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Run, Rabbit! Run

June 13, 2012

There is a big difference, one would think, between the path (in two, three or even four dimensions, it doesn’t really matter) of a rabbit grazing for food and the path of a rabbit running from the fox, trying not to be the food. Yet, economists and mathematicians will treat them as the same (basically, as a kind of martingale or random walk or even as a differential equation) but only the mathematicians are correct and then only because the domain of their theories is invariably carefully defined and will have nothing to do with running rabbits.

The economists’ problem is quite different and yet they want to use the same theories as the mathematicians, to say something, provably anything, about the world we live in.

The fundamental issue of economics – and what puts the money into “money” which is an undefined term in economics – is that there are always hungry men and women, who need food, clothing and shelter, and who wish to thrive, and it is they who will decide the value or worth of money as they exchange (or invest) themselves as workers, slaves or entrepreneurs, for what they need, and it is they who will ultimately decide the worth of money by what is created or destroyed by what they choose to investment in.  Woe to those who would deny them. And best that those who would, should know that now (we say).

However, there is only one investment problem and it can be described in a way that you have probably never heard of regardless of how much economics, finance and mathematics you have studied and mastered, and it is time to make a fresh start. If economics cannot solve that problem, then would it be fair to say that the only problem that “economics” solves is the problem of the continued maintenance of “economists”, and politicians, one would think?

The “N/B/W”-Financing Problem (or Model)

If the investors or owners have (N) and the bond holders have (B) and the investors approach the bond holders to strike a new deal with respect to forming or buying a company, or to restructuring the debt of the company that they own, what is the best outcome within the demonstrated societal standards of risk aversion and bargaining practice?

As you can see, the statement of the problem is loaded with terms that also need a careful definition – such as “investor”, “owner”, “bond”, “deal”, “form”, “buy”, “company”, “debt”, “best”, “demonstrated”, “societal”,”risk”, “aversion” and “bargaining” – nearly every word, absent the word is from the point of view of the mathematician, but it has a solution (Goetze 2009) and the solution has consequences that may be tested in the real world of our experience and the definitions, or distinctions, that we make. The solution is the following (and we substitute “has (p)” for “has N” in deference to the mathematics):

1. If an investor has (p), they might prudently expect a return of p(1+w) and (not or, the distinction is in the word and) be prepared for a loss to p(1-w); “prudence” is in the word “and” not “or” and “prepared” is in the word “guaranteed” that (p) shall be no less than p(1-w).

2. The “return” (w) has nothing to do with “volatility” or a “standard deviation” which must accept either p(1 ± w) without distinction, and whatever return an investor might suppose or hope for, we can calculate the value of (w) that must be expected within the demonstrated societal standards of risk aversion and bargaining practice, and we have a fair chance to obtain it.

3. If the return is “satisfactory” in the above sense, then we can show that 2/3 < (1-w) < 2; that is, the prudent investor should expect to lose no more than 1/3 of their capital and plan to gain no more than 100% and although we don’t need to – and probably can’t either logically or legally – guarantee the latter, we can guarantee the former.

4. Anything else is just a gamble.

This theorem has consequences that may be tested and verified: (1) for any equity there is a least stock price at which the company is “likeable” and which is the “price of risk” and (2) any market of stocks partitions into a portfolio of stocks that behaves like a “deep discounted risk-free bond” (B) and its complement (N) which behaves like an equity investment (“The Separation Theorem” (Goetze 2009) – please see The Perpetual Bond (B), June 2012).

As prudent investors who are risk averse – we want at least to get our money back else why would we make an “investment”  – but in so doing, we should be prepared for a loss of p(1-w) but plan for a gain of p(1+w) and we need to know how that would be obtained or how that could happen, unlike the “gamble” which, figuratively, provides p(1 ± w) without distinction.

The theory and its practise is not, however, the hard part. The hard part is deciding, as with the rabbit, are we to be the hunters or the hunted? A financial innovation such as The Perpetual Bond changes the game and there are lots of folks – governments, nations and empires – who don’t want it changed, thank you very much.

“Practical men, who believe themselves to be quite exempt from any intellectual influences, are usually the slaves of some defunct economist.”

– John Maynard Keynes (1883-1946) in The General Theory of Employment, Interest and Money.

Disclaimer

Investing in the bond and stock markets has become a highly regulated and litigious industry but despite that, there remains only one effective rule and that is caveat emptor or “buyer beware”.

Nothing that we say should be construed by any person as advice or a recommendation to buy, sell, hold or avoid the common stock or bonds of any public company at any time for any purpose. That is the law and we fully support and respect that law and regulation in every jurisdiction without exception and without qualification to the best of our knowledge and ability.

We can only tell you what we do and why we do it or have done it and we know nothing at all about the future or the future of stock prices of any company nor why they are what they are, now.

The author retains all copyrights to his works in this blog and on this website. The Perpetual Bond®™ is a registered trademark and patented technology of The RiskWerk Company and RiskWerk Limited (“Company”) . The Canada Pension Bond®™ and The Medina Bond®™ are registered trademarks or trademarks of the Company as are the words and phrases “Alpha-smart”, “100% Capital Safety”, “100% Liquidity”,  ”price of risk”, “risk price”, and the symbols “(B)” , “(N)” and N*.

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