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Is OCD obstructing long- term financial innovation ?. Dane Rook Smith School of Enterprise & the Environment. Public Service Announcement. Obsessive Capital Diversification (OCD) Communicable Early detection difficult Potential lethality. OCD Diagnostics.

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is ocd obstructing long term financial innovation

Is OCD obstructing long-term financial innovation?

Dane RookSmith School of Enterprise & the Environment

public service announcement
Public Service Announcement

Obsessive Capital Diversification (OCD)

  • Communicable
  • Early detection difficult
  • Potential lethality
ocd diagnostics
OCD Diagnostics
  • Economic justification for diversification:

Benefits > Costs

  • 3 (interlinked) budgets of asset owners

Capital

Governance

Risk

  • Time
  • Expertise
  • Collective commitment

AUM (£, $, …)

“Error”

interrogating platitudes
Interrogating Platitudes

“Diversification isn’t a free lunch”

  • Not gratis
  • May be mal-nutritious
  • Can cause indigestion
symptoms of ocd
Symptoms of OCD
  • Mistaking ends and means
    • Process, not state
    • Relative, not absolute
  • Moderator of expected returns, not generator
    • No better than best
    • No worse than worst
  • Dampens downside, does not eliminate
    • Conflation with hedging
maximum diversification a unicorn
Maximum Diversification: A Unicorn…?
  • Maximum Diversification
    • Own a share in everything of value,in proportion to its value
  • Single-factor exposure: systemic risk
    • Perpetual flux (non-stationarity)
      • Transaction and valuation cost impediments
    • Diversification spiral
  • Multi-factor exposure
    • Purposive or inadvertent selection/exclusion of specific risk factors (idiosyncratic exposures)
maximum diversification or dodo
Maximum Diversification…or Dodo?
  • Tail events: extreme events, black swans, crashes, rare disasters, catastrophes…
  • Leptokurtic distributions (“fat tails”)
    • High impact, ‘low probability’
  • Under many fat-tailed distributions optimality of diversification fails
    • Recognized since at least 1965 (E. Fama – Paretian forms)
    • Distributing eggs over many baskets presume independence of baskets
  • Selective exposure…factor-driven investment
    • Implicit or explicit
governance costs of ocd
Governance Costs of OCD

Time, Expertise, Collective Commitment

“Resource limitations (time and expertise) remain at the centre of many of the fund governance problems that asset owners experience”

  • Monitoring, learning
    • Quickening pace
    • Widening universe
  • In-sourcing, out-sourcing
    • Compensation
    • Alignment/trust

78%

convergence
Convergence
  • Diversification spiral and portfolio overlap
    • Diminishing air-space leads invariably to crashes
      • (Not just true of aviation)
    • Quantification begets credibility, but if everyone happens to be reading the same treasure map, there is less pro rata
    • In portfolio management, doubloons = βs
  • βs typically historically-derived, ergo reverse-looking measurement of risk/opportunity
    • Not just popular in asset management, but also corporate finance applications
  • βs all about variances (of various stripes)
variegated variance
Variegated Variance
  • Variance matters because financial markets are stochastic, not deterministic
    • If they were deterministic, diversification would serve no purpose
  • Variance comes in two flavours:
    • Historical (ex post; realized moves)
    • Future (ex ante; plausible moves)
errors and counterfactuals
Errors and Counterfactuals

Period 1 (historical)

Period 2 (future)

£121π=50%

£110π=50%

£110

£100

£88π=50%

£80π=50%

Russian nesting dolls of branchingWhat happened [is a subset of] what was considered [ is a subset of] what was possible

variegated errors
Variegated Errors
  • Flavours of error:
    • Aleatory: “casino-style”
    • Epistemic: structural misspecification
      • Outcomes?
      • Probabilities?

Error rates……can have error rates…

…can have error rates…

…can have error rates…

…can have error rates...

£132π=?

£121π=50%

£110

£88π=50%

£77π=?

infinite regress
Infinite Regress
  • Error ladders…at which rung do we leap off?
  • Alternatively, is it simply sufficient to admit that we “know that we might not know”, and would such a confession imply?
  • Pragmatic solution: tail-fattening
mitigants
Mitigants
  • Self-criticality
    • Not being afraid to climb the error ladder
    • Aspiring to dig deeper into results, both when they work and when they don’t
      • Counterfactuals lend insight to possibilities
  • *GENUINE* innovation
genuine innovation
Genuine Innovation
  • Emerging conventions are not durable innovation (in the global sense)
    • Illustration: credit derivatives
  • Control
    • Steering provisions
    • Comprehension (experience)
      • Don’t be wholly at someone else’s mercy and out of your depth…
  • Optionality