Why Polls are a Danger to Democracy

poll

Does this poll reflect the true preferences of the Dutch population?

It is 13 March 2017, and the intermediate polls of the Dutch election suggest that it is going to be a close call between the Dutch Liberal Party (VVD) and the populist Party for Freedom (PVV). Who is going to be the biggest party of the Netherlands? Both parties are currently leading in the polls, and the winner will lead the formation of a new government, and most likely provide the new prime minister. So the stakes are high.

Now suppose you don’t agree with the VVD. You prefer a more progressive party (such as GroenLinks or D66). However, one thing is for sure: you don’t want Geert Wilders (PVV) to win, let alone become the prime minister. What do you do, knowing that it is going to be a close call between the VVD and the PVV? Do you vote for the party that truly reflects your preferences (GroenLinks or D66 in this example), or do you vote for the Dutch Liberal Party, knowing that you prefer the Liberals to the Populists?

The last option (to vote ‘strategically’, or not on your most preferred candidate) is handed to you only because of the information you derived from the intermediate polls. It is only because you know what the result of the election will be – given that people will vote as indicated in the poll – that you can adjust your vote to it.

But this raises a question: do we want people to have the opportunity to vote strategically? Or differently: should we allow for intermediate polls?

Democracy as a reflection of voters true preferences

This basically comes down to another question: what do we want the election results to be a reflection of? Do we want the results to be a reflection of the true preferences of the members of a population (meaning: if 20% of the people most prefer the VVD, then the VVD will get 20% of the votes, etc)? Or do we want the results to be a reflection of both true preferences and insincere preferences (i.e., 30% of the people vote for the VVD, even though only 20% has the VVD as their preferred option, with the other 10% preferring the VVD to the PVV).

I think no reasonable person would say that we hold elections to elicit insincere preferences. After all: what is the point of a democratic election in case we want to end up with election results that don’t reflect the population’s true preferences? This might even contradict the notion of democracy itself. So we want to elicit the true preferences of voters through an election.

However, by publishing intermediate polls, we entice people to cast votes that don’t reflect their true preferences (i.e., voting for the most preferred candidate), as shown by the example above. Hence the election result will not be an accurate representation of people’s preferences, hence not an optimal form of democracy.

Bandwagon effect

But there is another argument to be made against polls: the bandwagon effect. The bandwagon effect implies that the rate of uptake of beliefs increase with the number of people already holding the belief. In practice this means that people, seeing a poll in which party x has more seats than party y, become more inclined to vote for party x than y, ceterus paribus. The result is that x gets more votes than it would have gotten in case the polls wouldn’t have been published, and another party – possibly y – less. Still: we end up a with election results that are different from what they would have been in case we didn’t publish the polls.

But you can also approach the issue from another angle by simply asking: what is the added value of polls? What do polls contribute to society? ‘Information,’ one could say: ‘information about the voting behaviour of the population.’ But what can we use this information for? We cannot use it to change the voting behaviour of others. So for that purpose it’s useless. It can only be used to change one’s own voting behaviour.

Banning polls

So it seems that the only contribution of polling is that it allows for changing your vote in light of the voting behaviour of others? Well, we have just established that this is not a good thing in a democracy. Therefore polling has no added value to society.

Assuming that all of the above is true, why then allow polls? Banning polls is not some far-fetched idea. It already happens in many countries, including France (on the day before the election) and Italy (15 days before the election).

And given the negative effect of polling on the democratic process, this might not be such a bad idea.

Why Central Banks Are Reaching a Dead End

Central banks have the duty to keep inflation below but near a certain level (2% in the case of the U.S. and the Eurozone). They use monetary policy for doing so. In case inflation gets too low, they decrease the interest rate, thereby spurring lending, hence inflation. In case inflation gets too high, they do the reverse. This policy is believed to be effective, and to have contributed to normalization of the inflation-rate in the past.

All well and good so far. But as anyone knows by know: there is something odd going on. We hit the 0% interest rate level in the U.S., and have even reached -0.4% in the Eurozone. This is a logical consequence of decreasing the interest rate more in times of accommodative policy than decreasing it in times of tightening: a downward trend, hitting 0%, and rates below 0%, at some point in time.

The down-trend in the interest rate

The year 2025

In principle, central banks could continue this downward trend in the interest rate indefinitely. In practice, most likely not. Lets take a look into the future, and see what would happen if we would continue this downward trend.

Suppose it is the year 2025, and, for whatever reason, we have (the risk of) deflation in the Eurozone. The ECB – having increased the interest rate from the level of -0.4% in 2017 – decreases the interest rate gradually from (let’s say) 1.5% to -1.5% (a decrease of 3%, which is less than the decrease after the crisis in 2007, hence not unrealistic). So now we have an interest of -1.5%.

Given such a low interest rate, either of two things are likely to happen, that we might want to avoid at all costs: the net income of retail banks gets literally nullified, or retail banks have to charge customers for keeping their money.

As shown in quantitative research, a decrease of 1 percentage point in the 3-month yield (which will occur in case of a decrease in the deposit rate to -1.5%) leads to a decrease in the net interest margin of banks (in advanced economies) of 60 basis points. What does this mean in case of our rate decrease to -1.5%?

Take ING (the largest Dutch retail bank) as an example. ING has a net interest margin of around 1.5% over 2016, resulting in a net interest income of around 13.2 billion euros, and a net income of 4.651 billion euros.

Inflation in the U.S.

A rate decrease to -1.5% will cause ING’s net interest margin to decrease to less than 0.9%, implying its net interest income will be 40% lower than in 2016, decreasing by +- 5.2 billion euros. Hence ING’s entire profit will obliterated. Assuming that the lion-share of cost-cutting has been done already in response to the crisis of 2007, this leaves little room to cut costs. And anyway: if the down-trend in the interest rate will continue, at some point the net interest income will become so low than no cost-cutting measures can make up for that.

Hence, decreasing the interest rate beyond some point will seriously put to risk the existence of retail banking in the Eurozone. Assuming that Draghi doesn’t want that to happen, the interest rate can never get lower then a certain level (-1.4% in our example – the real number might of course be different, but this doesn’t affect the principle at stake here).

Retail banks could of course adjust their business model, and charge people for holding their money. Suppose that, in case the interest rate gets below a certain point, banks will do so. How much can they charge people before people will withdraw their money and start putting it into safes? Let’s say that banks, due to lower net interest incomes resulting from the lower interest rate, charge customers 0.5% for holding their savings. If you own 200.000 euros, this comes down to 1000 euros a year. I can imagine this might already be sufficient for many people to start putting their money into a safe instead of their bank, hence causing significant draw-downs, and endangering the banking system. Again: the real interest rate at which this event might occur might differ from this example, but the principle still holds.

Assuming Draghi doesn’t want this to happen either, we can never lower the interest rate below a certain level.

What then?

But, assuming that we can never lower the interest rate below a certain level (which might be not too far in the future as showed by the reasoning above), what then can we do to deal with low inflation in the future? Lowering interest rates is no option any more.

One possibility would be fiscal policy. We could push the responsibility for maintaining a reasonable level of inflation from central banks to governments. But this might very well imply that governments have to borrow significant amounts of money to kick-start inflation. Judging by the amount of money pushed into the market by the ECB to increase inflation, this lending will lead to exorbitant increases in public debt, hence interest payments.

Central banks could of course buy other assets, such as equity, instead of bonds, when the interest rate has reached its lowest level. The problems from doing so are obvious: it might cause a significant disconnect between share prices and real business activity, resulting in bubbles. Furthermore, it might not be very effective in increasing inflation, because we don’t know how much of the money put into stocks will eventually reach the real economy.

Another option would be helicopter money. But what if the helicopter stops dropping money? Then we are left with higher prices, but not more money to pay for them, laying the foundation for another period of deflation.

Accepting deflation

We could also just accept deflation. We have been trying to fight it for over 30 years, like our lives depend on it. But do they? How problematic would it be for prices to decrease for an extended period of time? Would people really stop buying stuff, because it will become cheaper in the future? That seems unrealistic. People still need to buy food, clothing, and still need a roof above their head. So deflation might not be such a big issue after all – unless it becomes extreme, of course.

It is choosing the least worst option among a bunch of bad options. Hence we should not rule out any response to low inflation because its effects are undesired: it might still be the best option.

One thing seems crystal clear: we have to think about future responses to low inflation, because the path we have currently taken seems to be near reaching its end point.

Partnership TheYoungSocrates and the Institute of Arts and Ideas: ‘Unnatural Laws’

Scientific constructivism versus scientific realism: do we come up with our laws as a way to impose structure upon reality, or do our laws really capture the fabric of reality? Many of us dare to believe that science, via its rigorous methodology, describes the world as it really is. For suppose it does not. How then is it possible for physical laws to predict what will happen in the world given certain initial conditions to such an extreme level of precision? That would be a coincidence that is almost impossible to imagine.

However, over the course of many centuries, laws have been refuted, and new laws have come into existence. So it seems fair to say that our laws not necessarily give an optimal picture of the world as it is.

An interesting position that deals with this dilemma is structural realism. Structurual realism claims that our scientific laws capture the structure of reality, but not necessarily the objects the theory presumes. An example is Fresnel laws on the reflection of light. Fresnel postulated laws about the reflection of light, and he assumed the existence of an ether – some sort medium through which light moves – for doing so. Years later Maxwell postulated his laws of electromagnetism, which overlap Fresnel’s laws. However, Maxwell got rid of the ether. What we see here is two theories that latch on to the same structure in reality, hence Fresnel’s laws are still correct. But the objects that are being constructed in the process are not necessarily real.

These are all interesting questions, which I could write about for hours. But I give the floor to the Institute of Arts and Ideas with Episode 8 of their series ‘Philosophy For Our Times’: ‘Unnatural Laws’:

Partnership TheYoungSocrates and the Institute of Arts and Ideas: ‘Everything We Know Is Wrong’

I recently discovered the Institute of Arts and Ideas (IAI), a non-profit organization that attempts to make philosophical thinking more accessible to the general public. They publish podcasts and articles about all sorts of philosophical subjects, such as free will versus determinism, egoism versus altruism and philosophy of science.

I will regularly post their podcasts, starting with ‘Everything We Know Is Wrong’, about (the limits of) the scientific method).

It turns out that many scientific experiments are irreproducible, meaning: if you follow the same methods as a researcher who obtained certain results, it is not at all certain that you will get the same results. This raises questions about the scientific method, and whether it a proper way to obtain the truth, or facts at least.

It is fair to say that a difference should be made between social sciences and psychology on the one hand, and natural sciences on the other. Experiments in the later are, in turns out, reproducible in general, while experiments in the first are not that often. This raises doubts among certain philosophers and scientists about the scientific status of such fields. But don’t they just apply the same methods as physics does? Hence, shouldn’t the results obtained from the social sciences be treated with equal regard as results from the natural sciences?

These are interesting questions, many of which are at the core of Episode 15 from the series ‘Philosophy For Our Times’ of the IAI:

 

Why Bookmakers Didn’t Find a Brexit More Likely – and why everyone thought they did

Bookies made a lot of money on the Brexit

As anyone knows by now, the British people voted for a Brexit, meaning that the United Kingdom will leave the European Union. The stock market didn’t particularly like this news, as indicated by the fact that the German DAX index opened 1.000 points, or nearly 10%, lower on the day the results became known.

It appears the majority of people expected the UK to stay in the EU. This expectation was likely fuelled by the fact that news agencies worldwide said that bookmakers (companies making their money by accepting bets) found it highly likely that Britain would stay in the EU. They pointed at the odds, or pay-offs, the bookies gave. The day before the referendum, the odds Betfair (a big bookmaker) gave were as follows: 1.16 for Bremain, 8 for Brexit. Meaning: if you would bet 1$ on a Brexit, and it happened, you would get 8$. For a Bremain you would get only 1.16$.

Such a big difference in pay-off would only occur if Betfair was very sure that Britain would stay in the EU, right? Otherwise they would lose a lot of money, right?

Wrong. This is nonsense. Betfair didn’t find it more likely that Britain would stay in the EU. It probably didn’t even care, because they would profit regardless of the outcome. Let me explain this via some easy calculations.

First I show the reasoning used by the public and news agencies, such as CNBC (which said that bookies found a Bremain at least twice as likely as a Brexit, and that this was because “voting for the unknown takes higher conviction than voting for the status quo”). Suppose odds of 1.16:8 as given by Betfair. Now suppose a person bets 1$ on Bremain. In case Bremain happens, Betfair has to pay him 1.16$. If not, they earn his 1$ bet. The same reasoning goes for a Brexit: the person earn 8$ in case of Brexit, Betfair earns 1$ in case of Bremain.

Now, what can Betfair expect to earn from this 1$ bet? Either way, it will get the 1$ bet. Now take p to be probability of Bremain. Then Betfair will have expected earnings of 1$ – 1.16$p in case of Bremain, and 1 – 8$(1-p) in case of Brexit. The bookie of course doesn’t want to lose money. Now the only value of p at which it doesn’t expect to lose money, regardless of a Bremain or Brexit occurring, is 0.87 (calculate this if you don’t believe me). For any other probability, the person betting the 1$ can expect to make money by betting on either Bremain or Brexit. In case of p = 0.6, for example, Betfair expects to lose 1 – 8$(0.6) = 3.8$ in case of a Brexit. Given that Betfair is not stupid, and doesn’t want to risk losing a lot of money, they must be damn sure of this 0.87 probability of a Bremain. Or so it would appear…

But this is not how it works.

You can also use the expected value calculation in another way, the way used by bookies. Contrary to my example, there is more than 1 person making a bet. You can you use this information. Let’s say that 100 people make a bet of 1$ each. Let’s say the bookie sets a pair of random odds of 4 to 9. Now assume 87 people bet for Bremain, and 13 for Brexit.

Suppose there is a Bremain. Then the bookie will earn 100$ (100 times the 1$ bets he receives) – 87 * 4$(pay-out per person) = -248$. In case of a Brexit they will earn 100$ – 13 * 9$ = -17$. Something is going wrong here: the bookie will lose money in case of either a Bremain or Brexit. Apparently the odds don’t match the proportion of people voting for Bremain and Brexit.  In case the bookie changes the odds to 4:6, he will make money only in case of a Brexit, but not in case of a Bremain. Now, the only odds that will make sure the bookie never loses or earns any money, given the 87 people betting Bremain and 13 Brexit, is 1.16 to 8. This is the break-even set of odds.

Proof: in case of Bremain, the bookie will earn 100$ – 1.16$*87 = + – 0$, and in case of Brexit 100$ – 13*8$ = +- 0$. So irrespective of what will happen, the bookie will never lose money.  Now, by only charging a fee for using its service, or a percentage of the amount bet, the bookie will always make money. The bookie can also change the odds slightly, so that – given the same 87 people voting for Bremain and 13 for Brexit – he can make money without charging fees: if he would change the odds to 1.12:8, for example, he is still sure not to lose money in case of a Brexit, but he will actually make money in case of a Bremain.

You might think: these odds work only in case 87 of 100 people vote for Bremain, and 13 for Brexit. In case the ratio changes, so will the bookie’s earnings. That’s true. Maybe more people will be lured into betting Brexit by the 8$ pay-off. You might get 20 of the next 100 people betting on Brexit, giving the bookie a negative pay-off of 100$ – 20*8$ = -60$ in case of Brexit. What to do then? Well, you just lower the pay-off: in this case a pay-off of 5$ for Brexit will do the trick. You can even leave the pay-off of Bremain at 1.16$, implying that you will make money in case of Bremain and not lose anything in case of Brexit. The point being: the odds are constantly adjusted, reflecting the ratio of bets at the time, so that the bookie is sure never to lose money. He is likely to use some margin of error in the odds so that, until a more accurate set of odds is reached, he will still not lose any money.

So we cannot say that the bookies thought a Bremain more likely than Brexit. Looking at the odds, we can only infer that much more money was bet on a Bremain than a Brexit, as shown by the implied probability of 0.87.

But what was the real probability that British people would vote for a Brexit? Until two days before the Brexit, polls were published, which showed the referendum to become a very close call. Some polls showed Leave to be in front with 52% to 48%, others (such as the Financial Times poll) showed Stay to be in front. Either way you look at it, judging by the polls, there was no reason to assume that a Bremain was much more likely than a Brexit. Given an expected value calculation, and assuming probabilities of 55% for Stay and 45% for Leave, betting for a Brexit would give you an expected: -1 + 0.45*8 = 3.60$ while betting on a Bremain would lose you an expected: -1 + 0.55*1.16 = 0.36$. Hence you should have always bet for a Brexit. Not only in retrospect (I didn’t do this; read the sidenote).

This is one of the clearest examples of a positive expected value calculation I have ever seen in practice. There is pretty much a 50-50 probability of something happening, and choice A provides you with a pay-off of 1.16, while choice B gives you 8. Then what do you choose?

Sidenote:
I must admit that I expected the British people to stay in the EU. I didn’t think it likely that the average British person would vote for an option that, to me so, obviously seems to decrease their wealth, and therefore their well-being. Leaving the EU forces the UK to start a lengthy process of negotiating new trade contracts with the EU. While the EU has many parties it can trade with, since it already has many contracts in place, the same will not hold for the UK once it is out of the EU. This implies that it has a bad bargaining position, since the need for the UK to trade with the EU is much larger than the other way around. This will likely lead to suboptimal trade contracts for the UK. Furthermore, given the slowdown in economic growth and downturn in the financial markets that were to be expected, the average Brit could have expected a decrease in his material well-being, either through a decrease in job certainty or a decrease of his pension money. Not to speak of the 15% more expensive holidays and imported computers. It was a valuable lesson to me: do not fare on possibly wrong assumptions while the data is so clear.

Why Trading Is Not a Game Of Chance

Roulette is not like trading

I recently had a discussion with a friend of mine. He said to me: ‘Be honest now. Trading is no different from playing roulette, right? You either win or you lose. It is just a matter of chance’.

What he really meant to say was that investing is a game of chance in a way similar to poker, rolling a dice or roulette. But although I agree with my friend that uncertainty is an intrinsic part of trading (or investing for that matter), it doesn’t follow that trading is a game of chance in the same way that poker, rolling a dice and roulette is. Not because trading requires certain skills that might allow you to beat the odds – for the same could be said of poker. It has to do with mathematics, and probability theory in particular.

I want to show this through the notion of expected value. The expected value of a random variable is its long-term average, or the value the variable takes on average per execution of the respective random process. Very briefly: in the case of rolling a dice, the expected value is 3.5 ((1 +2 + 3+ 4 + 5 + 6)/6), because in the long run you will get an average of 3.5 eyes per throw.

Certain requirements have to be met in order to to be able to calculate the expected value of a random variable. First of all, one should be able to fix the sample space of the process, or ‘the set of all possible results’ of the random process. In case of roulette, this set is unambiguous: number 1, 2,….., 38, because the ball can fall on one (and only one) of these numbers. Now, knowing this sample space plus the probability of the ball falling on any of these numbers plus the pay-offs of the ball falling on any of these numbers, you can determine whether you should take a bet or not. For example: let’s say you get 100$ per every 1$ you bet on the ball falling on number x. Then the expected value of betting 1$ on number x is (1/38 times 100$) + (38/38 times -1) = 1.63, meaning that in the long run you will make an average of 1.63$ per round per 1$ you bet when following this strategy. Since you will make money on average, you should pursue this strategy.

All well and good, but what happens when we take the market, instead of a roulette wheel, to be the random process we focus at? Let’s help ourselves a bit, and focus on a very restricted part of the market: the Brexit-debate. We can take the relevant possible results of the Brexit-debate as our sample space, the value of the DAX-index to be our pay-off, and the probability simply the probability of each possible result happening.

Now we come to face a couple of great difficulties.

Problem 1: sample space and the unknown unknowns
There appear to be only two possible results of the debate – Brexit, Bremain. Now we can define a random variable X such that any outcome of the random process is mapped to a real value. We choose the DAX-index to be our real value. You can for example say that in case of a Brexit, the value of the DAX-index will be 9000, and in case of a Bremain 10.400. Assuming that you can define a probability function on this variable, you can calculate the expected value of a trade.

But are these really the only two relevant results when it comes down to the Brexit-debate? No, it appears. There could be an explosion in a chemical factory in Germany that coincides with the Brexit or Bremain, but that significantly alters the course of the DAX-index. Maybe a politician will be murdered in case of a Bremain, and the DAX-index will collapse, even though the UK stays in the EU. There is an infinite list of possible events, not all of which can even be conceived: the black swan events, or the unknown unknowns. Since these results are by definition unknown, but nevertheless possible to happen and relevant for the DAX-index, your calculation will necessarily lack all relevant information, thereby giving an incomplete sample space. Such a thing can never be the case in roulette.

Problem 2: pay-offs
Furthermore, it is unclear what the DAX-index will do in case of either a Brexit or Bremain.This can be seen from the many different predictions made by various analysts. No-one knows exactly what the result of a Brexit or Bremain will be. Hence it is impossible to put a value on each of these results. So the second component of expected value, the pay-offs, is doubt-worthy too. This too can never be the case in roulette.

Problem 3: probability
But there is another, at least as stressing, issue. For expected value to be calculated, every event in the sample space must be assigned a probability.  While this is relatively non-controversial in the case of roulette (probability of either 1,2,…, 38 is 1/38), how do you come to know the probability of an event such as a Brexit, an interest rate hike, or any event that has never happened before?

It seems impossible to apply the so-called frequentist interpretation of probability, in which you conduct experiments and measure how often an event occurs relative to the total number of experiments. First of all because it is impossible to conduct experiments of this sort in the market. And second of all: even if you somehow manage to calculate how often an event occurred in the past and divide that by the total number of experiments done, you will necessarily get a 0% probability for events such as a Brexit, which have never occurred before. This seems absurd.

Using a subjectivist interpretation of probability will not help you much further. You can of course assign a probability to Brexit or Bremain by judging the available evidence, but the question is: how should you judge the available evidence given that you have no information about what happened in the past given the same set of available evidence, for this set of available evidence is surely to differ from any set in the past (Bayesian probability). One thing is for sure: certainly no Brexit has ever happened, under no set of available evidence, so again, the probability of a Brexit should be 0% (in light of any set of available evidence, in case you apply the rules of Bayesian statistics rightfully), which seems absurd.

This shows why probability theory and trading are no happy marriage, and why trading is not a game of chance like poker, rolling a dice or roulette.

How Apple Can Cause Any Stock to Go Down

On April 28th of this year, Carl Icahn (a billionaire hedge fund manager) announced that he sold his entire stake in Apple. He said, among other things, that he was worried about China and cautious on the U.S. stock market.  No big deal you would say. Sure: it might be bad for investors’ confidence in Apple, knowing that a man with a history of successfully anticipating the stock market shows not to have confidence in their company. But it would certainly not affect an apparently totally unrelated European company, such a BMW, right?

Wrong. Via a complex set of relations, it does. Stocks worldwide are closely interconnected; even though the rationale behind these relations might at best be hard to find. Let’s for example track the chain of events that caused BMW to decline on the 29th of April.

Icahn announced him selling his Apple shares on the 28th of April, after European trading hours (i.e., when the European markets were closed). Following his statement, Apple’s stock fell from $97.5 to $94.5 – around 3%. Apple, being the biggest company worldwide and the largest component of the S&P 500 index, to a large extent determines the S&P 500 index. So if Apple goes down, the S&P 500 goes down. Hence, after the announcement, the S&P 500 index declined from 2095 to 2075.

Now we arrive in Europe. European algorithms detect the decline in the S&P 500, and – being programmed to arbitrage around a positive correlation between the S&P 500 and the German DAX index – sell the DAX index future (possibly while going long the S&P 500, so called ‘statistical arbitrage‘). The result of the selling? The DAX index future plunges from 10321 to 10038, or +- 2.7%, an extraordinary big intra-day decline for the DAX.

Other algorithms, detecting the DAX index future to fall, and arbitraging around a relatively stable premium between the future and the index, sell-off the funds making up the DAX index, thereby causing the DAX index (which is just a collection of stocks of big German companies) to plunge accordingly. Since BMW is part of the DAX index, algorithms sell the BMW share. This causes BMW to decline from 83.94 to 80.5, more than 4%, a significant decline.

Hence Apple causes BMW to decline. See figure 1 for a graphical depiction of this chain of events.

Figure 1: how Apple going down causes BMW to go down

You might think this chain of events is too far-fetched. That it is some kind of conspiracy made up in a desperate attempt to explain what is in fact impossible to explain. But I doubt it. On the 28th and 29th of April, nothing exceptional occurred (besides the Apple event), or at least nothing that would justify a 2.7% fall in the DAX index. Usually, given a decline of this sort, there must at least be one relatively big event to which the decline can be ascribed. Hence in this case we have no better explanation for the plunge than Apple’s stock falling. Furthermore, assuming that algorithms do the tasks I described above, which are strategies known to be followed by algorithms, this chain of events is nothing but an utterly logical consequence.

Algorithms of course don’t care about Icahn’s opinion of the Apple stock, or the stock market in general. But what they do care about is relations between financial products, since this is where they make their profits. And it is by profiting from any significant deviation from historical relations between financial products that they keep intact such relations, and form the intricate web that is the stock market.

How High-Frequency Trading Affects Human Traders

The machines have taken control

A lot has been written about high-frequency trading (HFT), especially since the 2010 flash crash, for which HFT is at least partially held responsible. HFT even caught Hilary Clinton’s eye, proposing a plan to tax cancelled trades, thereby hindering HFT’s business.

In my experience as a stock trader, who watches order books all day and follows the workings of HFT’s closely, you see many signs of the subtle workings of HFT’s. We, human traders, often complain about these ‘machines’; especially the more senior traders, who grew up in a time in which trading was something that happened between humans, sometimes get frustrated by the seemingly random price movements caused by the machines.

I want to give you some clues about how HFT has changed the job of a human trader. This might also shed some light on why today there are fewer and fewer human traders. Today, if you buy quite a large sum of stocks, let’s say 50.000 stocks ArcelorMittal or 10.000 stocks Shell, 9 in 10 times you will experience a sudden drop in the stock’s price (+- 1%). That’s right:  a drop, not an increase. This didn’t use to happen a couple of years ago, but from a HFT perspective, the price drop is easily explained.

For suppose you aggressively buy 50.000 stocks, meaning that you buy 50.000 stocks on offer. This implies that a certain HFT is short 50.000 stocks. Assuming the HFT wants to have a net position of zero, this means that it has to buy back 50.000 shares. But it doesn’t want to make a loss: it wants to buy back the shares at a lower price than they were sold for. Being a market maker, hence controlling the order book and therefore the share’s price, the HFT removes successive levels of best bid. Now it waits for other HFT’s to fill up the order book, until it detects an offer of 50.000 stocks at a price lower than the price the HFT sold the stocks for. Now the HFT buys back the shares, hence making a profit. For the human trader, who is on the other side of the trade, this means that he starts his trade with a loss.

Another way in which trading has changed, is in the extremity of price movements. A couple of years ago, human traders would prevent certain extreme price movements from happening – by buying when they deemed a stock oversold, and selling when it was overbought. Machines don’t follow this logic. They go with the flow, and if the flow is selling, they are selling too. Hence you see price movements that either go up or down continuously, without any correction. Furthermore, price movements get accelerated due to the high speed of HFT. This explains the increased volatility; another side effect of HFT.

Another issue that can be extremely frustrating to a trader, is that your orders do change the price of a stock – even if they are not executed. Let’s say you want to sell x number of stocks. If x is larger than a certain size, HFT’s will detect your order as being real, and use it build their order books around. Meaning: if you are best offer for 5.000 stocks at 4.241, a HFT will put an offer in front of yours at 4.240. Before you can blink your eyes, another HFT will lay down an offer at 4.239. Now the next person buying will pay 4.239 instead of your 4.241. Hence, HFT’s prevent your order from being executed, and cause the price of a stock to go down. You can of course sell your stocks at market, hence paying the spread, but always doing so significantly decreases your profits. There is of course nothing wrong with HFT’s offering stocks at a price lower than yours; it is that, when you put down an order, regardless of the price, the dynamics of the price will change in such way that your order will not be executed – no matter whether you are buying or selling. This process is also described in Flash Boys, Micheal Lewis’ book on HFT.

Adding up all such changes, you can imagine why the traditional way of trading has become increasingly difficult for humans, possibly explaining why relatively fewer and fewer humans trade.

Why 30 Years of History Shows the US Stock Market is Going Down

I hate preachers of doom and destruction. I think most of them just want some attention, and instilling fear into people’s minds works better in doing so than painting a rosy future. But something quite concerning recently caught my attention, and – even though you might have already noticed it – I want to point it out.

Governments worldwide decreased interest rates in response to the 2007-2008 financial crisis. The idea was that by decreasing the interest rate, it becomes cheaper for banks (hence people) to borrow, hence increasing the amount of money available to spend, thereby increasing the spending power of the economy.

As a matter of fact, the USA has had such a ‘stimulating’ economic policy for over 30 years to date. If you look at the United States Fed Funds rate, the main determinant of interest rates in the USA, you can clearly detect a down-trend since 1980:

This policy has shown to be effective, at least in recent years. The unemployment rate in the USA has decreased from 10% in 2010 to around 5% in 2016.   This might be a case of post hoc ergo procter hoc, but it seems hard to believe that the US stimulating policy has had zero positive impact on the economy. Furthermore, if you take the S&P 500 index to be the benchmark of the US stock market, you see that it has tripled since the bottom of the financial crisis in 2009; from 700 to 2100. In fact: the S&P 500 index has been in a clear up-trend over the course of the last 30 years:

You see the relationship? What we see here is a clear negative correlation between the Fed Funds rate and the S&P 500 index. The first question you should of course ask yourself when talking about correlations is: are the increasing stock prices a result of the decreasing interest rate, or is the deceasing interest rate a result of the increasing stock prices? The last relation seems to make no sense, for if anything, a higher stock market might be a symptom of a market overheating, hence encouraging restrictive instead of stimulating economic policy. So the relation seems to hold the other way: a lower Fed Funds rate causes the market to increase, which from a perspective of common sense, seems to make sense: lower interest rates means more money to spend, means more money to spend on stocks, means higher stock prices.

But the question that nowadays is very relevant is: what will happen to the stock market when the US government decreases its stimulatory policy? That is: what if the down-trend in the Fed funds rate stops? Currently the Fed has an overnight interest rate between 0.25%-0.50%, which is already higher than the 0.00% it has had for over 6 years. Now it is considering to increase it.  It seems fair to say that we can not go lower than 0.00% (although this has been done in Europe, but following up on this policy will lead to all sorts problem for the banking sector, not to mention a slippery slope). Hence the Fed funds rate can only go up. Given the negative correlation with the S&P 500 index, which is based on 30 years of economic data, there seems only one way for the US market to go, and it is not up.

Why Economic Growth is More Important than Gender Equality

figure 1

Figure 1: Taking care of moral issues enhances the economy

I think most of would agree that issues such as gender equality, education and malnutrition are important matters. Not only morally, in the sense that anyone of us should have the right to be treated equally, to receive education or to have proper feeding, but also because of their economic consequences. Studies have shown that gender inequality, lack of education and malnutrition affect the economy of a country negatively (see Figure 1). But fewer studies, at least none I could find, look at the relation the other way: what are the effects of economic development on gender inequality, education and malnutrition? Or more broadly: what are the effects of economic development on moral issues, instead of the other way around?

Let’s take gender equality, for example. I think it is reasonable to assume that when a country develops economically, the role of women in society will improve – in the sense that they are treated more equally to men. For suppose people have more disposable income, as a result of economic development. Then this money might allow families a sense of freedom that partially breaks down the traditional role division between the working man and housewife. The money might for example allow women to pursue their interests, whether this be education, painting or something else, thereby enabling them to develop in a manner similar to men.

Furthermore, economic development might reduce the number of children per family, thereby putting less pressure on either the man or woman to stay at home to care for the children. This enables both parties to participate more equally in, for example, the workplace.

Economic development might also increase the level of education in a society. In case there is a system of private schooling in place, this is obvious. For if people have more income to spend, they can spend more on the education of their children, thereby increasing the level of education received in society. Also, more income means more taxes. In case a country has public schooling, more taxes allows for a more elaborate educational system, thereby enhancing education. Also, when families have more income, their children might not have to do labour to increase the family’s income. This provides them with the time required for education.

Malnutrition; another problem. It is obvious how malnutrition might be bad for a country’s economy. But it is just as obvious how economic development might reduce malnutrition. After all: if people have more income to spend, they can spend more money on food, thereby decreasing the level of malnutrition. Furthermore, if an economy develops, the supply of food might increase, since there might be more economic demand for food. The food might also be cheaper due to increased mass production, hence increasing the availability of food for the common people.

I am sure there are many other moral issues I didn’t deal with in this article (think about poverty, or child labour), but that affect both the economic development of a country and are affected by it. But what each of these matters appear to have in common is that they can be improved by improving the economic development of a society. Hence, in case you want to improve the well-being of a society, as many charities might want to do, you might be better of developing a society economically than to try and solve each moral issue one by one (see Figure 2). Because why choose the hard way when there might be a much simpler solution?

figure 2

Figure 2: Economic development might (partially) solve moral issues

What do you think?

Why Voting on Trump Now is Especially Bad

Today another terrorist attack hit a major city in Europe. After Paris, today Brussels was hit. Naturally people are scared, and want to feel safe. Hence it seems attractive to support a political party which implements policies that at first sight seem to increase one’s safety. Think about people such as Geert Wilders in the Netherlands, or Donald Trump in the USA.

Geert Wilders for example wants to close its country’s borders, and stop emigration from Muslim countries. Wilders’ policies are part of a much broader agenda; an agenda that is characterized by a core of anti-Islam. He condemns pretty much anything that has to do with the Islamic ideology. Donald Trump might be even worse: he wants to ban any Muslim from emigrating to the USA.

Although such measures might appear to improve the safety of the average citizen, one can legitimately doubt whether such policies will make our lives safer, instead of less safe.

For suppose more people vote on Wilders or Trump. Then Wilders/Trump will implement more anti-Muslim policies, which not only creates a more apparent difference between Muslims and not-Muslims, but might also make Muslims feel more oppressed in their own country, which in turn could cause resistance. They might start thinking: ‘If you guys won’t accept us and our ideas, then we might have to force you to respect us another way’. Or: ‘Given that you don’t respect us, we see little reason to respect you’. This feeling might not directly cause terrorism, but it could lead to an increased sense of suppression within the country’s Muslim community, which might stimulate the occurrence of a breeding ground for (violent) resistance.

But even without political anti-Muslim measures being implemented, increased support for anti-Muslim politicians might in itself make Muslims feel like they are not accepted, not even in their own country, thereby creating resistance. After all: how would you feel to live in a country (such as the Netherlands) in which 1 in every 3 people on the street votes for a party whose main message it is to suppress your kind of people. I can imagine that you won’t feel much compassion for your fellow citizens.

Especially in this time, when the tensions between Muslims and not-Muslims seems relatively large, voting for people who increase this tension even further might be particularly problematic.

What do you think?

Why Do So Many People Want To Be in a Relationship?

Why Do People Want To Be in a Relationship?

Why Do People Want To Be in Relationships?

Sharing your life with someone else. Always being together: if not in person, then at least in mind. Sharing in the other person’s pain (but also in their happiness of course). Always having an obligation to someone. Not being fully free.

These are merely some of the consequences of being in a relationship. I wonder: what draws so many people into a relationship? Why do so many people appear to have the urge to always have that other special person in their lives?

Is it is to share your feelings and ideas with someone who truly cares about you? Who doesn’t judge you, who wishes the best for you and tries to help you? That might be true, but it seems like you don’t have to be in a relationship to have such experiences. You might just as well talk to friends – who by definition care about you, want the best for you and try to help you – and achieve pretty much the same results.

Is it for sex then? To have sexual intercourse with someone regularly without having to go through the seduction process over and over again? Maybe, but again: you don’t need to be in a relationship for that. You can have sex with pretty much anyone who wants to have sex with you; also with the same person, so that you don’t have to go through the seduction process over and over again. ‘But’, someone might object, ‘sex with someone you’re not in a relationship with is less intimate in some way, than sex with your girlfriend/boyfriend.’ But is it really? Because why would the fact that you are in relationship with someone, which appears to be nothing but a social construct, add to the intimacy of sex? It might be that being in love with each other does, but then again: you don’t need to be in a relationship to have that experience.

So why then, if not for companionship or sex?

Maybe it is to boost our own perception of ourselves. Maybe it is the idea that we mean so much to someone that that person is willing to give up a large part of their lives, time and bodies for us. And the prettier, smarter, kinder that other person is, the more special it is that that person chooses you. And it might just be that feeling of possession that we, insecure humans, crave for, and why we value being in a relationship with someone.

Or maybe it is because it is just the normal thing to do, according to the unwritten rules of society. But one could question whether this is ever a good reason to do anything.

The best reason I can think of is when you plan on having, or actually have, children with someone. For in case you have children with someone, it might only be fair towards that person to devote all your resources to him/her and your children – if only because it might be best for your children, which from an evolutionary perspective seems an important consideration in one’s actions. However, I doubt many teenagers, or people in their twenties, consciously decide to get into a relationship with someone for this reason.

None of this is of course a problem; not if both parties agree to the relationship. But it might shed light on the not-so-conscious reasons that drive people into a relationship.