The online version of my monthly Research magazine column — from the June issue — is now available. It discusses “a grand conundrum for the world of finance — we desperately need to make forecasts in order to serve our clients but we are remarkably poor at doing so.” I hope you will read it and the entire issue.
Regular readers of this site have seen this from me before and can read it on the masthead above: Information is cheap but meaning is expensive. But that wasn’t always the case.
For most of its existence, the investment business was driven by information. Those who had it hoarded and guarded it. They tended to dominate the markets too, because good information could be so very hard to come by. But the inexorable march of time as well as the growth and development of information technology has changed the nature of the investment “game” dramatically. Success in the markets today is driven by analysis — in other words, meaning.
As Clay Shirky has pointed out (based upon Dan Sperber’s Explaining Culture), culture is “the residue of the epidemic spread of ideas.” These ideas are, themselves, overlapping sets of interpersonal interactions and transactions. Thus culture is predicated upon a network consisting of the externalization of ideas (A tells B that “successful investing is…”) and the internalization of expressions (B decides that “successful investing is…”). This network allows for ideas to be tested, adapted and adopted, expanded and developed, grown and killed off based upon how things play out and turn out. Some ideas receive broad acceptance and application. Others are only used within a small subculture. Some fail utterly. All tend to ebb and flow.
That explanation of culture seems directly applicable to the markets, especially since culture itself is best seen as a series of transactions – a market of sorts. If I’m right about this, understanding the markets is really a network analysis project and is (or should be) driven by empirical questions about how widespread, detailed, and coherent the specific ideas – the analysis and application of information (“meaning”) – ultimately turn out to be.
Because there is no overarching “container” for culture (or, in my interpretation, the markets), creating (or even discovering) anything like “rules” of universal application is not to be expected generally, especially where human behavior is part of the game. That would explain why actual reductionism – lots of effects from few causes – is so rare in real life. Thus seemingly inconsistent ideas like the correlation of risk and reward and the success of low volatility investing can coexist successfully. Perhaps more and better information and analysis will suggest an explanation, but perhaps not, and we’ll never be able to explain it all.
“Einstein said he Could never understand it all.”
As information increases – within given markets and sub-markets or within the market as a whole – so will various efficiencies. That means that various approaches and advantages, as the ideas that generate them, will appear and disappear, ebb and flow, over time. Trades get crowded. What works today may not continue to work. As the speed of information increases, so will the speed of market change.
Markets – like culture – are thus “asynchronous network[s] of replication, ideas turning into expressions which turn into other, related ideas.” Some persist over long periods of time while others are fleeting. But how long they persist remains always open to new information and better analysis.
In today’s world, with more and more information available faster and faster, it’s easy to postulate that market advantages will be harder to come by and more difficult to maintain. But an alternate (and I think better if not altogether inconsistent) idea is that the ongoing growth and glut of data will make the useful interpretation of that data more difficult and more valuable.
The ultimate arbiter of investment success, of course, is largely empirical. Obviously, we should gravitate toward what works, no matter our pre-conceived notions. No matter how elegant or intuitive the proposed idea, only results should matter. In our information rich world, those who can extract and apply meaning from all the reams of available information will be in ever-increasing demand. Those who cannot will and should fall by the wayside.
Typical thinking — thinking that should be cast to the dustbin of history — fails to grasp the complexity and dynamic nature of financial markets. Which brings me to my topic today.
Note: This is my 1,000th post at Above the Market, which began publication nearly five years ago, in August of 2011. I remain as astonished as ever at the attention it has received. I am grateful to each and every reader. Thank you.
In 1821, a man named William Hart dug the first natural gas well in the United States on the banks of Canadaway Creek in my home town of Fredonia, New York. The well was 27 feet deep, was excavated by hand using shovels, and its gas pipeline consisted of hollowed out logs sealed with tar and rags. Natural gas was soon transported to businesses and street lights in town. These lights frequently attracted travelers, often causing them to make a significant detour to see this new “wonder.” Expanding on Hart’s work, the Fredonia Gas Light Company was formed in 1858, becoming the first American natural gas company.
Gas lighting is thus an inexorable part of my personal history. But I’m even more interested in gaslighting.
In the 1938 play Gaslight, a murderous husband is intent on inducing instability in his wife in order to accommodate his venality. When she notices that he has dimmed the gaslights in their house, he tells her she is imagining things—that they are as bright as ever – as a way to get her to question her senses and her sanity. The British play became a classic 1944 American film from George Cukor, starring Ingrid Bergman as the heroine and Charles Boyer as her abusive spouse, out to convince her that reality is not what she perceives. In this sort of story, our most dangerous enemies are always those closest to us, masquerading as lovers and friends. Gaslight reminds us how uniquely terrifying it can be to mistrust the evidence of our senses and of what we know to be true.
Taking off from the film, “gaslighting“ in contemporary usage means a form of intimidation or psychological abuse whereby false information is systematically presented to the victim, causing him to doubt his own memory, perception or even his sanity. As in the movie, gaslighting is a hallmark of domestic abuse, but one can see its use and impact almost everywhere. I wrote much of this while in Washington, D.C., perhaps the world’s gaslighting capital.
In the investment management world, the overarching priority for the vast majority of money managers is to gather assets and revenues and only peripherally to provide quality performance for investors. Gaslighting is routinely used to try to obscure those priorities and to convince investors that, despite the reality of what they see, investing in product X or with firm y is a smashing good idea. Continue reading
Thank you, StreetEye.
“[This is] the most important message taught by the history of science: the subtle and inevitable hold that theory exerts upon data and observation. Reality does not speak to us objectively, and no scientist can be free from constraints of psyche and society. The greatest impediment to scientific innovation is usually a conceptual lock, not a factual lack.”
The hurdles that money managers must overcome to meet Samuelson’s challenge and beat the market are extremely high. The vast majority of managers who try to do so will fail, even though many of them are extremely talented and dedicated. Casual investors have no need or reason to beat the market, no matter what active manager marketing may suggest. Owners of an S&P 500 index fund generally own shares in 500 excellent companies. There is nothing inherently wrong with that. Nor is there anything wrong with utilizing market “factors” to try to improve investment performance. But investors in “smart beta” or similar strategies shouldn’t expect outsized performance.
Investors who want or need substantial outperformance need to look for and at smaller funds with concentrated portfolios of quality assets that are held a long time to have a plausible chance of success. But these investors ought to understand that most such attempts fail and that the desired success is getting harder to achieve each and every passing day.
If you don’t read it already, the Five Books series is well worth your while. Its premise is simple and profound. In new interviews published every Friday, various experts recommend the five best books on their areas of expertise. Some good examples are linked below.
- Jason Zweig on Personal Finance
- Burton Malkiel on Investing
- John Gapper on Financial Speculation
- John Kay on Economics in the Real World
- Tim Radford on Science Writing
- Vanora Bennett on Historical Fiction
- Rick Telander on American Football (and its Dark Side)
Rather than simply stealing this idea and applying it to the investing world, I asked some influential people in the world of finance about the five books that most influenced them and didn’t limit their choices to a particular field or category. I hoped to get some broadening of our collective outlook.
My five books of this sort follow (in no particular order).
- The Black Swan, by Nassim Taleb
- Thinking Fast and Slow, by Daniel Kahneman
- Ubiquity, by Mark Buchanan
- Superforecasting, by Philip Tetlock
- Against the Gods, by Peter Bernstein
And since it’s my blog, I can add a novel because I think literature is so valuable and important. My choice is Lila, by Pulitzer Prize winner Marilynne Robinson, who I think is our greatest living writer. In fact, read the trilogy (which also includes Gilead and Home) and thank me later. And, since his back-story is similar to my own (in his case at Salomon; in my case at Merrill), I love Michael Lewis’s Liar’s Poker.
Here are the replies I got. If I missed you, please provide your five in the comments.
My April Research magazine column is now available online. Here’s a taste.
To repeat my assertion from last month’s column, proper financial advisor priorities begin with a recognition of what is important and what is achievable. Clients and prospects routinely have unreasonable expectations. But they are just as routinely egged on by financial advisors whose own claims and expectations are just as outlandish. The outrageously silly expectations of the consultants described above make the point beyond dispute.
No matter what the DOL and the SEC choose to do or not do in this regard, true success for both advisor and client will require carefully and truly doing the right thing, even when the client doesn’t see it that way. Doing so demands not just a higher standard of care, but also a much higher standard of practice. It should be axiomatic that a higher practice standard will require much higher training and educational standards. Fiduciary standards won’t hurt in that regard, but they aren’t nearly enough either.
I hope you’ll read it all.
It isn’t “Weird Science” (Oingo Boingo)…
…or “Brain Damage” (Pink Floyd)…
…or even “Insane in the Brain” (Cypress Hill).
It’s utterly human (and I write about it often). We are all deeply flawed. We have inherent flaws and weaknesses that impede good judgment and good behavior. Behavioral finance has done a pretty good job outlining these foibles and music does a great job demonstrating them. So let’s get started with our Behavioral Finance Playlist. Continue reading