Economic Parasites

A Question of Intelligence

A question that’s oft-perplexed economists is why some countries are so much less successful, economically, than others. Huge reams of research have been generated developing a wide range of theories until eventually someone came up with the obvious answer. Poor countries are poor because their people are stupid.

Fortunately what’s the obvious answer to one set of researchers is the departure point for another group. It turns out that while the simple and straightforward answer has an element of truth about it, it’s only a small part of the story.

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Value in Mean Reversion?

Many shall be restored that are now fallen; and many shall fall that are now in honour (Horace, Ars Poetica)

From Horace to Graham and Doddsville

The quote above is now a couple of thousand years old but was used by Ben Graham and David Dodds in their seminal book on value investing, Security Analysis, a term invented by the book's title. At root it’s a simple plea for understanding that current market conditions, no matter how placid or tempestuous, will pass. The job of the conscientious investor is, at worst, to ignore the short-term forecasts or, at best, to take advantage of them.

Some psychological quirk means that a small subset of humanity latches onto this concept instantaneously and holds to it, like an investing life preserver, through thick and thin. The rest of us either learn the slow, hard and painful way or, more likely, continue to be storm-tossed. Occasionally someone gets washed up on a tropical paradise and is accounted a genius but mostly we drown, quietly, where no one can see us waving.

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Mandelbrot’s Mad Markets

Haunted By Statistics

As we've wandered down the echoing corridors of behavioural finance we seem to be haunted by a troublesome spectre, which refuses to go away no matter how much we prove to it that it’s a figment of economists’ imaginations. Discovered by Francis Galton, appropriated by Harry Markowitz and embedded in risk management models ever since, our ghoulish apparition is a mathematical construct, the Gaussian distribution, aka the bell curve.

The Gaussian distribution keeps on reappearing throughout economic theories as a rule-of-thumb description of how markets behave. With which there is just the smallest problem – markets don’t behave as it would predict. We’ve known this for over forty years, ever since Benoît Mandelbrot showed that cotton prices bound around in a decidedly peculiar way. Markets behave madly far more often than the standard models predict so why anyone should be surprised that they fail catastrophically every so often is a bit of a mystery, really.

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Regression to the Mean: Of Nazis and Investment Analysis

Francis Galton, The Measuring Man

Francis Galton, cousin of Charles Darwin, was utterly uninterested in the both the workings of investment analysts and Hitler’s future plans for world domination. To be fair he died before both really got going. However, he has the dubious distinction of being at least partially to blame for some of the madder excesses of both.

What Galton was interested in was measuring things: mainly people, although he’d turn his hand to anything in the absence of a likely suspect or two. In so doing he uncovered a statistical phenomenon known as Regression to the Mean which lies behind many of the theories which still dominate stockmarket analysis and valuation techniques today and which many people misunderstand totally.

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