I want to be a cockroach

Baruch is worried these days, Bento, lying in bed staring at the ceiling till the early hours unable to sleep. Two weeks ago he made the mistake of re-reading the last chapter of Bookstaber’s Demon of our own Design, and it made a sudden connection with something which had been knocking about in his head for a while — and he had a brainwave that made him quite depressed.

He hasn’t wanted to use this site to make market predictions, but he has to accept a doom-laden prediction is sort of implicit here. He is quite embarrassed about it, and uncomfortable, especially as the stockmarket is going up. Of course, as said before, this is not investment advice. If you trade off  tips and ideas you picked up from anonymous websites, well then you are a very silly person indeed.

Basically, if you think we have seen weird unintended consequences of financial markets’ collapse, we may not have seen anything yet when it comes to the real economy. It may also explain why corporate spreads remain so stubbornly high.

We should spare a thought for Richard Bookstaber. Taleb is getting all the glory for “predicting” our current difficulties, is on TV more the whole time, can charge gazillions for speaking engagements etc. “Black Swan” is now part of the popular argot, like “Perfect Storm”, and is a staple of letters from hedge fund managers explaining how they lost you all that money even though they are supposed to be independent of market movements. Bookstaber wrote an equally timely and prophetic book and we don’t hear much about it any more.

Now, Baruch read Demons and disagreed with a lot of it, specifically with the idea that we can “design” market structures. I still stand by this, but there is a lot more to Bookstaber than a bunch of regulatory proposals.  What struck Baruch particularly on this third reading were Bookstaber’s thoughts on the importance of specialisation, “coupling” and optimisation in financial markets. Baruch apologises for not getting this 1st time round.

Bookstaber makes the contrast between the furu, or chiclid, and the humble cockroach. The furu is or was a genus of fish found until recently in spectacular variety in the evolutionarily pristine Lake Victoria in Africa. Its particular feature, he writes, is that it

specialised to a remarkable degree. . . over the . . . 12,000 year life of the lake to at least 300 species, ranging in size from 4-12 inches. There are furu that survive as scavengers living off the organic waste of the lake bottom; algae scrapers that feed off shoreline rocks: snail crushers [with] a second set of powerful teeth. . . snail shellers that have developed long teeth to pull the snail out. . . larvae eaters. . . prawn eaters. . . and “child eaters” that eat the newly hatched eggs of other furu just after they are released from their mothers’ mouth, or in some cases by first ramming the mother to dislodge the eggs from her mouth.

Most types of furus are now extinct; bigger, tastier and highly voracious nile perch were introduced to the lake by enterprising fishermen in the 1950s. The various furu species didn’t know what hit (ate) them.

Now the cockroach is stupid. It is uninteresting, without subspecies variation. A country cockroach is the same as a town cockroach. It doesn’t actually seem to do anything special, like run fast, jump high, have interesting teeth or interesting colours. Cockroach risk management is crude but effective. “Its defense mechanism is limited to moving away from slight puffs of air. . . that might signal an approaching predator,” says Bookstaber. This response doesn’t even depend on a brain to work. Nerves in those little cockroach legs take care of this, leaving the brain to think higher cockroach thoughts, probably about filth and how to frighten my wife, you would think. Actually no. Theyhave no brain. They are so very stupid you can chop their heads off and they’ll lead a normal cockroach life for the 3-4 weeks it takes them to starve to death or die of dehydration. They can eat everything, even live off the glue on the back of stamps. A masterpiece of simplicity, the cockroach has survived for hundreds of millions of years “through many unforeseeable changes,” concludes Bookstaber, “jungles turning to deserts, flatland giving way to urban habitat, predators of all kinds coming and going”. To which I would add, even the invention of the flip-flop.

Presumably you can see where this is going. Cockroach behaviour is coarse. It is limited. It misses lots of things. It is not optimised for a particular time or location. It is a simple, foolproof creature, and while it never dominates any ecosystem it exists in, its behaviour allows it prosper in almost any environment. As such it has been moderately successful over an extremely long time.

Now re-read Bookstaber’s description of the furu and ask yourself: isn’t that a spectacular metaphor for the idea of  the multi-strategy hedge fund? Except the “child eater” bit. Shooting out in all directions into specialised, fragile niches, like convertible arb, fixed income arb, merger arb, stat arb, quant and others, their spectacular exposion has been predicated, like the prisitine waters of Lake Victoria, on a special environment of low risk, low volatility and easy money. The longer that persisted, the more leverage could be used to goose returns. And more leverage had the effect of increasing the viable population following the strategy; the 2-3% returns these originally innovative but eventually over-used strategies were really earning could be turned into 20%-30% for more players than the unleveraged strategies could ever really support.  They were all furu now.

Of course what was also happening is that the structure was getting more and more vulnerable to a internal or external shock. For the multi-strategy hedge fund, the shock was the collapse in mortgage markets; for the furu, it was the nile perch. But eventually what did for them both was entropy, or “life.” The structures they existed under were set to fall apart under stress. The conditions that underlay their growth had seemed to persist for a very long time in the lives of the market participants. But the 12,000 years the furus thrived in Lake Victoria was a blink of an eye in biological time. Similarly the last 30 years or so of bull market, certainly the last 5, marked by what I and others call the Great Moderation, was a shake of a lamb’s tail in the history of functioning stockmarkets. Both the furu and the multi-strategy hedge fund had made a similar mistake — they suffered from sample period error.

Forget the furu, now we need investors who trade more like cockroaches. The most classic cockroach strategies have to be fundamental, sector-based, directional ones. These strategies have been around for hundreds of years. They purposefully cut themselves off from certain statistical information they do not understand, do not need leverage, but have drawbacks: they are not terribly scaleable; they are costly in terms of research; they can produce variable results which while solid over time are rarely spectacular. They persist and prosper in a limited way. They never take over the world, they merely inherit it.

Now it’s time for the depressing brainwave. This would all be fine. A few furu-like hedge funds blowing up won’t matter so much. Many will probably miss the actual furu-fish much more, especially those in the rare fish collecting business. But what keeps Baruch up at night at the moment was the realisation that we have “optimised”, in a bad way, many of our industrial ecosystems as well.

What do I mean by this? “Just in time” production, outsourcing, and specialisation is now all-pervasive. Look at the production ecosystem of a humble mobile phone; it is mind-bogglingly complex. Nokia designs it, then farms out a whole bunch of contracts to a whole series of companies, many of whom subcontract themselves. For instance, Texas designs the chip, but it gets made by a foundry company, which sends it on to a PCB assembler, who gets delivered the memory and other semi content from other providers, quite often the same foundry, or another one. The PCB assembler may make many of the mechanical parts components itself but the more specialised parts get sent from specialised component makers who make things like the camera lens and module, or the microphone, anyway, blah blah blah, you get the idea. Eventually it all gets delivered to a big warehouse, trucked off in a big box with a bunch of its brothers and sisters to Carphone Warehouse and sold with a contract from a big telecoms operator.

How many companies are involved in this process? Tens, dozens, a hundred? How many are critical to the process, or could not be replaced by someone else in the chain? More and more of them. It is a massive web of complexity, inter-relatedness and specialisation. This is just the handset space. There are similar spontaneous ecosystems that spring up around PCs, cars, aeroplanes, and for all I know, pogo sticks and chocolate. It’s the fricking furu of Lake Victoria all over again.

So you see where I’m going, right? Do you understand my paranoia about this? Could this be why corporate spreads remain so high? Why the bondmarket is discounting a wave of corporate default? Right now we are undergoing a massive reset in global demand for just about everything. These fragile ecosystems have sprung up to supply us with 10% to 20% more stuff than we seem to want right now, and in markets which remain incredibly competitive. There was not always very much profit for the companies involved in the first place, margins of 5-10% in many cases. Many of them have too much debt. They probably won’t make it. Not enough of them are cockroaches.

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13 thoughts on “I want to be a cockroach”

  1. Baruch and Bento — good post. Few people get the ‘tight coupling’ issue. Back when I wrote for Realmoney, I would write about that, but I called it layers of leverage, or something like that with respect to finance. With the real economy, I would use the older term division of labor, which has gotten very extended in the present environment.

  2. from a systems perspective, you can define how a system will interact broadly with crude rules. The extreme leverage that Var and other mean variance models allow leads to trouble. Get rid of VaR and simple notional leverage can constrain the boundaries a little more. Tight coupling which has occurred means we are more at risk. Ironically 2 key pillars of the Credit crisis, ratings agencies homogenous models, and the move towards Basel 2 are still in place. Symptoms are being treated (fiscal and quant tightening) and yet the systemic constraints that allowed for the flaws are still in place. Expect the next SIV type game the leverage model in a few years. The problem is with more people having homogenous risk “position” frameworks and regulatory required responses. Exogenous and endogenous shocks will prove to be more harmonic and thus systemically risky.

  3. Nicely done, Baruch. I did not know that bit about cutting off a cockroach’s head. I will make sure not to share that with my wife.

    I would make two observations. First, what you say is very, very true, and some/many/most? of the reasonably intelligent people I know in the industrial economy are worried about it. A lot. In fact, worrying about this very set of complex issues is what passes for risk management at large, complex industrial corporations that know what they are doing. As an investor, you should be very interested in what your target companies are doing in this regard. I am sure you already know this.

    Second, just because one is a cockroach–as an unspecialized advisory investment banker, I think I am the very model of the modern cockroach–does not mean per se that one will survive a generalized collapse of the system one inhabits. To stretch your metaphor further, being a cockroach investor/banker/industrial company will not save you if the building you live in collapses around your ears. Lots and lots of cockroaches get squashed in normal times, and billions must be destroyed in calamities.

    I suppose one could take comfort that, even if you yourself are squashed, billions of your brainless cockroach cousins will live to be squashed another day. That will be cold comfort to the cockroach who gets flattened when the mobile phone ecosystem flies apart or the global investment banking industry accordions into dust or the collapse of major multi-strategy hedge funds triggers massive, undiscriminating redemptions across the entire money management industry, but there you are.

    Cheery stuff, ain’t it. We’ve had our Taleb and Bookstaber. Now, I think we need a Wodehouse for this time.

    Pip-pip.

  4. You have no idea what you are talking about. The cockroach survives because of its specialized digestive system. You yourself said it, “it can eat anything”. Now that is the real edge. From that view point, a multi-strategy hedge fund can earn returns from anywhere. I’m not defending them, just making a point.

    From my perch, I’m actually enjoying the humbling of the investment bankers and hedge fund managers. I like the fall in pride and the heap of disgrace. They were the leeches, sucking the blood of the real economy.

    It will finally come to only three things: food, clothing and shelter. Everything else is optional. Companies that provide these three at a low enough cost will survive. Other fancy “aspirational” crap companies should go down the drain.

  5. Brilliant, inventive post as usual.

    I disagree that fundamental analysis as the cockroach approach though. The US long bond, which arguably has the worst fundamentals of any asset class, is one of the very few that is up for the year (+17%). Many assets that look “cheap” on a fundamental basis keep going down relentlessly.

    No the cockroach defence of fleeing at a puff of air– is strict risk management. By that I do not mean adherence to an elaborate statistical model. I mean things like– no matter what your conviction about the direction of any holding, adhering to stops, diversifying, limiting leverage, etc.

  6. Thanks, everyone, for the kind comments; even you, Jingle, survivalist “wackos” are particularly welcome here. Spinoza himself would not have agreed with Pascal’s wager (the ur-example of assymetrical returns), but personally I think it mostly harmless to suck up to them in case they’re right.

    TED, I agree that many, even most of us cockroaches (are you SURE you’re a cockroach, BTW? As a banker you may be more akin to a small rodent, like a rat) will get squashed in any coming conflagration.

    But if the sine qua non of surviving is NOT being a furu, or a dinosaur, and there is a clear survival advantage to be had by being a rat or a cockroach, even though lots of us might be crushed, trodden on or whatever, I know what I would rather be. And so would you.

    Yes, it is all depressing. I remember being very doom laden at dinner parties in 2002, saying I didn’t see how we were going to get out of it. We did get out of it, because there was a remaining asset class to finance consumption that had not been bubbled out, namely one’s own pad. Now I don’t see what we have left to inflate. My car?

    Brendan, yes, being a cockroach is more about risk management than anything else, you are spot on. But cockroaches also need to eat and to do that they need to find food. Fundamental investing is a way of finding food (ie making more money than you start with) that has not yet blown up; that people still do it argues it may actually work. Sadly it is still quite hard to do. Also, don’t confuse it with value investing — looking cheap is not enough, I need a catalyst too.

  7. individual cockroachs dont get to enjoy the life they lead, or compund their returns. they are saddled with a species-startegy tht maximizes the returns of the aggregate but at the expense of their life being interesting or fulfilling beyond some trivial level.

    a cockroach investment strategy seems like it would give individuals a microscopic allocation of the species portfolio, too little to make any risk or reward meaningful.

    to model a cockroach investment strategy looks like it would get eaten up in commissions unless you just buy the market and wait, without much hope or expectation of the final result.

    its a waiting game that favors final victory over other life forms on the planet, but if you win, you have a cockroach infested earth and no one to talk to. meanwhile the mammals have invented wine, women and song, and the possibility of debating the intrinsic and extrinsic value they may have

  8. Yes, Ken, it was fun being a mammal, but the party is over.

    Actually, I think the cockroach metaphor can be taken too far. I don’t REALLY want to be a cockroach, of course. By “cockroach strategy” I merely mean one that is viable in lots of different environments, and which uses non-discretionary risk management like what brendan above is banging on about.

    Paradoxically a “cockroach strategy” as I conceive it in my own special way can also be highly volatile, and as such trading costs can be the least of ones worries. This aspect is not at all cockroachy. It also makes the investors a bit leery.

    But hey, stocks ARE volatile! And all the strategies that pretend they aren’t blow up. Let’s not put lipsticks on pigs.

  9. Spectacular Essay! Always a pleasure to read.

    p.s. I think we need complex investment strategies. The reason is the diversity is mostly good and improves the total efficiency of our economic activity.
    However, what we need even more is understanding and realization that no particular financial model / strategy will ever be absolute.
    I guess we need a nuclear explosion here and there, in order for us to come back to practical reality and re-evaluate our approaches and views.
    The arrogance is a mind killer.

  10. Cockroach strategy – doesn’t this ultimately mean parking one’s dough in a broad index fund? Sure, a few of those individual stocks in the index might get their heads chopped off occasionally, or be squashed by a flip-flop, but the collective as a whole should survive, in a plodding, wholly unspectacular kind of way. Besides, index investing requires no brains whatsoever, even if it can be smart.

  11. “How many companies are involved in this process? Tens, dozens, a hundred? How many are critical to the process, or could not be replaced by someone else in the chain? More and more of them. It is a massive web of complexity, inter-relatedness and specialisation.”

    The division of labour which increases the complexity of the system produces interdepedance between system parts, not dependance.

    I understand where you’re coming from, but I think you are incorrect, the system is not undergoing a systemic stack of cards/domino effect in progress.

    Although it is true that a break in the chain linkage between company’s outsourced parts will result in no product, the division of labour has a oft-misunderstood side effect, it produces stability. Esstentially because the parts are broken down into the simplest parts possible, this creates the possiblity of ‘hot-swapable’ parts if you’re familiar with PC maintance.

    Basically, there is no ‘too-complex-to-fail’ in a capitalist system. Everything can and will fail eventually, but this is countered by the organic growth of companies springing up to fill the empty slot in the division of labour’ s product chain.

    However, I feel you would be correct in thinking that the temporary ‘inertia’; i.e. the time it takes to replace a system part’s producer, and all the time it takes to replace all of those links over time, does result in a natural upper limit to the complexity that the division of labour can produce.

    But until we reach a fully globalised world, then I wouldn’t believe we’ve reached that problem yet.

    Anyways; enjoy reading your blog. Disagree with about half of it, but that’s no biggee (being a ‘passive’ investor).

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