Tuesday, December 4, 2012

Emotional Arbitrage

While I enjoy reading finance magazines, I find that on the whole, they tend to be confusing, publish about many unnecessary things, and generally perpetuate the notion that money is really complicated and you need to pay other people lots of money to do manage it OR that you are competent and should try picking individual stocks to invest in.  (I disagree strongly with both.)  Still, three sentences that I read in Kiplinger’s express better than I could, why I have mixed/negative feelings about gold: “Few investments stir passion the way gold does.  Its advocates see it as insurance against inflation, economic calamity and profligate governments.  Its critics argue that gold’s price is driven by emotion and, therefore, trying to determine the metals’ true value is an exercise in futility”.

Gold is like Lindsay Lohan – it’s volatile, controversial, and everyone has an opinion on it.  We’re fascinated, weirdly enough have some sort of emotional attachment, but know that in the long term things probably won’t end well.  When institutions and people choose which companies to invest in, they consider various factors like price, price relative to estimated earnings for the next year, book value (asset minus liabilities – how much a company would be worth if it was immediately shut down and sold), book value relative to price, and expertise of management.  The reality is that regardless of why a company or stock does well, you win if it goes up (or down) as you predicted.  At the heart of businesses and their profits are their products and value (equipment, human capital), but the individual investors that make up a portion of the market are also human.  So even if a company isn’t worth a lot, or producing great returns, if people can be convinced that it’s great and should be bought, and you can predict people’s reactions, you can still make money.

One of the first finance concepts that I learned about in college is arbitrage.  Arbitrage is literally an opportunity where you can make money without doing anything special, or anything at all.  If the same product is priced differently, you can buy the cheaper one and sell it at the more expensive price – so if two index funds invested in the same 100 companies, but shares were priced differently, you could make lots of money easily by doing a lot of buying & selling of the shares.  Arbitrage is the unicorn of investing – some people believe it doesn’t exist, others know it has, but because investors will seize upon any arbitrage opportunity that exists, it is gone faster that you can say the word ‘arbitrage’. 

There’s a rumble going on between people who believe the market is efficient, ie everything is priced the way it should be, and those who believe there are opportunities to consistently obtain above-average returns in the market without needing to take on additional risk.  Many in academia are EMHers, while investment professionals (who need people to think they can do just that and should be paid lots of money for it) disagree.  Warren Buffett is laughing all the way to the bank, and a track record like his poses a serious inconvenience for those who claim that consistently beating the market without taking on additional risk is improbable and unlikely.

This might sound ridiculous, but people making significant money off of gold seems like evidence of emotional arbitrage.  I’ve mostly heard arbitrage defined as a mathematical concept: good x is valued at different prices, and making money from that is a matter of arithmetic.  But when different people value goods differently for emotional reasons, investors have the opportunity to leverage those two opposing viewpoints and make mullah.  It seems like emotional arbitrage would exist more than mathematical arbitrage, because we’re all nuts, and computer trading is much faster than any human at uncovering any literal (mathematical) arbitrage.  Makes me wonder, to be a good investor, is it more valuable to understand people or to understand accounting?

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