Novelty, Unicorns and the Stressed Investor

Bad Hair Days

There’s a Groundhog Day effect in financial markets: wait long enough and another crisis will occur and everyone will be stunned and surprised. In fact they’ll be just as stunned and surprised as they were the last time one occurred. We’ve the attention span of a distracted goldfish when it comes to noticing the disconcerting regularity of market mishaps.

But although market upheavals are frequent they’re not so frequent that we get used to them. The steady state is a constant background hum of noise punctuated by occasional bouts of excitement over some stock or other. When a crisis occurs it’s a novelty – and for most of us our response to novelty is to get stressed, and then run around like our hair is on fire. By and large, I'd observe, this is not optimal investing behavior.

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Quality Plays

Rational Exuberance?

One of the odder financial bubbles we saw in the last century was caused by a bout of temporary insanity in the 1970's over a group of the biggest and best American corporations. The so-called Nifty Fifty were, for a while, promoted as the must have, long term buy and hold stocks. And with a certain pleasing inevitability the stocks soared and then, in strict adherence to the law of financial gravity (and very grave it is, too), plummeted. Another mental meme dashed against the rugged rocks of reality.

Only this story isn’t so simple, because the Nifty Fifty weren’t a bunch of story stocks flung high by the whim of investors’ irrational exuberance. They didn’t just disappear having made their owners very rich and their shareholders poorer, and no wiser. The afterlife of the Nifty Fifty tells us an interesting story about the nature and durability of quality in the stockmarket: quality plays, if you understand the rules of the game.

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The Dangerously Miasmic Myth of a 4% Safe Withdrawal Rate

Miasma

One – rare – area where academic economic research intersects with the interests of private investors is on the topic of Safe Withdrawal Rates – the maximum amount you can safely withdraw from your investment pot each year following retirement. Opinion is divided on exactly how much is safe, but the general consensus is somewhere in the region of 4%.

Of course this is utter baloney. As usual, when academic analysis meets commonsense understanding it creates a perfect miasma of miscomprehension and, no doubt, bad retirement planning. Your safe withdrawal rate is dependent on you, not on some mythical, half-baked rule of thumb.

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Bah, Humbug … The Value of a Child’s Gift

Adulthood

One of the neat things about economics is that it provides different ways of thinking about problems. Take adulthood for instance. This, you might think, is a vague concept which has something to do with children no longer borrowing money from you and not giving it back. Or even leaving home and not returning. An economist, though, sees it differently: adulthood is the moment your child’s spending on Christmas gifts exceeds the value of those they receive. Bah, humbug.

The creep of economics out of its natural domains, finance and resource management, into other areas has a name: economic imperialism. This creep has supposedly been going on for a long time, and has happened so insidiously that it’s been hard to spot. Yet given that we all know that economics is less a science than an invocation of the dark arts of the necromancer this isn’t necessarily a good thing. Maybe, though, this points us in the direction of some overdue reforms of markets, shareholder rights and, perhaps, even capitalism itself.

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Ending The Divine Right of Bankers

"The bank mania… is raising up a moneyed aristocracy in our country which has already set the government at defiance, and although forced at length to yield a little on this first essay of their strength, their principles are unyielded and unyielding. These have taken deep root in the hearts of that class from which our legislators are drawn … and thus those whom the Constitution had placed as guards to its portals, are sophisticated or suborned from their duties."

Thomas Jefferson, Letter to Josephus B. Stuart, May 10, 1817

Kings By Any Other Name

Thomas Jefferson's fears about the potential capture of government by a wealthy minority mirrored his experiences in Europe where, acting as the American ambassador to France before and during the French Revolution,  he saw at first hand the effect of government under the control of the rich and the powerful, where hereditary monarchs ruled by divine right: by the will of God. In Jefferson's view the American constitution needed to ensure that the state was prevented from setting aside its revenues for a favoured few: because otherwise the difference between the actual aristocracies that governed Europe in their own interests and the "moneyed aristocracies" overseeing the United States would differ in no way meaningful at all.

Equating this version of democracy with capitalism is no great leap: if everyone is possessed of equal rights and opportunities then that some succeed and become wealthy and others fail and don’t is to welcomed. However, if the rich and powerful can suborn the government to protect their interests at the expense of everyone else, then this is not capitalism; and it risks being not democracy, too. That those who rig the markets in their favor then accuse those who protest of being anti-capitalists is no surprise, merely the behavior of tyrants everywhere.  Capitalism requires that those who take risks and win should be rewarded, and that those who lose should be punished, not bailed out by a compliant state like a medieval monarch dispensing largesse by divine right.

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Frankenstein’s Corporations

Immortal Corporations

Back in 1819 the US Supreme Court, an august group not usually known as a centre of radical creationism, took the unusual step of inventing artificial life. Moreover they then, in a Frankenstein moment, added the proviso that their monstrous offspring should be blessed with immortality.

The object of this life-giving largesse was the hitherto humble corporation, which was suddenly invested with superhuman properties. Unfortunately the lawmakers couldn’t artificially imbue corporations with morality or a sense of justice so having made them indestructible they left the rest of the world to deal with an ethical dilemma that sees companies given human rights without needing, or expecting, to behave so as to deserve them. Back to the courts …

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Triumph of the Pessimists

Bad Stuff Happens

Given that markets are pursuing their favourite pastime of bouncing up and down like a manic depressive doing the Hokie Cokie on a Space Hopper, investors might be forgiven for wondering what they should do next. Fortunately the world is full of people offering sage advice. Unfortunately none of it is very useful, at least where 20:20 foresight is concerned.

The underlying lesson is, perhaps, an odd one.  We should invert the normal mindset of the average investor, who's an inveterate, if rather foolish, optimist, and proceed on the basis that something is always about to go badly wrong.   After all, it nearly always is.

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The Proper Etiquette for Market Panics

Don’t Eat Soup With a Fish Knife

When we’re operating in situations we’re not entirely sure about we follow a simple rule of thumb: we copy what other people are doing. So if we’re attending a fancy dinner with a place setting of sporks and splayds we’ll probably do whatever the people next to us are doing, in an attempt to look as though we understand the proper etiquette.

Which works beautifully as long as someone knows what to do, but can be disastrous if no one has a clue. Which is all the explanation we need to understand why, currently, investors are trying to eat soup with a fish knife.

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Black Swan Down

Uncertainty Up

The world is suddenly full of uncertainty: tsunamis, nuclear threats, civil wars, regime changes and sovereign debt default are all high on the agenda. Yet, despite this plethora of potential pitfalls, markets have remained remarkably sanguine, for the most part.

We should expect, surely, that sudden and frightening events such as these, some of which at least are genuine Taleb style Black Swans, should send investors and markets into a dramatic tail-spin. Yet it ain’t so, and there’s a lesson here, which is that markets aren’t moved by events in quite the way we think they are.

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Moral Hazard, But Thanks For All The Fish

Vanishing Regulators

Regulators spend a lot of time worrying out loud about moral hazard, the problem that occurs when people don’t have to take risks commensurate with their potential rewards. This sort of ignores the point that if moral hazard didn’t exist most of the need for regulators would disappear overnight.

Still, there’s a sneaking suspicion that a lot of the problems investors face are less to do with moral hazard and more to do with the problems caused by behavioural biases that cause organizations to fail to manage information successfully. This so-called intellectual hazard, it’s suggested, lies behind some of the securities industries biggest boo-boos.

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Losing the Lender of Last Resort

Governments Aren't Risk Free

One of the carefully nurtured ideas that sits at the heart of most modern finance is the idea that there’s a risk-free asset that we can retreat to when we lose our nerve. This is the financial equivalent of the philosopher’s stone, capable of saving us when nothing else is.

Almost by definition the lender of last resort is the government and the risk-free asset usually ends up being government backed debt. The only slight fly in this magic ointment is that not only is government debt not risk-free but neither are governments themselves: it turns out they have a nasty habit of not being there exactly when you need them most.

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No Need For A Drawdown Drama

Get Out Less

Whenever markets go into free-fall we see a certain drama play out: participants firstly refuse to believe things are going wrong, then gradually subside into confusion before eventually capitulating and demanding that something needs to be done and that someone’s to blame. Generally, of course, the people most to blame are the ones in the mirror in the morning who’ve either let greed get in the way of good sense or fear in the way of opportunity.

Sadly these people are obviously getting out too much and not spending their evenings studying the statistical lessons of stockmarket history. What these tell us is that although we can have no idea how markets will next go loopy we can guarantee that they will. And every year that they don’t just makes the slippery slope that much steeper.

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Why Markets Crash

An Unsteady Aim

Oddly there’s little agreement amongst the experts about why markets crash. Although given that experts in fields without objective measures of success are generally less accurate than a drunk in a ship’s urinal during a storm that’s not really surprising. Still, if the best that the world of investment has to offer doesn’t know when stuff’s overvalued then how can we possibly hope for an end to boom and bust?

There’s no getting away from the reality that the inability of analysts to know whether markets are overvalued or not leads to serious problems. Pundits, who have a record of prediction that makes amateur astrologers look like geniuses, are delighted to proclaim the inadequacies of regulators and analysts but, frankly, have nothing better to offer. Sadly, history doesn’t offer much in the way of solace: it’s only hindsight that gives us superior knowledge.

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In Markets Bad Stuff Happens – Frequently

Numbers and Stories

We’ve seen before that investors are generally attracted to a good story and tend to shy away from the hard problems associated with analysing numbers. Worse, even if people do look at the numbers they tend to be swamped by information to the extent of not knowing what’s important and what’s not. Although generally this is only obvious in retrospect, anyway.

However, there are strong suggestions that our inclination to follow a good and particularly interesting story isn’t simply stuff that happens. It looks as though this is built into our processing centres and is a driving force behind a lot of what we do on an everyday basis. We’re simply misapplying the lessons of life.

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The Opportunity of a Lifetime – Again

In People We Trust, Not

In 1907 there was a nasty credit crunch. Then there was a financial crisis during the World War I and its aftermath, followed by the Wall Street Crash and the Great Depression. After World War II there was another market slump as everyone expected a repeat of the crashes after the US Civil War and World War I.

This was followed by the rise and fall of the Nifty Fifty, an eighteen year long market hiatus with an oil supply crisis thrown in, the unexplained crash of 1987, the Asian Crisis, the Long Term Capital debacle, the dot com crash and, with neat symmetry, another credit crunch. With clockwork precision an investing opportunity of a lifetime has arisen once a decade, if not more often.

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To Predict the Next Bust, Ask An Austrian

Revising The Mantra

It’s long been the mantra of the Psy-Fi Blog that no one can successfully predict anything about anything to do with finance; or anything much else, to be honest. To this, though, we probably ought to add a corollary – no one can successfully predict anything about anything to do with finance except when they do, but when they do everyone will ignore them. Tough business, this crystal ball gazing lark.

Although the history of the recent crash is too close to analyse, it is possible to look at what happened in the turn of the century debacle. It turns out that there are two groups of people who successfully predicted the market collapse – a bunch of value based investors and an obscure group of economists hailing originally from central Europe. In difficult times we must take our heroes where we can find them.

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Basel, Faulty?

Containment, Not Cure

The international banking regulations known as the Basel II Accord have come in for some stick, given the fallout from the banking crisis of 2008. This is, on the face of it, a bit unfair given that Basel II hasn’t yet been fully implemented in most countries and anyway was designed to try to head off some of the problems that have occurred.

Still, most observers reckon that Basel II wouldn’t have prevented the crisis and the tendency of regulators, like generals, to fight the last war means that proposed changes won’t help. Whatever causes the next crisis it won’t be the same as the last one and while regulators are busily building a Maginot Line to stop one kind of problem they’re unlikely to notice that they’re also incentivising banks to invade Belgium, or at least find a way to go around the new regulations. We need a new kind of regulation, one that recognises we can’t stop the disease, but that it can be contained if we act quickly enough.

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A Sideways Look At … The Randomness of Markets

Surviving Randomness on The Psy-Fi Blog

There are hundreds if not thousands of sites on the internet offering would-be investors self-help guides on how to become rich through investing in stocks. These cover the technical mechanics of investing, but generally fail to address the true art of the great investor, the management of one’s own state of mind.

Of course, here we swing to the beat of a different tune, holding fast to the syncopated rhythms of the mental processes within and between people which drive them to make investment decisions that seem often to ignore the basic logic of time and space. When examined closely it usually turns out that behaviour developed and honed to maximise our survival chances out in the real jungle is ill-adapted for the investment one. We’re frequently led astray by our instincts and unfortunately the markets trigger our reflexes all too often.

Here, then, is a selection of the Psy-Fi Blog’s thoughts on surviving the randomness of markets …

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Springing the Liquidity Trap

Bad Omens

We’re in the middle of one of the most dramatic experiments financial markets have ever seen. Central banks, across the world, have bet your house and mine on a gamble of extreme proportions yet, such is the unpredictability of markets, we’ll only know the outcome of this with hindsight, a notoriously unhelpful bedfellow.

The problem is that changes in monetary and market liquidity can trigger outbreaks of investor insanity and by pumping the world full of cheap money central bankers are gambling that they can manipulate markets to beat behavioural biases. The omens are not especially good for them getting this right.

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Panic!

Economic Stability Is Not The Norm

The exceptional market conditions of the last couple of years are a reminder that we should regard stable markets as a pleasant interlude rather than the normal state of affairs. In general, of course, people tend to expect tomorrow to be much the same as yesterday and to behave as such. It’s little wonder, then, that when everything goes wrong people start to panic, assuming the world is coming to an end.

Of course, so far, the world hasn’t come to an end – although a lot of people have lost lots of money in the meantime. What we can see from history is not that market panics are exceptional but that they’re the norm.

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