Zero sum trading, markets and the clever people resource

In highly efficient markets, however, educated guesses are no more accurate than blind guesses   –  Daniel Kahneman

I am currently thoroughly enjoying Daniel Kahneman’s new book “Thinking, Fast and Slow”. I’m currently half way through, and have just finished his summary destruction of the common belief that the most successful stock pickers on Wall Street are the most skilled. Instead Kahneman shows quite cleanly, with real trade data and interpretation difficult to refute, that success is mostly due to chance and that those traders that trade the most, lose the most. The best strategy, it seems, is to barely trade at all!

The classic stock market model is that the share price reflects all the information that is known about a certain stock. When a share is traded, certainly amongst professionals, it is very likely that both sides of the trade have the same information available, they are just interpreting this information differently. Essentially one side must believe the price will rise, the other that it will fall.

So far, all so good, nothing odd going on? This seems to indicate that there must be a skill involved, the accurate analysis of the data. Well, to some extent this is true. Much like with skill in poker, which is realised as profit by seeking out and beating fundamentally weaker opponents, so there are investors with poor fundamental knowledge. There is  a class of trader that does indeed make a consistent profit from these ‘amateur’ investors.

And that’s fine, caveat emptor and all that.

Success in trading, however, needs to beat the market. You can buy the market in a number of different ways, tracker funds and the like, so  hedge funds et al, they have to beat the market otherwise they have no purpose. The scary question, therefore, is this…

Why does either side of the trade think that their analysis and interpretation of the data will be more accurate than the market itself? Pricing a stock is what a market does.

If a market produces stock that is priced correctly and reflects the true value of a company’s assets, then a market is said to be efficient. It has done its job. This of course is the underlying belief that underpins free market ideology, that markets know best.

Is that quote at the top making sense now?

In an efficient market, all the data correctly analysed will suggest that the stock is priced correctly, the analyst’s estimation of a stock’s value will match the market’s. Any assumption of movement will be a guess. Obviously, even in efficient markets stock prices change. Why is there no skill in accurately predicting which way it will go? Because you have no data to analyse, its all already reflected in the market price. There is no immediate profit in the trade of an accurately priced stock, and accurate predictions of future movements in price are by definition, lucky guesses.

So, do we have highly efficient market’s? No not really, but over the years since Thatcher and Reagan they have been getting closer and closer with every passing relaxation of market regulation. Each time we increase the freedom in a market,, the whole business of trading stock moves closer and closer to a game of roulette.

Nothing here tells us that these traders are fools or idiots, although of course I’m sure some of them are. No. Rather, stock picking and investment banking, has of recent years been the destination of many of our finest. The best brains. These are sharp intellects and they make good money.

This, then, is the, so what? Here is the true crime of the situation; that our very finest are dedicating their lives to a zero sum game.

For every successful trade, there is an unsuccessful trade. Zero sum. To society, no value.

This is a view mirrored in this fascinating profile of Ray Dalio, an investor in the mould of George Soros, the chief force behind Bridgewater Associates, a hedge fund with a great record, a fund seemingly beating the market over the long term. His company has been accused of cult practices and has been the butt of jokes, but nonetheless in many ways is very impressive! A fascinating article actually.

Today, C.E.O.s and star traders routinely demand vastly higher sums to keep up with their counterparts at hedge funds. In addition to distorting salary structures elsewhere, the rewards that hedge-fund managers reap draw some of the very brightest science and mathematics graduates to the industry. Can it really be in America’s interest to have so much of its young talent playing a zero-sum game?



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