We are developing the social individualist meta-context for the future. From the very serious to the extremely frivolous... lets see what is on the mind of the Samizdata people.

Samizdata, derived from Samizdat /n. - a system of clandestine publication of banned literature in the USSR [Russ.,= self-publishing house]

Cargo Cult Finance

Mathematician John Allen Paulos, in his most recent book (A Mathematician Plays the Stock Market, Basic Books, 2003) coined a term which I had hoped would catch on throughout the finance community. He describes under-researched puff pieces on personal finance (e.g. Five Hot Stocks to Pump Up your 401k NOW!) as “financial pornography.”

One of the biggest purveyors of financial pornography online is the MSN.com website, and this column doesn’t disappoint: Seven Signs a Stock is Ready to Soar. The author purports to explain how to locate ‘hot’ stocks, those that are about to appreciate rapidly in price, by reviewing some research on what types of conditions most often preceded (notice I did not say caused, and neither did the research) a price increase.

It should not take a Wharton MBA to figure out what is wrong with the premise of the article. The cited research identifies the seven conditions that most often preceded a big run-up in the price of a particular stock, but nowhere does it suggest that these conditions were sufficient (or even necessary) to cause a stock price to take off.

Obviously, all of the conditions that make up the ‘CANSLIM’ acronym are desirable things for a corporation — for its management and for its ownership. But that doesn’t mean that the stock in question is about to outperform the market. I’m not a hard-and-fast believer in the semi-strong efficient market hypothesis — I think a few super-stud investors can outperform the market — but for the average investor reading MSN’s Money Insight column, the CANSLIM approach is not going to turn those people into super-stud investors. EMH is still going to apply to those investors; there are just too many other investors who have the same type of information and insights at their fingertips.

In his 1974 commencement address to Cal Tech, the late Richard Feynman described what he called “cargo cult science:”

In the South Seas there is a cargo cult of people. During [World War II] they saw airplanes with lots of good materials, and they want the same thing to happen now. So they’ve arranged to make things like runways, to put fires along the sides of the runways, to make a wooden hut for a man to sit in, with two wooden pieces on his head to headphones and bars of bamboo sticking out like antennas — he’s the controller — and they wait for the airplanes to land.

Feynman (about whom I will have much more to say in an upcoming post) was using the term to deride psychics and ‘paranormal’ advocates like Uri Geller. But the MSN piece is urging investors to do exactly what Feynman describes the naive south island natives as doing: falling hook, line and sinker for a post hoc fallacy.

16 comments to Cargo Cult Finance

  • Doug Collins

    I have recently been listening to a taped economic history course during a long daily drive to work. The lecturer said one of the most significant events of the 1970′s was the beginning of a drop in the annual productivity gain in the US that continues to the present. It is severe: from a high of 2.5% from WWII to the early 1970s to about 0.5% thereafter. He claims that the drop is worldwide. Its significance is that – like compound interest – over time it has caused an enormous opportunity cost. I had thought we actually had been increasing productivity – computerization and so forth- but he obviously is disputing this, at least up to 1999 when the tapes were made. Apparently economists don’t have any real idea why this has happened. It is a great source of dissertations, but no business has resulted.

    I bring this up because I have a keen personal curiosity about the lack of investor interest in wildcat oil and gas exploration in the face of some of the highest commodity prices in history. Investors continue to be enchanted with buying producing properties with marginal reserves, drilling wells offsettng existing production and so forth, but have little interest in riskier but potentially much more profitable exploration ventures. I just wrote a comment yesterday after an earlier Samizdata post on NanoWars
    led me to a Glen Reynolds
    post about business interests savaging the more interesting nanotechnology ideas and concentrating their affections on more prosaic ideas like ‘nanopants’ – stain resistant clothing. It’s the same problem we are having in the petroleum industry. It’s not that investors are averse to high risk, the problem is that they need to believe that they can exactly quantify the risk.

    It is here that the market opportunity for the cargo cult shamans exists. The problem is that while low risk/low return investments usually have a large experience base associated with them and an educated guess – which, the shaman’s protestations notwithstanding, is all that a risk specification ultimately can ever be – is fairly accurate and dependable, it is not reliable for the higher risk propositions. In the stock market, arbitrage situations can be very accurately evaluated, speculations cannot.

    Yet speculations must be made, wildcats need to be drilled and somebody needs to develop nano self replicators in the West before it is accomplished by the proverbial “Five smart guys in Somalia”. It may well be that most daring investments are doomed to fail. As the saying goes: Pioneers can be recognized. They are the ones with the arrows in their chests!

    Which brings me back to that productivity problem. Perhaps our difficulty is that we have all of our financial pornography in the stock market, and not enough in other fields. To extend the metaphor, productivity may start to increase again when investors in other businesses stop acting like Methodists caught in a brothel.

  • Hey, no fair leaving well-reasoned, level-headed commentary in the comments section!

    I’ll have to find some recent data, but I’m pretty certain that US TFP (total factor productivity) did accelerate after around 1994, and was back in the 2% range for most of the late ’90s. But the course is certainly correct in asserting that TFP fell substantially after the early ’70s.

    Why do we have so much “financial pornography” for the stock market and so little for the commodities markets, bond markets, etc.? That’s a great question — heck, maybe there’s another post in there somewhere.

  • Here (Link) is some data from the Bureau of Labor Statistics … looks like total manufacturing productivity increased at an annualized rate of 2.1% or so from 1993 to 2000.

    Why do I have to enter the spambot code to add a commment to my own post?

  • Guy Herbert

    There is a little on other fields in the popular press, but the Stock Market dominates because it is easy for the general public to understand at a basic level and get into.

    There’s a different class of financial pornography (financial erotica?) aimed at the professional. No newsletter is complete without some chartist nonsense.

    I can’t quite understand, Doug Collins, why encouraging uninformed or misinformed market speculation by the general public into different markets would have any consequence for industrial investment or productivity. The fact is almost all capital in the markets is in the hands of professional managers, who do operate in all markets.

    Productivity is hard to measure–or even to define–but an rate of increase that’s slowing down is still an increase unless it stops, you know.

  • fnyser

    I think the “Financial Pornography” monicker just doesn’t work. This is more like some crap bad advice you’d see in Cosmo or some teeny magazine f.eks. “finding the right guy” or “5 easy ways to keep him faithful.” Is there a single word/genre/name for those advice columns in womens’ magazines?

    There’s just not anything risqué or taboo. To qualify as financial porn there should be remorseless descriptions of illicit dealings to pump a portfolio and how the wife is unaware of all those night deposits…

  • Antoine Clarke

    Please, what are ‘CANSLIM’ and ‘EMH’?

    To quote the cop in ‘the Limey’: “The only thing I don’t understand, is every m*****-****ing” word you said.”

  • I think the “financial pornography” moniker is quite apt for that segment of the market aimed at the retail investor. After spending 10 years on Wall Street as 1st and analyst and then a portfolio manager, I can vouch that much of what is spit out is aimed at grabbing attention rather than imparting information. There is a huge gulf, however, between that dreck (flotsam? detritus?) and the missives aimed at the “insider” professional. They are not even second cousins.

  • jdm

    The only problem I have with this commentary is that it assumes that everyone should be in the market for good reasons. Those defined by X.

    I don’t want boatloads of smart investors, I want boatloads of dumb investors. That’s how I make money.

    I used to think that splits were great, and then I figured out that having two 10s instead of a 20 is irrelevant and so what’s the point? But finally I realized that most people like splits and they would rather buy two 10s (perhaps one at a time) instead of a 20. And so, if I own a stock, I like splits because of the effect they have on others.

  • JDM, of course we would all prefer to be surrounded by dumb / unprofessional investors who are easily swayed by the type of twaddle that makes it into the personal finance mags. But you need to remember that the outright majority of all stocks is owned by financial intermediaries (life insurance, pension funds, mutual funds et al) and thus are subject to professional management. I’m not sure where I “assumed” that “everyone should be in the market for good reasons.”

  • jdm

    Curious… you write a commentary about “financial pornography” and how, in essence, dumb it is. You provided an example. I guess I assumed, perhaps wrongly, that your point is that if only people would use better principles when investing they would be better off.

    All I’m saying is that I don’t want them to use better principles or be better off. I want them to be as irrational and superficial as possible so I can be better off.

    I absolutely depend on people who laugh at how simple the idea of “buy low, sell high” seems.

  • limberwulf

    I tend to agree with Doug in the area of why we are not growing as we once were. I think we are quite short on pioneers these days. Risk takers are also opportunity takers. There is far too much fear in the world today, and too many people looking for that seucre, risk-free life. This has been indoctrinated by our politicians who keep selling selling the idea of the “safety net” and handing out money to the down and out. And we keep eating it up, without realizing the cost of security.

    Which leads me to the second reason, loss of freedom. The greater the freedom someone has, the more opportunity that person has. That same person also had increased risk. I am free to win or lose, succeed or fail. Far too easily people have given up their freedom to cut their risk, most not recognizing that they have also cut their opportunity. We need more Ben Franklins in this world, men with the strength to say:”People who are willing to give up freedom for the sake of short term security, deserve neither freedom nor security”.

  • Antoine-EMH is Effecient Market Hypthosis; the basic idea that the stock market has factored in information already and that researching stocks isn’t going to be helpful. It comes in three flavors (excuse me while I crib from the notes I gave my Investments class earlier in the month)

    “Weak”-Price and volume data already factored into price, making technical analysis worthless (tested to be true-various technical schemes don’t make money once trading commissions are factored in)

    “Semi-strong”-Accounting data and other public news about company already factored into price, making fundamental analysis worthless (tends to be true; market tends towards semi-strong efficiency).

    “Strong”-All information is already factored into the price. (Not quite true-otherwise insider trading would be a non-issue; ask Martha Stewart).

    The bigger a stock is, the more likely the semi-strong form will hold.

  • jdm

    Thanks, Mark. I don’t know enough about investing to doubt your information, but I do have some questions.

    1) It would seem that smaller investors like myself would be better off buying small cap stocks because they would be less subject to EMH?

    2) How or why do large investment entities do research if, as you wrote, “researching isn’t going to be helpful”?

    3) How, if at all, does EMH affect index investors? I can go either way on this when I think about it; do the proponents of EMH have anything to say about this?

  • Doug Collins

    Guy-

    The professional managers, as you correctly pointed out, do handle the money in most businesses. My point was that they make their investments on the basis of risk/reward ratios.

    Because calculations of those ratios ultimately depend on predictions of various ingredient factors that have to be made based on experience, they are reliable for low risk/low reward/high experience situations and unreliable for high risk/high reward/low experience ones. Although their work seems very objective and analytical, it can’t get away from the experience factor. As a result, they avoid the investments that they cannot evaluate reliably.

    The problem is that occasional high risk/high reward successes are necessary to keep the supply of low risk/low reward investments from being exhausted. This is certainly true in my field where the offset development well prospects wouldn’t be there if someone hadn’t drilled the wildcat which discovered the oilfield sometime in the past. I suspect that this is true in other businesses too. Hollywood has been afflicted by sequels and remakes for a while now. Even as you read this, various ripoffs of the Lord of the Rings are being shown to the professional managers in that business. If you are sick of Rocky XXII type movies, be grateful that there is a New Zealand!

    To horribly mix metaphors: our economy, perhaps even our civilization, needs sacrificial lambs who enjoy financial pornography. These may be independent oilmen or garage nanotechnologists. Most of them will fail and lose their investments. That is to be expected for bad investments with poorly quantified risks. A few will succeed and keep the rest of the economy going. That, not the potential profit, is why speculation in ‘bad’ investments is a good thing.

  • Guy Herbert

    I agree with several commentators, including Doug Collins, that the concentration of markets in the hands of risk averse (or more professionally risk-avoidant) fund managers may be a problem because of a tendency to stifle innovation. However:–

    1. If you want the return of the personal investor (whether supposing he’s less rational and will allow you to snaffle his funds more readily or otherwise) then Cargo Cult economics is not the influence to worry about. Institutional investing is buttressed on either side by the tax system and an insurance culture.

    2. Institutions are not necessarily more rational than individuals. Often they are less, because it is easier to go mad with other people’s money than your own. (Certainly they too are strongly subject to confirmation bias.) It’s just they have different sorts of irrationality, different tastes in financial porn.

  • David Gillies

    JDM, a couple of points:

    the EMH doesn’t mean that no-one does any research, it’s just that for any given stock the reasearch has already been done by someone so that the price of the stock reflects its ‘true’ valuation. To be more technical, what the EMH says is that there are no unexploited arbitrage opportunities. Modern matched-bargaining systems have greatly increased market efficiency.

    Index funds are essentailly decoupled from the EMH. All the figures that go into your fund manager’s spreadsheet are derived from the index (one of the most important figures in portfolio managment, for example, is the correlation between the return on a stock and the return on the index -this is called beta). To all intents and purposes, the index is the market. If a security conforms closely to the EMH, then a fortiori the index does.

    Investing in small caps (OTCBB, Pink Sheets, etc) does give you a higher potential return. But your risk is concomitantly higher. Your investment strategy should be to pick a portfolio of stocks that puts you at a distance on the critical line away from the Minimum Variance Portfolio (for some given rate of return on the efficient frontier) that you are comfortable with. If that’s gibberish to you, then buy DJIA, QQQ or FTSE100 and hit the textbooks. You can lose your shirt here if you’re not careful. The fund guys can do a lot of things that are not available to the ordinary private investor (try getting a margin-enabled account, for example!). In my experience, ‘picking winners’ is a mug’s game without inside knowledge, and that’s illegal.