Gamestop and Engine No 1

I have been thinking about parallels between two surprising David versus Golaith episodes in the US capital market during 2021 which appear on the surface to be totally different and unrelated.

The first was the GameStop saga in which retail investors coordinated on Reddit (r/wallstreetbets) to drive up the stock price of a struggling company by several thousand percent. I blogged about this event at that time here and here. In short, many retail investors hated the big hedge funds who were short selling GameStop and hammering its stock price, and these retail investors came together on Reddit to engineer a short squeeze that inflicted heavy losses on these hedge funds.

The second was the successful proxy fight waged by the activist hedge fund Engine No 1 against ExxonMobil. This fund succeeded in getting three of their nominees elected to ExxonMobil's board though it owned only 0.02% of ExxonMobil's stock. Engine No 1 achieved its victory by gaining the support of major proxy advisory firms and many of the large institutional investors while individual shareholders tended to favor the company’s nominees. ("How Exxon Lost a Board Battle With a Small Hedge Fund", New York Times, May 28, 2021).

The first similarity that I see is that both demonstrate the importance of memes in the world of finance. GameStop itself is described as a meme-stock in a pejorative sense. But there is nothing pejorative about meme as originally defined in Richard Dawkins' The Selfish Gene. Memes in this sense are similar to narratives (as in Shiller's Narrative Economics), and they have a very significant effect on financial markets at least till the meme fades away. Climate change is as much a meme in this sense as GameStop.

The second similarity is that both these episodes raise tricky issues about assessing the rationality of the key protagonists. In the case of GameStop, the first impression of most observers is that of irrational investors driving prices far away from fundamentals. But my blog post at that time argued that rationality in economics requires only rational pursuit of one's goals, and does not demand that the goals be rational as perceived by somebody else. From this perspective, the Redditors pursued their goals quite rationally, efficiently and successfully. These actions might have been injurious to their wealth, but economic rationality does not require wealth maximization. Warren Buffet can give away most of his wealth through his philanthropy and still be a highly rational investor.

In the case of Engine No 1 also, there is a troubling question of rationality. The amount that this fund spent on the proxy fight was a very large fraction of the entire value of its investment in ExxonMobil. (Initially, it was thought that the amount spent by Engine No 1 on the proxy fight equalled 85% of the cost of its 0.02% stake in ExxonMobil, but subsequent estimates suggest that it might have been only 40%). The appreciation of ExxonMobil attributable to the proxy fight would almost certainly be far lower than even the lower estimate because the bulk of the stock price movement would be due to changes in the oil price cycle. Moreover, the proxy fight was quite close and even just before the voting, Engine No 1 could have expected only about 50% chance of success. When they began the proxy fight, the probability of success would have been far lower. It is hard to imagine a rational calculation in which initiating the proxy fight would have been a positive expected value bet for Engine No 1.

But there is a deeper level at which the proxy fight was quite rational. The proxy fight was a wonderful boost to the reputation and visibility of Engine No 1. It seems obvious to me that the same amount of money spent on advertising would have been far less effective in establishing it as a serious player in the hedge fund business. Engine No 1 appears to have pivoted away from climate activism and from activism in general, but it does run an active investment business which continues to benefit from the aura gained during that proxy fight.

The third similarity that I see is highly speculative and is probably something that finance professors like me should leave to psychologists and sociologists to think about. I wonder whether the Covid-19 pandemic led to a temporary change in people's goals and aspirations. Was there a temporary increase in the willingness of people to sacrifice short term self interest (narrowly defined) in favour of larger goals? As the pandemic faded away, and the battle between humanity and the virus gave way to wars between humans and humans, did this burst of altruism also decay giving way to the renewed ascendancy of narrow pecuniary rationality? If there is any truth in this wild speculation of mine, the rise and fall of meme stock investing and the rise and fall in ESG investing would both seem to me to fit in well with this explanation.

Posted at 1:05 pm IST on Wed, 11 Dec 2024         permanent link

Categories: behavioural finance

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Code is Law versus Contract is Law

“Code is Law” has been one of the slogans of the blockchain and cryptocurrency world. The core belief is that the intentions of the parties do not matter, and the only thing that matters is the actual software code that implements these intentions. Even if somebody finds a bug in the code, and exploits it to make money, “Code is Law” would regard this as a legitimate activity. The correct response to such a hack is to write better code in future.

Mainstream finance does not accept this idea. In 2022, Avi Eisenberg hacked Mango Markets, a decentralized finance (DeFi) trading platform on the Solana blockchain, and took out over $100 million. He claimed that he was an applied game theorist who had simply implemented a highly successful trading strategy that fully conformed to the rules of Mango Markets as embodied in their code (“Code is Law”). A jury did not buy this argument and convicted him for market manipulation in April this year. Courts obviously take into account the intentions of the parties.

Or do they? This week the Delaware Supreme Court affirmed the lower court’s ruling confirming an arbitration award that required the seller of a supermarket chain to pay the private equity buyers twice the purchase price. No that is not a typo. It was not the buyer paying the seller, but the seller paying the buyer, and that too twice the purchase price. The Chancery Court agreed that “the outcome that the Buyer achieved in this case was ... economically divorced from the intended transaction,” and the arbitrator also expressed a similar view. But Delaware law embraces strict contractarianism - “Contract is Law.” The arbitrator would not consider the intentions of the parties, and the courts would not step in either.

The US Justice Department and the CFTC prosecuted Essenberg for market manipulation. Should and would the Justice Department and the SEC prosecute the private equity buyers for market manipulation?

How is “Contract is Law” different from “Code is Law?” Do not the moral hazard argument work equally well in both cases? If “Contract is Law” encourages all parties to draft better contracts and read them more carefully, “Code is Law” encourages everyone to write better code and review them more carefully.

Posted at 2:18 pm IST on Thu, 14 Nov 2024         permanent link

Categories: blockchain and cryptocurrency, law, manipulation

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Art of risking everything

In my last post about my resuming my blog, I asked for suggestions on the scope and nature of the blog. Several comments requested me to write about the books that I have been reading recently, and I have embraced this idea. The caveat is that these would not be book reviews, but would be my reflections on what I took away from the book. Moreover, they would be highly opinionated, and would largely be about finance even if the book is not about finance.

Today’s book is On the Edge: The Art of Risking Everything¹ by Nate Silver, author of The Signal and the Noise and famous mostly for founding the election forecasting site FiveThirtyEight. This book is not about finance at all, and I had great difficulty wading through four uninteresting chapters about gambling and poker before getting to the relatively small bit of finance in the middle. The finance portion is mainly about venture capital and cryptocurrency.

Underlying all the disparate chapters in the book is the broader theme about attitude towards risk, and this is of great interest to any finance professional. Nate Silver begins by distinguishing between the “river” and the “village”, where the people in the river are given to analytical and abstract thinking and are competitive and risk tolerant (This is a bit of an oversimplification because Silver mentions a few other cognitive and personality traits also). The difficulty with this characterization is that in finance, attitude towards risk is not binary (risk averse versus risk tolerant), but encompasses a broad spectrum of risk aversion coefficients. The theoretical range of the Arrow-Pratt measure of relative risk aversion² is from negative infinity to positive infinity, but for most people, it probably lies between 1 and 10. Therefore, a finance professional would quite likely regard a risk aversion coefficient of around unity as being quite risk tolerant, though technically any risk aversion coefficient greater than zero signifies risk aversion. Zero represents risk neutrality and negative coefficients signify risk seeking.

At certain points in the book, Silver seems to imply that somebody with a risk aversion coefficient of unity or even somewhat higher belongs in the “river”. For example, twice he says that most gamblers regard the Kelly criterion³ as being too aggressive and prefer bets of only quarter to half of the Kelly bet size. The Kelly criterion corresponds to a risk aversion coefficient of exactly unity, and so this implies that most gamblers have risk aversion coefficients significantly above unity. At other points in the book, Silver seems to suggest that people in the river seek out any positive expected value opportunities which suggest risk neutrality (a coefficient of zero) if not risk seeking. Of course, Pratt showed that a rational person would take at least a tiny slice of any positive expected value opportunity. This is because risk aversion (which is a second order phenomenon) can be ignored for infinitesimal bets. Perhaps, this is what Silver means, but, in that case, the logic applies only to highly divisible bets.

At times, I got the feeling that all expected utility maximizers are in Silver’s “river”, and only people confirming to prospect theory or behavioural finance are in his “village”, but Silver mentions prospect theory only in a footnote and in the glossary, and he does not describe this as a “village” trait. He does emphasize that “river” people perform Bayesian calculations, and the distortion of probabilities in prospect theory would perhaps not be “riverine”. What I do not understand after reading the whole book is whether a highly rational expected utility maximizer with a risk aversion coefficient of 25 belongs in the “river” or not. The problem is that while Silver praises river people for “decoupling” (keeping different aspects of a problem separate), he works throughout with a tight coupling of the cognitive and personality traits of the “river” people.

Silver cheerfully admits to being a “river” person, and often suggests that the “river” is winning. But there is some ambiguity about what it means for the “river” to win. Does it mean that the “river” people collectively win, or that the typical or average “river” person wins? This distinction is illustrated by Silver’s discussion of the Kelly criterion on pages 396-400 (if you do not have the book in front of you, Brad Delong’s blog post which Silver cites in an end note provides a very similar treatment). Mathematically, the Kelly criterion maximizes long run wealth. The intuition is that when you have positive expected value investment opportunities, you definitely want to bet on them (recall Pratt’s result that the optimal bet size is never zero), but if you bet too much, you may be ruined and then you lose the opportunity to make more positive value bets in future. Long run optimization must therefore ensure long run survival to allow wealth to compound over those long horizons, and this leads to an optimal size of the bet.

Imagine three groups of people: (a) the “village” whose inhabitants do not participate in risky assets at all because of behavioural reasons or infinite risk aversion, (b) the Kelly “river” filled with venture capitalists who bet the optimal fraction of their wealth at each round on various risky (positive expected value) ventures, and (c) the risk neutral “river” comprising risk neutral founders who bet their entire wealth on their respective risky (positive expected value) ventures. Note that this is my analogy, and Silver does not use this interpretation during the discussion on Kelly. Most inhabitants of the Kelly “river” will outperform the “village” handsomely because Kelly ensures high returns with negligible chance of being ruined. But the risk neutral “river” will outperform both of the others on average. Almost everybody here would be ruined, but the one person who managed to survive would make so much money that the average wealth of the risk neutral “river” will be far higher than even the Kelly “river”. (For simplicity, I assume that the different ventures are independent.)

If you care more about the group rather than yourself, then the risk neutral “river” is possibly optimal in the sense that collectively this group is better off than the others. But the “river” people were supposed to be competitive and not collectivist and socialistic. So it is not clear whether this is the “river” at all. Brad Delong’s blog post uses the multiple universes interpretation of quantum physics to suggest that even if you are ruined in this universe, there is a parallel you in some other universe who has made it big. I think that this is closer to theology than to finance.

Silver’s book does have a long discussion about venture capitalists and founders and seems to suggest that the venture capitalists have to be rational, while the founders have to be irrational to willingly accept large probability of ruin. I do not agree because as Broughman and Wansley⁴ have pointed out, risk sharing between the VC and the founder can ensure that founders do well even when the venture fails. Recall Adam Neumann making a fortune even as WeWork went bust.

At the end of the book, I was left with the impression that Silver wants to self identify not with cold blooded rational calculators, but with daring risk takers, and this tendency colours a great deal of the discussion in the book. This attitude is best captured in the last of his thirteen habits of successful risk-takers: “13. Successful risk-takers are not driven by money. They live on the edge because it’s their way of life.” Nevertheless, by ignoring his personal preferences, I could learn many interesting things from the book, and some of these ideas are useful in finance as well. The “river” and the “village” are I think a useful way of thinking about classical and behavioural finance even if that was not what Silver had in mind at all.

Notes and references:

Posted at 1:36 pm IST on Wed, 30 Oct 2024         permanent link

Categories: behavioural finance, interesting books, risk management

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Resuming my blog

My blog has been suspended for nearly four years now. My term as a member of the Monetary Policy Committee of the Reserve Bank of India ended early this month, and I am now looking forward to resuming my blog.

However, posting is likely to be erratic for the next couple of months as I would be making a career transition subsequent to my retirement from the Indian Institute of Management Ahmedabad at the end of this calendar year. This career transition has yet to be finalized, and so I am unable to provide any details at this stage.

I am also contemplating some changes in the scope of the blog like a bit more of macro finance and perhaps more of finance pedagogy. Please feel free to make suggestions in the comments.

Posted at 11:27 am IST on Tue, 22 Oct 2024         permanent link

Categories: miscellaneous

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