tag:blogger.com,1999:blog-357707212023-11-15T10:49:31.698-08:00Fuzzy NumbersBroad perspectives on risk.Jamie Sakerhttp://www.blogger.com/profile/15584895824753615313noreply@blogger.comBlogger16125tag:blogger.com,1999:blog-35770721.post-70472852902912142432007-06-23T10:48:00.000-07:002007-06-23T11:45:27.875-07:00Progressive CastlesRecent efforts by Progressivists to control talk radio and other unconstrained discussion of ideas were brought to the forefront by Oklahoma Senator James Inhofe's <a href="http://www.foxnews.com/story/0,2933,285933,00.html">recollection of an anti-talk radio discussion</a> between Senators Hillary Clinton and Barbara Boxer, as revealed in a discussion with KFI talk radio host John Ziegler this last week. Inhofe's revelation brought further awareness of the growing interest of Progressive party leaders with the return of the <a href="http://en.wikipedia.org/wiki/Fairness_doctrine">Fairness Doctrine</a> and reminded many of the inability of the Left to sustain a viable, competing national talk-radio program.<br /><br />Without question, the Left's talk-radio failures have been dramatic and have raised question over the source of their inability. Countless millions of investment dollars have been lost by Progressivist investors in seeking to replicate Conservative success in talk radio. Failures have been so dramatic that many have begun demanding governmental control of speech that would have been unthinkable to anti-establishment children of the 1960s. <br /><br />Much of the confusion on the conservative-nature of talk radio stems from a misunderstanding of the media appetites of the Left and Right audience. Progressive conspiracies of rich station owners colluding with corporate advertisers in smoke-filled boardrooms aside, the real issue is that interactive talk radio is a format inconsistent with the method in which Progressivist orthodoxy is disseminated. <br /><br />Progressives, through their various incarnations, are centralized, command-oriented thinkers. Based upon a long-established societal framework that is best illustrated through the example of liberal feudal lords and their protected peasantry, beliefs in their model are originated and established at the political manor and dictated to the serfs to accept. From centralized, government-administered economic models to their approach in handling nearly all policy matters such as the demand for central determination of appropriate radio speech, they seek to have the protection and unaccountability of having the lords at the castle make all decisions.<br /><br />Subsequently, progressivist media is centralized. Besides a near monopoly of control in print and television, the Left disseminates its message through the radio medium using National Public Radio and British Broadcasting Company transmissions. Collaboration found in talk radio, being inconsistent with centralized though orthodoxy, is as useful to their peasantry as tampons for men.<br /><br />Even in interpersonal dialog, true discussion and debate over ideas is foreign to the progressive peasant. Countless examples of screaming Leftists at speaking events which dare host a Conservative viewpoint, confiscation of newspapers of opposing thought, banishment of Fox News from debates, and even physical attacks on those who seek to discuss an opposing viewpoint are common. False claims of "consensus" in their issues (e.g. global warming) are keywords for demanding blind acceptance of the Castle's dictates.<br /><br />Those who don't participate in the Left's feudal model should remember this isn't a new battle, nor does their model lack useful strategy and benefits. Indeed, feudal systems provide risk reduction utility for the peasantry and lords, at an exceptional cost of liberty, autonomy and peasantry wealth. From the perspective of societal risk management, the feudal model has numerous benefits, including:<br /><ul><br /><li>Effective dissemination and assimilation of messages under conditions of constrained economic and educational resources. Peasants are not critical thinkers and do not require advanced education to accept a unifying message.<br /><br /><li>Reduced inefficiency caused by friction in opposing thought. Viewpoints are consolidated and distort the community's beliefs in a leptokurtic (fat-tailed) manner, so as long as the central tendency is the correct strategy, the community's successful outcome is more likely.<br /></ul><br />In other words, the Progressivist model is often a superior strategy when the Castle leadership is right, and a dramatic failure when it's wrong. <br /><br />Opposing the Leftist assault on decentralized media isn't easy. It is important to remember that a good component of the population does not feel it possesses the ability to be accountable for their outcomes and would rather sell themselves into servitude to their lords in exchange for attaining a small portion of wealth confiscated from those who are more capable. If the central body of society's distribution is more comfortable with the Left's risk-reducing offer, decentralized free thinkers have little to offer.<br /><br />Leftist peasantry is motivated by fear and our open distaste for their co-dependent behavior only reinforces their support for those who would empower their parasitism. Their lords prey upon fear and distrust (read George Soros's <a href="http://www.amazon.com/Castle-Franz-Kafka/dp/082221900X/ref=pd_bbs_2/002-5123210-1421659?ie=UTF8&s=books&qid=1182623984&sr=8-2">"The Alchemy of Finance"</a> to understand how increased volatility, fear and instability are items Soros and his kin engineer in order to profit). In this climate, it's difficult for free persons to enhance trust and reduce the inclination for the peasantry to empower their lords. <br /><br />Only efforts that provide tangible improvement in the financial and social bottom line of the masses counts. While the Bush tax cuts certainly had their impact, notable administration failures include the inability to promote the Fair Tax, the lack of party support for Social Security privatization and other important efforts that would have given the masses less reason to seek the protection of the Left's Castle.<br /><br /><i>Recommended Summer Reading: Check out Franz Kafka's outstanding novel, <a href="http://en.wikipedia.org/wiki/The_Castle_%28Book%29">The Castle</a> (<a href="http://www.amazon.com/Castle-Franz-Kafka/dp/082221900X/ref=pd_bbs_2/002-5123210-1421659?ie=UTF8&s=books&qid=1182623984&sr=8-2">available on Amazon for $7.50</a>) for an exceptional insight into the motivations and frustrations associated with Progressive socio-economic systems.</i>Jamie Sakerhttp://www.blogger.com/profile/15584895824753615313noreply@blogger.com0tag:blogger.com,1999:blog-35770721.post-73023232213271671892007-05-12T07:30:00.000-07:002007-05-12T08:21:55.915-07:00Risk AvoidersIn a speech to Harvard professors and students yesterday <a href="http://www.thecrimson.com/article.aspx?ref=518804">as reported by the Harvard Crimson</a>, former President Clinton expressed a view on national risks that further illustrated the highly risk-averse nature of many American progressives.<br /><br />Explaining the preferred method for dealing with risk, Clinton said "“We’ve got to try to avert disasters—not just be prepared to bomb somebody if a disaster occurs.”<br /><br />In many respects, the former president's statement not only reflects two terms of that witnessed excessive avoidance of growing international threats, but also illustrates an approach that is increasingly common in corporations respective to operational risk. The sirens call of risk prevention is an enticing one, leading many into false hopes of the avoidance of all things bad. Indeed, some argue that much of the foundation of current progressivist thought is one based upon this avoidance philosophy.<br /><br />Unfortunately for these optimistic believers, when outlier risk events ultimately occur, the theory fails them and rational response measures are lacking. Instead, false causations are usually established and scapegoats found and punished. "If only we tried harder to prevent it and had more money to do so" is the conclusion presented in response to the inherent failure of the prevention strategy. Usually, such systems perpetuate a significant decline until the participants recognize the folly of a prevention-only rhetoric.<br /><br />For those less familiar with the pedagogy of risk, the former president's perspective can be described as one that believes the significant risks are outside the system and subsequently can be prevented. In risk nomenclature, this is known as exogenous risk, or risk that is "external to the system." The opposite believe, that risk is inherent to the system, is known as endogenous risk.<br /><br />In many operations environments, managers are likely to find a pronounced exogenous-believing, risk-avoiding culture. Assets are deployed for risk prevention. In my information security experience with community banks, this corresponded with purchases of network firewalls, host firewalls and the application of software patches as the overwhelming majority of the information security budget. Methods that detect risk were a small minority of the budget, usually limited to the periodic review of log files, while more expansive detection and response capabilities were simply nonexistent. Managers sought to believe that risk was outside the bank's information processing environment and could be protected by barring the virtual doors from threats. (in firewall culture, some refer to this as the "Great Wall" strategy where all defenses are focused on a single great barrier between the exogenous Internet environment and the company's internal network).<br /><br />In the event such a threat either passed through the barrier, threats usually magnify quickly, finding homogeneous environments in which to spread. Companies often operate the same type and version of operating system (at the same patch level) on their servers, administrative usernames and passwords are often the same, and defense approaches on servers identical. Once the threat has defeated one system's prevention capabilities, it has defeated them all. Only detection and response remain, but as we've seen, these have been neglected in many environments.<br /><br />Addressing this disparity requires the adoption of a philosophy in the business culture that risk is endogenous, e.g. "bad things can and will occur." Instead of fearing and seeking to ban all fires, a balance is made between cost-effective prevention and effective detection and response capabilities. In the information security practice, this balance is well supported by best practices communicated by numerous professional and regulatory bodies (e.g. the ISACA and the ISC2). In fact, a risk management approach I've found successful in smaller operational environments has been one that closely evaluates risk prevention systems in order to locate aversion-bias and the occasional behaviors that cause leptokurtic skew of the organization's risk environment. Overconfidence in prevention appears to be highly associated with operational risk leptokurtosis.<br /><br />Additional options may emerge, including one under evaluation in my research that focuses on the application of settlement processes (e.g. marked-to-market) to operational risk that support real-time risk recognition, similar to the daily settlement of futures positions found in <a href="http://en.wikipedia.org/wiki/Futures_contract">futures markets</a>. In such systems, the consequence of a risky position is felt quickly and usually with a moderate impact, providing the organization with immediate feedback. I'll be commenting more as this model evolves.Jamie Sakerhttp://www.blogger.com/profile/15584895824753615313noreply@blogger.com0tag:blogger.com,1999:blog-35770721.post-70714554312948084322007-05-05T08:47:00.000-07:002007-05-05T11:29:58.519-07:00The "Me" Generation Cashes OutWell-known Internet business columnist Robert Cringley <a href="http://www.pbs.org/cringely/pulpit/2007/pulpit_20070504_002027.html">writes yesterday about IBM's rumored layoffs</a>, expected to potentially reach nearly half the company at 155,000 workers. Such a shedding of domestic employees would certainly have a significant impact on the U.S. economy, but would deliver significant short-term compensation to the executives of the firm. Implicit in IBM's plans are massive outsourcing of domestic technology functions to foreign firms in China, India and other lower-cost locations. If successful, the move would transition the firm to being little more than a domestic holding company of outsourced contracts. IBM's era of innovation would be over, but for the firm's retiring managers, the one-time payout would be exceptional.<br /><br />Recently, leveraged buyout activities converting Fortune 500 public firms to privately held assets at the expense of firm cashflow and intellectual capital have escalated to new heights. With the carrot of a one-time gift of a few dollars per share, LBO firms obtain ownership of their targets financed by cashflows that a more visionary executive would be directing into innovation. Most of the LBOs I've analyzed have some interesting characteristics:<ul><li>Retiring senior executives seeking a massive cash pay-out that normal retirement options do not provide.<br /></li><li>Healthy cashflows that have been wasted by the senior management's lack of interest in the "next 20 years" and instead make the company a huge LBO target. That many LBO events occur with the full participation of senior management in companies with excess, under-utilized cashflow is no mistake.<br /></li><li>Stock prices that are undervalued for the cashflows in an economy that continues to value excitement (e.g. Goggle) or short-term gains over long-term strategy and fundamentals.<br /></li></ul>In a sense, it appears that there is little agency theory conflict between the actions of these retiring baby boomer executives and the shareholders they represent. Wall Street has championed the short-term view and long-term benefits (such as the open source efforts of IBM) really have no value to institutional investors. In the case of the LBO, shareholders get a one-time premium per share over the apparent equilibrium price prior to the LBO announcement, executive management gets a hefty retirement package and the new owners get massive cashflows to finance their own ambitions. As more executive boomers retire, more firms are subject to the retirement enrichment goals of their executives, delivering short-term, one-time cash gifts to the eager shareholders.<br /><p>Given that everyone seems to be sharing in the massive cashing-out of U.S. productive infrastructure, where's the problem with this cash party? Unfortunately, when a firm gives away its core competencies to foreign firms for a little cash, little remains other than short-term returns. In a sense, retiring executives are pawning the intellectual capital developed over 150 years of U.S. industrial effort for personal riches and a few dollars to coerce the shareholders into supporting these efforts. For the early movers, it certainly is a lucrative strategy, as Chinese, Indian, Malaysian and other developing market firms appear to overpay for the opportunity to assume U.S. operations and commensurate know-how. A few billion dollars invested bypasses 50 or more years of economic struggle, guaranteeing both advancement in operational knowledge and cashflows to sustain the growth from the U.S. firm that is liquidating its productive capacity.</p><p>However, this portrays a grim future for U.S. mid and large cap firms. Consider what the S&P 500 will look like in 20 years, having liquidated all of its manufacturing, innovation and production operations. Forget about sustaining an information economy, as sectors other than entertainment*, healthcare, pharmaceuticals*, utilities, corporate agriculture and professional services (mostly legal and financial) will no longer have any domestic function. Domestic production outside of the agricultural sector will cease. Worse yet, automation of much of the agricultural sector and continued support by both political parties for low-cost immigrant labor for that which isn't automated leaves little employment opportunity. Lacking any sector to serve as an engine for the domestic economy, the long-term prognosis isn't optimistic.<br /></p><p>For the "Me Generation" boomers, the cash-out is exceptional as it not only liquidates their improvements, but those of the predecessor generations. Worse yet, this generation has seen it fit to assume excessive long-term foreign debt to provide for low-cost prescription drugs (which they are most capable as a demographic in paying for), have poured trillions into ineffective social programs consistent with the counter-culture philosophies of their youth and rung up unsustainable foreign-financed Federal and trade debt to sustain their lifestyles. While those of the great generation would certainly be horrified that their children are pawning the product of their efforts for mega-sized second homes in Palm Springs, the boomers are fortunate to be mostly immune from their criticism.</p><p>So what's left for a liquidated economy? It'll be interesting to see what sectors survive. Younger generations still possess creative ability, but have been impaired in mid-to-large cap firms with the glut of senior-level boomers who've yet to retire. Certainly, some of the larger firms might be salvageable and some of their intellectual capital restored. Overall, it is most likely that if the economy is to recover its productive capital, this development will emerge from today's small to micro-cap firms. Once leveraged to the hilt in debt and having seen its intellectual capital sold off oversees for pennies on its true value, today's S&P 500 is unlikely to have much value in the long-run.<br /><br />* Even these sectors are seriously threatened by emerging economies that refuse to recognize the intellectual property laws that provide for return on investment in entertainment and medical innovation, as <a href="http://www.suntimes.com/news/otherviews/371919,CST-EDT-REF05B.article">Thailand</a> and <a href="http://www.alertnet.org/thenews/newsdesk/N04351721.htm">Brazil</a> have recently shown us. Even U.S. energy firms aren't immune from this risk as foreign markets <a href="http://business.guardian.co.uk/story/0,,2070159,00.html">like Venezuela</a> and Ecuador refuse to recognize property rights and seek to capture the financial returns for themselves.<br /></p>Jamie Sakerhttp://www.blogger.com/profile/15584895824753615313noreply@blogger.com0tag:blogger.com,1999:blog-35770721.post-14511985541446227872007-05-03T20:45:00.000-07:002007-05-03T21:21:26.170-07:00Schneier's quest for infosec perfectionBruce Schneier, information security expert extraordinaire, writes a surprisingly limited <a href="http://www.wired.com/politics/security/commentary/securitymatters/2007/05/securitymatters_0503">column today</a> explaining his recent interview in Silicon.com. In the commentary, Schneier essentially writes that if we could just have perfect software, hardware and networks, all of this information security stuff would be unnecessary.<br /><br />As an econometrician employed in the information security industry for one of the largest financial processors, I found Bruce's perspective both shocking and unfortunately not atypical. Bruce inadvertently touches on the fact that many executives and decision-makers elect to increase the probability of negative outlier events in their information security environment by naively expecting perfection in the inputs. It is little different from Dr. Deming's infamous <a href="http://maaw.info/DemingsRedbeads.htm">"Red Bead Experiment"</a> where manufacturing perfection would occur if only the darn employees would listen to management's directive specifying perfect output.<br /><br />Having served as a bank IT auditor in my previous capacity, I had countless interactions with bank managers who couldn't comprehend why the expensive, proprietary banking software system with an outlandish maintenance contract could be exploited with trivial efforts. "We pay them good money for that system to be perfectly secure!" Nor could they relate to the need to replace servers every three years, the very moment they went off of capital lease (instead, milking the asset for a few more free years of operation, at the expense of some hefty assumed catastrophic risk).<br /><br />In all of these cases, perfection was usually demanded, yet the reality of human imperfection ignored. The very environments that lacked the financial and personnel resources for appropriate compensating controls in separation of duties had even higher expectations of their technology assets to provide perfection that magically absolved the risk from these limited resource decisions. Increasingly, I found the seeking of technology perfection to be a risk aversion behavior that was common when a manager was overwhelmed by the always changing, never comfortable enterprise risk environment.<br /><br />Much of my independent work is on a model that anticipates this less-than-rational dynamic and provides a framework for controlling the risk (such as measures that reduce leptokurtic fat-tails where the math becomes rather fierce and the quantified financial impact analysis becomes absurd, instead pushing it towards a normal distribution of risk that lends to traditional risk management techniques). Instead of pursuing the path of avoidance by expecting perfection as Schneier has outlined, successful systems will recognize that risk is endogenous. Once we've accepted that condition, we can focus our efforts on more successful measures that handle it and keep most of the risk behavior controllable and manageable.Jamie Sakerhttp://www.blogger.com/profile/15584895824753615313noreply@blogger.com0tag:blogger.com,1999:blog-35770721.post-19202970486144839162007-04-23T19:54:00.000-07:002007-04-23T22:01:21.673-07:00Operational Risk Markets?One of my favorite reads from several years ago is Surowiecki's <a href="http://www.amazon.com/Wisdom-Crowds-James-Surowiecki/dp/0385721706/ref=pd_bbs_sr_1/104-0495786-1613552?ie=UTF8&s=books&amp;amp;amp;amp;amp;amp;amp;amp;amp;amp;amp;qid=1177384217&sr=8-1">The Wisdom of Crowds"</a>, in which the decision-making ability of uneducated participants consistently exceeds that of the brilliant, enlightened few. Coming from a significantly Bohemian ancestry that is likely to avoid nobility and entitlement, Surowiecki's writings are encouraging and hit the nail on the head of a risk phenomenon risk managers continually encounter: diverse, unrelated and uncorrelated viewpoints simply do a superior job in correctly assessing a problem than a few privileged geniuses.<br /><br />Group decision-making can be extrapolated to market behavior as we're essentially talking about an environment which facilitates autonomous decision-making. In this environment, the actor participating in the system has autonomy to make decisions (as outlandish as they may be), and derives benefit or consequence from this contribution.<br /><br />One of the more notable aspects of market/group behavior from the perspective of a risk manager is that the behavior of a market or group tends to be the most likely to end up approximating a normal distribution. Contrast that distribution with the excessively leptokurtic distributions found in command economies and a risk manager finds market dynamics to be his primary friend in keeping risk manageable. History is ripe with examples. <span style="">Khrushchev's infamous <a href="http://files.osa.ceu.hu/holdings/300/8/3/text/56-1-466.shtml">corn program</a>, which originated in my home state of Iowa, Hitler's selection of highly speculative weaponry (including missiles, jets and heavy-water nuclear weapons) at the expense of more traditional and demonstratively successful conventional weapons advocated by his generals, <a sici="0006-3568%28199706%2947%3A6%3C363%3AROTIPF%3E2.0.CO%3B2-1&size=" large="">Ireland's consolidation on a primary variety of potato</a> and countless other examples illustrate the cost of command-economy decisions.<br /><br />Why is it that command economies often facilitate the perfect storm? As my 14-year-old son can recall from a few too many History channel episodes his dad forced him to watch, it takes more than one mistake to create a catastrophe. Command economies suffer at least three "mistake coefficients":<br /><ul><br /><li>Poor information: command decision-makers are at a serious disadvantage to a market in obtaining and assessing information. Personal bias alone screens considerable useful data and distorts the process. Political dynamics, including the preference of information from favorite subordinates (versus reports by difficult, annoying and antagonizing employees who just don't know how to put the right polish on things like a valued counterpart of mine), <a href="http://en.wikipedia.org/wiki/Prospect_theory">prospect theory</a> dynamics, <a href="http://en.wikipedia.org/wiki/Risk_aversion">irrational risk aversion</a> and other factors all come into play to distort even the most objective manager's ability to correctly assess a situation.</li><br /><li>Homogeneous solutions: Command decisions often focus on a single approach to a problem, such as the decision to unilaterally grow corn, to ban handguns owned by law-abiding citizens (one can't ban the possession by those who circumvent the system), to grow one variety of potato, or to select a particular information technology vendor as the exclusive solution-provider (e.g. Microsoft). When a threat breaks out, it becomes horribly difficult to control as natural resistance that should slow the fire's spread have been removed through the homogeneous structure. If you doubt the significance of this effect, spend a weekend in greenhouse school and learn about micro-cultures as my son and I did. Then try applying your "natural" organic philosophy in this terribly unnatural environment and discover how viruses, bacteria and pests quickly dominate your micro-culture.</li><br /><li>Inflexible response: In spite of their great enthusiasm and confidence, command-economy leaders suffer an inevitable response lag as compared to market participants. While someone in the normal distribution of the market has inevitably conjectured the real risk (due to likely paranoid outlier behavior that for once in their life pays off), our command-economy decision-maker is a natural laggard. Confident in their original assessment, they're one of the last to abandon the false premise, inviting liquidity risk in to do its damage. By the time the brilliant manager realizes the fallacy of his/her assumptions, markets are illiquid, corn crops are frozen and campus students are dead.</li><br /></ul><br />So what's the point from an operational risk perspective? Given the structure of corporate decision-making, it is probable that many of us encounter environments that are little different from the flawed command-economy models which are highly associated with catastrophic loss and failure. Decisions are made lacking information, typically select homogeneous outcomes due to vendor preference or simply a fear of complexity, and inevitably suffer inflexibility in response.<br /><br />An appropriate solution given the premise may be a market-oriented risk management model, something which I've been working on for some time but certainly classifies as more conjecture than solution at this point. In the mean time, we all need to work on the those three factors identified and reduce their severity as much as possible.<br /><br />Thoughts? Feedback is certainly welcome.<br /><br />Jamie<br /><br /></span>Jamie Sakerhttp://www.blogger.com/profile/15584895824753615313noreply@blogger.com2tag:blogger.com,1999:blog-35770721.post-64164377770282775592007-04-18T20:32:00.000-07:002007-04-18T21:32:29.499-07:00Leptokurtic operations: Shunning Certain RiskWith the recent Virginia Tech shooting, I was reminded this week of the difficulties policy makers face in comprehending risk. In particular, executives and politicians alike tend to fear certain risk and end up structuring policies that trade off manageable "expected risk" for the mostly unmanageable, statistically difficult world of outlier uncertainty events. This choice unfortunately distorts the probability model of the risk environment and trades out often normal distributions with what are known as <a href="http://en.wikipedia.org/wiki/Kurtosis">leptokurtic</a> models.<br /><br />Consider VT's recent change in policy that banned the legal concealed carrying of handguns by individuals confirmed by the State of Virginia to be free from felony convictions, mental disability, and other disqualifying conditions. The VT administration held a mostly irrational fear (when measured from national statistical data of crimes committed by legal concealed carry handgun owners, which is conclusively nearly zero) that a permitted concealed carry individual would commit a violent crime in an act of uncontrolled rage. By enacting policy which prohibited this improbable event, VT administration narrowed the probability of such events, at the unfortunate expense of significantly fattening the risk tails. With a mostly undefended campus (and certainly given a lack of deterrence), they chose to make a highly catastrophic outlier event much more certain. A campus lacking any capacity to defend itself in real-time is an environment ripe for out-of-control outlier events.<br /><br />Such policy behavior is most unfortunate and exceptionally irresponsible. While catastrophic risk is impossibly difficult to quantify with precise certainty, expected risk usually yields to risk management techniques we possess. VT's experience is a lesson corporate executives and risk managers could certainly learn from as well.<br /><br />From a policy perspective, it's valuable to examine operational policies and procedures for indications that they're inducing leptokurtosis. Is certain risk (which can and should be managed through insurance, reduction, transfer, etc.) instead being avoided or shunned, causing participants in the process to distort information or engage in activities that transfer the expected risk to outlier categories?<br /><br /><div style="text-align: center;">Leptokurtic Model<br />Orange = Standard Distribution<br />Yellow = Leptokurtic Distribution<br /></div><div style="text-align: center;"><a onblur="try {parent.deselectBloggerImageGracefully();} catch(e) {}" href="http://www.trade-ideas.com/Glossary/Leptokurtosis2.gif"><img style="margin: 0px auto 10px; display: block; text-align: center; cursor: pointer; width: 320px;" src="http://www.trade-ideas.com/Glossary/Leptokurtosis2.gif" alt="" border="0" />Image source: www.trade-ideas.com</a><br /><br /></div>A good example of this dynamic is in the handling of capital technology assets past the conclusion of their underlying depreciation schedule and/or capital lease interval. Normally, the forecasted financial life of the asset should provide a reasonable indication of the low-risk lifetime. Not only is such equipment in a new state within engineered MTBF (mean-time between failure) and usually supported by insurance or vendor replacement provisions, but it is recent enough to have current internal expertise and documentation. A loss of the equipment during this period is well protected by risk mitigation measures in place at various levels.<br /><br />Once an asset has been fully depreciated, management experiences an increase in profitability from its operation, at the expense of increased catastrophic/outlier risk. This is where our normal distribution gets narrower and taller at the center, while developing alarming fat tails at the outliers. Replacement parts become rare, personnel familiar with the configuration and operation of the system depart, and documentation disappears. Normal vendor support for the antiquated technology asset also disappears. While the center of the risk model rises with the gains realized from lower-cost operation of the asset, leptokurtic fat-tails grow. When the inevitable system failure occurs, recovery is nearly impossible. Configurations are lost, internal and vendor knowledge absent and companies are often left with very few options for recovery. Occasionally, some firms don't survive the experience.<br /><br />The best solution for leptokurtic operational risk may be no different than practices accepted in credit and market risk: incur certain risk daily to keep risk models normal. As the certain expense of an insurance policy represents in a sense a real, certain loss every month for the policy holder, operational risk environments should seek similar policy counterparts. Operate only current technology assets under depreciation and schedule their replacement at the conclusion of depreciation. Specify certain lifespans of applications and kill legacy system with regularity. Force the company to bear the expense to keep the risk distribution mostly normal so that traditional risk management controls can be effective. Absent this recurring culling effort and known expense, catastrophic risk is certain to develop.Jamie Sakerhttp://www.blogger.com/profile/15584895824753615313noreply@blogger.com0tag:blogger.com,1999:blog-35770721.post-86897296603896908932007-04-01T19:24:00.000-07:002007-04-01T20:47:50.106-07:00Operational Risk FaultlinesOne of the more interesting phenomenon in operational risk is why managers experience such abnormally high levels of catastrophic risk when compared to credit and market risk environments. A potential answer may lie in the choice of risk outcomes managers make in the design and operation of their programs. Experience from credit and market risk suggests that when we refuse to recognize every day risk which allows it to be reconciled daily, we force it to hide, only to emerge when it reaches catastrophic levels.<br /><br />In credit risk, accountants and auditors would quickly jump on firms that extend commercial credit but fail to establish, forecast and maintain a reserve allowance for bad debt. No level of rationalization about the firm's exceptional credit screening process would convince a prudent accountant to ignore reserve requirements. Instead, managers use historical or probability models in accounting for expected risk, allowing the firm to experience the daily feedback from current lending practices. Through this process, risk is forced into the budgeted "expected loss" category, materially driving down the alternate and default "unexpected loss" category where catastrophic demons reside. Feedback is daily and risk appetites appropriately adjusted.<br /><br />Likewise, market risk managers have equally mature practices in forecasting recurring risk. <a href="http://en.wikipedia.org/wiki/Value-At-Risk">Value-at-Risk</a> or Capital-at-Risk models, portfolio loss reserves and other methods anticipate a certain level of loss from expected risk. Derivatives markets, intentionally structured to administer risk, often use daily settlement methods so that a day's gains or losses are immediately felt. Instead of deferring the realization of gains and losses to the end of a contract term, which attracts liquidity and default risk into the equation, winners and losers in these markets settle daily and risk levels are moderate but balanced. Risk is rarely allowed to stray too far from the expected loss category, and the demons of unexpected loss are again kept at bay. Again, feedback is provided on a near-daily basis, allowing the organization to appropriately adjust its appetite for risk.<br /><br />Operational risk, on the other hand, is rarely permitted to reconcile daily. Rather than maintaining an expectation of budgeted loss, managers set unrealistic "zero fault" expectations. Systems are pronounced to have "five nines" (99.999%) uptime, change processes are put in place that apply punitive, often professionally terminal consequences for technical administrators who recognize a risky condition, creating an atmosphere where participants in the system are encouraged to ignore risk or worse yet, cover up minor risk manifestations. Game theorists would find these outcomes unsurprising, yet many operations environments are littered with these risk landmines.<br /><br />The result is that normal risk is shuffled aside and hidden. Feedback is prevented, or worse yet, prohibited by organizational policy. In this state, catastrophic cousins are invited in, as the risk demon demands settlement in full, with obscenely compounded interest for his absence. Worse yet, operational environments tend to be rich with risk collinearity opportunities, as system failures tend to experience amplification due to homogeneous operating systems, hardware platforms and administrative personnel. A failure in risk mitigation to one system, such as an e-commerce webserver, bypasses most prevention-oriented defenses and permits a complete compromise to the environment to occur.<br /><br />What's the solution to reducing operational risk conditions favorable to catastrophic consequence? John Milton, the well-know author of "Paradise Lost" and other works wrote the significant essay <a href="http://en.wikipedia.org/wiki/Areopagitica">"Areopagitica"</a> addressing the importance of allowing a free press, in which the concept of an open "grappling of truth and falsehood" is encouraged. Applied to risk management treatments, we see Milton's prescription present in credit risk management, where individual accounts are periodically evaluated and forecasted for default treatment. Derivatives markets (in most cases) are forced to grapple daily, with gains and losses applied before one's position becomes too extreme.<br /><br />Operational risk requires this same treatment in order to reduce the opportunity for catastrophic loss, but can only occur in environments where the organization encourages the forecasting of expected loss. Loss must be recognized as a probabilitistic reality, rather than a culturally prohibited outcome. Absent recognition as a recurring expected loss, risk's demons will find their expression in unexpected catastrophic outcomes.<br /><br />As the FuzzyNumbers blog evolves, I'll share ideas about the practical treatment of operational<br />risk that converts risk from unexpected to forecasted (and moderated) states.Jamie Sakerhttp://www.blogger.com/profile/15584895824753615313noreply@blogger.com0tag:blogger.com,1999:blog-35770721.post-45860107328791492172007-02-27T21:39:00.000-08:002007-02-27T21:46:53.181-08:00Short-term Liquidity Risk?Jim Cramer's <a href="http://www.thestreet.com/_tscana/markets/activetraderupdate/10341324.html">post "How the System Failed Us Today"</a> quickly highlights similar observations of ETF activity leading the pack in today's shock event. Cramer suggests buyers weren't able to get into the market quickly enough, which could explain behavior observed in the ETF price to index error.<br /><br />Although I don't usually agree with Jim Cramer's perspective, his indication of aggressive ETF selling is supported by the data. Considerable analysis of how prices significantly strayed from their underlying index fundamental is necessary. It certainly appears that the market hasn't adjusted to the half-trillion dollars of leverage the ETF market represents, let alone the distinctive behavior it presents in market shocks.<br /><br />Regardless of China contagin conjectures, the rightful name for 2/27's shock is the "ETF Crunch: Part I"Jamie Sakerhttp://www.blogger.com/profile/15584895824753615313noreply@blogger.com0tag:blogger.com,1999:blog-35770721.post-23696651172291177582007-02-27T20:22:00.000-08:002007-02-27T20:32:13.981-08:00ETF Liquidity Risk in Market Shocks?Today's market shock (2/27/07) shows some interesting mispricing error between some of the most dominant exchange traded funds and their underlying indexes.<br /><br />Looking at the S&P 500, with an index daily return of -3.47:<br /><ul><li>SPY yielded a -3.91% return, off 12.68% from the index.</li><li>IVV (iShares S&P 500 ETF product) yielded -3.86%, off 11.24% from the index</li></ul>The NASDAQ ^IXIC returned a -3.86%, while the QQQQ NASDAQ ETF closed -4.11%, representing 6.48% of error from the index.<br /><br />Finally, the Dow Jones Industrial Average (^DJIA) returned a one-day -3.29% while the mirrored ETF DIA returned -3.75%, representing a remarkable 13.98% error.<br /><br />What's to explain for this level of mispricing? SPY and DIA showed more than four times the average daily volume, while IVV and QQQQ ran at about 2.8 times average volume. Preliminary analysis suggests liquidity risk factors are to play, combined with probable disruption to normal ETF arbitrage activities. It will be interesting to examine if the arbitragers (who normally exchange ETF for the corresponding securities basket, or vice versa) held back due to expectations of further drops in the index tomorrow.<br /><br />If so, ETF to index mispricing error may suggest some forecasting value in continued market direction. If not, arbitrage opportunities may extend to smaller investors who pick up the significantly discounted ETFs in shock events like today.<br /><br />-jrsJamie Sakerhttp://www.blogger.com/profile/15584895824753615313noreply@blogger.com0tag:blogger.com,1999:blog-35770721.post-21616517372144418662006-10-25T06:27:00.000-07:002006-10-25T10:21:06.833-07:00Corporate Ethics: Summit Seeking?Earlier this year, world-renowned mountain climber Sir Edmund Hillary criticized changes in climber ethics that caused some to ignore distressed and injured climbers on the mountain in their relentless, self-serving pursuit of the summit. The death of climber David Sharp, who had <a href="http://abcnews.go.com/International/wireStory?id=1999946">run out of oxygen on Mount Everest</a> and was ignored by more than 40 climbers, left experienced climbers like Hillary troubled. Hillary noted on ABC Radio's "The World Today":<br /><blockquote><br />"On our expedition 50 years ago, would have never considered leaving a man like that. We were very much aware of our responsibilities to look after any person on the mountain who was in distress. There's no doubt at all that there's been a lowering of standards in recent years, with the commercialisation; as a consequence people are being neglected and are dying."</blockquote><br />Hillary's recognition of the "summit seeking" ethic is notable. A similar viewpoint extends throughout many corporations and has a significant impact on enterprise risk which analysts, investors and auditors need to consider more carefully. Appropriately defined in corporate environments, summit seeking is the pursuit of return at nearly any cost.<br /><br />My own experience with summit seeking organizations spans nearly twenty years. Having worked in several high risk tech and telecom organizations, I experienced the same ethic in interactions with investment bankers, corporate partners, carrier and technology vendors and in a few cases, our own organization. First-hand experience with partners and executives at Inacom, Enron, Worldcom, Lucent and Level3 confirmed this ethic was exceptionally prevalent.<br /><br />Upon first inspection, summit seeking ala "our corporation seeks exceptional return for its investors" sounds great. What shareholder doesn't want outstanding returns? Yet somehow, this practice highly correlates to later catastrophic collapses of the same investments, usually leaving the stakeholders high and dry. Is there an explanation for this correlation? Is the corporate summit seeking ethic complicit in these catastrophic outcomes?<br /><br />It is my suggestion that this is indeed the case. Having worked through enterprise risk management assessments and operations audits, I would suggest there are significant, observable processes that cause this high-level ethic to eventually allow the organization to implode. Traditional risk management texts discuss the trade-off between risk and return. To an organization, this choice is made in the selection of its corporate risk/return ethic by its senior management. Specifically, organizations can choose one of the following:<br /><blockquote>1. Summit Seeking Ethic: Return is sought at any cost and processes that impair this pursuit are dismantled and discarded.<br /><br />2. Risk-Managed Ethic: Risk appetite is defined and budgeted. Return within that budget is maximized given the constraints of the risk-management framework.<br /></blockquote>While one would hope that the increased regulatory call for ethical corporate governance would predict the choice of the risk-managed ethic, experience indicates otherwise. Recurring corporate implosions, stock-option backdating scandals and periodic hedge fund disasters tell us the summit seeker is alive and well in many companies. It is possible that many organizations fall into the summit-seeking trap by failing to realize this is the default choice should they fail to establish a top-down risk-managed approach.<br /><br />Observing and predicting the presence of a summit seeking ethic can be difficult, but to the astute analyst, the evidence is present. At the operational level, summit-seeking directives from the top lead to the dismantling of mid-level controls. Credit quality standards get overlooked, maintenance is curtailed to leverage new projects and provide revenue growth, and product or service guarantees are complicated with unrealistic conditions in order to defer or eliminate ever-increasing customer returns, refunds and cancellations.<br /><br />Notable metrics that illustrate this condition include:<br /><ul><li>increasing delays in service delivery<br /></li><li>increasing levels of product returns or service credit requests<br /></li><li>difficulties in accounts receivables collections which may be attributed to unrecognized returns and credit requests<br /></li><li>inventory manipulation, including provisions that require customers take early or complete delivery of products to attain financing<br /></li><li>increasing litigation activity, either by the organization's own legal department or by customers in conditions where contractual performance is disputed<br /></li><li>indications of relaxed corporate credit, especially in organizations that provide substantial internal financing programs for customer purchases<br /></li></ul>For the risk-aware investor or analyst, a careful inspection of this risk/return condition is prudent. Summit seekers are poor partners as they're quick to ignore risk and will leave investors, creditors and customers behind at a moment's notice. Using this risk/return perspective, what signal does the management of your investment send? Does management's action through its acquisitions, use of funds and operational control suggest risk is their primary metric, or return?Jamie Sakerhttp://www.blogger.com/profile/15584895824753615313noreply@blogger.com0tag:blogger.com,1999:blog-35770721.post-61960195215638074572006-10-25T06:05:00.000-07:002006-10-25T06:24:15.734-07:00Google Politik?According to a <a href="http://www.guardian.co.uk/usa/story/0,,1930008,00.html">UK Guardian report yesterday</a>, Google has formed the political action committee "NetPAC" and has loaded up with prominant Democrats to direct its liberal agenda:<br /><blockquote><br /><i>Google has an impressive list of players on its team. As well as counting Al Gore among its senior advisers, Google's Washington office was set up about a year and a half ago by Alan Davidson. A well-known Democrat sympathiser, he served for eight years as associate director of the Centre for Democracy and Technology, a thinktank that opposes government and industry control of the web. Alongside him is Robert Boorstin, a former Clinton foreign policy aide from the Centre for American Progress, as Google's communications chief in the capital.</i><br /></blockquote><br />From corporate spending on <a href="http://www.post-gazette.com/pg/05308/600836.stm">self-described "one-upmanship" executive toys</a> to questionable acquisitions that establish significant goodwill on the balance sheet such as the recent YouTube purchase, Google appears to be ripe for a dot-com magnitude correction. While ad revenues may be propping up the beast, executive decision-making and ethics appear to be nonexistent.<br /><br />So what drives Google's executive philosophy? "Do no evil" is the often referenced founding principle. Unfortunately, such vague objectives leave considerable room for interpretation, relativism and activism. Yet true principled behavior is somehow lacking in recent decisions, including serious misteps on the support of Chinese government surveillance efforts using Google data, Chinese censorship efforts, destruction of the objective value of GoogleNews by excluding conservative viewpoints Google employees disagree with and now the formation of a liberal PAC to further attack half of their customer base. The Google definition of evil appears to be seriously modified to reflect corporate gain at the expense of ethics and objectivity.<br /><br />Certainly Google has quite an unusual approach to its fiduciary caretaking responsibility.Jamie Sakerhttp://www.blogger.com/profile/15584895824753615313noreply@blogger.com0tag:blogger.com,1999:blog-35770721.post-29924500986685514802006-10-21T07:27:00.000-07:002006-10-25T10:17:19.587-07:00VTI vs SPYIn the ETF portfolios models I work with, I usually use Vanguard's Total Stock Market (VTI) instead of the more well known S&P 500 SPDRs ETF (SPY). Since I usually have a few questions about the purpose of this substition and the significance of the differences, I thought I'd address them here (note: all statistics quoted here are as of October 20, 2006).<br /><br />As both are index based equities, it's important to pay attention to the index and its characteristics as that drives much of the behavior of the ETF. SPY is based on the S&P 500 Index, holding all of the S&P 500 stocks. For those that are curious, SPY was constructed as as SPDR (an undivided ownership interest) when ETFs were first emerging and has a somewhat different operational model than the more prevelant index-based passive mutual model that most newer ETFs (including VTI) use.<br /><br />VTI is based on the MSCI US Broad Market Index, which typically spans about 1,300 of the largest stocks traded on NYSE, AMEX and OTC markets. VTI is a Vanguard ETF product.<br /><br />Comparing the indexes, VTI is much broader than SPY and this accounts for the primary difference. Looking at <a href="http://finance.yahoo.com/q/hl?s=SPY">SPY's top 10 holdings</a>, compared to <a href="http://finance.yahoo.com/q/hl?s=VTI">VTI's top 10</a>, you'll note that SPY a higher concentration of individual holdings in the top rankings. For instance, SPY contains 2.99% of General Electric (GE), compared to VTI's 2.35% GE. This is accounted for by VTI's much broader coverage. Comparatively, SPY is a narrower, deeper pool compared to VTI's wide, shallow pool. Likewise, VTI's holding turnover is nearly double what SPY's is given its breadth. If you're paranoid about the S&P's weighting model and the impact of individual security problems (like investors deciding Google is a dot-com 2.0), SPY's higher concentration provides greater risk.<br /><br />So what does that mean for an investor in the two equities? Both have comperable yields (1.74 vs 1.72 SPY to VTI), composite P/E ratios (14 vs 15) and basic risk ratios, with 5-year standard deviations hanging around 12.70 for SPY and 12.87 for VTI. In many respects, they perform in a similar manner according to most risk measurements, but historically, VTI's breadth gives a little boost in returns, as illustrated in <a href="http://finance.yahoo.com/q/bc?s=SPY&t=5y&l=on&z=m&q=l&c=VTI">this five-year comparison chart.</a><br /><br />And don't forget to consider the expense ratios. SPY comes in at a modest 0.1%, while VTI is a low 0.07% (common for Vanguard ETF products). While 0.03% is insignificant to many, that's still extra money in your pocket.<br /><br />Downsides to VTI include underperformance when the largest of largecaps are outperforming the market comparatively (as has occurred this year), causing VTI to have a bit of penalty for its breadth. Likewise, VTI lacks the shear trading volume, market cap and liquidity that SPY has. SPY's average daily volume is around 50-60 million shares a day, compared to VTI's meager 50-150 thousand range.<br /><br />That said, VTI usually represents a solid proxy for SPY with very close index coverage and risk, with a slightly better returns on slightly lower index expenses. Combined with its greater diversification which I believe should be considered in any index containing Google and you've got a good candidate for broadbased large-cap index coverage.<br /><br />Disclaimer: I own both SPY and VTI in my personal portfolios.Jamie Sakerhttp://www.blogger.com/profile/15584895824753615313noreply@blogger.com0tag:blogger.com,1999:blog-35770721.post-18599071199396739012006-10-12T08:10:00.000-07:002006-10-12T08:47:48.153-07:00The Next Central Bank FailureAs <a href="http://www.emergingmarkets.org/article.asp?PositionID=2601&ArticleID=1079711">reported in EmergingMarkets</a> (free registration required), IMF managing director Rodrigo de Rato warned that we're due for another central bank failure, and given emerging markets haven't fully differentiated against risk, pragmatic approaches to the markets is prudent.<br /><br />So who's a likely candidate? de Rato suggests that while emerging Europe and Latin American reforms have made progress in reducing risk, sources quoted in the article suggest China's loans to Africa and India's export credits might be a place to look. <br /><br />Some interesting work has been done by Bussiere and Fratzscher in their paper <a href="http://www.ecb.int/pub/pdf/scpwps/ecbwp145.pdf">"Toward a New Early Warning System of Financial Crisis"</a> (2002, European Central Bank Working Paper Series) on developing a forecasting model for an emerging market "Early Warning System."<br /><br />They use six key indicators:<br />1. exchange-rate overvaluation (which has a strong weight in the crisis probability)<br />2. lending boom index<br />3. short term debt to lending reserves <br />4. cur account to GDP<br />5. contagion variables<br />6. growth<br /><br />While the predictive power of the model is only enhanced to 73.7% (from previous models at 66.7%), and false alarms reduced from 50% to 44.1%, it would be interesting to see an implementation of the model and I'm curious about the extent of use it's seen since the model's discussion in 2002.<br /><br />An interesting note by the authors is that in the 20-country sample, the only countries that never experienced a crisis are all emerging Europe nations: Hungary, Lithuania, Poland, Slovakia and Slovenia. <br /><br />-JamieJamie Sakerhttp://www.blogger.com/profile/15584895824753615313noreply@blogger.com0tag:blogger.com,1999:blog-35770721.post-10313933419804664072006-10-11T08:04:00.000-07:002006-10-11T09:17:17.262-07:00In Search of Dark AlphaMuch of the current focus of my ETF analysis has been been around an idea I've been referring to as "Dark Alpha." Alpha, according to the classic definition, is the extra return a security provides that is not explained by its correlation to beta (as defined by the correlation to the reference index; normally the S&P 500 but occasionally EEM is a little more of value in emerging market analysis).<br /><br />So if the S&P goes up 1% and EWJ (iShares Japan) goes up .99%, S&P goes down .5% and EWJ goes down .498% and this tracking stays very constant, we have a pretty good definition of a positive beta close to 1.00 (as well as a good value for R-squared, which tells us statistically how strong that beta relationship is between the two per explaining changes in values).<br /><br />Alpha seekers look for gains that occur on a particular security that are beyond that which the beta correlation predicts. If you think of the standard deviation fluctuation of the stock (the up and down movement over time as plotted on a graph), alpha seekers are looking for that extra unexplained boost on the peaks. It's like mountain climbing in a sense, looking for summits that are taller than the laws of physics might predict.<br /><br />On the flip side of mountain climbing is spelunking - typically a place where people long in the market don't really enjoy being. It's the bottom part of the graph, below the opening line. On our stock chart, beta predicts a correlation that is the full standard deviation round trip. If the S&P 500 has a rather bad day and goes down a full standard deviation, your beta correlation should stay true. You should experience the same correlation to beta when things go down as they do when they go up.<br /><br />However, just as the alpha summit seekers find "extra tall peaks" in some stocks, there are oddities on the other side of the chart, down in the caverns where bears reside. Akin to the concept of dark matter, deep in the caverns resides Dark Alpha. It's the unexplained non-loss that is not explained by beta. Technically, a non-loss is still a return, and one could argue that dark alpha really is alpha in that respect. However, there is a reason for splitting dark alpha apart from its cousin.<br /><br />When stock markets go significantly under the line (say, at least 1 standard deviation), the go into stress. This is interesting to some in that markets have been observed to misbehave under stress. Specifically, there's the saying that "under stress, correlations approach 1.0." That's a clever way of saying your highly diversified, low correlating portfolio suddenly decides to act like a single stock on days where the market really does poorly.<br /><br />But emerging market ETF analysis on "correlation under stress" shows this isn't always the case. Using a more aggressive stress model (using normalized z-scores < -2.0 for the index and then running a regression on various ETFs to the stressed index), there are some interesting results. Some markets immediately approach that 1.0, confirming our hunch. But others don't, and stay relatively unstressed.<br /><br />What that means to investors is that some emerging market indexes provide much greater diversification, as well as potential resistance to high stress global events, which is of significant value. As many add emerging market exposure to their portfolio for this very reason, it's useful to test if this insurance policy is really worth anything at all, as well as identify which policies do a better job than others.<br /><br />Of course, that data only points the direction of where to look further. My initial hunch is that we really have to think of what is in the ETF index once again (as my energy sensitivity analysis has shown - e.g. own an ETF like iShares MSCI Brazil [EWZ] that has more than 60% direct exposure to energy markets in its composition and you'll not surprisingly have an equity that behaves like an energy equity, not a "Brazil" equity whatever that would be).<br /><br />My next steps include re-running the models under less stress ( Index daily Z-scores < -1.0) to see the strength of the correlation there, and then move into ETF decomposition to see if we can identify some sectors within that are showing the immunity to beta-induced stress. Already, global financial sector holdings show some interesting resistance. If that holds true, it may be some of those bank vaults in Singapore and Austria are holding secret deposits of dark alpha.<br /><br />-jamieJamie Sakerhttp://www.blogger.com/profile/15584895824753615313noreply@blogger.com0tag:blogger.com,1999:blog-35770721.post-18031369650472906102006-10-10T20:20:00.000-07:002006-10-10T20:46:50.704-07:00Is this fuzzy enough for you?Well, I've had some comments already on the name. Funny how not everybody "gets it" right away when you're so pleased with how clever your thinking is. Hell, I haven't seen that many confused faces since I tried explaining the Internet to Omaha's Fortune 500 back in 1993.<br /><br />What Fuzzy Numbers really drives at is the realization that numbers indeed go somewhat fuzzy when we humans deal with them, and in a sense, they need to. Seeking endless precision may be useful in <a href="http://edition.cnn.com/2006/WORLD/europe/10/04/pi.memory.ap/index.html">memorizing pi to 100,000 decimal places</a> but other than that, it's at best a distraction and more possibly an indication of some serious issues with one's self-confidence.<br /><br />Consider an experience I had more than fifteen years ago, as I started out my career as a lowly cost analyst for a smaller long distance company in Omaha. An early assignment thrown my way was to calculate the total damage caused by an international calling card fraud episode our company encountered. Back in the early 90s, this involved getting data off of switch tapes and either crunching it in Lotus 1-2-3 or the bootleg version of Excel I snuck in on Windows. I spent nearly a week crunching data, calculating rate tables based on least-cost routing terminations for tens of thousands of rather difficult to cost international minutes. At the conclusion, I came up with a precise $155,210.18 +/- $1.00. Steve M., my boss at the time, seemed more amused than impressed, especially at the level of accuracy. After he could no longer conceal the laughter, he explained that an estimate with +/- 25% would have been sufficient, I was horrified (that estimate would have probably taken no more than a few hours to work up).<br /><br />Fortunately or not, I've had a few related experiences since then. Having moved into carrier network operations and engineering, a surragate for a more quantitative field (more on that at a later date), the desire for exceptional precision has continued to be a real factor. I've been fortunate to have several wise mentors who reminded me that the data really is only the beginning of the puzzle. Precision, in that respect, is only appropriate to the degree that it is required to reduce the error out enough from the model to make some sort of sense out of things. Hence... fuzzy numbers.<br /><br />I think David Maister and Geoff Considine really summed it up in their <a href="http://davidmaister.com/articles/24/99/">article called "An Entrepreneurial Journey</a> where they talk about the most important idea Geoff gained from reading "Managing the Professional Services Firm" is this:<br /><br /><i>“You are there to help, not to be right.” This single ‘Maisterism’ is one of the core ideas that Geoff repeats often to himself and when discussing professional services with others. People hire consultants because they want help with some issue. You don’t need to prove that you are smart — that is determined when they hire you.</i><br /><br />Think about that one, especially if you find yourself defining the quality of your work to clients on the accuracy, precision and "rightness" of your designs. Geoff and David's realization has immensely helped me in my risk management work with client banks. Often for your client, fuzzy to you is the answer they need to address their problems, and that's what counts.Jamie Sakerhttp://www.blogger.com/profile/15584895824753615313noreply@blogger.com0tag:blogger.com,1999:blog-35770721.post-1160439399844889932006-10-09T17:15:00.000-07:002006-10-10T10:28:44.873-07:00WelcomeWell, if the blog profile didn't scare you off already, welcome! Fuzzynumbers is where my discussions about emerging market models and related economic and technology aspects are thrown out for a little areopagitica (truth and falsehood beating each other over the head).<br /><br />If you're a follower of financial markets, you may be aware of Omaha resident Warren Buffett and his firm Berkshire Hathaway. Warren's company has a unique "<a href="http://www.berkshirehathaway.com/owners.html">User's Manual</a>" (which is required reading for those who invest in individual company stocks!). I'll present you with the highly condenced FuzzyNumbers version of that manual to kick things off around here:<br /><br />1. What can you expect from FuzzyNumbers?<br /><br />FuzzyNumbers is my forum for putting out ideas developed internally as well as observed externally and deserving of some attention, usually relating to capital markets, economics and related technological aspects. If you're interested in emerging markets, exchange traded funds, and really the whole gammit of the types of risk that tend to cause emerging markets catastrophies, FuzzyNumbers might be worth your time.<br /><br />A lot of my focus is in risk management models for emerging equity markets. I closely follow Central Europe and India in analyst mode and attempt to appropriately cover the gammit of other emerging markets, albeit at a higher level. However, I hopefully won't bore you with excessive analyst detail and will keep things clear enough that it's useful to a general reader interested in the topic but not necessarily possessing the same expertise.<br /><br />Better yet, I've found that coverage of market catastrophies tends to provide better entertainment value than the dry stuff finance and economics is usually known for - sort of like watching Amazing Sports Disasters videos. As I encourage my kids to learn from others misfortunes, the astute FuzzyNumbers reader will hopefully gain a similar return.<br /><br />2. What's your bias?<br /><br />As emerging market catastrophies are quite an interest that will be encountered here, I should profess a bit of bias in my approach to why these things tend to happen more frequently than some say they should. I'm quite partial to the endengenous model, which suggests that failure and catastrophy are built into the system rather than caused exclusively by external events (exogenous model).<br /><br />Consider the recent plight of the hedge fund firm Amaranth in its multi-billion dollar natural gas market, or the exceptional collapse of Long-Term Capital Management. While some point to the absence of an active hurricane season causing Amaranth's leveraged position to become problematic, or the international currency devaluations that tripped up LTCM, a more careful analysis of these episodes indicates that much of the catastrophic risk was built into the market and the firms approach to it. How curious is it that the lack of a natural catastrophy e.g. hurricane caused a real one for Amaranth?<br /><br />Thought of from an endegenous perspective, risk is inherent within the process (and is often magnified by our interaction with it, as LTCM and Amaranth can attest). The bad news is that this suggests we're unable to build perfect, risk-free models. The good news is that it provides for constant opportunity (as risk usually requires return), and hopefully if we recognize risk is inherent, we might take positions that expect and mitigate it.<br /><br />3. What's the credibility of the information here?<br /><br />My perspective is probably atypical to the extent of really classifying as an outlier in many respects to emerging markets analysis. I spent over 15-years of my career directly in the dot-com market, seeing aspects of capital formation and business operation that would probably violate most business theories tought. Responsible for starting the very first dot-com in the north-central United States (a Commercial Internet Exchange peering backbone Internet provider), I experienced an interesting world that ranged from predatory venture capital to penny stock scams. From raising capital in Geneva and Stockholm to dealing with Inacom executives with ulterior motives, I can certainly associate with the expression "swimming with sharks."<br /><br />Following that adventure, worked with a business that developed a consumer electronics digital merchandising technology that was developed for use at Berkshire Hathaway-owned retailers. I moved from that adventure to overseeing a multinational voice and data network in emerging markets (Latin America, Spain and the Middle East) which helped kick off my expanded interest in emerging markets. The past few years, I've worked as an enterprise and information systems risk manager and analyst in the commercial bank industry the past few years and have to obligatory CISA and CISSP certifications.<br /><br />4. What's my expected return out of this effort?<br /><br />After too many years of living in an exceptionally wide standard deviation environment, I've migrated to a more focused finance and economics approach. Call it the self-discovery of high volatility and diminishing realized financial returns! While the education has been invaluable, the experience has certainly taught me that one who ignores risk is almost certain to fail.<br /><br />FuzzyNumbers is my opportunity to share analysis and perspectives on risk, especially when it appears the firm or market has approached it in an unorthodox way (whether that's positive or not). The utility of this information to you (whether for informational or amusement purposes) and the process of attaining feedback and unique perspective on the analysis and models presented here is the return I'm seeking.<br /><br />5. What do I expect of you?<br /><br />If you find a discussion of interest or profoundly disagree, I'd really value your comments on the thread. If you're a fellow traveler in emerging market risk analysis, I'd very mcch like to hear from you as well.<br /><br />6. What conflicts and disclaimers should be made?<br /><br />I'll do my best to clearly disclose if I have any financial interest in any security or entity discussed here. I do not discuss issues respective to clients I work with, either through the information risk management firm I do consulting work through or my enterprise and financial risk management consulting firm, unless expressly released in writing by the client or represent in abstract forms that does not reveal the client.<br /><br />With all that said, welcome and enjoy. <br /><br />-jamieJamie Sakerhttp://www.blogger.com/profile/15584895824753615313noreply@blogger.com0