Thursday, August 18, 2011

Economists - roll the dice

This recent spate of financial problems around the world got me interested in finance and investing.  I have been doing a fair bit of poking around on the internet to try to understand what exactly is going on, and even more importantly to understand what people actually know about the whole situation.  The only thing I can safely conclude is that nobody knows anything of any use, even the professionals (especially the professionals?).  When I watch interviews with CEOs of big investment firms who talk about how Greece and Japan are going to default on their debts in very short order and then notice that people are still buying up Greek and Japanese debt it becomes clear that there is no consensus on what is right and what is wrong.

Of course this is how the market is supposed to work.  The value of something ends up being what people think it is and since there are plenty of informed, clever people who think that Greece will never be allowed to default and others who think that it will default for sure we end up with high yield Greek bonds that people do buy.  I saw an interview with Warren Buffet who firmly believes that the US is headed out of recession and into better economic times but the bbc quotes bankers as believing that we are headed into another year of recession based on market behaviour.  What is the average person to do in such a situation?  At the moment the answer seems to be "buy gold with all your money in mid July" but nobody has a clue about where things are going.  To be sure, plenty of them have strong opinions but since people all disagree and no one has a perfect track record or working model I don't think believing any of them is reasonable.

They have so many of us fooled.  We watch the evening news and economists say "when the government does X, Y will happen" and then when the government does X, Z happens instead.  Or the government does X slightly weirdly and C happens instead.  These pundits and advisers go to great lengths to establish that they understand the markets and can predict what will happen in the future and despite irrefutable proof that their claims are bogus we go on listening.  I guess it can be laid at the feet of the human desire to see patterns.  We want to think that the market is something we can understand, something we can control.  We assume that if someone has an impressive degree, an expensive suit and a high paying job that they must be better at predicting the future of the economy than darts thrown at a dartboard.  It turns out though that they aren't.  The best returns on investments are those run by a simple 'buy a little of everything' formula (index funds) and nobody beats the market.

When I was young I played a game called Stock Ticker that simulated a simple stock market.  Each turn you would roll the dice to figure out what stocks were going to move and how.  I assumed that real stock market players would know what was going to go up and what was not - just buying stocks and hoping wasn't how real people did it.  Turns out buying stocks at random and then consulting the dice to see if you are rich or not is actually an awful lot like the real stock market.  The people involved have all kinds of information and training and yet they still struggle to beat 'roll dem dice' investing.


  1. Corporate PlundererAugust 18, 2011 at 7:31 PM

    Plenty of people make gazillions on the stock market in a fairly predictable way... the financial district in NYC is full of them.

    Of course, they cheat.

    But just get down to the basics. If you start getting all macro-economic, it seems to be utterly random, and there's truth to that. But if you choose a *specific* company and buy into that, its performance is directly linked to its bottom line, its products, its revenues; all things you can plausibly predict with enough knowledge.

    It's on a larger scale where things are harder to gauge, except even there they're actually very predictable. The difference between the wildest extremes of predictions of Greek credit-worthiness are not huge, only a few percentage points. But *because* those are so predictable, investors leverage them on enormous margins.

    And that's the hidden role of ratings agencies; they *introduce* instability and risk instead of mitigating it.

    When an entity is given a great credit rating, then lenders will give fantastic leverage when investing in it. If you want to invest in US treasuries, for instance, you can bet that you'll get a loan to do that at a ten-fold margin (borrow 90% of the total investment) with minimal interest rates. Of course, you'll lose money in that case, because the whole system is generally indexed on t-bills, but you get the idea.

    Now, you might think to yourself: "That's crazy talk! Why, I can borrow 10x my actual funds to invest in T-Bills, then use *those* as assets to borrow 10x that and multiply my revenues 100-fold!" If you carry that to its logical extreme, then congratulations, you're Goldman Sachs.

    The end result of all this leveraging is that there's a fairly standard degree of volatility in every large-scale metric.

  2. I had to 'unspam' CP's comment... not sure why.

    I agree that people in the financial sector can find strange (to the layperson) ways to make money. There are all kinds of arcane financial instruments that are used to extract cash from the markets. However, what I really wanted to get at was that the guys working the market, by and large, simply can't pick stocks or predict trends better than a dartboard. By extension the stocks that are included in mutual funds are also not better than guessing. This means that as far as the average person goes the advice given by economists and financial pundits is utterly useless.

  3. Corporate PlundererAugust 20, 2011 at 6:05 PM

    I'd disagree. Three are plenty of people working the market who are very, very good at picking stocks and predicting the trends.

    The difference is they don't go on TV sharing their insights. They make a crap-tonne of money and move to Cayman (or some variation thereupon.) Also, their methods rarely scale up; if you know a stock is likely to go up over the next 3-4 years, you can only make so much money on that without unacceptable risk. But the methods by which you made your guess on that first company might not apply the same way to another.

    I guess what I'm saying is that there are gigantic bags of money being made on the stock market. Just by different people than those you're listening to on the radio. :)

  4. The thing is, if the stock market is completely random, then there will be people who make a ton of money on it by predicting it. There will just be an equal number of people who lose a ton of money on it by predicting it. The mere fact that some people manage to predict things correctly their entire lives and make tons of money doing so is not evidence that the market can be predicted or that those people have any special talent.

    I'm not sure whether I believe that anyone can actually predict the market or not. I tend to think that there are people out there who are actually better than random, but it's hard to know.

  5. I tend to think that there are some people out there who can consistently outperform the market by a couple %. Not many, but there are a few of them. Most of the people who made a ton of money did so in the way Sthenno suggests I think - gamble big, get lucky and win and then retire to the Caymans.