by Richard Robb
The purposeful choice model—which presents people as machines that process the sort of information that machines can understand—is good enough for many problems, but not for explaining much of what is interesting in financial markets. Although the overarching pursuit of profit is purposeful, purposeful choice cannot model out-of-character trading and investing. You can’t “make your own luck” by working longer and harder, undergoing apprenticeships and academic training, or steeling yourself to take a risk—although none of that would hurt. Because this type of investing involves unique one-time events, each leap into the unknown draws only partially on tried-and-true rules. It necessarily takes you from the realm of signals, risk, and reward into the murkier realm of hunches, judgment, and anxiety. Out-of-character trading and investing must, then, be understood as for-itself.
The Efficient Market Hypothesis
It is often said that the key to making money is knowing things that other people don’t know. A corollary to this maxim is the textbook definition of the efficient market hypothesis: markets are efficient if prices reflect all publicly available information. That is, no one can expect to beat the market unless they know more than the public. The standard approach to testing market efficiency follows from this definition. It assumes that information comes in one variety and that it is objective and accessible to everyone. It allows for uncertainty but assumes that risk can be modeled.
Since the 1960s, detractors of the efficient market hypothesis have identified potential anomalies in the data that a savvy trader could exploit, and defenders have counterattacked with one of three claims: (1) The detractors looked at hundreds of possible anomalies and only published one—even if markets are perfectly unpredictable, some patterns will appear by chance, (2) There’s a flaw in the detractors’ analysis (for instance, transaction costs would chew up apparent profit or the securities were not really available at the published price), or (3) Any above-market returns can be attributed to risk, since the payoff is positively correlated with other financial assets or human capital. In return, detractors point to alleged cognitive biases, such as loss aversion, as the reason that money-making opportunities persist. Defenders then respond that some people may be biased some of the time, but even a small number of arbitrageurs can force the market to its proper level.1
I am neither in favor of the efficient market hypothesis, nor against it. I am against the way it frames the debate: it mischaracterizes markets by ignoring different ways of possessing information. The standard definition of efficient markets assumes that information consists of no more than generic signals that tell the receiver something about the world. Thus, the informed trader, by effort, luck, or cheating, can acquire a superior signal. But the true key to making money is knowing things in ways that other people do not. It is a deep understanding of crucial information like that held by Hayek’s man on the spot that leads to profitable action.
To act on such opportunities, even the best-informed investor must take a leap. Because a unique event cannot be understood as an abstraction to which simple rules apply, investing with a likelihood of beating the market requires, as Richard Zeckhauser argues, an engagement with the “unknown and unknowable.” Zeckhauser tells a story about the economist David Ricardo, who bought British government bonds before the Battle of Waterloo on a hunch that the Duke of Wellington and his Prussian allies would defeat Napoleon. What was the probability of such a victory? What previous battle could have served as a comparison? It was a river that the world would step in only once. Ricardo made his bet and won big.2
If pressed for a reason, Ricardo might have argued that British government bonds offered a high potential reward for the risk. On the surface, this looks like a clear proposition, similar to “investors can achieve higher expected returns and less risk with a diversified portfolio than with a portfolio of a few randomly selected stocks” or that “stocks that pay high dividends generate, on average, higher total returns than stocks that pay no dividends.” But unlike Ricardo’s proposition, these two statements can be tested against data and proven true or false. Suppose France had won, or Britain had won but the bonds didn’t appreciate as Ricardo expected. The resulting loss might be chalked up to bad luck, although in this context it would be difficult to distinguish between bad luck and bad judgment. The conditions that spurred Ricardo to buy the bonds were deeply ambiguous. They had never arisen before and would never arise again.
Along with engaging with the unknown and unknowable, Zeckhauser proposes two further necessary conditions for beating the market: (1) The opportunity is available only to those with a particular complementary capability, such as the ability to develop an office building, and (2) It is unlikely that the party on the other side of the transaction is better informed. He also lists freedom from “blame aversion” as a likely condition—an investor who isn’t subject to second-guessing from her boss is more likely to beat the market.
I believe Zeckhauser is right in most cases about complementary skills (although there are exceptions, which I will discuss later). He’s also right, of course, that traders can’t succeed if they are criticized the moment they show a loss. “Blame aversion,” though, is a superficial term to describe the imperfect communication between a principal and an agent when the agent contends with unique events. “Aversion” suggests a psychological phenomenon, but these barriers to communication would remain even if everyone in the decision chain mastered their biases.
Zeckhauser’s idea of engagement with unknowable events is akin to what I call “acting out of character.” That doesn’t mean acting without principle or in direct conflict with one’s defining qualities, but that the engagement is not rule-based or systematic. Because this conduct doesn’t belong to the purposeful realm, it must be for-itself. Above-market returns can be made when the agent abandons fixed procedures, considers the particular situation on its own merits, for itself, and leaps.
For-itself investing has always been and will always be in short supply because of the anxiety it entails—people can only bear so much, and institutions are not built for it. When we confront a one-time event without the guidance of familiar rules, we’re on our own. This indeterminacy and freedom and the ensuing sense of isolation and responsibility can give rise to dread. Adam Smith expressed it perfectly when he suggested that “anxious vigilance” was the defining quality of a good manager, who must often operate under novel and uncertain conditions, doing that which can’t be transcribed into rules and delegated.3 Anyone who spots an opportunity to buy or sell because prices have drifted from their fundamental value places herself in opposition to the prevailing canon. It is hard to say, “This will make money,” when everyone has been taught that making above-market returns is impossible. It feels daring at best, uneducated at worst.
If you go against the grain, pitching to an investment committee a deal that’s similar to one that failed in the past, saying “this time feels different,” less sporting colleagues are likely to haul out the cliché falsely attributed to Einstein: “The definition of stupidity [or insanity] is to try the same thing over again and expect a different result.” If others have lost fortunes in certain securities, why should it be different for you? If you try in spite of these warnings and fail, then according to the cliché, you are stupid or insane. And since markets are efficient, it was foolish to even entertain the idea that you might beat them.
But that argument is too simplistic. It’s possible to hold simultaneously the views that markets are efficient and agents are rational, and that at least some investors can expect returns beyond what they might earn with a diversified portfolio of stocks. To realize these returns, an investor must act out of character on an informed hunch. For-itself trading falls beyond, and so reveals a limit to, market efficiency.
Institutional Investing
Let’s start by taking a look at credit markets that are the domain of public and private pension funds, sovereign wealth funds, insurance companies, university endowment
s, and other institutional investors. How can a hierarchical group undertake a leap that hinges on personal beliefs formed on the front lines? And having taken the leap, how can it hang on through signs of trouble?
From a trading standpoint, institutions differ from individuals in two ways: their resources give them access to esoteric and illiquid markets, and they have governance structures that prevent individuals from misusing resources. These governance structures naturally treat all trades as purposeful and none as for-itself, leaving institutional investors ill-equipped to engage with one-time events.
Suppose you’re a salesperson at an investment bank. An infrastructure project has unexpectedly run out of money due to mismanagement. A new investor with $250 million could seize the project from its distressed owners before it files for bankruptcy. With only one week to close the deal, the new investor would have to skip most of the usual due diligence. The decision requires speed, trust, and judgment. As the salesperson, are you going to show the deal to the California Public Employees’ Retirement System (CalPERS) or to a billionaire tech entrepreneur? At best, the CalPERS managers would say, “Yes, it’s probably a great deal but we don’t have time for approvals,” or “Yes, it’s probably a great deal but we have no bucket in which to put it.” The billionaire tech entrepreneur, sniffing a profit, will pounce.
Institutional investors manage funds more or less in accordance with a common formula. A board of trustees approves a policy that a chief investment officer (CIO) then implements. The policy usually splits the fund into “buckets,” “sectors,” or “asset classes.” Sectors can include domestic public equity, global equity, credit, illiquid credit, private equity, cash, absolute return (hedge funds), and the like.
The CIO assigns specialists to look after each sector. Equity managers handle equity; credit managers handle credit. For the public equities sector, some CIOs farm out stock selection to outside managers, and others invest passively in an index fund to hold down costs. Often a risk management department monitors the entire portfolio. In the case of pension funds, the board pays attention to how assets match liabilities to pensioners.
Funds define risk mainly in terms of exposure to the market as a whole. The term “alpha” is supposed to describe the expected return beyond what can be explained by correlation with the stock market. When trustees want to take on more risk, they dial up allocations to volatile investments, such as stocks. Some might decide to shift cash into hedge funds while preserving their stock market exposure. Or they might ask the CIO to deliberately “overweight” a sector or subsector, such as growth stocks. All this is predicated on the idea that risk can be modeled and aggregated. Few big institutions take risks by departing from conventional decision-making.
For-itself theory suggests an alternate approach: lining up investment propositions on the continuum of knowability. The most senior, most trustworthy individuals—those the board deems to have the keenest judgment—would deal with the murkiest opportunities and operate under the least oversight. They would be empowered to deal with each unique opportunity on its own merits and evaluated over a long-term horizon in a governance structure that understands that not all decisions can be justified using the standard metrics and terminology.
To enjoy the benefits of for-itself investing, an institution would, of course, have to tolerate occasional losses that look foolish after the fact. And the people closest to the decision would really feel the sting. Whether a fund manager must apologize to the CIO or the CIO must apologize to the trustees of a pension fund, there would be no theory or data to fall back on. In for-itself investing, individuals must bear responsibility for losses.
Individual Investing
Back before the financial crisis knocked the stuffing out of individual investors, a security guard at my office building often asked me for stock tips. He was a frustrated day trader. When he won, he felt on top of the world, like he’d found the magic formula. When his winning streak came to an end, he’d reproach himself for missing some signal or other. I’d congratulate him on good days and commiserate on bad ones, but he wanted more. He thought I was holding out on him. Finally, late one evening, I gave in: “Okay, I’ll tell you the secret.”
Boy, did I have his attention.
Then I explained, “There is no secret. There is no way for you to compete with Brad,” the trader at our fund. “He has technology, information, low trading costs, and twenty-five years of experience. If there’s an opportunity, he’ll take advantage of it before you possibly could. And even Brad wins only 52 percent of the time. There are no patterns—any patterns you think you’ve discovered are illusions. This is nothing personal. No one in your position, no matter how smart or hard working, has a chance of beating Brad’s record.”
That guard left my building years ago and, for all I know, he made some lucky trades, retired to a tropical island, and laughs at me every day. But I doubt it. He liked to read books on investing, and wherever he is, I hope he’s reading this one, because I’ve rethought my response a little. There is one arena in which an individual investor might get ahead: for-itself investing.
The nature of for-itself investing gives individual investors one clear advantage over institutions. While someone trading with her own money lacks the resources of an institution—she can’t fund the development of a new drug from scratch or buy complex derivatives when everyone else is trying to sell—she can do as she likes. For-itself investing can’t be boiled down to a set of rules or achieved through a mechanically applied procedure. It requires a leap outside of settled beliefs. The independent individual can more readily take such a leap.
I don’t mean short-term trading, which comes with high transaction costs that make it almost impossible for individuals to compete with professionals. Nor am I talking about trading based on market patterns or trends, since they don’t really exist. Even the concept of a “bull market” is unfounded. Stocks that go up one month are just as likely to go up (the trend continues) or down (the trend reverses or “corrects”) the next. The phrase “the stock market is going up” uses the wrong verb tense: it went up. Stock prices aren’t physical objects—they don’t have momentum. If the market were going up, arbitrageurs would take advantage of that fact and drive it immediately to its destination.
Successful investing has to be more than following rules. Any set of rules that led to effortless profits would immediately be arbitraged away. Consider the advice to “be contrarian” or “zig when others zag,” which is so conventional that it has become impossible to execute. If everyone decides to be contrarian, then everyone’s the same, and no one is contrarian. Rather than contrarian, thinking must be independent.
Individuals, though unable to beat hedge funds at short-term trading, can be more independent than any institution possibly could. An individual can act on a whim, without explaining herself to peers, managers, regulators, the press, or investors. She enjoys a close connection to her own money and long-term freedom from blame. The hedge fund manager with tentative control over other people’s money can’t compete with the coordination that takes place within a single mind. And while the fund manager might be pressured to fold on an investment that started out poorly, an individual can hold on indefinitely.
According to legend, in 1889, one of Van Gogh’s sunflower paintings sold for $125. The same painting sold in 1987 for around $36 million. This story is a staple of introductory finance courses to illustrate the wonders of compound interest. The annual rate of return works out to 13.7 percent, less than you might have guessed. The lesson is supposed to be: a plausible annual return can eventually turn into a mighty sum if you let it compound for a long time. But the real lesson is that 13.7 percent is a very high annual return to achieve year after year. In my more successful investments, I stayed on my toes, mined some vein I’d discovered, and kept it up for what felt like a long time—a few years. It’s amazing when an individual (or an institution that consists of a chain of individuals) can stay on her to
es for decades, never calcifying or leaning on rules, and continually unearth unique opportunities.
In a sense, the Van Gogh painting is not one investment, but many. Each year, the owner has to choose not to sell it when the price rises. If we imagine it is held by one family the entire time, the heirs must decide to keep the painting rather than cash in. At various junctures, the owner has to make a for-itself leap: look at the painting, think about selling, look at it again, and finally decide to hold. Only when we hear the story summarized and abstracted from temptations on the ground does it sound miraculous.
In addition to holding on for a long time, the lone individual can take for-itself action even when the evidence is scanty or ambiguous—it’s her own money, after all—while a fund manager rarely can. Individuals also have an obvious informational advantage in certain situations, such as investing in single-family residential real estate. In your own neighborhood, you are literally the man (or woman) on the spot. You can invest by buying a larger home than you require or by buying property to rent out.
Whatever investments you choose, even if you’re a professional trader, there will be moments when it hurts. There remains no such thing as a free lunch. All I can offer is an attitude, a few tips, and a theoretical framework. But I wouldn’t rule out the possibility that individuals can systematically make money in even the most competitive, liquid markets. The three years I traded on my own illustrate this point.
I started trading futures contracts for my own account after leaving my job at the Dai-Ichi Kangyo Bank. My first trade was a long position in May 2001, betting that the price of soybean futures would rise. I’m no expert in commodities and I’d never seen a soybean plant up close. Yet I knew that at a price of $4.28, farmers would lose $1.00 per bushel. Moreover, the market had ground steadily lower. I guessed that uninformed traders following what they believed to be a “trend” were depressing the price. Speculators who’d bought at higher prices probably had to sell when their losses mounted to levels greater than they could tolerate. In trader jargon, they were “stopped out.” But I could hold out as long as necessary because it was my own money. I even left room to buy more if prices fell. As it turned out, I never had a chance to add to my position: soybean prices rose and I sold my contract a month later at a profit.
