Sunday, 17 February 2013

Present value, broad frame, back pocket

Today ought to be my 'trading research' day but I still can't stop thinking there's so much in the Kahneman book that I want to say something about what I read there recently.  I've been thinking about present value and how organisations (and the culture generally) dress up various packages of cash flows to solve a number of non-financial constraints.  

The constraints I'm thinking of are thinks like tax planning, since some parts of the tax law in any country are in essence arbitrary, as is the seemingly clear cut distinction of capital and income upon which a lot of the tax code is based.  Second is to suit the cash flow needs of purchasers and providers of these products.  Third is to exploit or get exploited by the ever-shifting inflationary environment which timed money packages find themselves surrounded by. And fourth is a Kahneman-inspired point.  

I think the everyday packages of cash flow which underlie, for example, a modern mortgage deal, are also partly created to fool potential buyers.  This low level deception goes on at a straight forward level - for example in burying a fraction of a mortgage's cost in the an up front fee so that the headline rate looks more competitive than it really is.  That kind of deception is the sort of marketing deception we're all familiar with in our lives.  But more sophisticated variants of it are buried in an extended discussion which begins around chapter 31 of the Kahneman book. 

"Every simple choice formulated in terms of gains and losses can be de-constructed in innumerable ways into a combination of choices, yielding preferences that are likely to be inconsistent"
I was just about to make the same point about interpreting and equating (present valuing) packages of cash flows, with a view to showing how difficult this is to do in your head and here's Kahneman making a similar point about how our system I brain prefers reaching narrow frame solutions to immediate problems, where what's needed always is a wider frame approach.  In the case of present value, collating all of the cash flows, rates, retrocessions,  discount teasers, final adjustments, knock-ins, caps, floors, foll overs which we as ordinary financial consumers are faced with is an arduous task.  It is so easy to make the choice to hand with respect to a narrow frame of reference.  Broad framed decision making requires solving multiple problems in parallel in a way which is broadly optimal, not locally optimal.  With Kahneman the problems in question are collections of expectation calculations (typically bets with unquestioned probabilities and cash values which need to be valued multiply, sometimes with a kind of chaining of valuations often found in moderately sophisticated financial models) and with me the problems to be solved are present value valuations with a view to working out which deal is the best.

Surely for any given country the best discount curve isn't too difficult to construct at any moment in time?  Surely a high quality date, rate, data capture web front end wouldn't be too difficult to develop?  Why not a free iPhone app which took a lot of the pain away, a beautiful pocket discounter, cash flow valuer?  There are hundreds of them, but they're all rather confusing to use and force the discount curve on the user?  The app server should construct this for them, leaving dates, fees, rates to be entered.  Of course, many templates could be provided to assist, and there's nothing stopping the app from already doing this with competitive cash flow offerings out there in the marketplace.    Many websites do this, to varying degrees of business success but none I've found which simplifies the user experience for it to be maximally useful.

Quasi-public choice theory

James Buchanan made some telling points exposing the kinds of structural incentives which drive policy makers in the public sphere to promulgate dramatically sub-optimal policy.  A kind of political version of the so-called agency problem in the corporate world.  Of course, the financial world occupies such a murky in-between realm, it being so close to treasury departments the world over.  And especially when their lobbying power causes them to be too big to fail.  Surely the Buchanan of finance is already probing the warped incentives via his own form of quasi-public choice theory.  Any why not in corporations too and not just with the agency problem?  Even quasi-Austrians are focussed on the unintended consequent emergent behaviour of poorly aligned micro incentives in the quasi-public sector.