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Fisher Investments Analyst’s Book Review: The Shallows and Cogintive Surplus

September 29, 2010 Leave a comment

When society gets anxious, it tends to infest all corners of culture. Today’s age of perceived plight has turned its gaze toward technology. So, wonder of wonders, a recent batch of books reveals our nervousness, anxiousness—tensile jitteriness—about technology. This should be all the more striking compared to our decade-ago view of tech as economic savior.

Nicholas Carr’s book, The Shallows: What the Internet Is Doing to Our Brains, is getting a lot of attention. The book is about how the mind works in the internet age and asks the question: Is our technology making us smarter or dumber? He believes we’re getting dumber. Clay Shirky disagrees. His latest book, Cognitive Surplus: Creativity and Generosity in a Connected Age, argues technology and the information age are a source of goodness almost beyond our ability to comprehend.

Paradoxically, Carr’s book is often wrong but worth reading; Shirky’s is often right but should be skipped. We’ll tackle this review from two perspectives—the books themselves, and what they mean for investors.

I. Technology and Our Brains

This year, I had a mild career change. I went from being an analyst to managing some of them. A few months into it, my boss asked me how it was going. I said, “It’s changing my brain.” He looked at me sideways. But I meant it—I’ve had to think differently. Instead of contemplating just me and my work, I had a bunch of folks to consider, constantly. I’d get requests and interruptions all day such that I’ve had to learn to change focus on a dime, continually. At first, I worried this would affect my ability to think deeply and write for long stretches. Turns out, those things didn’t go away at all (these book reviews seem to be getting longer and longer!). Plus, I now have a new set of skills and new perspective.

Carr’s book, The Shallows, deals with this topic in earnest. He believes information bombardment from the net, email, smartphones, Twitter, text messages, and so on makes us less capable of deep, linear, focused thought and more prone to attention diffusion and interruption. Carr spends many pages making one point: Human brains are malleable, and so what we “feed” them dictates a lot of their wiring and thus how we think.

This ends up both right and wrong. True, the internet age will change our brains, but our neural abilities are so powerful this doesn’t have to be a bad thing and certainly doesn’t have to make us “shallower.” Through history, intellectuals have lamented mass paperback publishing, comic books, radio, television—saying they’d all ruin society and our ability to think deeply. They didn’t. Why? Carr goes to great lengths to prove that the brain is the finest computer of all time, but oddly doesn’t recognize our brains might have the ability to switch gears. Perhaps sometimes our attention is diffused on conversation, emails, and the like. And maybe other times, we can still sit quietly and read.

Carr cites a study that ostensibly proves a person’s brain changes materially with “just one hour of internet use a day.” From this, he concludes that if one hour does all that, think of what a whole day in front of the screen will do! One would expect interaction with any new medium to require a lot of energy and new neural activity before it becomes habitual. But that doesn’t mean the magnitude of new neural activity would necessarily continue unabated in each subsequent hour—or crowd out older, learned modes of thinking. Rather, and in keeping with Carr’s insistence on the primacy of neural plasticity, the marginal brain change would diminish over time. You only have to learn to ride a bike once and then riding is easy, making room for additional new learning and allowing the peaceful coexistence of all previous modes of thought.

More, Carr argues that solitary, silent reading and writing were the substrate for some kind of individuality that was imperative for the development of society. This is sheer nonsense and can be dismissed simply by examining the life of Socrates, who never wrote or read, but spoke and listened. This reflects Carr’s confusion on the important difference between the ability to think and how that thought is transferred. Transfer mechanisms, like books and language, influence thought, but are not thoughts themselves. (Steven Pinker has proven this over and again in his studies of language.) Further, our fabulous brains make room for many different transfer mechanisms (as discussed above)—the evolution of which have only furthered and deepened thought.

On one level, The Shallows is a sterling introduction to contemporary neural science—from studies on instinct and plasticity to the chemistry of memory. Carr is extremely well researched and authoritative here. (He even cites—and seems to have actually read!—David Bueller’s hugely turgid Adapting Minds, a seminal critique of evolutionary psychology.) But The Shallows is ultimately less than the sum of its parts—a grouping of well-written, thought-provoking pieces that never really prove the case. By contrast, Clay Shirky’s Cognitive Surplus is often generally right to argue that increasing information and technology is a good thing for society, but does so in tedious and tautological fashion. Shirky has a few important points:

  • There will always be folks lamenting the new opening of information and that always ends up wrong.
  • Though we feel busier and more anxious about it than ever, we actually have more time than ever and are more productive than ever. This is the “cognitive surplus.”

But we didn’t need a whole book to get to these points. Most of the text is a quagmire of tautology like, “the needs of the group and the needs of the individual should be balanced” for an online community. (Who needed to be told this, and what does it really have to do with the book’s topic?)

II. Technology and the Investor

I increasingly hear questions from clients about how to choose information sources, which ones to trust, and how to generally deal with the bombardment of information that hits us every day. One thing is certain: Just the mass influx of information causes heightened anxiety—it can be like drinking from a fire hose. Serious investors need to consider how technology and the availability of information affects their decisions.

Fifty years ago, with paper, pencil, and newspaper stock quotes, you could make a stock price chart and calculate a few things like P/E ratios. If you had the time and a big enough research budget—you could cleverly use all this to act on things others weren’t seeing or hadn’t thought of. (Have you ever actually graphed a stock price by hand? It takes forever.) Today, you can get every stock price or metric (any piece of data you can think up, really) free on the internet and crunch it any which way you like—in milliseconds. Where once all of this was only possible for an elite few, today all you need is a computer, the internet, basic knowledge of statistics, and spreadsheet software like Excel.

A good bit of investing used to be about how fast and comprehensively we gathered information, but today it’s more about the quality of our thought and analysis and how well we sort out the noise. The human brain still ultimately pulls the decision-making trigger and our brains haven’t much altered—we can only digest, think through, and understand so much, and rational thought is still influenced by subjective emotions. Said differently, more information hasn’t led to better investor returns. We live in a world where successful market forecasting is more than ever about interpretation…and less about finding that one “magic bullet” no one else has yet found.

Look no further than right now. We at MarketMinder have been truly breathtaken at how quickly folks have decided recent slower economic data automatically means double-dip recession. Fifty years ago, an average US investor couldn’t get a hold of, say, a breakdown of Japanese GDP without spending huge time and resources (and probably hiring a translator). And even if they could, it would likely lag weeks or months after it was reported. Today, a full breakdown of global GDP is available online, basically instantly, to everyone and for almost every country. So, the issue is how to interpret the GDP reports. Our analysis says this is a very typical deceleration of growth after what’s been a swift first stage of recovery. Recoveries—and expansions, generally—aren’t straight, smooth lines up. Others disagree. Whoever’s right, there’s no secret or hidden piece of data that tells the tale.

Thus, effectively sorting and interpreting, not just data gathering and computing, is more important than ever before. Or, as James Hillman has said, the “hungering for eternal experience makes one a consumer of profane events.” Determining what is truly holy to markets (what moves them) and what is profane (noise) is the crux of forecasting today.

*The content contained in this article represents only the opinions and viewpoints of the Fisher Investments editorial staff.

Fisher Investments Analyst’s Book Review: Think Twice

August 31, 2010 Leave a comment
Once the intellectuals get a whiff of new psychological theories, look out. With Freud and the “discovery” of the unconscious, the twentieth century wasn’t long in the tooth before repression and daddy issues made common cocktail party witticisms. Today, the pattern repeats with the psychology of evolution—there are literally thousands of works circulating on how our natural “instincts” lie at the root of most behavior.

Going all the way back to the 70s, the field of behavioral finance (where evolutionary psychology meets money) has kept a fairly low profile. But in the last decade, particularly these last few years, it’s made a leap to the mainstream.

A few weeks back, I wrote a little about the inherent weaknesses in behavioral finance. Popular works like Freakanomics and Predictably Irrational are good entertainment, but be wary—most such books are built on shaky science and are reductive to the point of uselessness. Other prescriptive works like Richard Thaler’s Nudge can be borderline dangerous—recommending mass public policy on the basis of such findings.

This is hazardous because, and no matter how much the intelligentsia may crow against this fact, psychology is not a hard science in the same way basic physics or chemistry is. It’s not even close, really. We don’t understand ourselves yet, and the empirical studies we do are too often overly reductive or poorly executed.

So, the reason it’s ill-advised to prescribe policy based on behavioral studies is more or less the same reason socialism ultimately never works: The world is too complex and various, as are human psyches, and the notion that elite rule can consistently fashion the best economic or societal outcomes is nonsense. For better or worse, folks must be free to choose for themselves.

Don’t get me wrong—psychology in investing can be hugely useful, and we at MarketMinder use it daily. Indeed, the study of human behavior is at this point a must for market forecasting success. Essentially, the economy constantly changes, even at an accelerating rate, but the human psyche has features to it that are relatively static. Thus, the situations will always be somewhat unique, but the basic patterns of greed, fear, love, hate, and all in between, will out. It’s simply fascinating—observing each day how markets move—how fungible human behavior can be. Behavior during a bear market panic transcends time, culture, and place. This is part of what makes global investing truly possible, the baseline commonality of people.

The last two paragraphs may appear contradictory. Well, welcome to psychology! What I believe psychology can do for investors is offerheuristics—“rules of thumb.” Unlike, say, the laws of thermodynamics, human psyches are too inscrutable for ironclad rules. People will tend to hate losses more than they enjoy gains (aka prospect theory), but that’s not always true. There are tacit patterns, but situational anomalies and exceptions. Economics, as with psychology, loves to study the general, the “norm,” the average. But, in fact, we are always living in the specific, the now, this moment. In big systems like economies, specific can be unique. (The paradoxes of moving from the general to the specific are one of the main puzzles, to my view, of market forecasting. But we’ll save that discourse for another time.) That there are no ironclad rules should be self evident since no one—ever—can beat the markets every time.

So as investors we must bravely wade into psychology, but tread carefully and be selective about what is trusted. In comes Michael J. Mauboussin—one of the finest writers on behavioral finance today. His current offering,Think Twice, won’t get as much fanfare among the intelligentsia as with gurus like Dan Ariely, but ought to. This is a practical book from a real money manager. It’s short, clear, light, and makes use of real world examples effectively—as demonstrations of psychological concepts in action rather than literary ornament.

Mauboussin makes an important move most others don’t: He links psychology with the study of complex systems (like stock markets) instead of framing it in the light of neoclassical economics. This enables him to make useful observations rather than pointing out where stuff like “rational man” or “equilibrium” theories fall short. Behavioral psychology is at the point where it needs to create better theories, not continually criticize old notions. Let’s hope Mauboussin’s ethos rubs off on the Academy.

Mauboussin doesn’t offer a bunch of rules in the vein of “if X happens, do Y, and then you’ll be rich!” What he does, ultimately, is promote self-awareness. Higher consciousness isn’t just the stuff of Zen masters. That’s the end lesson of all useful psychology outside the pharmacy. Know thyself! Learn to study the quality and method of your decisions, stop focusing so much on the outcome (which, in stock markets often contains much noise and randomness). Seek feedback, ruminate upon your mistakes and successes—understand why you did what you did. Raise your self-awareness.

Investors don’t spend enough time mastering their own selves; they believe too much that numbers and metrics have definitive answers. It’s a tough thing to do and requires much effort and honesty, but no mathematical valuation metric on earth can replace self knowledge. If next time you don’t want to give in to irrational exuberance, or panic at the bear market bottom…figure yourself out. Don’t blame the outside world. With this book, Mauboussin offers us the particulars of why this ethos can give rise to smarter investing.

Back in my graduate years, I conversed one night with another psychology student over a few beers: “We’ve gone past Freud!” she exclaimed. “He was a master, but he doesn’t work for us anymore. We have science now.” This is folly. As it pertains to psychology, anyway, science (and ironicallyfaith in it) is the great religious impulse of the Modern mind—we want so much to escape our subjectivity and find answers outside, in objective empiricism. Yet, much of psychology’s wisdom today can be culled just as easily (often more so!) from the wisdom texts of ages ago. The scientific part of psychology is a noble enough pursuit, but deeper understanding about what makes us human, not the escape from it, has useful answers too. Or, as the old master Carl Jung said, “Unconsciousness of one’s true self is the seedbed of sin.”

*The content contained in this article represents only the opinions and viewpoints of theFisher Investments editorial staff.

Fisher Investments Analyst’s Book Review: 13 Bankers

July 23, 2010 Leave a comment


With the “sweeping” financial reform bill effectively a done deal, I’m not sure who’s supposed to be happy about it—those wanting to address the underpinnings of the financial crisis got next to nothing, some increased transparency, banks got punished (and possibly put at a disadvantage to foreign banks, all of which ultimately hurts average folks who actually do banking), and we got a smattering of new oversight boards. Who got the satisfaction? This turned out to be a feckless bill full of “stuff” that makes it look like the politicians did “something.” Which means on balance this bloated bill will create some winners and losers and a general disincentive toward financial activity, but the world will go on.

Part of capitalism’s adaptive ability to create prosperity includes scraping out the bad (which can be violent, à la 2008). Now, we’re emerging from that destructive phase, and the new financial regulation had nothing to do with that recovery. After such dislocations, debate rages on the balance between markets and government. But the foundation of governmental skepticism—as old as the US—is to realize the dangers of a government with good intentions. The sheer nature of concentrated power corrupts, diverts, and distorts into eviler things. It’s quite telling of this bill’s plight to read long-standing Democratic economist and public servant Arthur Levitt excoriate the thing with malice in the Wall Street Journal.

Enter Simon Johnson and James Kwak’s 13 Bankers. A handful of clients have mentioned this book, noting its emphasis on the interconnectedness of Wall Street to the Beltway. On this topic, Bankers is a blitz of finger-wagging at both politicos and CEOs. But its premises, and the sum of its argument, simply don’t hold water.

Bad Banking Attitude

MarketMinder’s written extensively that today is an era of anger and pessimism. As such, we get books like Bankers operating from the baseline notion that banks are predatory and aggressive, and left to their own devices will suck the blood from anything they can. Moreover, if not regulated properly, banks will effectively, and consistently, commit suicide (via overleveraging or excessive risk-taking). All this acts as great populist rhetoric, but is untrue.

Maybe we can agree many high financiers aren’t cuddly teddy bears, some compensation incentives are perverse, and the potential for systematic problems exists without government oversight. But on balance, private banking has provided one of the greatest social functions in all human history—acting as a vital intermediary directing capital to more productive places. (That is, unless we don’t want a mechanism allowing us to fund entrepreneurship or buy cars, houses, college educations, and so on.)

By the last chapter, the fangs really come out. To Johnson and Kwak’s minds, banks essentially exist to “ensnare” (their word) fees from the unwitting public. This is more a rhetorical trick than reality. Banking costs for the average person have come down a lot over the years—from brokerage trading costs to checking fees. (Of course, that’ll change now that new regulation is coming to pass: “…banks are preparing new fees on basic banking services as they try to replace revenue lost to regulatory rules…” Talk about the Law of Unintended Consequences!)

And anyway, when did it become a crime to charge a fee for services rendered? Maybe we should refer to charges for all goods and services as “fees.” How can McDonald’s take such a fat (pun intended) fee for providing high calorie food? Why, I’ll bet they’re skimming 3 to 5% right of the top of each transaction! And what about the fees involved in purchasing the authors’ book? I would have thought, out of the kindness of their hearts, Messrs. Johnson and Kwak would at least give us the wholesale price. But I digress. The only way this makes a lick of sense is if you believe (as many of the intelligentsia do) that banks ought to be purely bodies serving the public welfare. In which case, profits are illegal.

What Deregulation?

Many have used this recession as a platform for rebuking capitalism, calling the last ~30 years (ostensibly starting with Reagan/Thatcher) the “Great Moderation” that led to the big panic—an era highlighted by few crises and high economic growth, allowing for deregulation that allowed predatory banks to kill the system. This is ridiculous. First, go back 30 years or more. What about the 70s was so idyllic that we should return to those years? Why is that viewed as an ideal? The 70s were a perfect example of what you get with government “guiding” markets.

Also, the last 30 years have been the most prosperous on human record globally, but also included much turbulence along the way—the Cold War, two Gulf Wars, 9/11, theS&L crisis, a massive tech bubble, most of South America defaulting, the Russian Ruble crisis, the Asian debt contagion, the market crash of 1987, Japan’s decades-long malaise…and much, much more. Also, Superman died for about a year in the early ‘90s (which broke my heart). It was a turbulent time. And today is no different; there was no Great Moderation, just a very prosperous time that I’m not convinced has ended and/or can’t accelerate from here.

Yet, the “Era of Deregulation” has now been accepted as gospel, as if it were an official thing. I want to see a study—some real, non-anecdotal evidence that we’re less regulated today than 30 years ago. Because for every dissolution of Glass-Steagall, there are 10 Sarbanes-Oxleys. This world is vastly more regulated today than bygone days. I think the confusion lies in a mix up between actual regulation (i.e., rules) and an era of privatization. Indeed, the last 30 years have been a global era of privatization—a tremendous thing, not just for stocks, but for society.

We had a bear market/recession with Financials as the hub, which is more damaging than having it, say, start in Technology because Financials are the epicenter of commerce and the engine oil of capitalism. But that doesn’t mean this was the end of finance, or that a bad 2008 for stocks means the 30 years of unprecedented economic stability and wealth were nothing but a “leading up” period. We’re going to have more bear markets on the way to higher highs and ever more prosperity.

US-Centric, and Concentrated Power

What Johnson and Kwak’s perspective reveals is an over-focus on the US. This is the sin of much investment and economic analysis. If this really was a 30-year period leading up to the worst bear and recession since the Depression, with the US as culprit, then how is it that the US is currently a recovery leader for the developed world and that the supposedly safer—and more regulated—Europe is ailing most now? The narrative simply doesn’t hold.

How then can the authors argue that more regulation is the key to a safer system? They start with US forefathers Hamilton and Jefferson. Theirs was a heated debate, seen largely in the Federalist Papers. Hamilton was amenable to banking and financial markets generally, while Jefferson was skeptical and supported tighter restraints. Hamilton saw the vast benefits of free flowing capital, and Jefferson feared consolidated economic power, particularly its influence on politicians. Through the latter part of the 18th and early19th century, the US was an emerging market. Much of its charge toward global economic leadership during the Industrial Revolution can be traced to market liberalization à la Hamilton, many of its 19th century travails to Jefferson’s antagonistic view of banking (I’m talking to you, Jacksonian-era politicians).

This is the strongest part of the book and the authors are quite creative in framing the discussion this way. Big banks are the center of today’s heated debate, and the US has a long history of (generally) successful trust-busting. Or, at least without hamstringing the economy fully. (Whether the government needed to break up companies in the early 20th century is debatable. The Titans probably would have declined of their own volition. After all, what killed big rail companies wasn’t rail competition, it was competition from newer industries like autos and aircraft. What brought Microsoft back to earth? Google and Apple, not antitrust hawks.)

Either way, now isn’t the same as then. To see that, resume thinking globally. It’s true the big US banks are highly consolidated (even more now than before the crisis—thanks largely to the government!) and enjoy a great deal of influence on the Beltway. But they aren’t the only game in town anymore. An average person can do business with banks across the world. HSBC, Barclays, and others are all over. Heck, my firm uses the brokerage services of a handful of foreign banks too. Thinking US-centric makes it seem likeGoldman Sachs rules the world and controls all liquidity. But in fact, especially in places like Europe and Asia, the biggest banks have much more government scrutiny and intervention, yet they fared no better in the crisis.

All this context leads to a near total misinterpretation of how and why 2008 happened. Johnson and Kwak view it as the aforementioned 30-year process, whereas the true causes stemmed from government itself—dreadful regulation and guidelines in the form of Sarbanes Oxley and FAS 157, mixed with inconsistent government response to spark the panic. (Again, MarketMinder has featured much commentary on this, so we’ll abstain here.)

But it should give us pause when the authors say the government-conducted banking stress tests turned the tide in the panic. (Huh? The tests were done in April/May ‘09—markets had rallied hard for two months by then.) Johnson and Kwak also claim that each time the government intervened with a new program or policy, panic waned a little, until panic finally ceased. The opposite is true—as Bernanke and Paulson haphazardly hopped from bank to bank, panic heated up in late 2008. And TARP didn’t stem jitters a wit.

In the end, much of this rolls up into the fantasy of exerting complete control over a complex system like the global economy. It would be so nice to prevent cyclical downturns, but we can’t and shouldn’t seek to. Government should play a role in establishing property rights, transparency, and enforceable rules of the game. The goal of regulation isn’t to prevent crises (those are a part of capitalism), but to increasingly deal with them effectively as they happen. If you preemptively dampen crises, you dampen potential prosperity—which actually makes us all worse off in the long run.

Few see this now, but my view is the end result of the last +30 years was a Golden Age founded on burgeoning financial innovations that moved into the mainstream, sparking some of the most profound wealth creation of all time. Capitalism’s engine always gets a bit overheated and must cycle back. And we’re getting through it now. But today’s world is a better one than decades ago, and tomorrow’s will be better than today’s.

*The content contained in this article represents only the opinions and viewpoints of the Fisher Investments editorial staff.

Fisher Investments Analyst’s Book Review: The Greatest Trade Ever

July 21, 2010 Leave a comment


I’m not accusing anyone of plagiarism—not at all—but…well, let’s just say, as I read Gregory Zuckerman’s The Greatest Trade Ever: The Behind-the-Scenes Story of How John Paulson Defied Wall Street and Made Financial History, I, um, realized it’s startlingly close in parts to Michael Lewis’ The Big Short. (Zuckerman’s book predates Lewis’ by about five months.)

I don’t know if they used similar sources or what (they did write a book about the same thing after all), but adjectives describing certain people and other situations seem very close. Again, I’m not accusing anybody of anything—I don’t have the time or desire to conduct such an investigation. It’s just an observation to make this point: These two books mostly function interchangeably. So read one or the other, but not both.

That said, Zuckerman’s book is a country mile better than Lewis’. (Read my review on The Big Short here.) Zuckerman’s book is about the main player, John Paulson, and does a better job describing how he profited in the bear market than other books I’ve so far read. One gets the sense Lewis would have loved to have his book be about Paulson, but couldn’t since Zuckerman beat him to the punch, so he had to focus on the smaller players instead.

Don’t confuse John Paulson with Henry Paulson, the former US Treasury secretary. John Paulson is a hedge fund manager. And, actually, isn’t all that interesting a guy. Zuckerman does his best to make the biographical bits about him seem provocative, but it’s a bore and I often skimmed those parts.

The real virtue of this book is its depiction of how Paulson became a billionaire in what some believe to be the most profitable trade in history (estimated to be $15 billion for his fund, and a personal profit of ~$4 billion). What’s fascinating isn’t just the innovation and forward-thinking required to profit by betting against real estate through this period, but also how difficult it was to do and the sheer determination needed to follow through on it.

Not only did Paulson have the whole world telling him he was crazy to bet against real estate, but most of those who also predicted the downturn in housing couldn’t figure out how to actually profit from it. Paulson was one of the very few who did that. In a nutshell, he bought insurance against the failure of CDOs in the form of credit default swaps. This was hugely risky and costly if he was wrong, and very painful for his clients as they continually saw the fund’s money used to buy more and more insurance contracts. It took awhile for the bet to blossom, and for a long time Paulson looked wrong.

From this, there are two important points for long-term investors.

First, the “biggest trades” just about always come from folks like Paulson because the best investors who think long-term never go for broke like this—they’re not even interested in betting the farm on a single, high risk/return scenario. That’s why it’s treacherous for long-term investors to regard the Paulsons of the world as ever-prescient gurus. They’re really all-or-nothing types who hit the jackpot. Let’s not forget the very many hedge funds that went bust too, and also that such things are not repeatable and Paulson has no prior or post history of being so “genius”-like. So let’s not mistake him for Warren Buffett. The best long-term managers can be wrong through periods such as these but still achieve their clients’ ultimate investing goals—a very different game than Paulson’s.

But, let’s also give Paulson a ton of credit. I still marvel at the kind of fortitude it must have taken to persevere with this trade…to be wrong for months and years, yet remain fully convicted and to keep pouring money into CDS contracts with no return. This is a tremendous feat and the stuff market legend is made of.

Second, let’s not vilify him. There’s no point. Populist politicians will always react to public anger when we see someone profit from plight. But plenty of investors benefit through upheavals and bear markets all the time. And we don’t have to love them, but we should at least respect them—there’s always someone on the other side of a trade.

In April, Paulson’s fund was mentioned in court fillings against Goldman Sachs where it’s alleged Goldman “materially misstated and omitted facts in disclosure documents for a synthetic credit default obligations (CDO)” to which Paulson’s fund was attached. As of now, Paulson’s fund specifically isn’t being sued, and it should stay that way.

Ultimately, this book is a good accounting of the frothiness of the housing market in the middle of the last decade. Like most of the crisis books I’ve reviewed in this space, it fails to sufficiently link how those problems infected equity markets and the broader economy. But, if you want to know how one of the most famous bears of the decade made his one killer trade, this is the right book.

*The content contained in this article represents only the opinions and viewpoints of the Fisher Investments editorial staff.

Fisher Investments Analyst’s Book Review: Myth of the Rational Market

July 16, 2010 Leave a comment
One of my favorite Saturday Night Live skits aired in 1994, the year of the Major League Baseball strike:

Super Sports Tours is proud to announce its 1994 Fall baseball cruise! On September 28th, it’s all aboard the Pacific Queen for a week of fun and sun with some of your favorite baseball stars. Including:

…Baltimore’s Cal Ripkin, Jr. And Chicago’s Sammy Sosa. And Mark Grace. And the Tigers’ Cecil Fielder. And the Red Sox Mo Vaughn. And also from the Yankees: Don Mattingly, and Mike Stanley, and Paul O’Neill, and Jim Leyritz and Danny Tartabull and Jim Abbott, and Randy Velarde and Gerald Williams and Matt Nokes. Annd don’t forget about the Angels’ Chili Davis, and Tim Salmon and the Padres’ Tony Gwynn. And many more!

The commercial went on and on, literally rattling off a hundred names plus—at a certain point the sheer inanity and repetitiveness became funny. Well, consider Jonathan Fox’sMyth of the Rational Market the financial equivalent of the Fall Baseball Cruise.

The book is a comically comprehensive recounting of the personas influencing efficient market theory, primarily over the last 100 years, but at times reaching all the way back to Adam Smith. Comical because, if you read the book’s title and synopsis, you’d think you were picking up a book of theory arguing against the idea of rational markets. This ain’t it. Instead, it’s a history book touching on everything from economic theory to financial innovations to behavioral finance to accounting principles to investing gurus to corporate governance…and more!

Which is a boon and a bane. Boon, because it shows how deeply the idea of efficient markets has influenced economic activity over the last century. Bane, because the book’s breadth ends up clouding the central question of market efficiency. On balance though, this was a worthwhile read.

What Is a “Rational” Market?

Among the greatest human technologies—ever—is market-based pricing. Just think of it—all possible information and opinion reflected in a single number! But we can only make that statement in a theoretical sense because in practice it’s not so clean and easy. There really is no “pure” market—distortions exist. Similarly, there is no “rational man” that always makes well-informed decisions, yet most economic theory is predicated on him.

So, pure theorists tend to dwell on the wrong issues when it comes to market efficiency. It ought to be self evident people aren’t fully rational, nor are markets fully efficient. The question for a practical person is whether markets are the best mechanism available to create pricing information and move capital to where it’s best used. It’s particularly appalling how often markets’ adaptive features are ignored in academic debate. When mistakes or “irrational” decisions are made by real people (which is constantly), it’s spellbinding how nimble and able economies, capital, and people adapt in a market environment versus, say, government bureaucracies. This is what makes Fox’s book so fascinating: it’s a tremendous panorama of the impractical debates that have dominated economic thought for decades.

Learn from the finance pros! Like Kenneth Arrow, Roger Babson, Louis Bachelier, Henri Poincare, Fischer Black, Myron Scholes, John Bogle, Warren Buffett, Alfred Cowles III, Irving Fisher, Eugene Fama, Milton Friedman, William Peter Hamilton, Friedrich Hayek, Benjamin Graham, Alan Greenspan, Ayn Rand, Michael Jensen, Daniel Kahneman, Richard Thaler! And many more!*

My own definition of market efficiency doesn’t include anything about rationality. It’s about bringing all the adaptive intelligences and perspectives—dumb and smart and all in between—together to reveal the true prices and values of things over time, better than any one mechanism, person, committee, or equation can. It’s not that anyone is perfectly informed, it’s that the balance of opinions tends to tease out the most accurate result over time.

So…markets are hugely efficient in the sense they generally reflect what’s widely believed to be true. Which means they aren’t always right, but are right more often than anything else we know of. That also means they aren’t a “random walk” of perfect rationality. Markets are as human as…humans.

In the short- or medium-term, markets can gyrate wildly and disengage from economic reality. But a simple overlay of corporate profits and stocks over time shows how closely these two things match in the long run, and how stock prices are consistently the best forward-indicator of future economic activity. But markets do need an overlay of strong property rights, oversight, transparency, limited and non-politicized institutions like the Fed, and also mechanisms to stabilize liquidity when appropriate. For two reasons. One, confidence is a key to market activity, and we need enforceable, stable rules to get that. Second, capitalism is sometimes wild and features occasional upheavals we’re not willing to put up with as a society. Pundits tend to describe this as a “shortcoming” of capitalism. It just is what it is—if we as a society decide to dampen capitalism’s “animal spirits” for social reasons, that’s a moral/social decision, not an economic one. Free market advocates (like me) tend to bristle at the creation of governmental stuff that doesn’t serve either of these two purposes (which unfortunately constitutes a lot of bureaucratic oversight), but only adds a layer of inefficiency. (I’m willing to bet, for instance, any new oversight committees created by the new financial overhaul will have a dismal record of overseeing so-called “systemic” risks.)

Economics: Not Fully Science, Not Fully Math

Another key lesson of the book: Economics isn’t even close to being a hard science, and much of finance is the same. Yet, economists have argued stridently for decades that they are. It’s simply delightful that Fox spends time arguing finance and economics owe much to philosophical scientific thinkers like Thomas Kuhn and Henri Poincare…and then uses them to display economics shortcomings based on those metrics. It both reveals economics as a social science and deepens our understanding of how “hard sciences” actually work.

For example, take the notion of “equilibrium” prices—the foundational metaphor of classical economics, borrowed from the hard sciences. Only in theory is equilibrium even a possibility for markets. There’s no sense in contemplating it in the real world. The idea gets constantly misapplied: a price is agreed upon by separate parties, it’s not a natural reverting point of settlement. Instead, markets (and prices) adapt and react in a continuum of dynamic, complex, and ever-changing circumstances. There’s never a point at which we settle upon an “equalized” state, as if markets were somehow homeostatic.

…other superstars of economic history like John Maynard Keynes, Hayne Leland, Mark Rubenstein, Robert Lucas Jr., Fredrick Macaulay, Burton Malkiel, Benoit Mandelbrot, Harry Markowitz, Jacob Marschak, Robert Merton, Myron Scholes, Merton Miller, Franco Modigliani, Wesley C. Mitchell, Oskar Morgenstern, John von Neumann, MFM Osborne, Victor Niederhoffer, Harry Roberts, Richard Roll! And many more!

Here is where Fox delivers his best insights: asserting that theoretical economic theory infected finance in the last decades—a field that once upon a time was concerned only with practicality. Essentially, finance started using the theory of pure market efficiency as a baseline for pricing assets. The result is bad accounting rules like FAS 157, which rely too much on market-generated prices where there isn’t enough liquidity or price discovery. In theory, it should work; in practice, it doesn’t.

Financial equations work great when circumstances are known and probabilities are clearly and easily assigned, like with a coin flip (only two possible outcomes and they’re both known). Anytime real uncertainty is added—that is, where the probabilities are not known but can only be guessed (which is how most of the economic world works), the math behind finance becomes grossly inadequate and even dangerous. This is why, for instance, bonds are somewhat easier to price than stocks, and the mathematics for bond pricing is more developed. Bonds have an end date, which makes the math for pricing them more reliable. Stocks have no end date, and thus there is no math in the world that can forecast a reliable price consistently. (This isn’t to say future bond prices can be gamed by math alone, there is still an element of uncertainty, just generally less than stocks.)

Theories Do Matter

Fox finishes what turns out to be a very fine book about the history of market efficiency with an important lesson: philosophy matters. It shapes how we interpret events, and how we decide to act. Theory is one of the vital ways we make sense of a chaotic world. And, even when it’s all hypothetical, theories are hugely important to how the real world ends up going. A few paragraphs ago, we were pretty hard on equilibrium. But then again, its ability as a concept to help us create economic models and heuristics has been a very useful thing.

One of the all-time free market fundamentalists, Ayn Rand, ranks as among the most lucid on the importance of theory and philosophy. Her nonfiction work, Philosophy: Who Needs It, is one of the most turgid but cogent books available on the nature of ideology, theory, and philosophy, and its role in real world decision-making. The prevailing worldview—however conceptual—shapes our decisions and opinions.

Fox’s book is exhaustive, but he has a light touch and a good feel for the material. If you find yourself soul-searching about capitalism and free markets these days (many are), this is a good place to go.

…hear the spectacular finance insights of Barr Rosenberg, Stephen Ross, Mark Rubenstein, Paul Samuelson, Leonard Jimmy Savage, William F. Sharpe, Robert Shiller, Andrei Shleifer, Herbert Simon, Joseph Stiglitz, Lawrence Summers, Amos Tversky, Edward Thorp, Jack Trainer, Meir Statman, and Holbrook Working…

…and many more!

*All these names were pulled from the book’s appendix, which is an exhaustive list of the cast of characters described in the book.

*The content contained in this article represents only the opinions and viewpoints of the Fisher Investments editorial staff.

Fisher Investments Analyst’s Book Review: Wrong

July 14, 2010 Leave a comment
Successful money managers are hugely pensive, introspective, and meditative on their mistakes (because they all make them, even the great ones, and with frequency). They stew and mull them, contemplate them, never forget them. They know their mistakes inside and out. So I’m always on the lookout for books that help identify wrongness of all kinds, searching for a better understanding about why and how it happens.

So I was excited, but ultimately disappointed, with David H. Freedman’sWrong. Or, the full title, Wrong: Why experts* keep failing us—and how to know when not to trust them *Scientists, finance wizards, doctors, relationship gurus, celebrity CEOs, … consultants, health officials and more. It’s a pyrotechnics show of all the stuff so-called experts flub on, but not much else. Disappointed, because I’ve otherwise enjoyed Freedman’s work (Brainmakers: How Scientists Are Moving Beyond Computers to Create a Rival to the Human Brain was a fun book!).

I was hoping for a thoughtful, multidisciplinary book positing a coherent view of how and why folks who are considered experts tend to be wrong in their prognostications. Instead, it’s a relentless showcase of examples where experts are wrong (which is very often), but you never really learn why at the cognitive level it actually happens. The book just keeps saying (over and over) stuff like, “This study was wrong! It turns out cell phones don’t cause cancer…or, maybe they do!” But what group of readers needed to be told fitness and financial gurus, or breathless studies about cell phones, are dubious?

In sum, the book functions more like an updated and cluttered How to Lie With Statistics. Most of it deals with how studies and findings get distorted and how wrong predictions or findings actually come to be. Freedman fills many pages with discussion not really germane to the book’s topic, saying, for instance, that Google and other internet filters/search engines aren’t good “experts” at helping us find what we’re looking for. (But who regards Google as an “expert,” and what does this have to do with “why humanexperts keep failing us”? My favorite example was a rant about how Netflix doesn’t recommend movies Freedman likes.) It’s bizarre, and one gets the feeling such topics were added simply to give the book a little heft. Why not burn a chapter or two about those few experts who do get things right? What characteristics do they share, and why, and what makes them different?

Even the “knowing when to trust them [experts]” part is trite, filled with a loose amalgam of advice that doesn’t add up to anything practical. For instance, saying to avoid advice from gurus that involves “steps,” or is overly “simple,” or is too “easy” to execute, or “confirms what people already thought,” and so on. But plenty of the best advice is heuristic-based, easily actionable, and simple. Like, the easiest way to increase savings is to make sure savings is the first thing to come out of your paycheck (most folks tend to make their savings a residual from the month’s expenses). This is a great little heuristic that came from tons of behavioral finance studies by experts in the field.

Some bright spots? The second appendix, buried at the end of the book, is a short history of wrong-headed experts—from the Pharaohs and Aristotle all the way to NASA—which was fun to read. Also, a full chapter diatribe on the biases and distortions in the academic world is worthwhile and will make you think twice before you trust a tenured professor again. The book also astutely observes that retroactive advice is always in high supply. It’s amazing how many “experts” came out of nowhere telling us how bad things were after the financial crisis hit. No sign of most of them beforehand.

Simply, and with all due respect to Freedman as a journalist, this book might have been better left to, well, experts. He seems to avoid stuff like the nitty gritty of financial markets prediction because he doesn’t fully grasp how it works. (It’s particularly telling that after so much text about the foibles of academic science, Freedman is mum on global warming—the ultimate of all expert scientific prognostications.) Also, Freedman goes into some detail about whether we can trust “the wisdom of crowds” (a la James Surowiecki’s bestseller), but he constantly misunderstands the differences between crowds and markets. Markets pit opinions against each other in a forum where prices provide information (there are always two parties in each trade who agree on a price), but groups and committees working toward a shared goal is something entirely different. He tends to use these things interchangeably, or lumps them together too often.

Perhaps the most frustrating part about the book is its shallowness. There’s little reflection, little weighing of the potential societal value of all these “wrong” opinions. Innovation, productivity gains, profitability, living standards—progress itself—is hugely dependent on a vast panoply of ideas, mixing and colliding, being tested and rejected or accepted by the public and other experts, and so on. There should always be many magnitudes more ideas than there are good ideas. Experts should often disagree and be wrong. And all that should be aired, freely, to whoever wants to listen. That’s the world we progress in, not some orderly, precise world where experts are always right and we only ever do what ends up being the sensible thing—Darwin would be horrified.

Later this summer, I’ll review Being Wrong: Adventures in the Margin of Error by Kathryn Schulz and Think Twice: Harnessing the Power of Counterintuition by Michael J. Mauboussin (one of my favorite financial authors), in search of some greater thoughtfulness on the topic of being wrong. In the meantime, you’re better served skipping this one.

*The content contained in this article represents only the opinions and viewpoints of theFisher Investments editorial staff.

Fisher Investments Analyst’s Book Review: The Rational Optimist

July 1, 2010 Leave a comment
I was in Austin, Texas recently and met with a client who is a retired French literature professor. After a lively afternoon discussing markets, economics, and geopolitics, the conversation turned to French modernism and Albert Camus. I quipped that Camus was a master author, but his philosophical writing is better than his fiction. Her eyes lit up, she sat up, and spoke through a wide smile, “Yes! Yes. The Myth of Sisyphus. Brilliant! Excellent! Oh!”That’s a lot of enthusiasm for a book about suicide! Well, that’s not fully true. The point of Sisyphus (a longstanding work of the modernist pantheon) is to start with the apparent meaninglessness and absurdity of life, but actually conclude with hope as the only rational response. Indeed, it’s in our nature to hope—to see a way forward, even be overconfident in our ability to achieve a brighter future. And it has been! Humanity’s traversed an accelerating upward trajectory for a long time, albeit with bumps along the way.

But we tend to be hopeful about ourselves, not the world at large. We worry about the world and its future. That’s probably for many reasons but this effect’s been pronounced over the last decade, as it was in the ‘70s. Optimism is the four-letter word of our time. The perfect antidote? Matt Ridley’s new book, The Rational Optimist. This is the best investing book of the last several years—bar none. A sweeping account of human history through evolutionary and economic lenses, this book is a devastating, fact-driven, often empirical, cogent argument against today’s de facto media dourness. Ridley uses economics and evolutionary psychology to chart the upward trajectory of human civilization with astonishing acuity and insight.

Yet, this book rarely mentions investing at all. I went on Amazon recently and noticed it ranked #2 in the category of Early Civilization and Civilization & Culture books, and #1 in Technology and Futurology, but wasn’t listed in the economics or investing categories that I could see. This is status quo, to my view. The best investing books and ideas are rarely explicitly about those topics. Economics and investing are too narrow—married to their metaphors of equilibrium, market efficiency, supply and demand, bizarre calculations, and so on. Their practitioners cannot usually see these are useful—but limited—metaphors for describing the world. Mistaking these things for real observations about the world, they regard equilibrium, for instance, not as an abstract Platonic ideal, but a real thing. Thus, many spend their time seeking precision and depth in a field founded upon abstraction, as if economics were a physical science. I’ve never been a big Paul Krugman fan (the Nobel laureate and New York Times columnist), but he’s dead right when he says economic theory is best used as a “scaffolding” for positing a point of view that can eventually be stripped away to baser elements of an argument.

Additionally, intellectuals writing economics books—as a group—don’t tend to be optimists. It isn’t becoming of them to be cheery (the rare times they are, look out…a bear market’s likely afoot). If they didn’t have warnings to the populace about stuff, why listen at all? (The recent popularity of Nouriel Roubini’s persona “Dr. Doom” is case in point.) Tiresias never had good news; seers generally have foreboding tidings. Yet, to view history broadly (especially market history) warrants a good dose of optimism.

As a staunch optimist, yes, Mr. Ridley is very biased. He’s a freewheeling, no-apologies capitalist. He believes capitalism is as natural as natural selection. He thinks humans’ natural overconfidence in themselves and capitalism are intertwined and symbiotic because capitalism is all about the pursuit of individual goals and not those of the elite. And while his rhetoric is highly compelling (in the opening chapters he bludgeons us with statistic after statistic of positive things in the world), one could easily argue he’s being myopically optimistic just as pessimists will be myopically pessimistic. It’s not until the end of the book that he balances his argument and acknowledges—almost in an obligatory way—much of the world is still a heinous place with big challenges ahead of it.

But at the very least, I encourage everyone to balance today’s thrum of pessimism and get a dose of optimism with this book. The part I have trouble with is that it doesn’t give pessimism its due. Worry, fear, and the preparation and adaptation they spur in us is a very necessary thing for the progress of mankind. Personally, I want folks overreacting to bird flu, the ozone layer, potential terrorism, etc. It makes us prepare and anticipate—often negating problems before they happen or expand. It’s just not a good baseline perspective for long-term investing.

Economics as Historical Lens

One of the main shortcomings of history is its lack of economic perspective. We have books aplenty about wars and revolutions, and scads of biographies about famous leaders, but little of real quality about the economic forces that truly shaped much of history. That’s mostly because we like narratives about people, not abstract, impersonal forces. (Though, Jarred Diamond’s attempt with Guns, Germs, and Steel is an often flawed but noble attempt to highlight those faceless forces.)

In a way, this book is a recapitulation of Adam Smith—both his Wealth of Nations and the less touted but equally tremendous The Theory of Moral Sentiments—with updated scientific language. Ridley’s crucial point: Economists and pundits who preach doom tend to ignore the most salient feature of life—adaptation. Which is also a baseline ingredient of capitalism. The human race is a collective problem solving machine. As individuals and as a society, we tend to figure stuff out and move forward. Which is a big reason why Malthusian arguments about food supply and energy constraints have never held. Sages and economists through the ages agree that the only thing that’s constant is change and dynamism. It’s therefore insane to extrapolate today’s situations and potential problems into the far future—the world will adapt and change. This is where Ridley is most convincing, and a point that, admittedly, requires some faith in order to be optimistic. There’s no explicit guarantee we’ll adapt through time, but I’d bet on it.

Ridley makes some excellent economic observations about adaptation and progress through history. For instance, birth rates tend to go down with developed, highly productive nations, helping solve future population problems. He provocatively explains energy development and the Industrial Revolution’s onslaught of efficiency effectively eradicated slavery through much of the globe—making slavery unprofitable and unneeded relative to steam engines, etc. But instead of going the route, as many do, of then worrying about how we’ll fight over fossil fuels in the future, he observes that the most likely outcome is we’ll figure out even better ways to harness and access energy, and as that happens our potential for even more prosperity also increases.

Ideas, Mating

Through all this, Ridley offers an interesting critique of science and the nature of innovation. He sees science as an appendage to the intellectual community where the real innovation and invention come from the mixing of ideas and technologies in the world at large. Ridley believes in trial and error as more powerful than hypothesis and testing. He predicates this on the observation that new discoveries tend to come from the private sector and via immediate needs, not the Academy or government. (Ask any major pharmaceutical company how they create new life-saving drugs, and you’ll quickly realize just how haphazardly new discoveries are often made.)

The basis for this view of progress is technology. Ridley describes technology as a “mash up” of existing things (piggybacking off of Brian Arthur’s excellent book, The Nature of Technology). Technologies are what create productivity, and therefore wealth. This is facilitated by idea exchange and self-interest (here’s where Adam Smith pops in), and by the economic “technology” of exchange for mutual benefit and division of labor (trade)—what human communities and their mechanisms of exchange (like markets) are designed to do. Which, to Ridley’s view, is the reason cities will naturally overtake rural areas—they bring us in to closer proximity and thus facilitate more exchange. In other words, the freer and more capitalistic the society and the more we’re interconnected, the more innovation we can have. Thus prosperity and higher standards of living ensue in a positive feedback loop. This feature can and has accelerated through time.

This is a form of evolution—but out of the biological realm and into human civilization/culture (Marvin Minsky observed this with his idea of “memes” decades ago). Ideas, just as much as machines, are a form of technology and are dependent on reciprocity, exchange, and community to create wealth. Interconnection is the key. Without trade, innovation can’t happen because there’s no incentive for it.

These are not new arguments, but remain provocative because synergy doesn’t come naturally to us—we tend to be very skeptical of it even though we behave in accord with it daily. We tend to be more comfortable with the idea of life as zero sum—dividing up a finite pie instead of making a bigger one. People think of trade and capitalism as selfishness because it’s not natural think in terms of mutual benefit—most of life on earth has been about the struggle for scarce resources. This is especially true since capitalism rewards value creation as a core value versus egalitarianism. But nothing’s been more effective at wealth creation through time.

The Nature of Hope

James Hillman, perhaps the greatest living thinker in the field of depth psychology, is harshly critical of hope. He views it an illusion. He says hope creates expectation, which can only lead to disappointment. We should live without the future and stay in the present.

That isn’t possible. We humans think forward, we expect, we build, we accomplish, and we transfer those ideals to the next generation. And with those innate drives, we hope. Hope isn’t an illusion, it’s the motivator—and it is undying. The will to survive and thrive, to move forward, this is a big part of what it means to be a person. It’s inherent and irreducible and even if it subsides for awhile (as it has communally these last years, at least in economic terms) it won’t go away.

And that reason alone is why—above all the economist-speak about incentive, laissez faire, self-interest, profit; above all the hyperbolic political talk about fairness, independence, and freedom; above all the psychology clap-trap of loss aversion, biases, and behavior—beyond all those things, hope propels the world and its economies onward, especially where capitalism allows it to flourish. Today is no different.

Long-term investors simply must on some level believe in that. To stake your future on investment in any form (that is, on the future prosperity of the world), but particularly equities, you must on some level believe that the world will grow, that wealth will continue to be created, that higher standards of living will prevail. To be otherwise is against our nature. As Camus says, “The struggle itself…is enough to fill a man’s heart.”

*The content contained in this article represents only the opinions and viewpoints of theFisher Investments editorial staff.
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