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Better Decisions, Better Results

Seeds of Thought
Where Cognitive Science Meets Investment Management

Issue 15-17
May 6, 2015

Rates as a Metaphor for Risk

A friend of mine was shopping for a new car and asked me to help him secure a great deal. Turns out I
am quite the negotiator, convincing the dealer to knock a full $20,000 off the price.
I know what youre thinking. Before assessing just how good my negotiating skills really are, youd
probably want to know what kind of car it was that he was shopping for, wouldnt you? I mean, $20,000
knocked off the cost of a new Corvette Stingray would get me a How to book deal. However, if it was
the $1.6 million Koenigsegg Agera R, youd likely wave it off as a rounding error, and rightfully so.

As I mentioned in the previous edition of Seeds of Thought, when I asserted in my presentation at the
Drobny Global Macro Conference that markets are experiencing a moment of incredible risk aversion, I
faced serious pushback. How could I possibly characterize this moment as one of risk aversion when
there is a desperate search for yield going on, as evidenced by historically tight yield spreads? Ill be
perfectly honest with you, this line of thinking is astonishing to me. Just as you wanted to know the cost
of the car before assessing just how good that $20,000 discount was, mustnt you also consider the ratio
of returns on say EMBI+ relative to the 10 year US Treasury, rather than simply the spread? In other
words, doesnt it matter what the base rate is at the time of comparison? Of course it does.
Proportionality matters. Always. When I suggested this to one of the more outspoken audience
members, he argued that it doesnt matter. According to him, an additional 100 bps offered by an
alternative investment when the risk free rate is zero means the same as an additional 100 bps when the
base rate is 1,000 bps.
To be honest, while that kind of response may have shocked me in the past, I have heard enough similar
comments from other traders to know that he is not alone in his beliefs. Several of them even occupying
very senior investment positions. The reality is, concepts such as proportionality, probabilities and others
fundamental to statistical analysis, are regularly dismissed by many in the industry. For example, when I
!
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Bija Advisors Seeds of Thought

Issue No. 15-17

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made an argument against a position in his portfolio based on a simple expected monetary value
analysis, using his own expectations of event probability, a former CIO of mine exclaimed, I dont
believe in statistics.

A Crippling Dislike for the Abstract

In Black Swan, Nassim Taleb discusses the events of December 2003, when Saddam Hussein was
captured and markets reacted. However, I prefer Daniel Kahnemans explanation, because he puts it in
the context of cognitive science. Specifically, he explains how System 1, the auto-response part of our
brains, immediately attempts to create order out of uncertainty, which it does by creating a coherent
causal story that links tiny bits and pieces of information that are readily available, and at least
superficially related.
Bond prices initially rose on the day of Saddam Husseins capture in his hiding place in Iraq. Investors
were apparently seeking safer assets that morning, and the Bloomberg News service flashed this
headline: U.S. TREASURIES RISE; HUSSEIN CAPTURE MAY NOT CURB TERRORISM. Half an
hour later, bond prices fell back and the revised headline read: U.S. TREASURIES FALL; HUSSEIN
CAPTURE BOOSTS ALLURE OF RISKY ASSETS. Obviously, Husseins capture was the major event
of the day, and because of the way the automatic search for causes shapes our thinking, that event was
destined to be the explanation of whatever happened in the market on that day. The two headlines look
superficially like explanations of what happened in the market, but a statement that can explain two
contradictory outcomes explains nothing at all. In fact, all the headlines do is satisfy our need for
coherence: a large event is supposed to have consequences, and consequences need causes to explain
them.1
The same could be said for the price action of the past couple of days. It is clearly a shake out of
positioning. The kind of thing that happens all the time. Nothing more than short-term noise. However,
for those who are losing money on it, and I would assume a great number of traders are, it can be
painful. It is very difficult to chalk up a very painful experience to little more than random noise. So
System 1, that auto-response part of our brain, immediately goes to work trying to create order out of
chaos, and according to all the research, it will succeed. Unfortunately, it isnt very good at thoughtful
analysis and reasoning. Therein lies the problem. While it will indeed generate a narrative to explain
what is happening, it isnt likely to be a reliable one.
1

Kahneman, Daniel (2011-10-25). Thinking, Fast and Slow (p. 75). Macmillan. Kindle Edition.
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Bija Advisors Seeds of Thought

Issue No. 15-17

If you can take a step back though, and resist the temptation to think only about your particular
position(s) and the impulse to generate a causal connection for its recent price action, and instead
consider all of the markets that are moving simultaneously, and thoughtfully consider what it is that
connects them all at this moment, I believe youll come to a far more rational, and profitable conclusion.
In other words, give System 2 a good kick in the pants to wake it up. Force it to interrupt System 1s
impulsive need to draw conclusions from a pile of rubbish. When you do that, I believe you will gain the
confidence to begin stepping in front of this train and take advantage of the short-term pullback to reload
on some of those core positions. In particular, the 10 -30 year US Treasuries are getting close to very
attractive levels.
As I said in Macro Radar back in October, While it sounds like the only possible outcomes are slow
and steady risk on or cataclysmic risk off, its the ebb and flow in expectations between the two that is
likely to continue exacting the most pain. This is one of those moments. Only you can wrestle control
back from your own impulsive self.

About the Author

For more than two decades, Stephen Duneier has studied cognitive science, applying what we know
about how the brain works, how we deal with uncertainty and solve problems to develop a whole new
approach to business, investing, and life itself. The result has been top tier returns with near zero
correlation to any major index, the development of a billion dollar hedge fund, a burgeoning career as an
artist and a rapidly shrinking bucket list.
Duneier now teaches Decision Analysis at the University of California Santa Barbaras College of
Engineering while delivering his distinctive brand of actionable intelligence to top decision makers
across numerous industries via Bija Advisors publications.
As a speaker, Stephen has developed a series of informative and inspirational talks on topics ranging
from how global macro analysis can help us understand the world around us, how cognitive science can
improve performance, and the keys to living a more deliberate life. Through the years, he has earned a
reputation for delivering his unique insight via beautifully woven, 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 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.

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Copyright 2015 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