Feb

22

Here is an amazing spectacle. Everyone knows that the house must win and the players, over time, must lose. And yet casinos flourish all over the world. Nor, contrary to the standard arbitrage argument for efficient markets, does the smart money, the house, end up with all the capital in the world while the dumb money, the players, go broke losing the capacity to sustain inefficiencies in the market. To the contrary (and contrary to one of Jarrow’s assumptions) there is a continuous source of wealth for the house to keep winning; the dumb money is constantly replenished.

From the fantastic article: "How Big is Almost?: or why the finance professoriate is clueless about managerial effectiveness"

Stefan Jovanovich quotes from the paper: 

"The paradoxical notion that uncertainty is absolute, that randomness is an objective quality, first and foremost of nature but by extension of social and economic life as well, has been rampant in our time. It was at the heart of the Copenhagen debate over the direction of quantum physics. It drove Keynesianism and Marxism and Smith’s replacement of the entrepreneur with that invisible—but oh so heavy—hand. It drove centuries of absurd debate over the relative importance of “capital” and “labor” as if they were objective fungible commodities with capabilities separable from the particular capitalists and laborers who wielded them."

"(t)here are men who consistently hit the bull’s eye at 300 yards and men who never hit it once. There are baseball players who hit .300 over a career and those who ride the bench. There are engineers with dozens of important patents to their name and those who never amount to much. There are farmers who prosper year in and year out and those for whom the weather is always bad. And generally we say the successful shooters and hitters and engineers and farmers are “good” at their jobs and the unsuccessful ones less good. We do not generally say (unless we are feeling envious), “Oh, they were just lucky,” or “they were breaking the rules.”

Can securities markets be so special among all markets, among all the arenas of our experience that in them alone diligence and skill and judgment and even raw talent do not correlate with good outcomes?"

"Randomness or “incomplete knowledge” is a subjective phenomenon. Different observers will have more or less knowledge and more or less uncertainty as a result. Moreover we can gain knowledge by dint of hard work, natural talent, and sometimes luck. We can be well prepared or poorly prepared to make a decision, discover special relativity, or buy a security. Even our best efforts to increase our knowledge may be insufficient. We may know a lot but not quite enough. We may fool ourselves about our positive expectation. There is no guarantee that our search for knowledge will bring us close enough for success. But neither is there any basis for a dogmatic ssumption of failure—or futility."

"We celebrate successful investors with other successful entrepreneurs as risk takers. This is true in the sense that the successful investor, like the entrepreneur, routinely makes judgments in the face of uncertainty. Nevertheless, the essential job of both investors and entrepreneurs is to reduce that uncertainty. Successful investors make money not by accepting risk as a given, as Modern Portfolio Theory tells us to do, but by increasing their ****

chance of making good decisions as compared to the less informed, less diligent, less talented. Admittedly how good investors, or entrepreneurs, do this is not entirely obvious. Edison helpfully told us it was 99% perspiration and 1% inspiration, but he was distinctly unhelpful in explaining how we might come by that crucial 1%. The progress from the objective uncertainty of a coin flip to sound judgment or even inspired creation is only partly a matter of quantifiable factors like more research or better math. Psychology or character or knack or what you will play an enormous role. Ultimately it does seem to matter not only what the investor or manager or entrepreneur."

Easan Katir writes: 

This is the most articulate rebuttal of the random walk theory ever! Thank you for posting.

If the heat of debate contributes to global warming, then this long conversational thread alone may have raised the earth's temperature a degree or so.

Gary Rogan writes:

It still all comes down to how predictable and persistent someone's ability to outperform SOMETHING is. Whether or not the mathematics of price movements are distinguishable from brownian motion, which they clearly are, this whole never-ending argument is about whether outperformance is reliable enough to (insert your own criteria here, like "bet the house"). The world is a confusing place, for instance Victor seems to really like "Random walk down wall street" year clearly he does other things besides putting everything into some total world ETF. Even if someone has stellar history, how can you ever know that starting tomorrow they will be on a long losing streak that will either reverse all of their gains up to now or make them quit the game?

 


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6 Comments so far

  1. steve on February 22, 2012 9:57 am

    I plan on studying this article much more in detail over time.

    I think of a few quick thoughts:

    I have only played 3 games in a casino in over 30 years of visiting them. Craps, Blackjack and Poker. I consider myself an expert in those tree. Today I only play poker and then only sparingly.

    The greatest lesson I ever learned with respect to gambling is:
    The goal of gambling is to play each event (pass,spot,hand) with full attention and detail. Stated differently, the goal is not to win money but the play as well as I can under the circumstances. The rest takes care of itself.

    What does this mean? Nobody plays perfectly. Everyone makes mistakes. Forrest Gump said “It Happens” Be prepared for it understand it and embrace it. You will go through streaks that are inhumanely brutal yet they will appear. They will stay with you for days, weeks, months and sometimes years.

    With respect to trading and speculation, there are so many who could vastly improve their returns if they adhered to this one principle. The ones who get into trouble are victims of their own hubris. They become their own worst enemy. They stop dancing with the girl that they brought to the dance. They try untested themes, overtrade, and succumb to the traditional actions that gets so many into poor positions. In the end, all you can do is manage yourself, and manage the trade. This is all we as humans are expected to do.

    Hank Greenberg, great baseball player, was once asked why Bob Feller would consider throwing anything other than fastballs. His reply was “I don’t know maybe he gets bored.” Words to live by.

    When you get bored. STOP! Take a break. Do something else for a while. Get away from the table. Come back when you are refreshed. The game will still be there.

    Best wishes to all

  2. Alice Allen on February 23, 2012 9:44 am

    Required reading and discussion. How could the academics miss from their models the human ability–albeit difficult to apply–to “quit while you are ahead!”

  3. Bastiaan Agtereek on February 23, 2012 6:40 pm

    First: Facebook (don’t know howmany people are using it now but saw an documentary just a few moments ago: more people than the US and Europe have as citizens) Not recommending the IPO that’s not the issue. Probably a couple of hours a day spending on Facebook by the random user; nearly all students on Univerities and college’s around the world are using it.(addicition)

    These people are not studing the markets. I do not buy the argument that those hours were formerly filled with atlethics or volutanary work or something

    Saw an article on Forbes about ‘investing is dead’.

    People are turning away from investing or as you wish gambling the markets. Easy money gone. Hence in my opinion its not rare that HFT (quands) is making a lot of money (short term) and pension funds are losing there shirts (long run) (a cynical guy or girl will say, the ‘little man gots to pay no matter what’.)I think thats on target.

    Smart money is feeding on eachother. See the results on many hedgefunds last year. See howmany smartguys are leaving (with at least a few hunderd million or even billions)the game (for now)

    Jobs insecure, houseprices way down, (to be honest, i havent followed on CNBC the hours working and wages and or overwork, but people are earning less on there jobs, fuelprices through the roof)Savings down. I mean you got to have money to play. They always come back, until now.

    Not smart enough to figure it out, but coming up BRIC countries has also something to do with it. If Total Wealth on Earth is a given, Commodities are becoming more scarse than ever, so i think its decreasing.(total wealth) (I know they just found that diamondrock down under)

    Sidestep Gobal Warming. In our country (the Netherlands) we had a problem just recently. Too much rain, day after day. Because of the storm on the Ocean, The dams (”gemalen”) couldn’t work to pomp the water from our canals and lakes to the Sea. People say you must build higher dikes because of the melting water from the North and South pole, making our country on big bathtube. They will have an answer for it, but the main reason i say this is that i assume there will be enough water, in some regions, to have even bigger alocations of humanbeings and animals.

    One movie who someone i admire has pointed me too is the 1975 movie from Stanley Kubrick named Barry Lyndon. It gives some answers to the questions of the article and reactions.

    Thanks for reading me.

  4. dvdw on February 26, 2012 10:11 am

    This paper says the right stuff, it perfectly frames the academics as the compartmentalists they are.

    You can tell White Box has awareness of Quantum Mechanics, a field that places binary many in the zoo, and this is good for those of us whose efforts everyday, are to accept “Prices as Artifacts of prevailing systems intent”, and then proceed to counterprogram the circular references of binary mans ego.

    I hope the author finds and begins contributing to my new thread on SI; Quantum Economics 2012 and Beyond, because this is the stuff of QM where the pass fail metrics of the binary, fold into multi valued reference spaces to be celebrated by all who have grown tired of the binary compartmentalists schemes and deductions.

  5. Orson Terrill on February 27, 2012 2:28 pm

    They assume way too much rigor in the EMH: “There is no guarantee that our search for knowledge will bring us close enough for success. But neither is there any basis for a dogmatic assumption of failure—or futility.”

    By “proving” that does not disprove general efficiency in prices.

    Here was Fama did say (because he is not here to defend himself):

    http://www.indexingblog.com/2011/03/27/efficient-market-hypothesis/

    Eugene Fama interviewed by David Salisbury-Chairman of DFA Europe

    FAMA:
    …So you have to realize that market efficiency is a model-which means it is a simplification of the world,-which does a good job on almost everything-but there are some things on which it doesn’t do a good job-so insider trading would be one, there is momentum phenomenon is another one, and maybe this post earnings is another one…

    …But they are few and far between, these things, and for practical investment purposes, the market is efficient for pretty much everybody.

    Q. So if I can sum up in layman’s terms-what you are saying is that EMH is not a perfect explanation of everything that happens in the markets-but it is the best working proposition for use by investors in a practical sense-that most investors should presume that the only way in which they can reliably effect the expected return from their portfolios is by verifying the level of risk they are prepared to take.

    A. Absolutely true.

    Q. And nothing that has happened in the last 12 months that has altered that in any way?

    A. No, I don’t see any informed opinion to the contrary on that. There are some people claiming that markets are not efficient-but they are not claiming there are easy profit opportunities out there, which seems like a conflict to me – it is either one or the other.

  6. Bill Graybeal on May 20, 2012 1:44 pm

    Best Article of the Decade… Mr. Katir is absolutely right too. This explains why those 1/2/3% of street smart traders are able to make large sums of money using gambling techniques and skill, while highly educated academics mostly fail.

    The authors point out the important key to trading success: that price “is less random yet” as time moves forward, meaning that you can then recognize more easily if a real trend is actually developing or not, and then judge whether to trade or not at a certain point in the move. This simply cannot be judged well in the short term moves.

    Ed Seykota says; “You need to know when to break the rules” and George Soros always says something like; You increase your trade size, when you are right ! The authors have come to these very same conclusions - Truly successful managers do not just always follow the same trading patterns, but base their positions and their timing, on the probabilities shown by the move.

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