Posts Tagged ‘wall street’

Liar’s Poker is the first book Michael Lewis published and the one that transformed him from a bonds salesman to a writer. It tells the tale of how he came to work at Salomon Brothers and key figures at the company that oversaw rise and fall. It’s an interesting insight into the excess of Wall Street.

When someone says the phrase “high frequency trading” (HFT), most of us have no idea what it means. Even those of us with some idea, probably think it is trading by computers, but essentially doing what traders do – wheeling and dealing in an attempt to make some money.

Michael Lewis’s book “Flash Boys” tells a different story. High frequency trading is all about front-running. You want to buy 10,000 shares in Apple? Great, I’m going to buy them before you can and then sell them to you at a higher price. It’s illegal, or it was, but with the deregulation of central stock markets in favour of competition between markets, you can now exploit milliseconds it takes for them to talk to each other.

This caused huge investment into the history with HTF firms making enormous profits. The banks didn’t say anything because they were making money from selling the HFT companies the data they needed. The stock markets didn’t say anything because they were making money from the huge increase in trading activity. Everyone was getting rich from scalping the ordinary investor.

I say was, but the problem has not gone away. However, the book also discusses how former trader Brad Katsuyama has gone on to set up IEX, a private stock exchange that tries to eliminate all the unfairness in the market.

It is a fascinating by scary read. To see how totally wrong the entire banking industry is. We all kind of know it, but it really brings it home.

Two of the books I have read recently, Everything Is Obvious and The Signal and the Noise, made references to Burton Malkiel’s book “A Random Walk Down Wall Street”. They pointed out that the stock market is entirely unpredictable and therefore investment bankers are just guessing. I was curious to read more, so I picked up the book itself.

An index tracks stock market movements. For example the FTSE 100 tracks 100 companies on the London Stock Exchange, while the Standard & Poors (S&P) 500 or Russell 3000 track a far more broad range of stock prices. These therefore provide a good indication of whether the stock market moves up or down.

Now take a mutual fund – these are professionally managed funds that the general public put their money in for someone to manage on their behalf. The benchmark here is not whether they can grow their investment, but whether they can grow their investment at a better rate than the index (because the stock market generally moves up anyway). If they were just guessing, you would expect 50% of mutual funds to beat the index, and the other 50% to fail, in both cases just due to chance.

However, the research, as discussed at length in A Random Walk Down Wall Street, shows that only 40% of mutual funds can beat the index! This is not just guessing – this is worse than guessing. Professional investment managers not only do not add any value to the funds they are managing, they actually subtract value.

You could make the case that there are just a lot of bad fund managers. However, the research refutes this too. As Malkiel describes, if you take the top performing funds over a five year period they almost invariably fail to beat the index over the next five year period.

This should not actually be that surprising. The Wall Street Journal has long shown that throwing darts at the stock listings produces a better return than the experts; a noticeably better return once you adjust for risk. To see it in practice (I include this as an anecdote to make the facts more believable) just watch the BBC documentary Million Dollar Traders in which eight complete notices only lose 2.5% in a period where their multi-millionaire master-of-trading coach loses 5%.

Of course it is hard to believe. Why are all these people employed if they add no value? That is a fact I find hard to reconcile. Surely if we are talking about efficient markets, at least one bank would have realised they could fire all these traders and replace them with monkeys? Counter arguments to this suggest that the average trader actually earns a pittance, and that because it is in the interest of traders (justifying their own job) and brokers (getting rich of the transaction fees from all this needless trainers) to maintain the illusion that they actually do something, the industry keeps selling these products to the general public who simply don’t realise.

The evidence, at least if Malkiel is to be believed, is clear. You should invest all your money in an index tracker with the lowest fee you can find. That produces the most consistent returns compared with a mutual fund that charges you higher fees to produce a lower return. Nate Silver says the same thing.

In the final part of the book, Malkiel goes on offer some investment advice for those who do not want to use an index fund. He also hints that he picks individual stocks too. This is odd as it goes against a lot of what the evidence he has presented says, but is consistent with what the psychology says – that we have a really hard time accepting what the scientific evidence says when it contradicts our own pet theories, achievements and so called “common sense”.