BijaAdvisors

Better Decisions, Better Results

Seeds of Thought
Cognitive Science Meets Investment Management

Issue 15-26
July 30, 2015
Originally published:
February 10, 2013
AlphaBeta Soup
I start with the platitude that one cannot judge a performance in any given field by the results, the
quality of a decision cannot be solely judged based on its outcome, but such a point seems to be
voiced only by people who fail (those who succeed attribute their success to the quality of their
decision).
Nassim Nicholas Talebs Fooled by Randomness
In this edition of Seeds, I will attempt to make the case that the current environment is no more
challenging for generating alpha than it has been at any other time in history. It is however, far more
difficult now to generate beta and have it masquerade as alpha.
Easy Money
In general it is impossible to stay fearful of something for a long period of time. The prefrontal
cortex can inhibit fear through repeated exposure.
Iconoclast: A Neuroscientist Reveals How to Think Differently by Gregory Berns.
Between 1981, when US rates peaked, and the bursting of the tech bubble in 2000, investors should have
been extremely disappointed with a manager who didnt provide spectacular returns. Over that period, the
10 year US treasury rate dropped from 15% down to 5%. Simply put, earning carry had been an
exceptional way to generate returns. The stock market rallied 85% of the time and winning years provided
returns 3 times the size of the pullbacks. Again, simply put, being long equities had been an exceptional
way to generate returns. After 19 years of what was essentially easy pickings, it was only natural for
investors to begin overvaluing their investment skills, thus setting the stage for a bubble.
This Almost Never Happens To Me
Things that have never happened before happen all the time.
The Limits of Safety by Scott Sagan.
In 2000, the tech bubble burst and stocks did the unimaginable; they went down. While markets were still
vulnerable, the horror of 9/11 occurred and the carnage continued, resulting in three straight years with
negative returns for the S&P. The first time that had occurred since World War II. In response, interest
rates were pushed even lower, thereby extending the 20 year rally in rates. Simply put, being long equities
was now risky, but earning carry continued to be an exceptional way to generate returns.
Lolo Jones and the Hurdle of Doom
Embedded deep within insurance policies is a hurdle rate. It is the minimum return the policy writer
assumes they can attain on the premiums they take in, thereby allowing them to meet their future
obligations. Everything above that rate is profit. Everything below represents a loss and a potential risk
that those obligations cannot be met. From 1967 right up until 2002, the risk free rate (10 year US
treasury) had not been below 5% and averaged nearly 8%, so it made sense that life insurance companies
were using 5% as the hurdle rate for their policies. It also made sense that pensions were using roughly 8%
returns in their assumptions when strategizing how to meet future obligations. I worked for a major insurer
in 2002 and recall a meeting in the Czech Republic where the heads of its investment groups were brought
!
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Bija Advisors Seeds of Thought

Issue No. 13-4

together to discuss an urgent matter. For the first time in 35 years, the return on risk-free assets had fallen
below the hurdle rate. Future policies would be adjusted accordingly, but they still had massive obligations
on the books that would now require them to take risk. We were to make a push into sovereign debt across
the board. Sixty-two countries were now on the approved list and we were to become a dominant presence
in each of them. Simply put, earning carry on riskier assets was about to become an exceptional way to
generate returns.
Risky Business
When a wall of money comes at a market segment like that, the immediate outcome is absolute. When an
outcome is certain, inherent risk is wiped out. As the risk free rate collapsed and all other rates quickly
closed the gap, investors sought other ways to enhance their returns. Why not sell protection against risk?
In other words, sell volatility. As a result, implied vols embedded in option prices plummeted. With yields
compressed and implied vols at historic lows, the only option left for enhancing returns to meet those longterm obligations was to leverage carry trades and move back into equities. Simply put, leveraging carry,
selling volatility and being long equities were exceptional ways to generate returns from 2002 until the end
of 2007.
Its My Party and Ill Try If I Want To
The survivor (a category including people who avoid accidents) does not impose pre-existing
patterns on new information, but rather allows new information to reshape his mental models.
Laurence Gonzalezs Deep Survival: Who Lives, Who Dies, and Why.
Since 1999, the S&P 500 has had nearly as many losing years as winning, and the average year-on-year
loss has been 22% greater than the gains. Simply put, for the better part of a generation, equities have been
a bad bet and that makes people leery about jumping in with both feet, especially when the fundamental
data isnt supportive either. Thats why few have participated fully in the current rally. Regardless of
whether it makes sense or not, when you dont keep up with a major benchmark, you have produced
negative alpha.
Thinning of the Herd
As soon as the amygdala is triggered by unfamiliar or perhaps threatening stimulation, it raises the
brains level of anxiety and focuses the minds attention on the immediate situation. Under these
circumstances, our attention is shifted away from the hippocampus and focused toward selfpreserving behavior about the present moment.
My Stroke of Insight: A Brain Scientist's Personal Journey by Jill Bolte Taylor.
The crisis of 2008 crushed credit growth but it didnt destroy wealth. Thats the important distinction. It
didnt destroy wealth, because the wealthy were bailed out by the worlds governments. Effectively, that
wealth destruction was delayed and diluted via dispersion, but not without a cost. With a bill so large,
someone has to take the blame. That someone is the ultimate American icon, the often romanticized, but
currently demonized, risk taker. In the eyes of a public hungry for someone to blame for this mess, the risk
takers, the financial innovators, the bankers, those guys on Wall Street, bear the brunt. Weve come full
circle from the go-go eighties when we cheered Gordon Gekkos Greed is Good speech. In 2013, no one
wants to become the face of greed. No one wants to be seen taking risk. Whereas in the years leading up to
the crisis, fund managers couldnt accumulate enough leverage, this time around no one wants any. That
leaves less than 2% returns for the risk free carry trader and not much more for those willing to expand
their horizons. Simply put, the lack of a layup trade in equities, the lack of desire to lever carry and the
seemingly low level of implied vols, makes for an environment that would appear challenging to alpha
generation. Truth is, alpha has always been difficult to generate. What makes this environment uniquely
challenging is that unlevered carry beta can no longer beat the hurdle rate and equity beta triggers the
amygdala. No wonder the herd is thinning.
Safety in Numbers
At a time when jobs are scarce, industry uncertainty is high and risk takers are demonized, investment
professionals are incentivized to spend more time analyzing career risk and less time concerning
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Bija Advisors Seeds of Thought

Issue No. 13-4

themselves with the fundamental data. Losing money being long equities when the fundamentals dont
support it and no one else is in the trade, will likely cause you to lose your job. However, lose money
being long equities when the fundamentals dont support it, but everyone else is in the trade? Thats just
good business sense. As the masses begin to re-rationalize their fundamental analysis to better coincide
with the prevailing price action, the old bubble pump is once again being primed. As with all bubbles, a
premature bet on its demise can be as painful as being caught in its downdraft.
About the Author
For nearly three decades, Stephen Duneier has applied cognitive science to investment and business
management. The result has been 20.3% average annualized returns with near zero correlation to any
major index, the development of a billion dollar hedge fund, the turnaround of numerous institutional
trading businesses and career best returns for experienced portfolio managers who have adopted his
methodologies.
Mr. Duneier teaches Decision Analysis in the College of Engineering at the University of California Santa
Barbara.
Through Bija Advisors' publications and consulting practice, he helps portfolio managers and business
leaders improve performance by applying proven decision-making skills to their own processes.
As a speaker, Stephen has delivered informative and inspirational talks to audiences around the world for
more than 20 years on topics including global macro economic themes, how cognitive science can improve
performance and the keys to living a more deliberate life. Each is delivered via highly entertaining stories
that inevitably lead to further conversation, and ultimately, better results.
Stephen Duneier was formerly Global Head of Currency Option Trading at Bank of America and
Managing Director of Emerging Markets at AIG International. His artwork has been featured in
international publications and on television programs around the world, and is represented by the world
renowned gallery, Sullivan Goss. He received his master's degree in finance and economics from New
York University's Stern School of Business.
Bija Advisors LLC
Web: BijaAdvisorsLLC.com
Email: info@bijaadvisorsllc.com
Twitter: @BijaSeeds
Podcast RSS: BijaSeeds
LinkedIn: Duneier
Phone: 805 452 9429

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Copyright 2013 by Bija Advisors LLC.; BijaAdvisorsLLC.com
Reproduction or retransmission in any form, without written permission, is a violation of Federal Statute
Important disclosures appear at the back of this document