Firefighter from Idaho

The generality of an AI process could save your pension and also assist firefighters. I wrote this first back in 2016. The rules of AI are simple, they work if you can explain it to mom.

Explaining to Mom

If you can explain your money management innovation (rule-based portfolios) to your mom, it is golden. My mom gets it. Succeeding in selling and marketing a new financial innovation just like any other innovation will be about design. If it is not intuitive, no overselling, branding and marketing money is going to stop the jumping from the ship.

Millennials are about accountability, show me the rules, show me the maths. They do not bite their tongue. They speak what they think. And if your financial innovation is not generational, you better get ready for some harsh questions. If you aspire to shine in the financial business or stay in business, keep in mind, that the mom that I am talking about is not going to be a baby boomer mom, she is going to be a millennial mom, maybe a single mom. And she is more likely to be able to separate the maths from the story.

Meeting Sam, the firefighter

On my way to New York for the Inside Smart Beta conference [1], I met Sam, the firefighter from Idaho. He said he loved his job, trained people, used anticipatory systems in firefighting, explained to me how winter was the season for fires, allocation of resources was essential, and the team was important when it came to firefighting. Then it was he who asked me what I did. And then I remembered the golden rule. If I can explain it to my mom, I could explain it to Sam. The logic was straight and clear.

So I started, "Sam, you have a pension". Pensions are about investing and not trading. Trading has a cost. Trading is short term. Investing is longer term in nature. This is why Pension money is invested in baskets, portfolios of bonds, equities, commodities etc.

Pension and Low Fee Baskets

The popular 150-year-old basket is a portfolio of stocks also called as the benchmark. The basket of top 500 stocks in the US, the S&P500. Beta [2] is another name for it. The Mutual funds were the oldest financial institutions who used to build such baskets. The mutual fund managers used to adopt a discretionary selection approach. Over the last 150 years, these Mutual Funds have not only failed to beat the benchmark (the popular basket) but also have charged higher fees. More of a reason for your pension money to be invested in simple low fee baskets, the S&P500 (the popular basket), aka the beta.

The baskets are built by simple rules. You can equal weight it or you can create another method that allows a different weight construction. Then came Smart Beta in 2002. A new set of rules, new weights, same components which claim to enhance the Beta i.e. do a better job at managing risk (more performance at same risk). So as one would expect, the Beta and Smart Beta is part of growing industry because it not only allows pension funds to allocate money at a low fee but also get a better performance. Because just like firefighters, a pension fund also has limited resources, which they had to allocate optimally among the financial choices available. A better basket performance meant better prediction. This is the new trend in the financial industry, a rule based competitor to the discretionary fund manager, a dying breed.[3]

Four Stages of Firefighting and Finance

So if financial thinking could be challenged by simple rule-based systems that improve your pension performance than there could be simple rules that could simplify firefighting. As both areas have predictive needs, needs for enhancing performance. And if the same rules of finance could be extended to firefighting that would just prove the universality of these rules. The innovation is about defining all natural systems as four distinct problems integrated into one architecture [4]. The four stages of finance similar to firefighting i.e. Low Fire (dormant) which continues to stay Low and die out, Low Fire becomes Big Fire, Big Fire becomes Bigger and Big Fire starts to become Low in intensity. This is similar to the four stages in Finance; Winner stays a Winner, Winner starts to Lose, Loser continues to Lose, Loser starts to Win. [5]

The four stages of finance or firefighting are connected to the two statistical laws. The law of Rich Get Richer by Pareto (1902) [6] and the law of Poor Get Richer by Galton (1884) [7]. Looking at four stages probabilistically explain how looking at core. i.e. outside the Big Fire and Low Fire, or Losers and Winning stocks is an inefficient use of resources. Predictability and performance are about focussing on extremes because it is the extremes that destroy or create, extremities in terms of crises or bubbles or extremities in terms of Big Fire and Small Fire that becomes devastating in time.

Uncertainty

Be it solutions for weather or finance, there are always limited resources. The need for precision is high both in firefighting and for managing risk in finance. The uncertainty which is considered as the problem does not come as much from the extremes but more from what’s near the mean, the average. There is more predictability regarding a Low Fire’s chance to become a Big Fire in time. Low Fire may seem low risk, which is why it surprises when it becomes a raging beast. A High Fire also has a high probability of remaining a High Fire and hence needs attention. The idea of Rich Get Richer (Pareto) and Poor Get Richer (Galton) work simultaneously. Everything else between the Low Fire and High Fire, the Loser and the Winner is where there is a more probabilistic uncertainty [8]. It is in the core, the rest where the probability of getting High (Fire), Richer (Finance) is low. If our firefighting systems, like the ones in finance, are focused on the extremes i.e. the Low Fire and High Fire, we might be able to do a better job of resource allocation and containing them.

[1] Inside Smart Beta, etf.com, Sep 21-22, New York

[2] Lawrence, G. “Fund Management: The Rise of Smart Beta”. CFA Digest,. Vol. 43. No. 4. CFA Institute. November 2013.

[3] Lakonishok, J. “Is Beta dead or alive?”, 1993

[4] Pal, M. “Reversion Diversion Hypothesis”. SSRN, 2015

[5] Pal, M. “Mean Reversion Framework”. SSRN, 2014

[6] Newman, M.E.J. “Power laws, Pareto Distributions, and Zipf’s law”. 2011.

[7] Galton, F. “Regression towards Mediocrity in Hereditary Stature”. Anthropological Miscellanea, 1886.

[8] Pal, M, How Physics Solved Your Wealth Problem, SSRN, 2016