Even Honest Games Can Be Hard

Insider trading and other nefarious stock market operations seem to be on our minds lately. I guess this is natural. Despite eye-popping returns since March we are still living in the aftermath of disaster and periods of market stress have historically been periods of concern about an unequal playing field.

For example, the SEC was established in direct response to the 1929 crash in order to enforce a new set of rules that would make the stock market a fair game for all. I can’t believe that very many people thought that the crash was due to insider trading and its ilk, but I guess it seemed like a good time to clean up the the street.

One reason why we worry more about fairness when the market goes down may simply be that when the market is chugging along to new heights it is hard to see flaws in it of any kind. Everybody is fat, happy, and getting richer. It is only on the inevitable downswings that the scales fall from our eyes and we notice problems that were always there.

But there is another big reason we start to dwell on cheating when the market goes down, even if at some level we realize the two are unrelated. As I wrote in April, when things get really bad we tend to get angry. Our sense of loss morphs into a sense of having been wronged and a yearning for justice to be meted out to those who have done this to us.

The latest insider trading case to grab our intention is the indictment of the manager of a hedge fund called Galleon and his ring of tipsters. Like all large illegal conspiracies this one was doomed to failure. With enough people involved, it is only a matter of time before somebody rats it out. (This, by the way, is why I think only a few people could have been in the know about the Madoff scheme. It lasted 20 years.)

The Galleon operation was, apparently, tabloid-friendly in its simplicity. Galleon paid for tips from people with insider knowledge of what tech companies were going to do. Prosecutors even have a tape of a phone call in which one conspirator discusses how much trouble she would be in if what she was doing came out.

Galleon makes for a good news story, but I worry it gives a misleading impression of how the stock market works. The truth is that doing what Galleon is accused of doing is a very tough way to beat the market. Truly useful inside information, the kind that will allow you to make a quick profit by buying or selling a stock, is pretty rare stuff. In order to get enough of it to run a fund you would need to cast a wide net, and that sort of net is likely to end up in handcuffs.

People who don’t invest in stocks for a living often think that success in the market is based on how much information you have. It’s not. It’s based on how much you can figure out, based on access to essentially the same vast supply of information that everybody else has. Beating the market means predicting the future, and although having more data to work with doesn’t hurt, it’s skill at predicting that separates the winners from the losers.

If this were not the case, then you would see a tendency for large investment managers with the resources to gather massive amounts of data habitually outperform the little shops with comparatively few resources. If anything, the opposite is true, the small and nimble outperform the big and sluggish.

Just to be clear, I think that the Galleon conspirators should be locked up for a long time. But the news story doesn’t just reinforce the idea that the market players with the most info win, it reinforces the idea that the reason an ordinary person is unlikely to beat the market is because the game is rigged.

And concluding that the market is rigged and so therefore you will lose money is, for some, backwards. More troubling are these who went from losing money to concluding that it must therefore be rigged.

It’s not rigged, or at least the degree to which it is rigged has a trivial effect on investors. Beating the market is predicting the future more accurately than others. And that is, very honestly, hard to do.

Investing | Frank Curmudgeon | October 26, 2009 12:29 pm

51 Comments

By bex, October 26, 2009 @ 5:57 pm

Could you elaborate a little on the statement:

“People who don’t invest in stocks for a living often think that success in the market is based on how much information you have. It’s not. It’s based on how much you can figure out, based on access to essentially the same vast supply of information that everybody else has.”

After I read “Confessions of a Street Addict,” I figured that the key to making money was the following:

Barely legal bribes for barely legal insider information.

I’m not a stock broker, so I could have mis-read it… but it does seem to be an information game. Yes, the small outperforms the large on occasion, but is it in a statistically significant way?
By Rob Bennett, October 27, 2009 @ 11:12 am

Beating the market is predicting the future more accurately than others. And that is, very honestly, hard to do.

We disagree, Frank.

Beating the market is as easy as eating a slice of apple pie. Intellectually.

It’s not emotionally easy. Stocks are dangerous when they are insanely overpriced. To become insanely overpriced, there have to be millions of people fooling themselves about how stock investing works. When millions are fooling themselves, those millions insist on social taboos against reporting the realities of stock investing accurately. To invest rationally is to buck these social taboos.

I have explained to my nine-year-old what it takes to beat the market. He gets it. He understands that buying something when it is priced at three times fair value is a horrible long-term value proposition. All the rest of us above age nine are able to understand that as well. If we care to.

My nine-year-old possesses a huge edge. The rest of us are emotionally invested in a model for understanding stock investing that gets it all 100 percent backwards (no model that didn’t get it backwards could possibly have become popular during the years when stocks were insanely overpriced). To invest effectively, we would need to learn how to say the three hardest words to pronounce in the entire English language — “I” and “Was” and “Wrong.”

The first step to learning how to invest effectively is acknowledging that the idea that beating the market is hard is a myth. That’s the only part of it that is even a tiny bit hard, in my assessment.

Rob
By Frank Curmudgeon, October 27, 2009 @ 4:08 pm

Bex: In spite of myself, I like Jim Cramer and Confessions is most enjoyable. But how he made money in his fund is a bit obscure. I think he’s a guy with a great nose for a story that will sell stocks (he started as a journalist then as a salesman, after all) and his show seems to be all about short pithy stories. The book vaguely implies he was getting barely legal info from brokers, but I have a hard time buying this, as a) brokers don’t know much and b) he was actually a fairly small customer. I think he was good at listening to a hundred pitches on stocks and picking the 10 with stories that would appeal to others.

Rob: I when I say beat the market I mean pick individual stocks that beat the average. That’s hard to do, any way you slice it. If it is easy for you, why waste your time on my blog? (And can I have a job?)
By Rob Bennett, October 27, 2009 @ 7:18 pm

when I say beat the market I mean pick individual stocks that beat the average.

I agree with you that that’s a harder way of beating the market, Frank.

The good news is that there’s no need to beat the market that way. Those who beat the market by adjusting their stock allocation in response to big changes in valuations are able to retire years earlier than those who believe that Passive Investing can work. That’s such a big step forward that I don’t see it as being a big deal that it is hard (but not impossible, in my view) to pick stock effectively.

Rob
By bex, November 3, 2009 @ 4:20 pm

From “street addict,” Cramer mentioned that one of his tricks was to buy and sell stocks an insane number of times from the same brokers, so those brokers got nice, fat commission checks. He would buy and sell things he didn’t even want — frequently taking a loss — to transfer that cash legally.

Eventually it would pay off, because one of the brokers would give him an information edge just moments after it became legal to have that information… and Cramer claimed that information edge was extremely helpful.

As you said, it’s certainly not his only trick… he probably has an intuitive grasp about when to listen and when to ignore pitches for stocks.

It probably is not as simple as bribery… although bribery helps!
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