Benford’s Law: Are Euro States and US Stocks Fiddling Their Figures?

Note: the author of the Benford analysis on US stocks has (at least temporarily) recanted: "D'oh, I've discovered an error in my original calculation on Benford's law.  I will post a revised analysis when I'm confident in its accuracy, but in the meantime I'm keeping this post up for the public record only.  The results and conclusions below are not to be trusted."  (http://econerdfood.blogspot.com/2011/10/benfords-law-and-decreasing-reliability.html).  Ahh, the dangers of non-peer reviewed material …

Scary Statistics

As we’ve previously seen, Benford’s law – one of the odder practical truths revealed by statistics – is a great tool for identifying fraudulent accounting, a good indicator that’s there’s something afoot in the footnotes. Now, though, we have a couple of new examples of forensic analysis using the technique, and they don’t make comfortable reading if you’re long of equities; or indeed anything other than sub-automatic weapons and a bricked-up cave.

So on one hand we have evidence suggesting that US corporations are systematically manipulating their accounts, and on the other that the real depth of the issues in the Eurozone are yet to be revealed. If true, we’re a long way from resolution of this particular, and peculiar bust.

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Forensic Finance, Benford’s Way

Misnamed and Mad

One of the more curious statistical anomalies of the universe has turned out to have a range of practical applications in the world of finance. It also turns out to be one of the stranger laws underpinning the stockmarket, although figuring out why is a painful process.

Above all, Benford’s Law can be used to spot financial fraudsters because of a psychological quirk that means we humans are dead useless at pretending to be random. All of this comes from a law that was discovered by one man, explained by another and named after a third. Now that’s random.

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Spamanomics

Choking on Spam

Spam is a habitual hazard of publishing your email address. Sadly if you don’t tell anyone how to contact you won’t get contacted, so spam is an unfortunate reality of life. However, spammers aren’t jamming up our inboxes for the fun of it, they’re pursuing a business model with measurable success.

Of course spam isn’t simply an economic issue, it’s a problem for investors as well because so-called stock spam is surprisingly effective at manipulating markets. Micro-cap investors need to be careful that they don’t choke on the stuff.

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Gaming the System

Bankers and Politicians

Using the rules of any system for personal gain is, in the parlance, “Gaming the System”. We’ve seen a lot of this recently. Not only have a variety of financial executives and employees absconded with bonuses for profits that turned out to be illusory but here in the UK the whole political system has been rocked by revelations of the extent to which our elected politicians have been using their expenses system as a personal cash machine.

Charlie Munger states that the people who design easily gameable systems belong in the lowest circle of hell. However, the reason why this happens is rooted very deeply in human psychology and causes all sorts of effects that are bad for us as societies. Those people who invent mechanisms that prevent systems being gamed do us all a favour, and this matters hugely to investors.

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