Factor Models: Outmaneuver Risk
Suppose you are in a light saber fight and you have to decide what position to take where your stock position proxies for your sword position. The typical person assumes he is taking risk when he holds a position in stocks but he may hold very little idiosyncratic factor in that stock and may actually hold factors on macroeconomic and industry positions by holding that stock. The attribution of the risk of a stock into buckets of fundamental and macroeconomic factors is based on the arbitrage pricing theory and allows us to selectively hold risk. Notably, we are not saying that we can’t bet on macroeconomic or industry factors, only that there is a stock related factor separate of macroeconomic or industry factors. So in other words, it is like a stock’s motion is driven by its risk, and its risk is divided into three storm epicenters: an individual epicenter, an industry epicenter, and a macroeconomic epicenter. Observations from data show this to be the case. Perhaps there don’t exist these separate storms but only general patterns exist across industries and macroeconomic factors, but nonetheless if you hold a particular stock you are subject to the stock’s individual changes as well as the industry and the macroeconomic movements. Take for example my view on Harvard at any given moment. If I raise my light saber in a Form One Basic guard stance to defend my language which is my ability to describe what went on with my life, I would start with Harvard where I went to school. There are three stories going on. Harvard as just a school is the most intuitive one, and I see something akin to the Iliad as Harvard sorts out a civil war of sorts with its own student population over single gender clubs. Just a lot of disorganization and not a lot of war really. But if you were to own Harvard’s stock, this is not really what you are getting as the idiosyncratic risk isn’t all there is to it. Inadvertently, you would bet on another story which is Harvard as an Extension School. Is a separate story a separate source of risk? Not really. The real concern is the unforeseen in the first story. The Illiad may sprout multiple heads. What you thought were Trojans and Greeks may change to another group of people and the drama may change. What is detailed as simply fiction may suddenly come to life as the unforeseen grips your reality. As they said in Massachusetts Phi Beta Kappa, the courage to ask unrelenting questions required the inordinate flexibility to adapt to the answers and solutions required. You must be prepared to live fiction if you are prepared to overcome reality. Finally, there is some risk at Harvard as a research institution where I worked in a biology lab that investigated the genetic basis of behavior. We find that Harvard investigates many things but because I worked in a biology lab that risk is pertinent to me. Just like a stock will move on many factors but when you look up why it moved you will look up what you know. The lesson from the biology lab is that you can learn by osmosis which is that you can piece together things out of order and learn gradually. Therefore, we don’t need to take a great deal of risk to learn as there are ways of learning that can be built up naturally. Anyway you see how there are many risk factors in a given trade position, but we can understand what we own by understanding these factors or isolate factors to bet on them individually. In my opinion it is truly difficult to isolate a factor and it is much more profound to understand factors rather than to shift factors around in mathematical constructions and pretend like you understand what you are moving when you are hedging positions over a threshold. The Iliad at Harvard is best managed by Star Wars again by shifting to Form Two Acrobatic which is economics: what would give the economics for Harvard students to still interact with one another? And the answer is the rebuilding of Germany under allied sanctions after World War One. Our house tutor even openly asked us at graduation to learn from the challenges of Weimar Germany and how the most advanced scientific state fell to the Nazis in twenty years. Well, that won’t happen. Because West Germany will make sure of that. West Germany is the part of Boston that has overcome problems in chemistry and will overcome more. East Germany in Boston is biology. Prussia is up in New Hampshire and is physics. One of my good high school friends went up there to study physics. Our great friends from Austria come from the southeast Rhode Island to study mathematics. And in the Danzig of Poland-equivalent and in the German-speaking part of Czechoslovakia-equivalent, we have people studying Bayesian networks in computer science in Boston and molecular biology in medicine in Boston. Germany is unified in Boston and the cover story was we were importing the concrete to build homes that were demolished to make way for superhighways connecting us to other countries but really we used the concrete to build highways connecting all the different parts of Germany together in Boston. Now, if we used a risk model we would see we have dispelled one such risk, the so called Nazi risk, as our formation of a strong centralized state has prevented the rise of a German folk that would have seized the apparatus of the state in its own interest. What substituted for the folk? A communion. “And if you break faith with us who die, we shall not sleep though poppies grow in Flanders Fields.” – McCrae. Canadian poet. But I am with a different people now. A different God. As you see this whole post was a outmaneuevering of the risk of social breakdown over race in the unification of the German model and if you were lucky enough to have seen the article in the original form, you saw how close that came to fruition as if I didn’t make myself a nobody you would have seen how close I was at losing control yet again to the hordes of people who take advantage of hordes of people. At least this here in the West where Kennedy died was not where the West was lost, but was where I found God.