October 21, 2010
Economics Department
Windy Investments
Mark's review of Michael Lewis's The Big Short: Inside the Doomsday Machine sounds interesting. I generally find finance and economics difficult to read about, but I may give the book a go.
From the sound of it, the author and I seem to have a couple of similar arguments about what is wrong with the efficient market. One premise I like to start with is that efficient markets require free and open knowledge of the marketplace. This is the reason corporations and, pretty much anything you can invest in, have reams of information regularly produced and distributed as mandated by the SEC.
In business school, intro finance courses spend most of their time explaining how to read all of these reports. (If they went beyond that, I must have fallen asleep by that point in the lectures.) In theory, this is what keeps everyone in the marketplace aware of what is going on, and allows the efficient market to work. I believe this system has been running into trouble for a couple of reasons.
One is touched upon in your description of what Lewis calls fraud. Even when it isn't called fraud, fudging the numbers in quarterly and annual reports seems to be standard operating procedure these days. If you can't hide the numbers anymore, just spin off a new corporation and hide the numbers there. Much of this seems to be legal, though I would still call it fraud. The purpose is to deceive investors and cloud the reality of the marketplace. You can't do this forever, but people can become millionaires or billionaires in a very short time, so the deception doesn't need to hold for too long. In this respect corporations, and to some extent the markets they are traded in, become like a game of musical chairs. The last investor standing loses. The last investor is often the one who thinks their investment is long term.
"Short term thinking" goes beyond simply not seeing that your investment isn't good in the long run. Short term thinking can be a money-making trading strategy that investors can keep using in the long run. The concept of day trading is based upon catching (very) short term trends. Buy (or short) a stock in the morning, perhaps because you anticipate a reaction from a news item, then sell in the afternoon before the long term impacts can be digested by the market. This sort of very short term view, it seems to me, is starting to become more prevalent in the markets.
I don't mean that there are more and more day traders, but that the entire market is now looking for shorter and shorter returns on investment. When you chat with traders and ask them about their long term investments, you often hear statements like "Sure this is long term. We may even keep it more than a year!" Technology, in particular computer networking, allows for the rapid dissemination of information and traders are treating every week, or even day, as if that were the day quarterly statements for an investment came out. The actual quarterly and annual reports are increasingly becoming nothing more than when you happen to update some of the numbers in your trading model instead of being an indicator of whether you want to keep the investment or not.
As the investment horizon is shortened, this way of thinking must start to become part of the corporate culture as well. After all, ultimately the management of a corporation is working for the investors as represented by the board of directors. Since wealthy individuals need to diversify their investments (to protect against the unpredictability mentioned by Lewis) very few individuals have controlling interest in any major corporation anymore. Large investment funds have replaced the individual and now have the influence to affect corporate management.
Something else I was taught in graduate business school, way back in the ancient mists of time, was that top corporate management was mainly supposed to concern itself with the far future of the firm. They were to think 10 to 20 years into the future, or even beyond. Wealthy individual investors in the past often shared this view and often hoped to maintain their investment for decades. This culture became so ingrained that business schools taught that top managers should shun any short term projects.
Do you think that there's an investment fund out there today that is capable of thinking of a corporate investment beyond 1 year? Beyond 5 years? Probably not, and, under the free market, they are correct to focus on the short term. Any long term investment will wax and wane over time and anyone who is interested in becoming a millionaire this year will ask why the fund failed to sell before any drop and buy before any gain. The fund will only grow if they pursue a (winning) short term strategy, and the corporations will only get investment funds if they deliver on short term promises. The large-fund controlled board will hire management that can deliver. The market works, so to speak, just not the way that is best for the future.
So yes, I see the fraud (legal and illegal) as a major impediment to the efficient market, but I also see the market working against its own future by an obsessive (valid?) focus on short term returns and trades as enabled by modern computer networks and databases and encouraged by the efficient market itself.
I think we should become fund managers who get paid for transactions. You do have the windyinvestments.com domain reserved, right? The more transactions we make the more money we earn. We need to be sure to tell our clients to never hold onto an investment for more than a week or so...
Of course we probably don't have the seed money for this. With the kind of money we could put together we wouldn't be called fund managers, we would be called loan sharks. Charles Ponzzi had a way around that, but it's only legal if you are deemed to big to fail by the government.
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I don't think I like your pay-per-transaction idea. We'd have to do trades to get paid, and that sounds like a lot of work. I prefer the old-fashioned approach of getting paid a percentage of the fund off the top to as a management fee. Or better yet, we'll advertise that we do the management for free, but then pay ourselves through a shell corporation as "advisors."