Sunday, September 6, 2009

Long Term Solution: Education as a Market Force 1.0

Economics is unique in comparison to the other sciences in that the way we observe the world has a very large impact on how the world actually works. If an astronomer improperly observes the movement of stars it doesn't actually change the way those stars move. If a physicist theorizes some physical constant, it doesn't alter whether or not that constant exists or what the metrics of that constant are. If a biologist theorizes an evolutionary path it doesn't alter the actual course of evolution. If an economist, however, theorizes that communism or capitalism is the best course of action.... well then that is how things shake out.

You get the idea. The behavior of the economy is almost entirely dependent on how we perceive the economy. To this end, the education of market participants (all of us) is a very important factor in the functioning of the economy.

Until very recently (today) I was of the view that education didn't have that much of an impact on the movements of markets. I was of the view that such incongruences were of minimal impact at the macro level. My revelation came in the form of a very simple problem:
"A man buys a horse for $50 and then sells it for $60. He then buys the same horse for $70 and then sells it for $80. What is his total profit?"
The answer is $20.

The person who gave me this problem is in college studying to be a teacher. She is a senior, already teaches in the class room, and I generally regard her as bright and studious. The above problem was given to her class (all seniors) which was divided on the answer: half of the class said $10, half of the class said $20 (aforementioned teacher was split between the two answers). I cannot tell you how disturbing this was to me. I was shocked. I couldn't believe it. Such a simple problem yet well educated people, educators mind you, couldn't manage to consistently answer it correctly.

I didn't know what to make of this, so, like any good economist, I conducted some real world research. I presented the problem to everyone in my immediate vicinity, to my friends, to the cashier at Publix.... essentially everyone I came in contact with for the rest of the day. The results were shocking. I heard a variety of answers including $10, $20, $30, and $130 along with a slew of numbers that were clearly gross arithmetic errors. All told, I probably surveyed twenty people. Of those twenty only six answered the question correctly. Six.

This was a very basic profit/loss problem. How would these people have done if I had asked them the difference between nominal and real wages? I don't need to drag this out. Any economist or skilled investor can see where I'm going. Simply put, the assumption of rational market participants is bunk as is the assumption of symmetrical and perfect information.

Now let's consider the investment community. The principles that these investors preach/practice vary wildly. Some adhere to the concept of value investing. Some trade short term volatility others adhere to Buffett like principles such as "buy and hold." Of particular interest to me are the turtle traders (also known as momentum traders or trend traders). This form of trading, made famous by the legendary CBOT trader Richard Dennis, is essentially a form of bet management with rules for when to buy, when to sell, when to double down, and when to take part of a position off. There are many arguments in favor of trend trading which usually sound something like "the information is already priced into the market...the technicals/chart is a reflection of that information...the trade itself has no meaningful impact on the direction of the market or it simply reinforces the market consensus."

Many of the arguments in favor of trading trends are very elaborate and very correct (if by correct you mean history of success). But what happens when every trader (market participant) is a trend trader? What happens when a large portion of traders are trained to trend trade? Is such activity not conducive to "bubbles"? The question of trend trading doesn't just apply to equity, bond, futures, and forex markets. It also applies to real estate markets and government spending. Humans are educated, it seems, to assume that trends, however irrational, will continue.

It turns out that I'm not the first economist to consider the rationality of market participants (not by a long shot). Indeed, most economics curricula focus on policy based economics in order to compensate for irrational market participants. The University of Chicago is a shining example in this shift of thought. Once home to the free-market luminary Milton Friedman, the Chicago school is now noted for policy centric economists such as Austan Goolsbee a member of Barack Obama's Council of Economic Advisors.

Notice that I put "1.0" in the title. I did that because I intend to revisit this theme several times in the future. For now, I'll leave you with a closing thought. Instead of compensating for irrational market participants, as "new social" economists seek to do, we should give serious thought to better educating market participants starting from the elementary level. At the very least we'll achieve a world in which a grocery store cashier doesn't have to endure a P/L word problem from a crazy customer.

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