Feel Lucky Punk?

The fact that others are biased does not justify your disagreeing with them, if you have no reason to think you are much less biased.  Via Brad DeLong, from a 2002 Fortune article by Justin Fox on "Is The Market Rational? No, say the experts. But neither are you–so don’t go thinking you can outsmart it:

The dirty little secret of the behavioralists is that, for all their work on investor irrationality and market anomalies, they still believe that markets work pretty well and that trying to outguess the collective wisdom of millions of investors is usually futile…. But efficient-markets theory has a dirty little secret, too, which is that for the market to remain efficient, there have to be lots of rational investors who believe enough in the market’s inefficiency to spend their careers trying to beat it….

The argument of modern behavioralists includes a crucial observation that wasn’t in Keynes–that professional investors are now under so much pressure from their customers that they cannot make the kind of long-term bets that might beat the market. If they do, as was the case with a lot of value-oriented mutual funds in the late 1990s, they can soon find themselves without any customers’ money to invest. That gets us to a world in which an investor with enough staying power and contrarian gumption can beat the market, but the vast majority of mutual funds and hedge funds don’t. In other words, the behavioralists have reconciled the success of a Warren Buffett (which efficient-markets purists have absurdly termed dumb luck) with the overwhelmingly empirical evidence that most professional money managers fail to beat the market.

This is, we posit, a major intellectual accomplishment. What does it mean for you? That’s easy: Buy and hold. Diversify. Put your money in index funds. Pay attention to the one thing you can control–costs–and keep them as low as possible.

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  • http://yahoo.co.uk Firozali A.Mulla MBA PhD

    Sir;

    Look no further.. Women voters shun Royal….
    for Woman thy name is jelousy….

  • http://yahoo.co.uk Firozali A.Mulla MBA PhD

    Sir
    When I was in UK for my ACCA my friend told me one phrase. The British had this against the Asians
    “We have nothing against the Asians, We just cant stand them”

    May be these may have changed after the Pakis terrorits caught. But no sir. British have very strong memory.

  • http://yahoo.co.uk Firozali A.Mulla MBA PhD

    Can we state that the fake goods are the biased goods. Patent stolen and sold at the peanut price?

  • http://yahoo.co.uk Firozali A.Mulla MBA PhD

    The Future Humanity University …NOW when we are warming the globe and killing all the civilization and trying to impose democracy in the countries that do not want, we want the Muslim ladies not to wear the Hijab but the nuns wear similar dress. That is okay. Where is the justice?
    No I do not think even after the 40 year USA killed all all the Red Indians and the queen visit to USA the USA is safe for the Little Running water girl of Big Chief knowhownow.

  • http://www.nancybuttons.com Nancy Lebovitz

    It’s obvious that the market is neither perfectly rational nor perfectly irrational. Is there any good way of figuring the proportions in the mix?

  • http://profile.typekey.com/sentience/ Eliezer Yudkowsky

    Nancy, the strange thing is that the market mix should not be exploitable (or rather should be just barely exploitable enough to provide a small risk-adjusted return to professional market rationalizers) despite containing large irrational elements. That’s the hard part.

  • http://profile.typekey.com/halfinney/ Hal Finney

    I’m confused by this excerpt. It seems to be saying that you can in fact beat the market, by making the kind of long-term, contrarian bets that value-oriented mutual funds were making in the late 1990s – buying undervalued, out of fashion sectors and the like. But the problem is that in today’s investing environment, fund managers are under pressure to produce immediate returns, hence these kinds of strategies are not being practiced by the professionals. This leaves an opening for contrarians like Buffett to make substantially above-market returns. His results are not luck, they are the result of a consciously applied value-oriented contrarian strategy that effectively exploits the limited time horizons forced on most market professionals by their customers’ short-sighted demands.

    That’s what his analysis seems to be saying. Then he immediately contradicts this by suggesting generic investments in index funds, selected primarily on the basis of low costs and fees. A more logical conclusion from his analysis would be to buy or emulate Buffett’s funds’ strategies; to invest in value-oriented mutual funds; or to choose your own out of fashion, long-term investments and wait for them to become popular again. If he is right, these strategies should produce above-average returns and let you “beat the market”.

  • http://profile.typekey.com/robinhanson/ Robin Hanson

    Hal, I think the idea is that we each face incentives like those mutual fund managers. We have spouses, parents, friends, colleagues etc. who will think less of us if we act very contrarian for very long.

  • Carl Shulman

    Robin,

    There is clearly a wide range in the time horizons of investors and ability to sustain a contrarian position. Are you suggesting that we should be wary of overconfidence about the degree to which we possess those qualities? Why not use commitment devices like buying a share of Berkshire Hathaway and placing it in a trust for 7 years outside one’s control?

    Eliezer,

    The markets for capital with different liquidity, risk-tolerance, and time preference levels are sufficiently distinct that the market-clearing prices can vary. Legal restrictions on the maximum number of investors for private companies and hedge/venture capital/private equity funds mean that they value $10 million investments at more than ten times a $1 million investment, but the supply of such investors is limited so a premium can exist. Seeing a similar effect on time horizons is not exceedingly surprising.

    It’s far more striking that Berkshire Hathaway itself was able to maintain its consistent high returns, across a large enough number of successive investments that survivorship bias was insufficient to explain it, without seeing investors pile in and drive the price so high as to end the excess returns. This is even more puzzling for the period after Buffett wrote this article on value investing, the EMH and survivorship bias: http://www1.gsb.columbia.edu/valueinvesting/research/public_archives/DOC032.PDF

  • http://profile.typekey.com/robinhanson/ Robin Hanson

    Carl, yes, most people claim that they don’t care what other people think, but aggregate human behavior clearly suggests that most of them are quite mistaken about this.

  • zzz

    Eliezer: if market rationalizers are doing their job, they’re soaking up all of the excess return from “large irrational elements”. I don’t see what’s so hard or strange about this.

    In this context, “contrarian strategy” is just another kind of market rationalization. If your time horizons and other attitudes are unusual enough, you can theoretically earn excess returns.

  • michael vassar

    Robin: I suspect a strong selection bias. Possibly most people at GMU’s politically contrarian economics department claim to not care what other people think, but in larger society even the claim is uncommon, and the claim plus even a single personal example quite rare.
    On a related note, most people most of the time don’t even nominally want *not* to be manipulated. They often call it things like “treated with courtesy”. An extreme case was an interview where my wife Aruna sat with some other interviewers and judged a series of candidates. One of them was looking for a checklist of characteristics from a “how to get a job” type guide, e.g. was trying to amplify the known biases in their own behavior.

  • Stuart Armstrong

    Nancy, the strange thing is that the market mix should not be exploitable (or rather should be just barely exploitable enough to provide a small risk-adjusted return to professional market rationalizers) despite containing large irrational elements. That’s the hard part.

    That doesn’t seem that hard. If the sum of all the irrationalities just ends up being random, we’d get the same result. As zzz pointed out, the non-random effect of irrationalities are mostly removed by the market rationalizers.

    But efficient-markets theory has a dirty little secret, too, which is that for the market to remain efficient, there have to be lots of rational investors who believe enough in the market’s inefficiency to spend their careers trying to beat it….

    Is there a way of distinguishing “the market is efficient” from “you can’t beat the market”?

  • http://profile.typekey.com/bayesian/ Peter McCluskey

    I disagree with this claim:
    “professional investors are now under so much pressure from their customers that they cannot make the kind of long-term bets that might beat the market”
    Calling mutual fund managers “professional investors” reflects confusion about what they’re paid for. Few mutual fund investors are able to recognize managers who can beat the market (if many did, the relevant inefficiencies would vanish), so there’s no reason to expect those managers to be expert at anything better than implementing their customers’ strategies.
    Also, the implication that investors need longer-term bets is misleading. I doubt that investors who beat the market make significantly longer-term bets than others.

    The basic message of this article is right – the average investor would do better by acting as if markets are efficient.
    Does this mean that adopting false beliefs about market efficiency constitutes a good cognitive bias? I see strong signs that more people are able to adopt such beliefs than are able to produce the equivalent results by rationally overcoming their overconfidence biases. But I hesitate to recommend such false beliefs because I doubt that people can combine false beliefs in market efficiency with a commitment to truth elsewhere where it’s needed.

  • http://cob.jmu.edu/rosserjb Barkley Rosser

    Two points before this scrolls off (I have been out of town and computer free).

    Buffett makes long term bets, and the proportion of investment firms that are “value-oriented” rather than “growth-oriented” has increased since the 2000 crash.

    Buffett also does something few can do, obtain inside information. He has the resources to do so, which most of us lack. So, reportedly before he makes one of his long term investments he does serious in-depth investigations of the firm in question, well beyond what one can get by public information. I have heard that this has gotten even as far as having paid sources hang out in executive washrooms to pick up on inside gossip, and similar such stunts. Of course someone who can afford to get better info than almost anyone else can make bets that will consistently beat the market. It is the average slob listening to TV and radio financial talk shows who has little chance of doing so.