Only bards do well in markets

A question that has always intrigued me is “Why do some people read the markets much better than others?” Having observed those in the investment community who do have a genuine ability, my conclusion is that they are just that. Readers. Of a story, or narrative. They are not necessarily the smartest people in the room — often they seem quite unimpressive — yet they seem to have an intuition, a way of putting together the story, that is more true. This leads to another conclusion. That it is the reading (or creation) of stories that is at the heart of all financial analysis. Markets are not rational machines, they are giant narratives in which “the facts” are just details for the myth making. In a sense it is a statement of the obvious to say that humans have been, and always will be, moved mostly by stories, but the obvious has been forgotten, subsumed under mountains of quasi-scientific analysis.

So let us sketch out what these stories look and sound like. There are several levels:

1. The ideological story. This narrative starts from a kind of morality dressed up as historical insight. Markets are ipso facto good and all that is needed to create benefits for all is to let them operate unfettered. Governments are mostly useless and corrupt and should be confined to only the most basic of operations. From this it follows that democracy and markets are two sides of the same coin; two aspects of freedom. We are seeing the latest episode for this in the euro crisis. The evil or misguided socialists and corrupt governments in the south have created unsustainable levels of debt, unlike the rest of the developed world, creating terrible peril for the world financial system. It is interesting to look at the actual data. The US total debt relative to GDP (279%) is actually higher than Greece’s (267%). But the proportion that is government debt for the US (80%) is lower than Greece’s (130%). And of course everything governments do is ipso facto bad, while private activity is ipso facto good.

The ideological story does, of course, have a lot of underlying truth to it. But that is not what matters most; what matters most is the power of the story itself. In particular, the narrative has blinded people to two important points. One is that collecting tax is critical to sound government. If government is bad, taking tax must also be bad, because it funds governments and allows them to get bigger. This is being promulgated by the Republicans in the US at the moment with their insistence on only cutting spending, not too mention our own newly formed Tea Party here in Australia, the Liberal Party.

Trouble is, there is a very strong correlation between economies that function well and the effective collection of tax. Poor tax takes have been a feature of Latin American countries. China collects of 20% of GDP in tax while in India tax paying is only an option. Greece has very poor tax collection and so on.

The other blind spot produced by this story is that money can somehow operate independent of government. This is nonsense (literally) and the decades of “financial de-regulation” have created the havoc that could only come from such nonsense. Because money is rules, it cannot be separated from the rule makers. What happened is that governments, accepting for the most part the ideological story, have let traders make up their own rules, such as $700 trillion of derivatives. This should have been fine because governments were letting markets create freedom for all. It wasn’t, and we are seeing the consequences now, with governments desperately trying to save the rules of money. But the story remains as strong as ever, which is why so little has been learned.

2. The finance story. This narrative works on a kind of quasi-science. Because money can be recorded as quantities, then mathematics can be applied to it. If mathematics can be applied it must be possible to use the mathematics to predict how the system will behave. Ergo, if you are clever and well trained enough or have won a Nobel prize or once worked for the Fed or lost your job with NASA, then you will have some mysterious insight into the operating of the system. Or, even better, you can disapprove about how the system isn’t behaving as it should when your predictions are wrong.

What is wrong with this, is, self evidently, that the market is made up of people who are trying to use the same mathematics to predict what will happen in the system — activity which is never included in the mathematics. It cannot be. Which is why those who try to read the behaviour of those looking for the predictable (what is predicted according to the mathematical models) will tend to do better. Because they are reading the story, not looking at what the data is indicating or trying to apply a model. There cannot be a mathematical model that predicts human behaviour when the humans can understand the mathematical models. There is an implication that markets should balance because financial transactions are meant to balance (debt versus equity). But much of the time they either do not, or do not in an expected time frame. Even that circular argument does not work very well, although that does not stop legions of financial analysts from applying it.

3. The business story. Business stories are much more diverse, but one can say the ability to sell a story is key to any businesses’ success. That is what the difference between earnings multiples of two companies in the same industry represents: one company selling their story better than another. Business analysis is always confined to retrospective data; even the operators of the business do not know what the future holds. Yet business valuation is a projection of future performance. The only way to fill the gap is with stories.

In the film Margin Call the head of the investment bank, played by Jeremy Irons, says he is where he is for one reason and one reason only. His job is to hear what “the music is” to determine whether the game of musical chairs will go on. He decides he hears nothing, deciding that the game is over. This character is reading the story of markets. It is those readers who are the ones who tend to do well, not necessarily the most clever players.

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  1. the reading (or creation) of stories that is at the heart of all financial analysis

    True, as it is at the heart of our lives all the way from birth to death.

    The story that works for me is that the market’s behaviour unfolds in patterns, in a fractal manner, at all degrees of trend. Trying to decipher the market’s patterns is a fascinating and ever changing puzzle. Sometimes the pattern clears, the trend is clear, and you can profit from that trend.

    I like to keep things simple.

    On your point 1. The ideological story. I think markets are made up of people, and the rules that govern the transactions between those people. Markets exist. Full stop. They are neither good or bad. They fluctuate according to the mood of market participants. They are there to played and profited from. Reading good or bad in to the markets is not part of my narrative, I guess is what I’m saying.

    Thanks SoN.

  2. Those who do best out of a story are those that write it! Why else do we have so many well-off politicians? They either wrote a story before public service, a few chapter having been written with the benefit of political association, or after they got there.

  3. History is written by the winners. People will pay more attention to a dumb winner than a smart loser, so the winner can tell the tale of how they won. Effectively becoming a “bard” after the fact.

    The Jeremy Irons character in _Margin Call_ believes he can ‘hear the music’, yet no doubt the heads of every other investment firm believe the same. They, however, are about to get slaughtered in the collapse, becoming the losers. Irons’ character will continue to believe he is the music man, and will be making sure the world knows this.

    Probability tells us there will always be winners, losers, and those in the middle. Some people can keep winning almost indefinitely, simply out of luck. After reading Nassim Taleb’s “Fooled by Randomness”, I’ve come to believe that luck plays as much a role in success as skill does. Just don’t tell the “winners” that.

    • Critical Influence

      Dunkz you nailed it in my opinion. The people who are ‘winning’ at most points in time will create a narrative to explain why they are ‘better’… or others (like SoN) will do so for them. But in the end almost none can sustain an advantage and randomness gets most who are not taking cautious positions… the rest are just lucky.

      Following on from your Taleb citation… I love his example of a million monkeys sitting on a trading desk. Over time one of those monkeys might have a winning day every single day for many years… probability would imply this as likely. Does this mean the monkey is a better “reader” of the market?

      I wish SoN would put some more context in his/her “market philosophy”… the last piece had The Economist (of all people!) targeted as a pusher of Anglo-centric mis-information… this piece is lacking any application to support the theory of ‘winners’.

      • Does this mean the monkey is a better “reader” of the market?””

        what a stupid question. YES! OF COURSE IT DOES! what else explains the constant outperformance? is federer just lucky at tennis. becuase out of 1000 players on the circuit one is prbably going to win and it just happens to be him? or is he actually just better at it than most?

        • Critical Influence

          GB you must be a stockbroker or hedge fund analyst, or an aspiring one. Classy response.

          The monkeys I am referring to do not have any skill – simply random button pressing. Read the book.

          Federer is a poor analogy. Professional tennis players play hundreds of matches each year, and the probability that anyone could get to number 1 world ranking who was not extremely good is virtually zero.

          On the other hand the probability that a monkey (or two) from Taleb’s example of a million random monkeys pressing buttons would have an excellent record is nearly 100%.

          Another link for you:

          • CI,

            Very interesting concept but how does skill, knowledge, education, experience ect fit into you theory?

            Also how can anyone disprove the monkeys theory because it is theoretically conceivable that one can have a run on for longer than we keep records?

    • “Some people can keep winning almost indefinitely, simply out of luck”

      disagree. luck eventually runs out and its skill, ability, talent, whatever you want to call it that is the difference.

      same as any other persuit, game, profession, there are those that excell in markets and those that dont. these people have the ability or gift to see around corners and its got very little to do with luck.

      • I agree, in general luck does run out eventually, which is why I said “almost” indefinitely. But take a hundred people and get them all flipping coins. On average, heads should come up 50% of the time, tails the other 50%. But chances are, one individual will achieve 100% heads after ten flips, and another will achieve 100% tails. Are they any better skilled than those that were “average”?

        The markets, granted, are not pure chance. But this also allows the winners to keep on winning. If one individual has enough success through luck and tells their story well, they can gain a strong following of people who want to replicate their success. The followers will buy up whatever asset class the “winner” is in, thereby bidding up the price.

        The winner then goes on to write a series of self-help books on how you too can be a property/share/gold/fine art/tulip market success story.

        There is a skill in all of this, and that’s the skill of writing a good story. My point is that the story is told after the fact.

        • This deciphering of skill/ luck has forever intrigued all of us.

          Apportionment of an outcome over the two is an interesting exercise. It’s the relative dose in any activity that determines a probabilistic outcome set. Luck definitely mean reverts, albeit, over long time frames: averages are longer time frame constructs. Skill is a persistence trait. A sole focus on results may make one indifferent to processes than just outcomes.

          The relation to markets is that are infinite stories or chutzpah to out-performance. Which one shall succeed when? Can it e modeled ex-ante? Can the character of market participants be controlled to decipher the independence?

          Streaks in market performance could be a more common observation due to a greater role of luck or any composite charachter e.g. leveraging environment. However streaks in professional sports are largely a result of persistent skill.

          For those interested an interesting read on topic is:

    • Of course it’s luck. Just listen to the person on the street explain the success of someone they know. He was lucky he went to the right school or they were lucky they inherited the right genes. These successful people, more than likely, used 99% perspiration and 1% inspiration to know when the music stopped. As for believing that luck plays as much a role in success as skill does, reminded me of what my mother used to say. “Your brothers have the brains but you will be the most successful because you’re the lucky one”. I almost believed this until in my early twenties, when people were telling me how lucky I was, I realized, the harder I worked the luckier I became.

  4. I see markets as a poker game.

    -Your a dealt your cards and have to make the most of them.

    -The good players can make a crap hand a good hand.

    -Looking at the World Poker Tour, 16mill 1st prize. There is usually never any pro’s on the final table. The reason why? because luck or randomness had them take a bad beat, or they simply just had a bad day.

    -Over the long run people will come and go at a poker joint but the ones who sit there, grind it out, play consistently will always be the winner over time due to skill and experience.

    -The only person guaranteed to win in poker is the house which in real world is the government…

    Life is like a poker game, understand this and it will give you a better perception of how the world works.

    • dumb_non_economistMEMBER

      Don’t agree Georgie, the real winner is vested interest, govs come and go! Govs pander to said interest in the hope to gain/retain their support.

      • Yep. I’ve been wondering for a while where the term “political elite” comes from. At least the European leaders for a large part do not have elite level salaries and their power is quite restricted on an individual level. I would think the same would apply elsewhere.
        We should all have learned by now how it works
        muppets= investors
        overlords= the vested interests with the most money to spend.

  5. interested party

    The winners stand back and observe the crowd/market and read people…..and are deemed lucky, and the average/losers mingle with and compete in the crowd.A bit like trading off weekly charts against daily charts… much noise to think.

    Define the crowd and do the opposite.
    Should give better than 50/50 odds.

  6. What this and other analyses miss is that all businesses have a major cost factor -energy- that has increased greatly since 2006. Eg, oil has gone from USD20 a barrel to 105 now. Close correlation between energy spikes and recessions- no more growth rates of 4-5% pa in western countries until energy costs cut.

  7. Markets are the sum of the views and means of their participants.

    How views are formed is critical to understanding markets.

    One thing I always recall from an undergraduate marketing class is to target the sales narrative at the right mode of appeal for the target audience, either rational or emotional. In various instances one will be more effective than the other but in general the stories that makes sense to the audience on both levels will be the most successful. Apple for instance.

    However I can think of companies that have performed exceptionally well on the back of an almost purely emotional appeal (One particular QLD based copper exploration company comes to mind..).

    I have also witnessed many times companies with strong fundamental appeal that have not performed nearly as well as others through a lack of ability to sell as story. A lack of emotional appeal.

    When trying understand the world and its people one of the best statements I ever read was that ‘Decisions are made emotionally…they are justified rationally’.

    On the subject of luck vs skill Malcolm Gladwell’s books are awesome for explorations into the relationship between the two and also on matters of how skills in prediction are developed over time.

    The story in Blink of the psychologist who has identified a few critical features about functioning relationships and can consequently identify within a few minutes of observing couples whether their marriage will succeed or fail with a 95% accuracy rate was great.

    Some people have the skills in observation to identify these critical features, improving their powers of prediction.

    Others never or are much slower to discover these critical components and just get perennially lost in the noise.

    The thing with markets though is that some of the rules change over time making the process of prediction more difficult than in other fields even for those that have identified the critical components.

    (P.S Always enjoy your deeper and more ‘freudian’ insights into market dynamics SON, keep up the good work!).

  8. SoN. It’s your ideological narrative that is of increasing interest! One week embracing Marxist-ish views on wages/salaries, the next applauding expropriation of private interests by the State in Argentina, this week a clapping of hands for big government (and commensurate big taxes?). Or am I misreading you.

    Anyway, I didn’t know the Liberal Party was the new arm of the Tea Party movement. It appears Australia already has a fully fledged Tea Party:

    Can’t imagine what next weekend’s musings might entail… 🙂

    • dumb_non_economistMEMBER

      How was SoN’s piece support for “big gov?” It appears to me that he has just given an opposing view against the “any size gov” is bad routine as well as all taxation is bad.
      You’re as guilty of applying a broad brush to SoN’s comments as you have accused others of doing to you.
      In my view rampant free enterprise is as bad as rampant gov control, there’s a middle ground, some where.
      As to the the Oz TP, love to now who is funding that. The “aussie bob” voice over is somewhat outdated and vomit inducing for me, appears more inline with something from the 30-40’s.

    • I believe that was the point of this post: The most enthusiastic storyteller here at MB wanted to shed some light on how the craft is practiced.

      We were treated to a heavy dose of myth-making last week, presumably instigated by the pathological liars that make up the Argentine government, but brought to us by this ever-faithful anti-Anglo blogger. So if anyone is qualified to ruminate on the mischievous myth-making of nefarious financial market operatives, it’s SoN.

  9. ceteris paribus

    The skill:luck ratio in producing an outcome obviously varies according to the game you are playing .eg. football, exams, different card games.

    What about playing the markets? There is one thing that makes me suspicious about the amount of luck involved. Spread across the pages of every Weekend AFR edition, four or five “experts” are typically asked to comment on their outlook for the share market. Most often, their predictions contain contradictions.

    • interested party

      “Spread across the pages of every Weekend AFR edition, four or five “experts” are typically asked to comment on their outlook for the share market. Most often, their predictions contain contradictions.”

      The great indoctrination of the “Muppets”…..vis a-vis baffle them with BS.

      The reason so many of us seek alternative opinions and view points arrive at sites like this.
      Keep going,MB.

  10. Mkts have little to do with average probability.
    Mkts aren’t an exact science, yet does give those with the skills the ability to do the work and get things roughly right.
    I’ve often found it is more to do with the macro risk, than the stock specific stuff. Companies can be valued reasonably well, yet the macro stuff is what catches many.
    The smart guys seem to be surrounded by micro analysts, plus add their own instinctive view on the macro side.
    I was chatting to one of these socalled guns once at the races, when he said there was no way he would ever bet on the races,pokies, etc as he had no control over the outcome.
    His view was that with mkts, if your good enough you can make money, often by taking money off people just a tad sillier than you.