What’s Right With Finance

Morgan Housel wrote a great piece this week called What’s Wrong With Finance where he laid out four problems that stem from the fact that finance is strange in so many ways. Here were his four problems:

Problem No. 1: Extreme bias toward action, mostly due to exploitative fee arrangements.

Problem No. 2: An overuse of numbers and formulas and an underuse of psychology and sentiments.

Problem No. 3: No consistent measures of performance.

Problem No. 4: People have no money when compound interest is in their favor, and lots when it’s not in their favor.

I’ve seen firsthand how each of these problems can make it difficult for investors to make rational decisions. But Morgan’s piece got me thinking about the other side of this – what’s right with finance? Here are four things I think finance gets right.

No. 1: It’s a System Based on Trust. At times it boggles my mind that the financial markets function as smoothly as they do day in and day out. When you really think about it, the entire system is based almost exclusively on trust. No one really knows what any public company is worth since today’s value is based on uncertain future cash flows. There’s more guessing that goes on than people care to admit. And very few investors actually understand all of the interconnected, behind-the-scenes work that allows the system to function as it does. I’m in awe sometimes that we were able to create the financial markets in their current form.

To explain the markets to those outside of the world of finance, I like to give the analogy of a driving your car through an intersection with a traffic light. When the light is green you drive straight through without a second thought. You don’t stop to look both ways before going through. You trust that everyone else will follow the rules and stop if their light is red. But every once and a while someone runs a red light and there’s an accident. That’s basically how the markets work. Sometimes the trust gets called into question after an accident, but it always seems to come back eventually. Without faith in the system it wouldn’t work.

No. 2: You Get to Put Your Money Where Your Mouth Is. What’s the single best way to invest? Ask this question and you’re sure to get a different answer from traders, buy-and-hold investors, stock-pickers, trend-followers, robo-advisors, quant investors, macro hedge fund managers, technical analysts, long/short investors, indexers or any number of other investment philosophies.

Want to see investment professionals get into a heated debate? Ask them their thoughts on the Efficient Market Hypothesis. Or the relative merits of active vs. passive investing, the correct historical data with which to base their back-tests on, how much you should pay for financial advice, whether or not the market is over/undervalued, the future direction of interest rates and so on.

If there were no differences in opinions between market participants, the markets wouldn’t function properly. We need there to be two sides to every trade. Let’s say you received an early copy of the Fed’s statement from yesterday afternoon. You could have given that statement to another investor after looking it over and both of you would have interpreted the market’s potential reaction to the statement in completely different ways. Even if you could gain access to information before other investors, it still tells you nothing about how investors will react to that information. Investors form their opinions based on their experiences, perception of risk and their perception of the perception of others. This is why there is always a buyer for every seller.

Think about it this way – at least 50% of all investors (and many more after accounting for costs and behavior) are taking one for the team and underperforming the markets. Certain investors have to lose for others to win. But there are also winners and losers over different time horizons. I could be wrong about the short-term but still do quite well for myself over the long-term while the person on the other side of our trade could make out like a bandit over the short-term but still lose their shirt over the long-term. Or the reverse could be true. The variations are endless.

But there will always be other investors lining up to take the other side of your trade in hopes of outsmarting you and hopefully, not outsmarting themselves. Even those investors that lose on a consistent basis will continue to come back for more as hope springs eternal.

People can’t agree on anything these days and that’s a good thing for the financial markets and for those investors that are rational enough to take the other side of the decisions made by irrational investors.

No. 3: Investors Are Constantly Sharing & Collaborating. How many other professions outside of finance do you know of that have a majority of the greatest minds in the field sharing their wisdom through books, publicly available client memos, shareholder letters and interviews? Marks, Dalio, Buffett, Munger, Lynch and many others have all made it a point to share their past successes and failures in the markets. The greats want individual investors to learn from their experiences. Even though you will never be the same type of investor as them, standing on the shoulders of giants is possibly the best way to learn about how the markets actually work and the importance of emotional intelligence.

Just this week Bill Gates wrote about how great it is that Warren Buffett shares so much wisdom in his annual shareholder letters:

I am lucky to call Warren a friend and to be able to learn from him personally. (I also serve on Berkshire’s board and own stock in the company.) The fact that everyone who cares about business and finance can benefit from his wisdom—just by reading these annual letters—is pretty amazing.

I agree.

No. 4: The Markets Are Kind Of, Sort Of, In a Round-About Way, Efficient. The markets don’t get everything right. And when they make a mistake, investors are quick to point out how inefficient they are. But these huge inefficiencies are rare compared to the trillions of dollars in activity that takes place on a daily basis in the various markets. Investors have to process an incalculable amount of data, news, past experiences and expectations about the future, which all filters down into the price-setting process. Markets mostly get it right most of the time. Sure there are short-term inefficiencies, but investors wouldn’t be successful if markets weren’t fairly efficient over the long-term.

Plus, you have this cycle where certain investors discover a strategy that works in the markets. Eventually those ideas find their way into academic research, which becomes widely disseminated, consumed and used by other market participants. Finally those ideas become mass market and fail to work anymore – either for a period of time or maybe forever, depending on the anomaly. These cycles are speeding up because of the ease of access to information and the competition for outperformance from all corners of the investment world.

Having others take out short-term inefficiencies is a great thing for actual investors, because it only reinforces the idea that those with a well-thought out long-term process can still succeed if they’re patient.

I agree with Morgan that there are many areas of finance that don’t make much sense. But I’m also fascinated with the evolution of the public markets. It’s not a perfect system, but it allows investors to allocate their capital in a myriad of different investment options, facilitate the sharing of ideas and allows corporations to raise capital in a fairly efficient manner.

Sources:
What’s Wrong With Finance (Motley Fool)
Warren Buffett Just Wrote His Best Annual Letter Ever (Gates Notes)

Further Reading:
Is Technology Speeding Up Market Cycles?
What Happens When the Umbrella Shop Gets Too Crowded?

Here’s what I’ve been reading this week:

• The long-term only matters if you have a plan for how to deal with it (Bason)
• Not all index funds are created equal (Irrelevant Investor)
• How the framing effect can impact historical market analysis (Alpha Architect)
• Questions investors simple don’t ask themselves (My Own Advisor)
• How the cash allocation with the new robo-advisor from Charles Schwab is like free chocolate (Finance Buff)
• Trusting an advisor costs something, but also lowers stress levels (Alpha Architect)
• 5 rules of business (Medium)
• How over-thinking kills your performance (Psychology Today)
• A dozen lessons about investing and life from Morgan Housel (25iq)
• How emotional intelligence can make you a better investor (Institutional Investor)
• Why fear is a mind killer (Millennial Invest)
• Video: Reading should be part of your job as an investor (Reformed Broker)
• Jesse Livermore: “Investors are trained to think that volatility is a bad thing–but it’s actually a good thing, at least for long-term shareholders. It mathematically increases their total returns.” (Philosophical Economics)