The first factor driving high returns is sometimes called by practitioners “going short on volatility.” Sometimes it is called “negative skewness.” In plain English, this means that some investors opt for a strategy of betting against big, unexpected moves in market prices. Most of the time investors will do well by this strategy, since big, unexpected moves are outliers by definition. Traders will earn above-average returns in good times. In bad times they won’t suffer fully when catastrophic returns come in, as sooner or later is bound to happen, because the downside of these bets is partly socialized onto the Treasury, the Federal Reserve and, of course, the taxpayers and the unemployed.
America’s mortgages are structured so that the lender-investor is going short on volatility. If interest rates do not move much, the lender does well. If home prices do not move much, the lender does well. But if interest rates rise, the lender is stuck with a below-market asset. And if home prices fall, the lender gets stuck with a house with a value below the amount of the loan.
Tyler is saying that for the typical financial market player, going short on volatility is a great personal strategy. When it works, you get a nice salary and bonus. When it fails, someone else–a shareholder, a taxpayer–bears much of the cost.
If you know your Nassim Taleb, you will recognize going short volatility as “fragile,” with the opposite strategy as “anti-fragile.”
I wonder if stock market investment is one of those fragile strategies nowadays. You can make money year after year going long the market–until it stops.
Anyway, Tyler argues that the changes in the income distribution of recent decades
a) have been focused at the top 1 percent, not between the 99th percentile and the lowest percentile
b) been driven by finance
c) and within finance have been driven by these short-volatility, fragile strategies.
He is pessimistic about regulators’ ability to stop the short-volatility strategies. I think he is wise in that regard.