Part 15: True and Useless

Here's another financial story. I first heard it with respect to stock prices in December, but the details don't matter as much as the pattern.

An investor recognizes the pattern (e.g. stock prices drop in December because people are making last-minute capital gains decisions; stock prices then rise again in the new year). The investor wants to profit off this pattern, so they buy stocks when the price is low and sell again when the price is high. Pattern exploited. Buy low, sell high. Predictable profits from having seen beneath the veil and understood more deeply than others. Genius rewarded and all that jazz.

Problem. There are many investors, all of them hungry for patterns. Their data analysis will eventually show the same (apparent) statistical regularity. They will see the same (apparent) opportunity to profit from the same predictability. More and more people buy when the price is lower... so that the price doesn't actually go lower. Everyone expects a dip, and it never happens. Later, after the new year, people are supposed to rush back into the market and make the price higher. But everyone sells in anticipation of the second half of the pattern, and the price doesn't actually go higher. What used to be bumpy and predictable ends up flat and profitless.

To notice the pattern is to destroy the pattern. To predict correctly is to lose the ability to correctly predict.

This is the same idea we've been discussing. The market price will manage to incorporate the information that people notice about it. The market absorbs available information, which is equivalent to saying that the market will destroy all easily available patterns and predictability. We can't outguess the market. It's already internalized the information.

This is one of the most important ideas in all of finance, or even in all of economics. We can call it here the Unpredictable Market Hypothesis because I don't much favor its real name. The pure form of this idea -- that the market incorporates all available information, and so can never be beaten except by luck -- is laughable. It isn't close to being true.

But that doesn't mean it isn't useful. A useful lie. I, for one, would almost never bet against it. Ideas doesn't have to be literally true to be approximately true enough, often enough, that individual human judgment is no adequate substitute.

What we're talking about here is the near impossibility of recognizing real human skill when the world is constantly changing.

I've seen gamblers claim that they can win at the slots, of all games, because their technique with randomness is so advanced. If people can maintain delusions about winning a game of pure chance with a machine specifically designed for independent trials -- and they do -- then they will similarly maintain delusions about winning a game where skill typically plays a non-zero but nevertheless small component. This is not to dismiss the existence of skill. It's just about impossible to read about Michael Burry, profiled in The Big Short, and believe he was one of the lucky ones. If the story is accurately told, then that was as close to pure skill as anything in the investment community comes. But that doesn't mean that the typical investor who times their short-sale correctly is also similarly skilled, as opposed to lucky, and even more importantly, a few anecdotes about a few select people being completely right at one time in one particular market situation does not provide us with any tools about how to consistently differentiate between luck and skill across many markets and longer time periods. If the boy who cries "wolf bubble" eventually turns out to be right, is that luck or skill? Should we listen to the investment consultants who have correctly predicted nine of the last five market collapses?

John Paulson was probably the biggest winner of the subprime collapse. What an authority! Many investors flocked to his fund to take advantage of his oracular vision... only to lose massive amounts of money as his apparent predictive power subsequently flagged. Was it originally luck? Was it skill? If skill, where did his skill go?

I don't deny skill, but the problem with these sorts of skills is that they are, unfortunately, inescapably linked to a fallible human mind. The world is always changing. New shit is always happening. The picture in our heads which we use to understand the world, even if it is a correct picture that was skillfully created by many years of experience, can nevertheless become archaic overnight with one shift in the fault lines. A person who has been enormously successful one time, with one model, will almost invariably over-rely on that model in the future even though the world has changed. The fisherman who's worked his coast the last two decades is naturally an expert in his local waters, but only until the tsunami comes. We're skilled until we're not. How do we find experts that never fall behind the times, never get too focused on their little territory so they don't miss the wider waves?

The Unpredictable Market Hypothesis is not true, but as fictional abstractions go, it's one of the most useful ones I know. What it warns against, most of all, is human pride and hubris. I, as an individual, can't possibly know everything. The market will fairly consistently give the most reliable estimate, based on the information available. It's not even remotely close to perfect, but in the vast majority of contexts it tends to be the least wrong of all the sources of information we have available. Yes, sometimes people are dead right to bet against the market. But how am I supposed to figure out who they are? And even if they get one big important thing right, how am I to know they will continue to get things right in the future? How are we to know all of the secondary consequences as the shockwave spreads, when people like Paulson couldn't cope? Knowing that housing is a bubble is one thing. Knowing that the Fed will allow the biggest drop in NGDP in the aftermath of the housing collapse is something else entirely. The downturn we experienced wouldn't have been nearly as large without the subsequent, and preventable, drop in aggregate demand. It was a failure of political will. How can people possibly predict that? How can underpaid regulators possibly predict that?

I'm willing to listen to alternatives, if there is data. It seemed fairly clear there was a housing bubble going on (though I for one didn't have the slightest idea of the broader possible repercussions). The problem is, there is seldom truly convincing data. What we as people do is tell stories with psychological allure to each other. Our minds are built to fall for the narrative, but that doesn't mean the narrative is right more often than the market price aggregated from countless people around the world.

Despite how terribly wrong a market price can be, the good thing about it is that it will eventually correct. The price will fix itself. If we keep paying attention, we will update our own beliefs with it. I'm willing to listen to alternatives, but my own habit will always be to look first to the institution that is always in the process of updating itself, rather than relying on fallible pride that a single individual like me can somehow consistently find the truth better than a system which by its very design acts to aggregate the information of many people, nearly all of whom with access to small pieces of relevant esoteric knowledge that others necessarily lack. If we add government regulators to the mix, whose incentives even in the best of circumstances are not perfectly aligned with the greater good, we should been even more wary of trusting their prideful judgments instead of looking to the market. This refusal to look at the evidence by mostly well-intentioned government regulators is pretty much the whole European experience right now.

The market will be horribly wrong in some way, come the next big political sea change, but so will almost every individual person. Even if some people end up with the "right" decision, they're nevertheless likely to be right for lucky reasons. What we have in the Unpredictable Market Hypothesis is a tool, and we shouldn't expect perfection from it, just accept that it's usually the best we have available. The market price isn't right, but it's often the best information that we have.

I think Minsky's theory is substantially correct. And I think it doesn't matter that Minsky's theory is substantially correct. If our policy is to try to detect bubbles, then the policy won't work. We fool ourselves too often.

We need a policy that's robust enough that it doesn't rely on bubble detection. We need a policy that relies on markets as our primary source of information. Bubbles are true. The idea of bubbles is useless.

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