The hidden maths of derivatives unlocks powerful signals for investors

The hidden maths

Tom May, Chief Executive & Investment Officer

A little under a hundred years ago the world was hit by the worst stock market crash in history. The causes of this earthquake were initially hard to identify for contemporaries who had only days earlier been gayly bidding up stocks minute by minute.

One man who tried in the years after the crash to understand it was the economist Ken Arrow.

He won the Nobel prize for his efforts as he sought to understand how so many people could have missed what was coming. Yet when war broke out, Arrow was pressed into war time service like everyone. He was recruited by the US Department of Defence to build a mathematical model to predict the long-term weather patterns over the Pacific. The model he built was used to determine when young pilots would be sent out on dangerous missions.

After some time putting together this model Arrow had something of a crisis of confidence. He knew he was one of the greatest mathematical minds of his generation and he knew this was probably the best model on earth for predicting the weather. But he also knew it did not work.

Racked with guilt that lives were in his hands using this broken model he wrote to the Department of Defence to tell him he could not predict the weather and ask for the programme to be halted.

Days later, as he awaited for his disbandment he received a terse reply from the Pentagon by telegram: ‘The Commanding Officer is well aware the models are no good. However, he requires them for planning purposes.’

It is easy to mock those generals for their oxymoronic military intelligence. Yet in reality they were doing what we in finance do every day.

We make predictions about a future that in our heart we know is far more uncertain than we admit. The best brains in the brightest financial institutions often fail to spot the most fundamental changes taking place in the world. One of Arrow’s later key collaborators Paul Samuelson recognised this and produced a piece of work called ‘Samuelson’s Dictum’. It argued that the market is very good at spotting small changes in the world – for example estimating Barclays earnings next quarter to within a penny or so. But it’s very bad at understanding the big things that change in the world – political upheaval, technological change, pandemics.

For most investors the inability to be right about the future does not stop them trying.

We are taking a different approach at Atlantic House. Instead of trying to pretend we know the future we focus on the more manageable and more realistic goal of making that future just a little bit less uncertain. We build investment products acknowledging that whilst we don’t know where the market is going we are able to say with a high level of confidence how our investments will behave in a variety of different market conditions.

As we enter 2023, we showcase here what is on offer from us for investors who wish to build predictability into their portfolios. We will see how the expected return on our Defined Returns fund is higher than it has been for some time. We will also examine how the strong correlations that we have seen over the past year can be tackled to find genuine diversifiers with our Uncorrelated Assets fund.

We hope that you find these investments valuable as you seek to build resilient multi-asset portfolios.

CAPITAL AT RISK