Wednesday, January 09, 2019

The Model Thinker #2 : Seven uses of models

Image result for seven supermodels

In this second installation of The Model Thinker, I will talk about seven uses of models.

The author uses the REDCAPE acronym to illustrate these seven uses which I will illustrate here for folks interested in their personal finances :

a) Reason - To identify conditions and deduce logical implications

One of the best illustrations of this usage is Ray Dalio's Big Debt Crises he showcases one way to look at how accumulating foreign debt can lead to a depression later on. A detailed discussion of this model, unfortunately, cannot be done on a blog. We do know that taking on a lot of foreign debt can led to tragedy later on.

b) Explain - To provide testable explanations for empirical phenomenon

I attempted to explain the underperformance of a REIT portfolio due to an investor's preference for REITs run by 'good' sponsors using quantitative backtesting. This racked up a lot more unhappiness than I originally intended, but I will possibly do up a sequel to that article quite soon.

c) Design - To choose features of institutions, policies and rules.

The CPF Life program defaults to the Standard Plan which is drawn from the concept of choice architecture illustrated in the book Nudge by Richard Thaler. The government obviously wants more people to load up on annuities in their retirement plan so a sneaky way to do it is to make it the default. This is excellent policy design, but I fully intend to switch to the Basic Plan the moment I get to do that.

d) Communicate - To relate knowledge and understanding.

If you follow my block, you might know that I am getting rather obsessed with building a taxonomy/epistemology of financial knowledge. I was inspired by the TCP/IP stack and a writeup from a finance professor. I hope to explain the problem of financial knowledge better. If I fail, at least the IT guys and engineers will appreciate my use of this model.

e) Act - To guide policy choices and strategic actions.

A very simplistic way to locate Singapore's position in the market cycle is to look at trends of CDP growth, inflation and unemployment. Once we can guess at our market cycle positioning, we can start to determine our asset allocation. At this point of time, we might be in a contracting phase - this means buying bonds in spite of their lack lustre returns over recent years.

f) Predict - To make numerical and categorical predictions of future and unknown phenomenon

What does it mean when my strategy of buying stocks yielding more than 4% and having a P/E less than 12 returns over 20% ? A lot of folks misinterpret this as  projection of future returns of 20+%. Actually, I build quantitative models to maximise the chance of outperforming the market average. So I am predicting that this 4% yielding and PE would do better than holding a basket of Singapore stocks in equal weights - a less dramatic prediction than +20% gains every year.

g) Explore - To investigate possibilities and hypotheticals.

Over the next few days, I will be investigating whether REIT's with 'good' sponsors have a larger average volume over the past 6 months.  I hope to use these insights to see whether I can put a second nail into the "Good REIT Sponsor" idea that many investors currently have.

In summary, models are very powerful tools to assist an investor. Hopefully as I explore this book further, I will learn of new ways to structure an investment plan.

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