Tuesday, June 24, 2008

The Lie Must Go On

There's a pretty good piece on Portfolio.com (link down below) about a guy named Blaine Lourd, a reformed stockbroker who moved from investment bank to investment bank, disillusioned with his job. His job would be to sell hot stock tips by cold calling rich people and apparently, he got sick of losing all his clients' money. Eventually, he bought into the "efficient market hypothesis", a Truth proselytized by every self-respecting academic (i.e. the idea that it's impossible to beat the market). He cynically concluded that Wall Street was a place:

"where arrogant con men get paid ridiculous sums to perform work that is of no value to their clients or society."

I have no problem with the first part of this assertion. By any reasonable account, Wall Street does seem to employ arrogant con men, and these testosterone-filled self-righteous assholes do get paid a ridiculous sum of money. However, I feel like I need to take issue with the second part of Lourd's statement.

Finance does all sorts of good things for the society as a whole. It's a bit difficult to wrap your mind around, but what our Financial system does is allocate capital and diversify risk. What does this mean? Well, imagine you're a central planner of the old USSR. Let's say that a couple new inventions come out: first, the Xerox machine and second, satellites. How many resources should the USSR put towards building each invention? It's a trick question. There's no right answer - thus, why soviet central planning was such a spectacular failure.

As it turns out, financial markets can solve the allocation problem almost by magic. James Surowiecki coined the term, "the wisdom of crowds". Don't believe me? Here's a fun science fair experiment for you: get a jar of pennies and have people guess how many pennies are in the jar. Measure the average of all the guesses, and take note of the guesses that were closest to the real number of pennies. Most of the time, the average guess will be much closer to the actual number than that of any of the individuals. Pretty wild, huh?

So yes, this process is of allocating capital is of plenty of value to society; without these markets, capitalism wouldn't function. The capital from initial public offerings goes to companies that use the money to hire more employees, build factories, expand, etc. The money raised selling municipal bonds pays for our hospitals and bridges. And what's more? Through our financial system almost exactly the right proportion of capital goes to each company!

Another amazingly important function of Wall Street is to diversify risk. What does this mean? Well, over the years, banks have been smart enough to slice up both corporate ownership and big loans into bite sized "securities" - stocks and bonds respectively. Back in the 19th century, if you wanted to own Heinz you would have to be incredibly wealthy and buy up part of a partnership. Nowadays, anyone can own a little piece of Heinz, and a little piece of Google, and a bit of Comcast, maybe some Exxon Mobil...

"But Chris! All of that is well and good, but you're talking about primary markets! What about the money that I put in a mutual fund, a hedge fund, or the hot tip that Blaine Lourd gave me over the phone?" The key here is to separate what's good for the client vs what's good for society. Yeah, it's true: if you, as an individual, are putting a chunk of your equity into a mutual fund or actively trading it yourself, you're a fool. Everyone in finance knows this. If they say otherwise they're either: a. an idiot, b. lying to themselves, or c. lying to you. 99.99% of individual investors should call up Vanguard and buy up a handful of low cost index funds and forget about them until they're 65.

But suddenly we get to a dilemma - what if everyone did just put all of their money in index funds instead of foolishly trying to beat the market? Well, our financial system would cease to function. This is another concept that's difficult to wrap your mind around, but it's important. Every single financial market depends on one thing and one thing alone - liquidity. What is liquidity? Well, going back to the Finance 101 definition, how liquid an asset is how easily you can "covert it into cash" (i.e. sell it). You can sell a stock much faster and easier than you can sell, say, a car. Why? Because there's a big, centralized market for stocks in New York that has a whole lot of prospective buyers; the market is very, very active. So in literally minutes, even seconds, you could sell your stock. But why is the market so active? Because there's a whole class of people that think that they can beat the market by picking stocks, timing trades, etc (even if they can't). The primary market that we were glowingly talking about earlier (the IPOs of stocks and bonds and such) depends on this lively, liquid aftermarket.

So now we've reached a contradiction. What is best for the individual is not what is best for the group. The very concept that people can systematically beat the market is very wrong, but deeply ingrained into our society. I remember watching a TV show called "Wall Street Warriors" on CNBC. This show was fascinating for a Finance dweeb like me. It chronicled the success stories of all sorts of young "day-traders", who would attempt to beat the market through silly things like chart patterns and volume signals. What fascinated me wasn't the young traders themselves, who were using downright stupid and reckless strategies and are probably broke by the day I'm writing this, but the characterization and idolization of these people as Geniuses. Indeed, going to school in Boston and even moreso in Hong Kong, I'm bombarded by these self-righteous, self-proclaimed geniuses that tell stories about all money they've made day-trading. "I bought Google at $200!", they'll bombastically proclaim. But then I dig a little deeper, asking what strategies they use or inquiring about a written chronicle of their trading history, and it turns out it's all bullshit. Maybe they did buy Google at $200, but then again, maybe they also bought Bear Stearns at $130. Maybe they never owned Google at all. It makes me laugh, but deep down I know that this person will go onto make an excellent broker.

So what's the point? The idea that smart people can beat the market is a compelling narrative. Active money management is a lie, but it is a Useful Lie. And the Lie Must Go On. And the Lie Will Go On, because humans are designed to believe it. If your neighbor gets rich, it's not a satisfying conclusion to say, "well, he got lucky using risky strategies based on the random fluctuations of a complex system". It never will be. "He got rich because he's smart - and daring. And if he could do it, goddammit, I can too!"

If you view trading within a microcosm, it is a silly game. But the silly game must continue, because our economy depends on it.

The Evolution of an Investor
Michael Lewis

1 comment:

timothy said...

i was that young day trader in wall street warriors that u're referring to who turned $12k into $2mil, i invite u to check out what i'm doing now...up 60% since november, trading part-time no less!