Gillian Tett raises some interesting questions in her Financial Times article today: “What can be done to slow high-frequency trading?” (http://www.ft.com/cms/s/0/d72966fa-bc2d-11df-8c02-00144feab49a.html)
She closes her piece with the most important economic question that can be asked: “To my mind, the real question which needs to be discussed—but which regulators are still ducking—is why ultra-fast trading is needed at all?”
The answer: people believe that they can make money if they have a slight edge in the speed at which they can make trades.
I don’t think that this answer is changed by going into the debate relating to the neurological research which argues that “the brain has two contradictory instincts: part of it is hard-wired to chase instant gratification; however, another part of our brain also has the ability to be ‘patient’, and delay immediate gratification for future gains.”
This is just the argument raised by the behavioral finance and economics researchers. (See my review of the book “Snap Judgment” for a discussion of this issue: http://seekingalpha.com/article/145660-book-review-snap-judgment-by-david-e-adler.) The general assumption that accompanies this train of thought is that “instinctional” behavior is irrational and therefore not productive.
To quote from Tett’s article, “in practice innovation…has a darker, impatient side too: as markets have become deeper, and more liquid, that has enabled trading to become more frenetic; similarly, as information has become more frequently available this has encouraged skittish, herd behavior.”
But, life is full of situations in which “instinct” or the ability to make quick decisions is of crucial importance. For example, we need military leaders that can make decisions “on-the-spot” as well as those that can plan out strategies for long, drawn-out battles. The military trains people over-and-over again to develop the perception and experience to make decisions in the “real time” that is necessary for winning battles and winning wars.
We can find examples in many fields where “immediate” action is needed. The education and training in these areas is intense and efforts are made to find the people that are the very best in their ability to diagnose a situation and come up with the “right decision” as often as possible.
The real difference is the capability of the person or persons making the decisions. In the military, in medicine, and in many other professions, there is a hierarchy in terms of who makes the decision. Hopefully, the people that rise to the top are those individuals that can perform well and are able to make good “snap” decisions if they are needed.
Sometimes there is licensing or other forms of identification that require test taking and hurdles to overcome in order to get the certification or advancement that will put the “right people” in the “right spot” for a specific type of “real time” decision.
In economics, these tests or hurdles are called “barriers to entry”.
In the trading of stocks and other investment vehicles, there are low barriers to entry into the industry and this includes the costs one must pay to enter an industry. As a consequence, there are many traders and not all of these have the “jet pilot” capabilities to execute trades at the speeds that are now available.
The crucial thing is that in areas where quick decisions need to be made, a premium is paid to those with the education and training, the experience, and the mental capacity to make such decisions. As I stated in the post cited above, successful decision making, over any time period, depends upon “cold analytical methodology and steely discipline, characteristics that most people, who rely too much on their instincts, don’t possess.” That is, some people are better decision makers than others, even in the very short run.
People are going to engage in an activity where they believe that they can make money. So high-frequency trading is going to take place. Individuals that cannot perform within such an environment are going to lose, and could lose a lot.
The concern of the other market participants is “what damage can these not-so-good traders do to the overall market?” As Ms. Tett states, one result of the move to high-frequency trading seems to be “more market volatility.”
The fear in this: “rising levels of speed, impatience—and short-terminism—might have actually made the (financial) system less efficient, and rational, than before” this increase in speed.
My feeling with this is that speed is something we are going to have to live with. I have argued this point before in my post “Banking at the Speed of Light”. (http://seekingalpha.com/article/208513-banking-at-the-speed-of-light) The point is that this “speed up” is happening all over the world in different kinds of decision making. It is just that high-frequency trading is getting a lot of publicity now and thus attracting a lot of debate.
In the post just mentioned, I cite the example of events happening in South Africa relating to the use of mobile phones by commercial banks to develop their customer base. In this example the discussion was around the 15 million adult South Africans that had previously been excluded from the financial system. And, the players in this effort are not small.
But, this points to another issue, the growing strength of the “new rising powers” in the world as discussed in an opinion piece in the Financial Times titled “The new disintegration of finance.” (See http://www.ft.com/cms/s/0/938e7228-bc55-11df-a42b-00144feab49a.html.) The authors, Stéphane Rottier and Nicolas Véron, are concerned about how the effort to organize and co-ordinate global financial regulation and supervision is facing issues that might reverse the trend to great co-operation. One of their concerns is that “Financial institutions from emerging countries are beginning to overtake their western peers. New financial centers are gaining market share, while emerging countries are asserting themselves in global financial rulemaking, and increasingly resist standards proposed by the member of the old north Atlantic consensus.”
This is the world of the future. This is how competition is going to progress. See “The New World Order: Smaller and Faster”, my post of August 31, 2010 (http://seekingalpha.com/article/223127-the-new-world-order-smaller-and-faster). I think most of you know how I feel about the ability of regulations to control this world. I think most of you know that I believe that many, if not most, of the big players have already moved beyond what American…and world…regulators are trying to do with respect to financial institutions and markets. Laws, regulations, and regulators must deal with processes and not “outcomes.” I have written about this many times in my posts.
Hold on, it is going to be an interesting and exciting ride!
Showing posts with label behavioral economics. Show all posts
Showing posts with label behavioral economics. Show all posts
Friday, September 10, 2010
Tuesday, July 28, 2009
Does Economics Work?
Does economics work?
A lot of people seem to be questioning the validity of economics these days.
My answer to this question is an emphatic yes! Economics does work!
It is only when we forget the basic principles of economics that we get into trouble. In recent years we have forgotten some of those principles and this has resulted in the economic chaos that we find ourselves in today. I would like to concentrate on just three of these principles for I believe that in forgetting these we have created a lot of our own unhappiness.
The first principle relates to what can be called the “value proposition”. Basically in economics it is argued that value or wealth is created when economic units produce goods or services that provide people with utility. That is, unless the economic unit that is producing something adds value to the resources used in the production of those goods and services, people will not purchase them and wealth will not be created.
Innovation is very important to this process because innovation creates new value in developing something new that people come to want. Where there is not a lot of competition in a particular market because the good or service being produced is new or where firms can achieve what is called competitive advantage, the rate of return on invested capital can exceed the opportunity cost of the capital used to produce those goods and services. In other words, under circumstances like these, firms can find projects or investments that have a positive net present value. Wealth is created in such situations.
But, economic units respond to incentives and when other economic units discover an area where the rates of return on invested capital exceed the opportunity cost of raising capital, they will be attracted to enter that market. And, unless there are barriers to entry in entering that market or some other economic factor or government license, patent, or regulation preventing that entry, competition will increase and this will drive down the excess of return on capital over the cost of capital. In the process, more and more goods are produced at lower prices.
Thus, the creation of wealth in society has to do with the fact that economic units must produce goods and services that are of value to others within the society. This is the value proposition.
The second principle is the “no arbitrage” principle. This principle has to do with trading goods or trading financial instruments. Trading occurs when the prices of an asset or of similar assets differ in different markets. The different markets might relate to different geographic areas, to different time zones, to different countries, to any situation in which there might occur a difference in the price of a good. These differences occur because of transaction costs, incomplete information, lack of computing power, and so on.
The “no arbitrage” principle essentially argues that trading opportunities such as these will attract investors seeking to take advantage of the price differentials and through trading to profit from these differentials the differences will go to zero or will be reduced to a spread related to transaction costs. That is, the incentive to profit through arbitrage trading will be eliminated or reduced over time. In other words, the expected value of arbitrage trading is zero. It is a zero-sum game.
There are two things that must be remembered with respect to trading. First, as more and more people discover the price discrepancies in different markets the potential gains from such trading are reduced. As these potential gains decline, traders may attempt to maintain rates of return on such trades by working with riskier assets, by mismatching the maturities of the arbitrage transactions with the funds used to achieve the position, or by increasing the amount of leverage they use. History is clear that as the potential returns to trading decline, traders take on more and more risk in an effort to enhance their performance. Research indicates that the big winners in trading are those that discover the discrepancies before anyone else does.
Second, the whole basis for this kind of arbitrage transaction is that the prices of the assets in different markets move in the opposite direction. This is obvious in a common assumption of arbitrage trading called “reversion to the mean.” In this case, the price of the asset in one market is above the mean price and the price of the asset in another market is below the mean price. The arbitrager is betting that over time the price of the asset above the mean will fall and the price of the asset below the mean will rise and money will be made.
The problem comes when these two prices move in the same direction! Unless the arbitrager is able to continue to finance his/her position over a long period of time he/she will have to take a loss, possibly a substantial loss. Keynes argued that arbitragers will find that they cannot maintain their financing over a sufficiently long period to keep up such an arbitrage position. This is, of course, what happened to Long Term Capital Management.
The third principle is related to the creation of money and credit. The basic idea here is that the creation of money and credit cannot exceed the creation of the real goods and services being produced by a society. In other words, when the growth of money and credit in a society or, in a particular sector of the economy, exceeds the growth rate of the economy or the growth at which goods and services can be produced in a particular sector, prices can become inflated. In terms of the general economy, inflation can occur. In terms of particular sectors of the economy, like housing or companies, asset bubbles can occur. In either case, economic dislocations result that, if the inflation or asset bubble continues, a correction will eventually have to take place. This correction results in a slowdown in economic growth, either in the economy as a whole or in a particular sector, as economic units get their balances sheets back in order with the use of much less debt. That is, credit inflations are followed by debt deflations.
One further complicating factor is that during credit inflations, like those described in the previous paragraph, the economy usually shifts from the emphasis on the value proposition to emphasis on trading. This only exacerbates the dislocations that occur in the economy and makes any correction just that much broader and deeper. Trading, in these situations, is not the basis of a robust economy; creating value is. A correction restores the balance between value creation and trading.
Yes economics works! These three principles are still in place. And, my guess is that they will remain in place for many more years. We only forget them to our own harm!
A lot of people seem to be questioning the validity of economics these days.
My answer to this question is an emphatic yes! Economics does work!
It is only when we forget the basic principles of economics that we get into trouble. In recent years we have forgotten some of those principles and this has resulted in the economic chaos that we find ourselves in today. I would like to concentrate on just three of these principles for I believe that in forgetting these we have created a lot of our own unhappiness.
The first principle relates to what can be called the “value proposition”. Basically in economics it is argued that value or wealth is created when economic units produce goods or services that provide people with utility. That is, unless the economic unit that is producing something adds value to the resources used in the production of those goods and services, people will not purchase them and wealth will not be created.
Innovation is very important to this process because innovation creates new value in developing something new that people come to want. Where there is not a lot of competition in a particular market because the good or service being produced is new or where firms can achieve what is called competitive advantage, the rate of return on invested capital can exceed the opportunity cost of the capital used to produce those goods and services. In other words, under circumstances like these, firms can find projects or investments that have a positive net present value. Wealth is created in such situations.
But, economic units respond to incentives and when other economic units discover an area where the rates of return on invested capital exceed the opportunity cost of raising capital, they will be attracted to enter that market. And, unless there are barriers to entry in entering that market or some other economic factor or government license, patent, or regulation preventing that entry, competition will increase and this will drive down the excess of return on capital over the cost of capital. In the process, more and more goods are produced at lower prices.
Thus, the creation of wealth in society has to do with the fact that economic units must produce goods and services that are of value to others within the society. This is the value proposition.
The second principle is the “no arbitrage” principle. This principle has to do with trading goods or trading financial instruments. Trading occurs when the prices of an asset or of similar assets differ in different markets. The different markets might relate to different geographic areas, to different time zones, to different countries, to any situation in which there might occur a difference in the price of a good. These differences occur because of transaction costs, incomplete information, lack of computing power, and so on.
The “no arbitrage” principle essentially argues that trading opportunities such as these will attract investors seeking to take advantage of the price differentials and through trading to profit from these differentials the differences will go to zero or will be reduced to a spread related to transaction costs. That is, the incentive to profit through arbitrage trading will be eliminated or reduced over time. In other words, the expected value of arbitrage trading is zero. It is a zero-sum game.
There are two things that must be remembered with respect to trading. First, as more and more people discover the price discrepancies in different markets the potential gains from such trading are reduced. As these potential gains decline, traders may attempt to maintain rates of return on such trades by working with riskier assets, by mismatching the maturities of the arbitrage transactions with the funds used to achieve the position, or by increasing the amount of leverage they use. History is clear that as the potential returns to trading decline, traders take on more and more risk in an effort to enhance their performance. Research indicates that the big winners in trading are those that discover the discrepancies before anyone else does.
Second, the whole basis for this kind of arbitrage transaction is that the prices of the assets in different markets move in the opposite direction. This is obvious in a common assumption of arbitrage trading called “reversion to the mean.” In this case, the price of the asset in one market is above the mean price and the price of the asset in another market is below the mean price. The arbitrager is betting that over time the price of the asset above the mean will fall and the price of the asset below the mean will rise and money will be made.
The problem comes when these two prices move in the same direction! Unless the arbitrager is able to continue to finance his/her position over a long period of time he/she will have to take a loss, possibly a substantial loss. Keynes argued that arbitragers will find that they cannot maintain their financing over a sufficiently long period to keep up such an arbitrage position. This is, of course, what happened to Long Term Capital Management.
The third principle is related to the creation of money and credit. The basic idea here is that the creation of money and credit cannot exceed the creation of the real goods and services being produced by a society. In other words, when the growth of money and credit in a society or, in a particular sector of the economy, exceeds the growth rate of the economy or the growth at which goods and services can be produced in a particular sector, prices can become inflated. In terms of the general economy, inflation can occur. In terms of particular sectors of the economy, like housing or companies, asset bubbles can occur. In either case, economic dislocations result that, if the inflation or asset bubble continues, a correction will eventually have to take place. This correction results in a slowdown in economic growth, either in the economy as a whole or in a particular sector, as economic units get their balances sheets back in order with the use of much less debt. That is, credit inflations are followed by debt deflations.
One further complicating factor is that during credit inflations, like those described in the previous paragraph, the economy usually shifts from the emphasis on the value proposition to emphasis on trading. This only exacerbates the dislocations that occur in the economy and makes any correction just that much broader and deeper. Trading, in these situations, is not the basis of a robust economy; creating value is. A correction restores the balance between value creation and trading.
Yes economics works! These three principles are still in place. And, my guess is that they will remain in place for many more years. We only forget them to our own harm!
Thursday, July 9, 2009
Uncertainty: The King of the Market and what to do about it
This is a time that is particularly conducive to impulsive or instinctive behavior. It is a time that behavioral economists love because it proves their case about irrational human behavior. People react and they react on the basis of a gut feeling or a snap judgment.
These researchers tell us that this type of behavior is what has helped the human species survive. However, it is not necessarily the kind of behavior that leads to decisions or actions that are in our best interest when investing. “Relying only on intuition in finance can lead to very bad outcomes, not only for individuals but also for markets.” (This quote comes from David Adler’s new book “Snap Judgment”: see my post that reviews this book, http://seekingalpha.com/article/145660-book-review-snap-judgment-by-david-e-adler.) Yet we humans, individually and collectively continue to perform in this way.
Right now, the concern is whether or not the economy is bottoming out and starting to recover. We get “green shoots” here, but then some other indicator of economic activity comes in worse than expected. Alcoa puts up better than expected loss numbers but retail sales come in lower than expected. Sales of existing homes improve yet we get wind of another wave of subprime mortgage problems. (See “Subprime Returns as Housing Woe,” http://online.wsj.com/article/SB124709571378614945.html#mod=todays_us_money_and_investing.) And, what about the problems in commercial real estate, credit cards, and Alt A mortgages?
Then there is the question about whether or not there should be a second round stimulus bill. Paul Krugman has argued for a long time that the first stimulus bill was not enough. Yesterday Laura Tyson indicated that she thought that there needed to be a second round. Now the debate is all over the place. But, wouldn’t another stimulus bill add more to the government budget deficit going forward? And, there are questions about the possibility that the government has already committed to too much debt.
So the Dow Jones average goes up from 6500 and looks very strong approaching 9000 and then goes into a swoon. The price of crude oil was approaching $40 a barrel in February and then shot up to above $70 but now has returned to the $60 range. The yield on the 10-year treasury issue was nearing 2.00% in December 2008, jumped up to around 3.90% in the middle of June and traded at 3.30% yesterday. An index relating the value of the dollar against major currencies was around 70 in July 2008, popped up to the mid-80s in March 2009 and has since declined to about 77.
When the economic indicators seem strong the price of oil goes up as does the stock market and the price of bonds and the value of the dollar decline. When the economy seems weaker we get just the opposite movements. And, my bet is that it is going to continue this way for a while. So, uncertainty, and hence volatility, rule the marketplace.
This is the short run. Recently, however, I have been writing more upon the long run, what deficits do to long term interest rates and to the value of the dollar. Over the longer run, historically, some patterns repeat themselves over and over again. This, of course, brings to mind the statement made by John Maynard Keynes, “In the long run we are all dead!” Still, we need to take the long run into account.
This is where we need to take heed of what the behavioral economists advise. We, as investors, must not rely on intuition or gut reactions. We must not over react to the environment we now find ourselves in. Research has shown that acting in this way is not necessarily in our best interest.
The research also indicates that investing based on fundamental economic reasoning does work. Therefore, it seems as if now is a time for discipline and hard work. And, it is a time for patience.
But, this does not mean that one needs to totally ignore the short run. It is perhaps impossible to expect that most people will just sit out this stage of the economic cycle and invest their funds in safe, low-yielding assets. So, what kind of strategy might work here? My suggestion is that one needs to segment one’s portfolio, allocating some money to playing in the current market volatility, but allocating a larger share of the funds to potential future fundamental investment choices.
The smaller part of the portfolio can be allocated to playing both sides of various markets. Obviously, getting into the market near a “bottom” would be very profitable, but selling short near a “top” would also work. But, by all means consider any investments here as short term in nature because it is highly likely that the “bottom” may not turn out to be a “bottom” at all. Likewise for a “top.” So, one must be very agile in investing this way. Don’t hang onto losses, but let gains ride. Behavioral finance tells us that people tend to operate in the opposite way hanging onto losses hoping for the best and quickly selling gains to have something to show for their efforts. This is where discipline and focus are crucial.
Furthermore, remember that, on average, the expected returns on trading are zero: and there are still fees that need to be paid. But, using part of your funds in this way keeps you “playing the game” while still keeping the major part of your portfolio available for “value” investing to take advantage of longer run opportunities.
As research has shown, the fundamentals do apply over longer periods of time. Perhaps, however, it is not quite time to commit to some of these “value” propositions. People are worried about the potential inflation that may come about due to the large government budget deficits and the possibility that the Federal Reserve will have to monetize a substantial amount of the debt created. But, there are many people who think that deflation is going to be more of an issue in the near term. Hence, it is perhaps a little premature to put funds into investments that will prosper from a future period of high inflation. This part of the portfolio should be kept safe, but also should be able to be accessed when the time is right to commit to the longer run fundamentals. Research, however, has shown that it is alright to be a little early on these types of investments because the possible returns on such a commitment to fundamentals are substantial enough that being a little early is not harmful.
It is also important that an investor should stay in the areas of the market that they know best. If your skills lend themselves to the technology sector of the stock market then stay there. If your skills are in the government bond market then stay there. If your skills are in the foreign exchange market then stay there. Again, discipline and focus are all important.
Uncertainty is going to remain with us for quite some time in financial markets and commodity markets. The behavioral economists have warned us that this is a dangerous time to act in just an impulsive or instinctive manner. So, if being methodical is not your “cup of tea” then beware for the statistics are not with you. Chasing every “green shoot” or market reaction is not going to produce happy results. Acting in a focused and disciplined way may be very difficult for us to achieve but we need to try. That is what humans have learned they must do in activities like investing in financial or commodity markets.
These researchers tell us that this type of behavior is what has helped the human species survive. However, it is not necessarily the kind of behavior that leads to decisions or actions that are in our best interest when investing. “Relying only on intuition in finance can lead to very bad outcomes, not only for individuals but also for markets.” (This quote comes from David Adler’s new book “Snap Judgment”: see my post that reviews this book, http://seekingalpha.com/article/145660-book-review-snap-judgment-by-david-e-adler.) Yet we humans, individually and collectively continue to perform in this way.
Right now, the concern is whether or not the economy is bottoming out and starting to recover. We get “green shoots” here, but then some other indicator of economic activity comes in worse than expected. Alcoa puts up better than expected loss numbers but retail sales come in lower than expected. Sales of existing homes improve yet we get wind of another wave of subprime mortgage problems. (See “Subprime Returns as Housing Woe,” http://online.wsj.com/article/SB124709571378614945.html#mod=todays_us_money_and_investing.) And, what about the problems in commercial real estate, credit cards, and Alt A mortgages?
Then there is the question about whether or not there should be a second round stimulus bill. Paul Krugman has argued for a long time that the first stimulus bill was not enough. Yesterday Laura Tyson indicated that she thought that there needed to be a second round. Now the debate is all over the place. But, wouldn’t another stimulus bill add more to the government budget deficit going forward? And, there are questions about the possibility that the government has already committed to too much debt.
So the Dow Jones average goes up from 6500 and looks very strong approaching 9000 and then goes into a swoon. The price of crude oil was approaching $40 a barrel in February and then shot up to above $70 but now has returned to the $60 range. The yield on the 10-year treasury issue was nearing 2.00% in December 2008, jumped up to around 3.90% in the middle of June and traded at 3.30% yesterday. An index relating the value of the dollar against major currencies was around 70 in July 2008, popped up to the mid-80s in March 2009 and has since declined to about 77.
When the economic indicators seem strong the price of oil goes up as does the stock market and the price of bonds and the value of the dollar decline. When the economy seems weaker we get just the opposite movements. And, my bet is that it is going to continue this way for a while. So, uncertainty, and hence volatility, rule the marketplace.
This is the short run. Recently, however, I have been writing more upon the long run, what deficits do to long term interest rates and to the value of the dollar. Over the longer run, historically, some patterns repeat themselves over and over again. This, of course, brings to mind the statement made by John Maynard Keynes, “In the long run we are all dead!” Still, we need to take the long run into account.
This is where we need to take heed of what the behavioral economists advise. We, as investors, must not rely on intuition or gut reactions. We must not over react to the environment we now find ourselves in. Research has shown that acting in this way is not necessarily in our best interest.
The research also indicates that investing based on fundamental economic reasoning does work. Therefore, it seems as if now is a time for discipline and hard work. And, it is a time for patience.
But, this does not mean that one needs to totally ignore the short run. It is perhaps impossible to expect that most people will just sit out this stage of the economic cycle and invest their funds in safe, low-yielding assets. So, what kind of strategy might work here? My suggestion is that one needs to segment one’s portfolio, allocating some money to playing in the current market volatility, but allocating a larger share of the funds to potential future fundamental investment choices.
The smaller part of the portfolio can be allocated to playing both sides of various markets. Obviously, getting into the market near a “bottom” would be very profitable, but selling short near a “top” would also work. But, by all means consider any investments here as short term in nature because it is highly likely that the “bottom” may not turn out to be a “bottom” at all. Likewise for a “top.” So, one must be very agile in investing this way. Don’t hang onto losses, but let gains ride. Behavioral finance tells us that people tend to operate in the opposite way hanging onto losses hoping for the best and quickly selling gains to have something to show for their efforts. This is where discipline and focus are crucial.
Furthermore, remember that, on average, the expected returns on trading are zero: and there are still fees that need to be paid. But, using part of your funds in this way keeps you “playing the game” while still keeping the major part of your portfolio available for “value” investing to take advantage of longer run opportunities.
As research has shown, the fundamentals do apply over longer periods of time. Perhaps, however, it is not quite time to commit to some of these “value” propositions. People are worried about the potential inflation that may come about due to the large government budget deficits and the possibility that the Federal Reserve will have to monetize a substantial amount of the debt created. But, there are many people who think that deflation is going to be more of an issue in the near term. Hence, it is perhaps a little premature to put funds into investments that will prosper from a future period of high inflation. This part of the portfolio should be kept safe, but also should be able to be accessed when the time is right to commit to the longer run fundamentals. Research, however, has shown that it is alright to be a little early on these types of investments because the possible returns on such a commitment to fundamentals are substantial enough that being a little early is not harmful.
It is also important that an investor should stay in the areas of the market that they know best. If your skills lend themselves to the technology sector of the stock market then stay there. If your skills are in the government bond market then stay there. If your skills are in the foreign exchange market then stay there. Again, discipline and focus are all important.
Uncertainty is going to remain with us for quite some time in financial markets and commodity markets. The behavioral economists have warned us that this is a dangerous time to act in just an impulsive or instinctive manner. So, if being methodical is not your “cup of tea” then beware for the statistics are not with you. Chasing every “green shoot” or market reaction is not going to produce happy results. Acting in a focused and disciplined way may be very difficult for us to achieve but we need to try. That is what humans have learned they must do in activities like investing in financial or commodity markets.
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