who have been investing for
decades that have the higher quants (pun intended) of bona
fide wisdom.

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On 2008-03-19 11:17:15 -0700, Tad Borek <borekfm[at]pacbell.net> said:

- quote -

All models are based on assumptions, and they break down when an
assumption that nobody thought to question turns out to be wrong. And
the unforeseen events happen more than you might think. Buggy whips
were a great investment (as long as horses were the mode of
transportation and cars had not yet been invented). Brokerages are good
places to buy stocks (as long as brokers stay honest). Banks will
always be a safe place to keep your money (as long as there is no
nuclear war). Etc., etc.

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Funny ... I could have *sworn* I've been saying the same thing for the
last two years on this site, that "risk" as measured by these guys is
a mathematical concept extracted as a broken fragment from portfolio
management theory which is not really theory at all, but hypothesis.
What a good investor attempts to do rationally is reduce risk by
analysis, as Benjamin Graham advocated. Buffett doesn't sink $100
billion into bonds because his "risk model" tells him "the fortelling
bones landed favorably." "Diversification" is another fragment
extracted by "Dr. Dentists" - 1,000 junk bonds will not do better than
1 bond that makes all payments.

(Personally, I liked my spaceship in the soup analogy :-)

I wonder how long it will be before I see someone posting "Oh, the
problem with the mortgages wasn't so much the housing market - we
could have handled that! The BIG problem was that these dinkies with
their PhD's leveraged all that borrowed money 30 -to- 1, and then
couldn't cover their behinds! Then they SOLD it off to bankers who
believed what they said because they were recognized authorities! THAT
was the problem that sank banks as far away as China (or the same
block in NYC) in a HUGE liquidity crisis!"

On Mar 19, 1:17*pm, Tad Borek <bore...[at]pacbell.net> wrote:
- quote -

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Elle wrote:
- quote -


My BS-ometer hits a 10 every time I read a quote about "five sigma
events" or about a financial event that "should happen once every 7,000
years" - I actually saw that in print the other day. These are emperor's
clothes kinds of statements that to me immediately discredit whatever is
being talked about. At least, in the context of "event frequency".

You can make those kinds of statements about, you know, fruit fly
mutations -- how often the green eyed one has short wings or whatever.
But the data series on finance is extremely short and lumpy. Even the
25-year events couldn't be identified yet, if they came in any sort of
describable distribution that is, which of course they don't.

-Tad

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... hear the words of Paul Volker, quoted the other day in
the Wall Street Journal: "The market was being run by
mathematicians that didn't know financial markets. And you
keep hearing, you know, god, that event should only happen
once every hundred years, according to my model. But those
every hundred years events are coming along every two or
three years, which should raise some questions."

Commentary on the model developed for layering debt:
"Trouble awaits those who blindly trust the model's output
instead of recognizing that they are making a bet based
partly on what they told the model they think will happen.
[Model creator David Li] worries that 'very few people
understand the essence of the model.'"
http://infoproc.blogspot.com/2005/09...rivatives.html

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