Wednesday, February 5, 2014

The Market is CatDog Eating Itself

There is only one iron-clad law in the marketplace: for every buyer there is a seller.  Everything else is dependent on circumstances, but only this is always true: if you want in, somebody needs to want out.  Thus it has always perplexed me that colleges, by definition mainstream institutions designed to teach an accepted worldview, give classes on investments and portfolio management.  This bothers me because let's suppose they really do have something to offer: buy these securities using these quantifiable rules and you will come out ahead.  Who is going to sell them to you?  In other words, if it is true that these classes can teach you how to spot outperforming assets consistently, these assets would cease to be traded as nobody not suffering from Mad Cow Disease would want to give up such an asset, at least until he marks it up to a price that is no longer attractive.  I therefore have to think that the current academic popularity of efficient market hypothesis and by extension, the outperformance of passive allocation is the phenotype of the overall market participants' active trading strategies.  In a bizarro world where most people's assets are allocated passively, the few active traders will outperform greatly and in a M. Night Twist, academics will be tripping over themselves to prove how everyone should actively trade.

To be fair, academics are mostly correct in the sense that most people have no skill in the markets and thus should leave active trading to the professionals.  This is absolutely true, but this is not unique to the marketplace.  I wouldn't challenge the Crips to a turf battle until putting in at least 500 hours in Call of Duty.  Academics should get no brownie points, let alone PhDs by the bucketload, pointing this out. Some academics' attempts to nudge this fact of life into some overarching rule of financial markets, that nobody can beat the markets, are grossly overreaching.  (Paradoxically, passive asset allocation is just another school of speculating, as one is betting that the historical relationships between asset classes hold and that society, on average, will get wealthier.)

Any backtesting to find outperformance needs to be accompanied with a time machine.  The real value lies in quantifying market participants' strategies going forward.  From there, it becomes a cakewalk to figure out what they would want to want buy at a certain price/time and get in line in front of them.  In essence, get paid to provide their liquidity.  Of course, this leads to a Mobius strip as people get in line in front of you.  This cycle thus provides two meta-answers: never change your strategy and trade less when you are losing and trade more when you are winning (for classic traders) or continuously change your strategy to remain one step ahead (for smart people with large egos).  This is why self-awareness is the only knowledge you really need: how smart are you really?  The second plan is more profitable if executed correctly, but are you good enough?  Be honest.  Nobody sees your PnL but you.