Guessonomics

Investing, as it is presently conducted by the investment industry, is a lot like throwing darts at a dart board that is constantly moving in a random manner, not knowing exactly where the board will be but throwing the dart where it is thought the board could be. When you hit the board, you score points; when you miss, you lose. This dart board analogy came to me a short time ago when I had finished reading two related articles. The first was an article that stated RIM’s sales forecast for the current fiscal quarter did not meet analysts’ expectations/forecasts/projections of what they felt RIM should achieve. The second article was an interview in Report on Business magazine with Bill Kanko who is a respected funds manager. Mr. Kanko stated he firmly believed in “the unreliable nature of economic forecasts, especially our own”. Let’s look at this for a moment.
First the big picture in which this forecast is situated, the economy. Now as far as I can make out, no one truly understands how the economy really works. That is why Nobel Prizes are awarded in economics and why we have a plethora of economic theories and investing models which often contradict each other.  Not to mention all those can’t miss economic initiatives or investment opportunities that have been presented to us that, well, missed and missed catastrophically. Not only do we really not understand how the economy functions, the economy also is very susceptible to randomness. That highly insightful saying ‘shit happens’ comes to mind. Wars break out, Mother Nature defies our need for control and unleashes her uncontrollable power to show us where we really stand in the evolutionary pecking order, terrorism, technological glitches like power grid failures or new technologies having negative often unforeseen impact on how we live or do business, pandemics, luck, someone dies unexpectedly, bad timing, unforeseen consequences occurring from poor business decisions, all of these instances, and numerous other instances that a lack of space on this blog preclude me from listing,  have the capacity to disrupt the best planned economic undertakings.
Back to RIM and its forecasts and the forecasts of the analysts who follow RIM. Their projections, then, are based on an economy that can be highly unpredictable or random in its actions. So, projections are made on a firm that operates in an environment, the economy, which is unpredictable. Analysts study a firm’s financial statements, the industry of which the firm is a part, the state of the economy as that relates to the firm, they look at the firm’s management practices and competitive position in the market place, use whatever model they have been trained with to push all this information into and then make a prediction on what they think the firm should do profit-wise primarily in the short term. Firms also go through this same process for themselves to set out their financial expectations in the short term. They make a prediction. In other words, both the analysts and the firm itself come to a best guess at what they think the firm will do. This guess is overlaid upon an economy that is, in the end, unpredictable. Further, these forecasts are taken one more irrational step. These best guesses based on an ultimately unpredictable economy are turned into hard goals by the investment industry against which the firm’s performance is benchmarked. A guess, its dictionary definition being an opinion formed from little or no knowledge (in this case of this unpredictable economy), has now morphed into a hard and fast benchmark that will relate success or failure to the investing world. The guess now has been dressed up as rule approached by the investment industry much like a physicist approaches the law of gravity. In terms of the dart game analogy, the analysts have decided they know where the randomly moving dart board will be in the future. The firm’s share price will depend upon how successful the firm is in achieving this guess-rule – not whether or not it made a profit (the dart hits somewhere on the board) but whether or not it achieved or exceeded the guess (the dart has hit the bulls eye). This random hit or miss in turn has a good possibility of positively or negatively affecting the society you and I live in.
I recently spoke to a financial advisor who told me these predictions tend to be right more often than they are wrong. They hit the dart board more than they miss it. He quoted me a 52/48 right to wrong prediction ratio which is quite scary when you think about it. Even if his ratio is off, lets be really positive here and say it is a 70/30 right to wrong ratio, does this way of managing our economy, let alone our investments, ever take into consideration that just one wrong guess (one miss of the dart board), one “hot” derivative that turns out not to be so hot, such as derivatives based upon sub-prime mortgages, can wipe out the gains of all the right guesses combined? Has anyone ever stopped to think just how crazy our market economy is? Or consider that the less regulated that market is, the more likely it will blow up due to outright greed and fraud of the dart throwers? Further, how crazy are we, that’s you and me, to allow guessonomics to form the basis of our social and economic lives?

High Frequency Trading

I just read an article that has caused me to stop and reflect. The article was about high frequency traders who, through the considerable power of high speed computers, trade millions of shares in what can be milliseconds. In one of the main forms of high frequency trading, the trader will capitalize on the difference on the price of a particular share that is traded in different markets. For example if a share is trading for $1.00 in New York but for $1.01 in Toronto, the trader will quickly buy large amounts of that share in New York and sell it in Toronto before that gap closes. $0.01 profit on each share of thousands or more shares traded done many times over the course of the day adds up. My concern is what is the point of this form of trading? Most high frequency traders use their own money or their own firm’s money, they don’t have clients in the traditional sense so the only one or ones who profit are the trader and/or the trader’s firm.

Stock markets were originally set up as places where companies could go to sell shares in themselves to investors in order to raise capital so those companies could further grow and develop and through that growth and development create jobs and provide a further base for taxes and, generally, better the economic condition of society as a whole. Today, much of what goes on in the different markets, is not about creating a more robust, stronger society through the improvement of companies looking for investors to help them grow. Now much of the activity in the market place is simply about making a profit for the banks, investment firms, and some investors with little or no regard for building up society through investing in companies to allow them to grow and in so doing make society a better place for us all. For much of our investment industry, it is now about profit for profit’s sake and if society is impoverished through this hunt for profits, well who cares? That’s what investing is all about, eh? The chase for profits with little or no regard for the society that provides the infrastructure for that profit chasing to take place.

The article on high frequency traders high lights this point I’m making. Such trading builds nothing for society as a whole; its sole purpose is profit only for the traders with no care whatsoever that that profit chasing could well have a negative impact in the long run on all of us. One of the problems around high frequency trading is that we don’t know what its long term effect on society (and the market place) will be. Its proponents say it can only do good – high frequency trading, they say, creates more liquidity (anyone can get an order filled quickly at the market price) and lessens the spread between the high price traditional brokers charge clients who want to buy and the low price those same brokers offer clients who want to sell . However, its critics say such trading could have the effect of blowing the markets up much like the more traditional trading in those toxic investments that precipitated the economic meltdown of 2008/2009. It makes me nervous that once again we, the public, are unwittingly riding the tail of an investment dragon that could well have a serious negative impact on our way of life. Where is the due diligence from both the investment industry’s supposed self-regulatory system and our government on how trading in such a risk filled manner is still, even as we are slowly recovering from the last economic disaster created in large part by a failure by all parties in their regulatory responsibilities, allowed to operate when the real consequences of that form of risky trading are not known?