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December 08, 2007

Businessman's Pornography

By Ankush Khardori

It's not exactly groundbreaking, but Michael Lewis' piece in Portfolio magazine is fairly impressive when you consider that he and the magazine are basically arguing that a decent chunk of their readership is full of crap.  The odds of you or your stockbroker or your money manager "beating" the market are pretty much zero, as Lewis explains, which is why index funds are such a safe bet. 

So what is going on with all this investment advice in magazines and on cable?  Eugene Fama, one of the key proponents of the efficient markets hypothesis, and Weston Wellington, a principal at a firm that purchases what are more or less index funds, have some pretty compelling explanations:

"You can tell a story every day about stocks," [Fama] concludes. "That’s what the media are all about. They tell a story every day about today’s stock returns. It’s businessman’s pornography."
[Wellington] punctuates the porn show with some general lessons. One is that the financial press isn't in the business of supplying useful information; it’s in the business of feeding people’s lust for predictions. "You keep buying the magazine regardless of how the forecasts turn out," Wellington says, "and they’ll keep supplying the forecasts."

That strikes me as basically correct, at least as applied to magazines (like SmartMoney) and shows (like MadMoney) that are in the business of providing people with investment advice as opposed to straight-up financial news.  A lot of the folks behind these things are in the precarious position of having to dress things up -- convincing us that they have some unique insights -- so as not to quickly render themselves obsolete.  This whole sector of the media is essentially a gigantic hype machine, perpetuating what is basically a myth -- out of incompetence, self-interest, self-delusion, or some combination of the three.

December 8, 2007 | Permalink


The article is itself incredibly trivial and insubstantial. The core of the argument must be whether a strong-form Efficient Market Hypothesis or Theory is true. The article simply presents a "believe in Eugene Fama, because he's a very well-respected finance academic" argument - which is an argument from authority. (Which, again, is not much different than just doing what your broker tells you to do because your broker works for a well-known firm or is an "expert".)

Instead, Eugene Fama is himself also placing a narrative on the question. "These are the facts." Actually, the facts are in massive dispute. Such substantive dispute actually, which is why Fama, who was one of the youngest members of the first generation of the Chicago School of Economics, will probably not win the Nobel everyone expected (and he himself clearly anticipated) he would.

And, of course, everyone outside the little glass bubble that ate economics (the Chicago School of Economics) doesn't have too many problems figuring out why the Chicago School needed EMT so badly. Their theory actually requires all markets (that is, every market in beans, stocks, bananas, Mercedes Benz, Beanie Babies - everything everywhere at all times) to be efficient. Without that, their theoretical superstructure collapses. Their practical difficulty is that, upon investigation, either no or very few markets seem to act as efficiently as the theory needs them to. So, they early retreated in the 1940s and 1950s to confining themselves into a financial market EMT, hoping to prove the theory there solely and later gradually try to establish that EMT worked everywhere else too.

This is why Fama's initial 1966 research article was so heralded. The piece itself is quite primitive in it's analysis. Even more problematic is that the piece made extremely grand claims based on very slender evidential reeds. But that's precisely what the Chicago School needed in their soon to become hot war with the Keynesians in the 1970s (from which they emerged victorious) - they needed something, well almost anything, where the market was efficient. Or they could pretend it was.

So, there ends up being effectively a hilarious problem: all economic arguments are rhetorical and narrative arguments. The people most loudly proclaiming that their own arguments aren't rhetorical (the Chicago School of Economics) are perhaps even more ideological (i.e., believe in a master narrative) than other economic schools. Fama is just as much a storyteller as everyone else must be. Indeed, if you've seen any major Chicago School economist lecture, they're all great story-tellers as they (themselves unwittingly perhaps) are trained to be.

"A lot of the folks behind these things are in the precarious position of having to dress things up -- convincing us that they have some unique insights -- so as not to quickly render themselves obsolete."

But how is that different from anything else? Everybody (or nearly everybody) claims to be wise - whether that claimed wisdom is universal or philosophic or scientific, or in repairing cars, trading stocks, training horses, growing corn, leading armies, creating laws, writing novels or anything else - and clearly, most people are not nearly as wise as they wish to present themselves as.

Posted by: burritoboy | Dec 9, 2007 5:20:45 AM

And how is it, if the brokerages are doing no better than index funds, can Wall St. be so obscenely compensated? Average weekly compensation $17,000 per week, up %40 since 2003.

Posted by: bob h | Dec 9, 2007 8:17:21 AM

Yes, Fama is a paid-in-full member of the Chicago School, and very conservative economically. But to blithely dismiss market efficiency because of that seems as trivial a reason as Lewis's appeal to authority in the original article (which I thought was pretty entertaining--and let's face it, a magazine like that is not going to suddenly start trying to explain CAPM and Sharpe Ratios and the capital market line to its readers, much less heteroskedacity.)

But even a layman can understand that if the market return is X, than half the market returned better than X and half returned worse. This fact alone makes fund managers' claims about being able to systematically beat the market suspicious. Of course, they are legally forbidden from promising good returns in the future. They are required to tell you, "Past performance is no indication of future returns." But investors are suckered by past performance all the time, which is a kind of "late look bias"--the poorly performing mutual funds are all dead, so the only ones you, as an investor, see are the ones with hitherto good returns, or new funds with no track record either way.

Managing money is complicated and daunting for people, so it is understandable why they pay professional managers for it. But my feeling is that this is mainly a way to hoover fees out of investor's pockets.

The funny thing is that because the market for liquid securities like publicly traded stocks and bonds is, in fact, pretty close to efficient, it provides fund managers to create their own inefficiency and arbitrage it for their own benefit. That inefficiency is information asymmetry. That asymmetry is not about having more information about a given stock, because all public information about a given stock is reflected in its price. The information asymmetry is in knowing how well funds generally do. That was one of the things that was poignant about the article. Blaine Lourd knew he wasn't beating the market, even if he didn't know why, but he was still selling a service of beating the market to his clients. He atypically had the decency to feel bad about it. So if you want to see a place where market efficiency completely breaks down, this is it. That's why there are regulations about what a mutual fund can say to it's investors. I wouldn't mind seeing those regulations strengthened though, since most people don't seem to be getting the message. (Don't tell Eugene Fama, though.)

Posted by: RWB | Dec 9, 2007 8:53:11 AM

The empirical claim that a market is "efficient" is typically weak in form -- that the market responds measurably to new information. The theoretical claim, however, is typically strong in form. Economic theory being formulated using the calculus, it is often extremely strong -- efficiency to the limit.

Rare, indeed, is a measurement of just "how efficient". If no one was investing in financial and economic research and applying it to calculating risk and returns, the market could not possibly be "efficient" in any substantive form.

On the theory that there could not possibly be a lost $20 bill just lying on the ground, because someone would have already picked it up, it cannot be that all those analysts and star fund managers are wasting their time. The same reasoning that leads to the efficient market hypothesis, leads to the hypothesis that the amount of actual research and analysis going on, reflects an optimal equilibrium balance: that research at the margin returns net zero, but that inframarginal research does pay.

There's plenty of respectable evidence that research pays. Plenty of studies have confirmed, that, yes, Virginia, a Value Line informed portfolio does consistently demonstrate a modestly superior return.

The point that Lewis could have made, which any serious market participant knows, is that the stock market attracts a number of gambling addicts (including a large number of compulsive losers). This people do, indeed, feed an extensive cottage industry in hucksterism. The thundering herd attracts wolves. Big surprise.

Posted by: Bruce Wilder | Dec 9, 2007 11:19:04 AM

Why's the article so entertaining? Because it's a clever narrative, not because of a particularly interesting underlying set of facts. Indeed, the article could just be a single table with Blair Lourd's client performance record, which would (hopefully) tell us that performance was up after Blair stopped randomly steering his clients into crap (surprise!). The fact that the article itself doesn't even contain that table, but instead a long and amusing narrative, indicates that economic knowledge is of a different kind or order or type than that which we thought it was.

The problem is that the article ultimately IS about whether EMT (particularly the Chicago School version of EMT) is an accurate depiction of reality. If an investor still needs to be told at this point that their broker is probably a fool at picking stocks and that active investment management with alpha is very difficult to find, they need to put away the toys and go to bed.

"But to blithely dismiss market efficiency because of that"

Well, I wouldn't say I personally blithely dismiss market efficiency because of that - I don't find EMT very persuasive as a strong-form theory because:
1. The data simply doesn't support a strong-form version of EMT - as even Fama found out. (in fact, DFA entirely relies on strong-form EMT - Fama's lifetime goal - being simply wrong. Under Fama's theory, DFA itself should simply be achieving higher returns in return for adding greater risk.)
2. The assumptions within the superstructure of the theory that underlie EMT are dubious.
3. The mechanisms of economic activities depicted by Chicago School finance theory are also often simply incorrect or exceedingly dubious.

Posted by: burritoboy | Dec 9, 2007 12:31:51 PM

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