"If people are so dumb, how come ...

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bertilak
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"If people are so dumb, how come ...

Post by bertilak » Thu Jul 19, 2012 4:57 pm

... more of us smart people don't get rich?"

That's a quote from Peter Bernstein's Against the Gods. It is on page 283 of my paperback edition.

In context, it is towards the beginning of his multi-chapter discussion of behavioral analysis, or irrational decisions by investors. The idea is that we (us smart guys!) might be able to recognize this irrational behavior and take advantage of it -- buy when the "dumb guys" are selling and vice-versa.

I have the inklings of an answer to that question, based on information theory and cryptography. Some points:
  • I see that as being able to recognize a signal in the noise of stock market information, both technical and fundamental.
  • One way to do encryption is to mask a signal with random noise. Well, at least noise that looks random to someone who doesn't have, or can't recreate, that noise so as to un-mix it from the masked signal. (With a one-time pad, the mask truly is random noise.)
  • Couldn't we expect irrational behavior to result in random noise? Of course, if we could find a pattern in the irrational behavior we could predict the noise so as to be able to unmask the real signal.
  • A pattern might not exist if the noise is the total of many personal irrationalities, as opposed to some mass, or herd, behavior. This is how many encryption techniques work -- mixing together multiple signals, or overlapping parts of the same signal in feedback loops.
  • I guess my thoughts are leading to the idea that even in a market that is inefficient due to irrational behavior we need to treat it as completely efficient, meaning that there is no "signal" to be found that will let us exploit the non-rational behavior. EDIT: I don't mean the signal isn't there, but that it is undiscoverable.
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Re: "If people are so dumb, how come ...

Post by zaboomafoozarg » Thu Jul 19, 2012 7:22 pm

We all have the capacity for dumbness. Smart people are the ones who realize they are inherently dumb.

And as quoted in Bogleheads' Guide to Investing:

"Every man is a fool for at least five minutes every day; wisdom consists of not exceeding that limit."

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Re: "If people are so dumb, how come ...

Post by umfundi » Thu Jul 19, 2012 11:22 pm

bertilak wrote:
  • I guess my thoughts are leading to the idea that even in a market that is inefficient due to irrational behavior we need to treat it as completely efficient, meaning that there is no "signal" to be found that will let us exploit the non-rational behavior. EDIT: I don't mean the signal isn't there, but that it is undiscoverable.
If a tree falls in the forest ...

I agree, though I have a slightly different view: The signal may be there, but I am to stupid to recognize and exploit it, compared to everyone else.

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Re: "If people are so dumb, how come ...

Post by Alex Frakt » Thu Jul 19, 2012 11:48 pm

Don't forget that even if you can discern the signals from the noise, you still have to overcome the transaction costs, capital/margin costs, and the cost of your time. IMO, the second of these is the most significant. My favorite example is Empirica Capital, Nassim Taleb's hedge fund. Taleb has written extensively about his method of making bets that pay off only when there are very large market drops. The basis for this is his calculation that the market charges far too little to take these bets since they appear much more frequently than is predicted by the standard model used to price them. Empirica launched in 1999, appears to have had one good year in 2000 (with a low asset base) and then went nowhere (on a much larger asset base) for the next couple of years and then was shut down in 2004 as the investors bailed out. Of course, he was proved to be right a couple of years later, but neither his fund nor his investors profited from it.

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Re: "If people are so dumb, how come ...

Post by livesoft » Fri Jul 20, 2012 5:16 am

Folks are looking for large signals or a signal that signals large gains. OTOH there is RBD.
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Re: "If people are so dumb, how come ...

Post by nisiprius » Fri Jul 20, 2012 7:06 am

Alex Frakt wrote:Taleb has written extensively about his method of making bets that pay off only when there are very large market drops. The basis for this is his calculation that the market charges far too little to take these bets since they appear much more frequently than is predicted by the standard model used to price them. Empirica launched in 1999, appears to have had one good year in 2000 (with a low asset base) and then went nowhere (on a much larger asset base) for the next couple of years and then was shut down in 2004 as the investors bailed out. Of course, he was proved to be right a couple of years later, but neither his fund nor his investors profited from it.
Taleb has a very fancy and sophisticated way of saying "I like to play long shots."
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Re: "If people are so dumb, how come ...

Post by richard » Fri Jul 20, 2012 7:27 am

The standard answers to why smarter people don't get rich are

1) Many of them do, often through management fees

2) Price is generally set by the smart people. The dumb people trade somewhat randomly and their trades effectively cancel each other out over time, leaving pricing to be dominated by trading by smart people. The smart people are not competing against the dumb people (a competition they could win), the smart people are competing against other smart people (a much more difficult competition).

The response to the second story is that sometimes dumb people move as a herd (i.e., in a single direction) for extended periods and smart people can't afford to trade against them for such long periods, due to limits on financing, etc. (see the classic paper, The Limits of Arbitrage).

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Re: "If people are so dumb, how come ...

Post by bertilak » Fri Jul 20, 2012 7:56 am

richard wrote:The standard answers to why smarter people don't get rich are

...

2) Price is generally set by the smart people. The dumb people trade somewhat randomly and their trades effectively cancel each other out over time, leaving pricing to be dominated by trading by smart people. The smart people are not competing against the dumb people (a competition they could win), the smart people are competing against other smart people (a much more difficult competition).
Excellent point! There is no hidden signal to discover as the irrationalities have actually cancelled each other out, not just obscured something that is still there if only we could decipher it.
The response to the second story is that sometimes dumb people move as a herd (i.e., in a single direction) for extended periods and smart people can't afford to trade against them for such long periods, due to limits on financing, etc. (see the classic paper, The Limits of Arbitrage).
Another excellent point. In other words, "the market can stay irrational longer than you can stay solvent."
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Re: "If people are so dumb, how come ...

Post by Stryker » Fri Jul 20, 2012 9:00 am

Before seeing this thread, earlier this morning I was reading a chapter in Classics An Investor's Anthology, called "The World's Smartest Man Syndrome" by Bennett W. Goodspeed. It appeared in The Journal of Portfolio Management during the summer of 1978, and unfortunately on the internet I was only able to find a brief snippet, but you'll get the gist of the article, just by the title alone.

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Re: "If people are so dumb, how come ...

Post by rdmayo21 » Fri Jul 20, 2012 9:09 am

.....

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Re: "If people are so dumb, how come ...

Post by yobria » Fri Jul 20, 2012 9:57 am

I'd say the human mind loves to hunt for signal, when in fact often all there is is noise. Don't forget the three hardest words to say in the English language: It. Was. Random.

The idea of false intelligence also reminds me of a George Burns quote: "Too bad that all the people who really know how to run the country are busy driving taxi cabs and cutting hair."

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