A casualty of chance

April 20, 2009 in Finance,Risk

I discovered this Atlantic article ("Why I Fired My Broker") on MB's blog.  I came to enjoy it in the end, but while I was reading it I was struck by how representative it is of contemporary financial journalism.  This is the new cookie cutter article: naive reporter is encouraged by rich capitalists to invest, loses everything, gets insightful quotes from capitalists on what he did wrong.  Along the way, he - and we, his audience - learn a bit about the markets.

We start out by meeting our journalist, Jeffrey Goldberg, who promptly informs us "I took a random walk down Wall Street and got hit by a bus."  Good start.  He follows it with the obligatory quote from a "financial advisor" (Richard Bernstein, Chief Investment Strategist of Merrill Lynch), urging him to adopt a buy and hold strategy so to give his "strategy time to reach gestation." To which Goldberg wryly observes

But my investment strategy gestated for 15 years. And then it died.

This was, for me, a red flag that maybe Goldberg wasn't going to be as insightful as I hoped.  If he's had a portfolio for 15 years, then this is his portfolio's second death, the first coming seven years ago.  But the disclaimers come marching - worst recession in history, going to get worse, everything is bad - so we'll give him the benefit of the doubt.

And it's a good thing we do, because his interview with Robert Soros is worth the price of admission and then some:

I went to see [Soros] at his office, where he spent two hours performing an autopsy on my assumptions.

“You think a brokerage should be a place you go to pay commissions for fair and unbiased advice, right?” he asked.

“Yes,” I said.

“It’s not. It never has been.” He then cited another saying of Buffett’s: “‘Wall Street is a place where whatever can be sold will be sold.’ You are the consumer of their dreck. What they can sell to you, they will sell to you.”

“But they told us—”

“They lied.”

He went on: “You should be disheartened and disappointed. But don’t kid yourself. You’re a naive capitalist. They were never your advisers. Do not for a moment think that a brokerage firm is your friend.”

“So who’s my friend?”

“You don’t have one. This is the market.”

“Okay, that’s Merrill Lynch. What about the others?”

“They’re not your friends,” Soros said patiently.

“What about Chuck Schwab?”

“All brokers move products based on volume and commission,” he said.

And so we have insight #1: brokers are salesmen. Period. Cynically, if they could pick stocks better than anyone (because presumably, that is their qualification), then they would be.  Now there are in fact excellent brokers out there - but do not confuse paying for their insight with paying for their execution.

Goldberg imparts a second important point via parable, when two close friends alternatively give him convincing arguments for why he should/should not buy gold.  Insight #2: anytime someone gives you investment advice, he is wrong. If two people give you completely opposite pieces of advice, they are both wrong.  Even when history bears out one of their opinions, it remains nonetheless wrong.

If you took bets on whether a fair coin would land heads or tails, would you attribute the winners with any special knowledge of coin dynamics? (I'm such a statistician... I can't even write about a coin toss without specifying it's "a fair coin")  So it is with stocks: reality will end up reflecting one opinion or the other, but that is merely a casualty of chance. One could argue that the stock market is not random, that there is real reaction to news and if you can predict the news you can predict the market.  In my mind this is like saying that the coin's path is deterministic: it is subject to the initial velocity and rotation it gets from my finger as well as friction from air molecules it passes, not to mention wind.  Sure, with knowledge of the exact state of the world you can tell me what side will land face up.  But you don't have it.  And as long as there are people willing to take opposing opinions in the markets, you don't have it there either.

The eventual outcome of an asset's price is determined by the push and pull of millions of people expressing their various opinions.  The result of that outpouring of noise is that, by chance, one side will win out, because the marginal person agrees with that opinion.  And to the extent that everyone suddenly acquires the same opinion, the market will jump quickly and - yes - efficicently to reflect that fact, leaving you (the naive journalist) no time to participate.  Compound that with a constant flow of new information and the market participants' fickle mindset and you have an absolutely unsolvable puzzle.  So the next time someone claims to know exactly how the market will turn out, remind them that enough people must find the alternative just as obvious, or there would be no opportunity for debate.  There are people who actually do know what's going to happen.  Most of them are figments of overblown marketing and bull market longs, but they're out there.  Maybe your friend with the stock tip is one of them.

Interestingly, the Wikipedia article on Brownian motion (the statistical behavior most commonly used to model asset prices) includes the following example:

Consider a large balloon of 10 meters in diameter. Imagine this large balloon in a football stadium. The balloon is so large that it lies on top of many members of the crowd. Because they are excited, these fans hit the balloon at different times and in different directions with the motions being completely random. In the end, the balloon is pushed in random directions, so it should not move on average. Consider now the force exerted at a certain time. We might have 20 supporters pushing right, and 21 other supporters pushing left, where each supporter is exerting equivalent amounts of force. In this case, the forces exerted from the left side and the right side are imbalanced in favor of the left side; the balloon will move slightly to the left. This type of imbalance exists at all times, and it causes random motion of the balloon. If we look at this situation from far above, so that we cannot see the supporters, we see the large balloon as a small object animated by erratic movement.

Substitute "stock price" for "balloon", "buy" for "right" and "sell" for "left", and you have quite an interesting piece of financial journalism there.

But I digress.

Goldberg then descends into the world of the survivalists and I'm going to skip that part because, while entertaining, it's hardly relevant.  He does have an interesting conversation with Seth Klarman, in which one of the fundamental truths about the American economy is revealed:

“I haven’t leveraged myself,” I said.

He asked me if I had a mortgage. Yes. He then asked me if the amount of money I had invested in the stock market was greater than the amount I owed on my mortgage—could I liquidate what remained of my portfolio to pay off my mortgage? I could.

“So you are leveraged."

America runs on Dunkin debt.  It's how we got where we are, and it's how our government plans to get us out. But most of us don't realize that.  There is nothing inherently wrong with leverage, it is merely a tool of capitalism (albeit a sometimes dangerous one).  But there is a massive problem with not understanding how it impacts one's finances.

But the most important line in the whole article was when Goldberg protested thusly:

“But if I dump my portfolio now, I make my losses real.”

This is not the first time I've heard the very strange notion that losses on paper are somehow less than real. It's not an attitude restricted to naive journalists. In fact, it is similar to the attitude which has frozen our markets - banks hoarding assets, terrified of marking them to market, as if hoisting its value on the balance sheet somehow translates to reality. The very crux of the mark to market argument is that your asset is only worth what someone will pay for it. The second your investment drops $1, you just lost $1.

I think part of this is grounded in the idea that equities will, inevitably, go up.  In that world, to exit a position is to surrender the opportunity to make money when they resume their climb.  The catch, of course, is that equities don't always go up.  That seems to be the underlying assumption of every naive journalist piece - how come my stocks stopped going up? Stocks are a risky asset; if they weren't, then they wouldn't rise much at all (see: Treasury bonds). Risky assets fall sometimes; that's what makes them risky.  There was a lot of attention lately to the finding that over a long timespan bonds had outperformed stocks.  Is there anything else in the world about which people would be surprised when a less risky strategy outperformed a more risky one over time?

One of Goldberg's early arguments revolves around the notion that you have a 46% chance of losing money by investing in stocks on any given day, but the chance decreases over time (an obvious statement).  Unfortunately, probability of loss is not really the metric by which we make investment decisions.  Otherwise we would all own CD's and nothing else.  Instead we balance the promise of return with the risk of loss, massaging our personal utility functions until we feel comfortable with an investment's profile.  Unfortunately, we are utterly unequipped to asses either risk or return.  Goldberg finally resigns himself to "3 or 4 percent gains a year, or 1 or 2, if necessary." I'm left wondering if he realizes that can be had - with absolutely no risk - if he just buys Treasuries.  But in naive journalist form, he remains confident in equities, feeling that now that he's seen how bad it can get (for the second time, remember) he'll be wiser for the lesson.

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