Idiot Noise Traders

Who's Noisy Now?

In 1985 Fischer Black published a paper entitled “Noise”.  In this he argued that much of the irrationality in financial markets could be explained by people trading without information: essentially using various spurious signals to decide when to buy or sell. In fact there’s an argument that without such people markets couldn’t work at all. The downside of this is that it’s difficult to separate the noise from the information.

Black predicted that there would be people who spend their lives trading on noise – so-called “noise traders”; people that Paul Krugman calls "idiots". Unfortunately these idiots generate so much noise that it’s very hard to determine the real information, which would suggest that if we're not careful, at root, we’re all idiots.

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Insider Trading – the Director’s Cut

Equivocable Insiders

Insider trading – the use of inside information about a corporation – to trade its stock to personal advantage is a major concern of regulators everywhere. Laws against this abound, and the penalties if found out are often significant: jail time awaits the unwary insider.

Of course, the ultimate insiders are company executives and there have been a lot of studies trying to figure out whether directors are any good at exploiting internal information. The evidence, such as it is, is equivocal and the reason seems to be that these privileged insiders don’t know as much as we think they do. Meanwhile insider trader laws are actually damaging the ability of markets to set prices efficiently: as ever, unintended consequences abound.

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Seeking Alpha, Finding Omega

Institutional Efficiency?

Having hopefully now established that behavioural bias in finance isn’t a figment of various researchers’ fevered imaginations we still need to think about whether the total market might, possibly, be a bit efficient. For even though psychological maladaptation seems to be everywhere we look this still doesn’t show that markets might not be basically sensible under the covers.

Consider that in the US over 50% of the monies invested in markets aren’t under the control, even by proxy, of demented, short-term private investors. No, in fact the majority of investment funds are under directed by a relatively small number of people – so-called plan sponsors – who are responsible for how institutional groups invest their cash. As they’re responsible for over six trillion dollars worth of investments these people matter – a lot – but fortunately, as they’re professionals, we can sleep comfortably knowing that markets are basically in safe hands.

That’s a joke. Kind of. Sort of. Ha ha.

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Finance: Where The Law Of One Price Doesn’t Apply

Differentiating Financial Products

Even the smartest amongst us can be fooled by the pricing structures of relatively simple financial products. In any normal industry we would expect the law of one price would be prominent – in efficient markets all identical goods must have only one price.

Now whether or not the market for financial services is efficient or not is a moot point but the industry’s ability to create a vast swathe of differentiated products could almost have been designed to prevent the law of one price from operating. With the documentation for even simple financial products running into several pages of hieroglyphics in a convoluted and slightly sinister attempt to promote “clarity” the chances of anyone actually recognising that any two products are identical is minimal. In such a situation efficiency is a pipe dream.

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Buy and Hold, the Least Worst Option?

Trigger Happy Traders?

The arguments over market timing versus buy and hold are likely to continue until the end of time. Often these debates aren’t really over the actual merits of one approach or the other but centre on the philosophy of the methods.

Proponents of timing strategies can’t understand why anyone would ever adopt buy and hold as it’s “obviously” a worse method of investing. Meanwhile supporters of buy and hold regard market timers as a bunch of hopeless goons with itchy trigger fingers. As ever, the truth is sitting about one inch behind your eyes.

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