Tuesday, October 21, 2008


Seems like everytime I read the newspaper, nowadays, I want to throw it. To make a big scene of exploding pages and indignation. Given my stance on the role of government and the virtue of Lassiez-Faire, I've often wondered how the people of the times (particularly the thirties) allowed government to take on the role that it has. I think I understand now, its nothing but a shortsighted self-interest and a lack of skepticism and curiosity. People are concerned about their 401(k)s, and they assume that the talking heads offering solutions to their concerns are well-informed, self-disciplined, and clear-sighted.

The possibility that those same talking heads are bewildered, overwhelmed, and frought with conflicting interests seems anathamatic. People seem to assume that officials' lofty positions have elevated them to a level of unquestionability; "they must know what they're talking about, after all they must have been qualified to make it to their position." History offers an unfortunately large body of evidence against that latter point, I'm afraid. The political party divide exasterbates the issue, turns it into an us-vs-them situation where people end up supporting one side just because they dislike the other more.

I'm reminded of the "parable of the champion coin-flippers." It goes like this: a competition is held to find the best coin-flippers in the land. Ten thousand people assemble and simultaneously flip their coins, all trying for heads. Of course, about half of them succeed. The winners move on to the next round, where they all concentrate really hard on getting "heads," and again, about half succeed. The elimination rounds proceed untill at last there's just a few super-successful coin flippers left over. In anticipations of the final rounds to determine has the most skill in thier art, the press showers the champions with attention, asking for interviews, granting book deals. Some of the coin flippers are academically inclined and publish carefully thought out papers on exactly how they've attained their phenominal streak of winning tosses. They're celebrities, widely revered for their skill. And so on.

The point is that in any unpredictable phenomenon (such as a coin toss) with a large population of people involved in making guesses about it (such as our competition), some portion of them are likely to be right. If the process is iterated, the people who were right more often (even if purely by chance!) derive an aura of credibility from their "success."

"Ok," you might say, "that makes fine sense in the silly hypothetical case, what applicability does your story have in the real world?" Its been well demonstrated that stock (and other) markets follow a "random walk." That is to say, there is no strategy that will consitently predict the next steps of a market based on information about its previous steps. People consistently try, and when they succed for a noticiable period of time (whether or not by chance!), they get that aura of credibility, and people listen to them and take their advice.

"If you're so smart, why aren't you rich?" is the question that the random-walk hypothesis evokes in investors hopeful to prove the researchers wrong. Of course, many of those original researchers are wealthy, and the attained their wealth by following their own strategy. The random walk hypothesis doesn't suggest that there is no successful strategy for investing in markets, merely that you can't consistently rely on arbitrage to make you rich.

The successful strategy is, quite simply, putting your money to work in places more productive than where it currently rests. Money is increased by increasing value, and value is increased through good ideas, hard work, and discipline. The purpose of investing is to enable people who have those attributes to use them to benefit others, and that benefit is the reason that investing is a reward-bearing activity.

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