This book does an excellent job of reporting important evidence showing that group decisions can be wiser than those of any one individual. He makes some good attempts to describe what conditions cause groups to be wiser than individuals, but when he goes beyond reporting academic research, the quality of the book declines. He exaggerates enough to give critics excuses to reject the valuable parts of the book.
He lists four conditions that he claims determine whether groups are wiser than their individual members. I’m uncertain whether the conditions he lists are sufficient. I would have added something explicit about the need to minimize biases. It’s unclear whether that condition follows from his independence condition, partly because he’s a bit vague about whether he uses independence in the strong sense that statisticians do or whether he’s speaking more colloquially.
Sometimes he ignores those conditions and makes unconvincing blanket statements that larger groups will produce wiser decisions.
He makes exaggerated claims for the idea that crowds are wise due to information possessed by lots of average people rather than the influence of a few wise people. For instance, he disputes a Forsythe et al. paper which argues that a small number of “marginal traders” in a market to predict the 1988 presidential vote were responsible for the price accuracy. Surowiecki’s rejection of this argument depends on a claim that “two investors with the same amount of capital have the same influence on market prices”. But that looks false. For example, if the nonmarginal traders make all their trades on the first day and then blindly hold for a year, and the marginal traders trade with each other over that year in response to new information, prices on most days will be determined by the marginal traders.
It’s not designed to be an investment advice book, but if judged solely as a book on investment, I’d say it ranks in the top ten. It does a very good job of explaining both what’s right and what’s wrong with the random walk theory of the stock market.
He does a good job of ridiculing the “cult of the CEO” whereby most of a company’s value is attributed to its CEO (at least in the U.S.). I was surprised by his report that 95% of investors said they would buy stocks based on their opinion of the CEO. They certainly didn’t get that attitude from successful investors (who seem to do that only in rare cases where they are able to talk at length with the CEO). But his claim that “Corporate profit margins did not increase over the course of the 1990s, even as executive compensation was soaring” looks false, as well as being of questionable relevance to his points about executives being overvalued. And I wish he had also applied his argument to beliefs of the form “if we could just elect a good person to lead the nation”.
Chapter 6 does a good job of combining the best ideas from Wright’s book Nonzero and Fukuyama’s Trust (oddly, he doesn’t cite Trust).
He exaggerates reports that the stock market responded accurately to the Challenger explosion before any public reports indicated the cause. He claims “within a half hour of the shuttle blowing up, the stock market knew what company was responsible.” I don’t know where he gets the “half hour” time period. The paper he cites as the source says the market “pinpointed” Thiokol as the culprit “within an hour”, but it exaggerates a bit. If the percent decline in stock price is the best criterion, then the market provided strong evidence within an hour. If the dollar value of the loss of market capitalization is the best criterion, then the evidence was weak after one hour but strong within four hours.
He also claims “Savvy insiders alone did not cause that first-day drop in Thiokol’s price.”, but shows no sign that he could know whether this is true. He seems to base on the absence of reported selling by executives whom the law requires to report such selling, but he appears to overestimate how reliably that law is obeyed, and to ignore a large number of non-executive insiders (e.g. engineers). He does pass on a nice quote which better illustrates our understanding of these issues: “While markets appear to work in practice, we are not sure how they work in theory.”
Investing
While browsing through charts of various stocks, I came across a company (Manchester Inc., symbol MNCS) with a chart that’s unusual enough that I had to check around to reassure myself that my primary source for stock market prices wasn’t playing tricks on me.
It has a history of unusually steady increases with few signs of the randomness that I normally see in stock prices. If you had bought at the closing price any day this year and held for ten trading days, it would have closed higher than your purchase price (your average gain would have been over 3 percent), and it was almost as predictable the prior year.
A paragraph in the middle of this Forbes story explains why its market value looks strange.
The only guess I have as to what might cause this is an unusual form of manipulation where the manipulators produce this phenomenon until traders who buy purely on price trends provide enough liquidity for the manipulators to cash out. But even that is pretty implausible – if that’s what’s happening, why wouldn’t they create a bit more day to day randomness to disguise it a bit? And how could they afford to risk as large an investment as I suspect that would take on an approach which seems different enough from anything tried before that it ought to be hard to predict whether it will work?
For those investors who (unlike me) can’t afford to do fundamental analysis on a large number of companies (and if you can’t afford to analyze thousands of companies, you’re probably using a questionable method to select which ones to analyze), there’s a new class of ETFs which sounds like fixes some of the worst problems with typical stock funds.
Most people invest in funds that are based on a capitalization weighted index, which means that any time there’s a bubble affecting some of the stocks in the index, the fund is buying those stocks at the peak. The more popular those funds are, the easier it is to create bubbles in the stocks they buy.
There’s a new ETF (symbol PRF) that weights its holdings on dividends instead, which will sell stocks that are affected by bubbles (except in the unusual case where the company increases its dividend in step with the bubble).
The Political Calculations blog mentions similar strategies which appear to work about as well (the dividend weighting selects against small immature companies, and it ought to be possible to avoid that).
Weighting on revenues sounds like it works well, although it overweights retailers and underweights successful pharmaceutical companies and oil producers that find cheap sources of oil.
Weighting on the number of employees should work (although that underweights companies that outsource).
I’m somewhat partial to weighting on book value, but instead of the standard book value, I’d use tangible book value plus an estimate of amortized R&D expenses.
Shorting the 5 or 10 companies with the largest market capitalizations would probably be a good way to invest a modest portion of a portfolio in a way that would reduce risk and improve returns.
These strategies do have the potential to underperform if they becomes as popular as buying and holding S&P 500 funds was around 2000, but it will take some time to become that trendy, and even if it does there will probably still be funds using unpopular versions of fundamental weighting that will remain good investments.
Book Review: When Genius Failed : The Rise and Fall of Long-Term Capital Management by Roger Lowenstein
This is a very readable and mostly convincing account of the rise and fall of Long-Term Capital Management. It makes it clear to me how the fairly common problem of success breeding overconfidence led LTCM to make unreasonable gambles, and why other financial institutions that risked their money by dealing with LTCM failed to require it to exercise a normal degree of caution.
The book occasionally engages in some minor exaggerations that suggest the author is a journalist rather than an expert in finance, but mostly the book appears a good deal more accurate and informed than I expect from a reporter. It is written so that both experts and laymen will enjoy it.
One passage stands out as unusually remarkable. “The traders hadn’t seen a move like that – ever. True, it had happened in 1987 and again in 1992. But Long-Term’s models didn’t go back that far.” This is really peculiar mistake. The people involved appeared to have enough experience to realize the need to backtest their models better than that. I’m disappointed that the book fails to analyze how this misjudgment was possible.
Also, the author spends a bit too much analysis on LTCM’s overconfidence in their models, when his reporting suggests that a good deal of the problem was due to trading that wasn’t supported by any model.
Paul W.K. Rothemund’s cover article on DNA origami in the March 16 issue of Nature appears to represent an order of magnitude increase in the complexity of objects that can self-assemble to roughly atomic precision (whether it’s really atomic precision depends in part on the purposes you’re using it for – every atom is put in a predictable bond connecting it to neighbors, but there’s enough flexibility in the system that the distances between distant atoms generally aren’t what would be considered atomically precise).
It was interesting watching the delayed reaction in the stock price of Nanoscience Technologies Inc. (symbol NANS), which holds possibly relevant patents. Even though I’m a NANS stockholder, have been following the work in the field carefully, and was masochistic enough to read important parts of the relevant patents produced by Ned Seeman several years ago, I have little confidence in my ability to determine whether the Seeman patents cover Rothemund’s design. (If the patents were worded as broadly as many aggressive patents are these days, the answer would probably be yes, but they’re worded fairly responsibly to cover Seeman’s inventions fairly specifically. It’s clear that Seeman’s inventions at least had an important influence on Rothemund’s design.)
It’s pretty rare for a stock price to take days to start reacting to news, but this was an unusual case. Someone reading the Nature article would think the probability of the technique being covered by patents owned by a publicly traded company to be too small to justify a nontrivial search. Hardly anyone was following the company (which I think is a one-person company). I put in bids on the 20th and 21st for some of the stock at prices that were cautious enough not to signal that I was reacting to potentially important news, and picked up a modest number of shares from people who seemed to not know the news or think it irrelevant. Then late on the 21st some heavy buying started. Now it looks like there’s massive uncertainty about what the news means.
Arnold Kling reports that free markets are more popular in China than in the U.S.
That reminds me that I should give more thought to investing in China-related companies.
Arnold Kling writes some interesting comments about the uses of oil futures markets.
I recall reading that the President of Exxon was forecasting oil prices much lower than the futures markets and thinking that if he believes his own forecast, then he should put his company up for sale.
I think there’s a genuine inconsistency between Exxon’s talk and its actions, but selling the company isn’t the optimum response. We don’t know that Exxon’s stock price currently reflects the prices forecast by the futures market (I decided 6 months ago that energy-related companies were underpriced relative to the futures market and sold my last 2009 futures contract while keeping a large position in energy-related companies) or that the market for large oil companies is liquid enough for Exxon to be sold at a good price. It makes more sense for Exxon to hedge larger fractions of its production by selling more futures contracts.
Maybe the long-date futures markets are illiquid enough that prices would approach what Exxon’s president thinks they should be, in which case Exxon would make slightly more money than under its current policies (assuming the resulting prices are right, which Exxon ought to assume is the best available guess). Or maybe the markets have enough liquidity that Exxon would hedge a large fraction of its production at prices near $60/barrel, which would help Exxon dramatically if Exxon’s president is right, and forgo big profits if he’s wrong. It’s fairly clear the market doesn’t have the liquidity to keep long-dated futures prices over $60/barrel if Exxon tries to make big hedges overnight, but if Exxon were fairly patient about building up the hedge positions, I don’t think we can know what would happen without performing the experiment. There are lots of people out there who think that betting against Exxon would be a good deal. Their confidence in their beliefs remains untested.
The government has all sorts of subsidies for alternative energy. However, the most efficient subsidy would be to buy oil futures contracts. If we must have an energy policy, it should consist solely of strategic futures market purchases.
Buying oil futures contracts would be the least wasteful way to subsidize the solar energy market, where there are many designs that are close to providing competitive mass-produced products. But financial markets are pouring enough money into that market that there’s little reason to think government subsidies are valuable.
Buying oil futures won’t provide the kind of subsidy that, say, fusion advocates would want. If markets are inadequately funding fusion research and government is benevolent enough to do better (a suspicious pair of assumptions, but without assumptions of that nature the popular demand for a government energy policy is a mistake), then oil futures markets won’t solve the problem because the problem is something like markets having inadequate information to target the right research or patents not providing inventors with the optimum fraction of the social benefits of their inventions.
Last week in a ski lift line I overheard a college-aged guy bragging about how he was making money in the Florida housing market before going to college.
This kind of anecdotal evidence is not as reliable as I would like, but market bubbles rarely have conclusive evidence, so I feel a need to make use of all evidence. If housing market peaks are much like stock market peaks, this is definitely evidence that we are near at least a short-term peak in the housing market.
Book Review: Unconventional Success : A Fundamental Approach to Personal Investment by David F. Swensen
This book provides some good advice on how an amateur investor can avoid sub-par results with a modest amount of work. It starts by describing why good asset allocation rules should be the primary concern of the typical person.
I found this quote especially wise: “While hot stocks and brilliant timing make wonderful cocktail party chatter, the conversation-stopping policy portfolio proves far more important to investment success.” Fortunately for those of us who make a living exploiting the mispricing of fad-chasing investors, the most valuable points of this book aren’t in the kind of sound bite that will make them popular at cocktail parties.
But even if you choose investment ideas for cocktail party conversation rather than for building wealth, you should be able to find some value in his explanations of how to avoid being ripped off by fund salesmen and why ETFs are better than most mutual funds.
His attacks on the mutual fund industry are filled with redundant vitriol that may cause some readers to quit in the middle. If you do so, don’t miss table 11.3, which gives an excellent list of ETFs that most investors should use. I was surprised at how much I learned about the differences between good and bad ETFs from this book.
His arguments against investing in foreign bond funds are weak. I suspect he overestimates the degree to which foreign equities diversify exposure to currency risks.
He advises investing more in U.S. equities than in equities of the rest of the world combined, even though his reasoning implies more diversification would be better. But I’ve been slow enough to diversify my own investments this way that I guess I can’t fault him too severely.
He has a plausible claim that not-for-profit organizations that provide investment vehicles on average treat customers more fairly than for-profit funds do, he goes overboard when he claims not-for-profits have no conflict of interest. The desires for job security and large salaries create incentives that would cause many investors to be fleeced if they switched to not-for-profits without becoming more vigilant than they have been.
His faith in the U.S. government is even more naive. He says “U.S. Treasury Inflation-Protected Securities, which provide ironclad assurance against inflation-induced asset erosion”, “Treasury … bondholders face no risk of default”, and “The interests of Treasury bond investors and the U.S. government prove to be better aligned than the interests of corporate bond investors and corporate issuers. The government sees little reason to disfavor bondholders.” But a close look at the CPI shows that indexing to it provides very imperfect inflation protection (e.g. its focus on rents hides the effects of rising home prices), and the current reckless spending policies combined with large foreign holdings of U.S. bonds can hardly avoid creating a motive for future politicians to inflate wildly or default.
The rationalizations that I’m noticing from people who want to deny the existence of a housing bubble are becoming more obviously contrived.
Last spring, the strangest one I noticed was this Tyler Cowen post, which notes the unusual rent-buy ratios, then ignores that anomaly and devotes the rest of the post to questioning a weaker argument for the housing bubble theory.
This month I noticed someone on a private mailing list who had enough sense to realize that current housing prices probably depend on a continuation of unusually low and stable long-term interest rates expressed confidence that the “psychological consensus against inflation” would make that likely. If such a consensus existed, I would have expected to see people expressing concern that the Fed’s policy being too inflationary, when in fact I see people jumping at any excuse (e.g. a hurricane) to advocate a more inflationary policy. Plus I see politicians racing to expand the federal debt to levels that will give them massive incentives to inflate or default when the baby boomers retire.
Now Chris Hibbert comes up with some stranger rationalizations:
The worst historical cases that I know of were times when housing prices dropped 10 or 20 percent.
I thought he read Marginal Revolution regularly, but that comment suggests he is unaware of this description of Shiller’s apparently more accurate housing price history which includes what looks like a 50 percent drop in U.S. housing prices. But that deals with a national average, which gives you the kind of diversification you might get with a mutual fund. Chris’s real estate investments sound less diverse – is that safer?
Continue Reading
