Comments

I keep meaning to renew my subscription, but never get around to it. Fortunately, the technology folks at the Economist never seem to get around to updating their subscriber lists, so I can still access the online version...

Anyway, this article made me think of Moneyball: you have a bunch of deep-pocketed elite colleges overpaying for a small group of the best academic talent, leaving the poorer colleges at a disadvantage. Given the cutthroat competition for tenure-track jobs at the lower levels, it seems like the perfect opportunity to exploit the market inefficiencies and sign some undervalued young-but-accomplished prospects.

-- IndependentGeorge - 26 Sep 2005

I LOVE MONEYBALL!

I was telling Carolyn to read it just yesterday!

-- CatherineJohnson - 26 Sep 2005

hmmmm

I'm trying to get 'market inefficiencies' back online (online inside my head, that is).

Needless to say, having read every word of MONEYBALL, I am highly motivated to acquire enough math to be able to spot a bona fide market inefficiency before everyone else does.

I have to say, though, that I still don't know what one is, exactly.

-- CatherineJohnson - 26 Sep 2005

Actually, there's an interesting phenomenon, which is that Ivy League universities never give tenure to their own junior faculty. They only pick up tenured faculty from other universities.

So public universities pick up their stars from the ranks of people who've begun life as assistant professors at Ivy leagues.

Ed refused to consider an assistant professor job at an Ivy League school for that reason. He went to UCLA, which gave him tenure. Then jumped to NYU (not Ivy League, obviously, but they were buying stars & near-stars.)

-- CatherineJohnson - 26 Sep 2005

From the perspective of my lowly AB degree, 'market inefficiency' is often fuzzy economics at its best. As in: if the outcomes don't match my hypothesis, well, then, clearly there are market inefficiencies at play :)

More seriously, it occurs when there is asymmetrical information in the marketplace, and a player over/underpays for a resource. It's generally unavoidable in the small scale - somebody always knows more or less than somebody else. On the larger scale, efficient markets hypothesis argues that all of the small inefficiencies balance out over a larger scale, so the market price of a good is almost always very close to its true value. What's intersting is that market players always think that they have the advantage, when in fact 50% are always wrong. And that's why I invest in index funds :)

I think it's an apt term for faculty hires because the surperstars usually get the big contracts after their best work had already been completed. In essence, the universities are paying for past performance, rather than projecting for future performance. This is like

-- IndependentGeorge - 26 Sep 2005

As in: if the outcomes don't match my hypothesis, well, then, clearly there are market inefficiencies at play

Hey!

That's what I thought it was!

-- CatherineJohnson - 26 Sep 2005

More seriously, it occurs when there is asymmetrical information in the marketplace, and a player over/underpays for a resource. It's generally unavoidable in the small scale - somebody always knows more or less than somebody else. On the larger scale, efficient markets hypothesis argues that all of the small inefficiencies balance out over a larger scale, so the market price of a good is almost always very close to its true value. What's intersting is that market players always think that they have the advantage, when in fact 50% are always wrong. And that's why I invest in index funds :)

OK, that's terrific, though I'm going to have to meditate on it. (It's a little counterintuitive--it's funny, the way people think they can beat the market, etc. Just the other night we went out with a guy who is actively playing the market, and I kept thinking, Isn't that statistically impossible?

In fact, he said that he had lost more money than he had gained.

-- CatherineJohnson - 26 Sep 2005

Not that I have a lot of spare money lying around to invest, but what I do have is in index funds.

-- CatherineJohnson - 26 Sep 2005

My favorite market-like statistic, from Shelley Taylor's HEALTHY ILLUSIONS (wonderful book) is that 95% of all Americans say they 'drive better than average.'

-- CatherineJohnson - 26 Sep 2005

OK, this is starting to sink in.

I needed to hear 'asymmetrical information' in the context of 'efficient market hypothesis.'

Your comment is an excellent example of metacognitively-aware explicit instruction!

-- CatherineJohnson - 26 Sep 2005

I'm serious.

-- CatherineJohnson - 26 Sep 2005

...and what were you doing in a karaoki bar?

I was a karaoki judge one time. Yep. Highlight of my career.

-- SusanS - 26 Sep 2005

I wasn't singing.

-- CatherineJohnson - 26 Sep 2005

Requisite Simpsons Quote (RSQ):

(following the annual Harvard-Yale football game)

Mr. Burns: I don't know why Harvard even bothers to show up. They lose almost 50% of the time.

-- IndependentGeorge - 26 Sep 2005

Hmmm.... I seem to have lost half of my last paragraph. I'm missing a predicate!

Well, since I haven't the foggiest idea what i wrote, I'll just go back to yammering about economics in general. For me, the toughest thing about economics wasn't the math (though that was plenty hard enough - ok, all the math and physics majors in the house can stop snickering now, thank you very much), but the fact that just about everything you study runs counter to our native intuition. Here's a paper on Folk Economics, which theorizes that our intuitive understanding of economics comes from a brain which evolved in an environment completely alien to the modern world. Anecdotally, that sounds about right to me; it pretty much describes what I went through when I first started studying econ. I was in favor of rent control/living wages/farm subsidies/tariffs/etc. before I was against it; at some point, I have argued each issue sincerely, vehemently, passionately from both sides.

Efficient markets hypothesis really is an interesting paradox. Basically, it only works because the players don't think it works. If everyone believed in it, and invested only in index funds, the index funds would lose all meaning. Information arbitrage would cease, and markets would soon become inefficient. What happens then is that somebody will gain an information advantage, and play the inefficiencies to his benefit. Once this happens enough, people will see that the market is inefficient, and start behaving as such, and trying to take advantage of whatever advantages they perceive. This, then, brings us back to the efficient market conditions we started with. It's almost a reverse placebo effect - because I believe it is false, it is therefore true.

I should point out that while there is a consensus towards efficient markets, it is by no means unanimous. Behavioral economists argue that markets are irrational far more often than we realize, and that fluctuations have more to do with social psychology than with underlying economic conditions. Personally, I think there is a lot of truth to this, even though I'm pretty firmly planted on the efficient markets side. After all, Harry Truman once famously remarked that he wanted to hire only one-armed economists, just because they couldn't say, "well, on the one hand..."

-- IndependentGeorge - 26 Sep 2005

Yes, the counterintuitive nature of economics is hard. That's what I love about it, but it makes understanding a book like MONEYBALL a challenge, which it shouldn't be.

-- CatherineJohnson - 26 Sep 2005

(Given what a good writer he is, I mean.)

-- CatherineJohnson - 26 Sep 2005

I was in favor of rent control/living wages/farm subsidies/tariffs/etc. before I was against it; at some point, I have argued each issue sincerely, vehemently, passionately from both sides.

I had the exact same developmental sequence--all kinds of stuff that sound Obviously Good, like 'Let's pass a law saying rents have to be reasonable' turn out to have a gazillion consequences that are just bewildering when you first take a look at it.

Then when you take your 2nd, 3rd & 4th look it's still fairly bewildering, because economic reality is complex & slippery.

-- CatherineJohnson - 26 Sep 2005

Efficient markets hypothesis really is an interesting paradox. Basically, it only works because the players don't think it works. If everyone believed in it, and invested only in index funds, the index funds would lose all meaning. Information arbitrage would cease, and markets would soon become inefficient. What happens then is that somebody will gain an information advantage, and play the inefficiencies to his benefit. Once this happens enough, people will see that the market is inefficient, and start behaving as such, and trying to take advantage of whatever advantages they perceive. This, then, brings us back to the efficient market conditions we started with. It's almost a reverse placebo effect - because I believe it is false, it is therefore true.

I don't follow this part.

Why would an index fund lose all meaning?

-- CatherineJohnson - 26 Sep 2005

Think of it this way: an index fund is an easy way of spreading your money across a broad range of assets - essentially, you're betting that you can't beat the market, so you'll join it. The prices of the individual stocks, however, reflect trades made by players trying to game the system. The reason that the price approaches the actual value is that, when that stock is bought or sold a thousand times a day, the asymmetry in information between buyers and sellers tends to even out. Individual traders might not know the true value of the stock, but they can guess. Each guess is probably wrong, but all the guesses put together even out to a pretty good estimate.

If everybody starts investing in index funds, that means you're no longer getting the individual trades. Nobody is trying to outsmart anybody else, because they're convinced they can't. So, they just buy a little bit of everything. Now, two major changes affecting price have occurred: for the companies, their stock price is no longer tied to their performance. For the traders, nobody is haggling over the last cent of a stock price based on what the CFO ordered for lunch last Tuesday. The impact of the former is pretty obvious, but think about what happens with the latter. Every sale requires a buyer and a seller, proceeding on different assumptions. Both think they're getting the better deal, but only one is right. Repeat it enough times, and the sales don't reflect information; they are information. So when those individual sales disappear, you're eliminating vast quantities of information.

An index fund is esentially a bet that if I spread my money around enough, it'll rise in value because the winners will outnumber the losers, even if I can't pick them individually. But, if everybody repeats my strategy, then the information exchange that occurs with each trade no longer exists. Prices are transparent - now, they truly are guesses, rather than a clearinghouse of information.

If prices no longer reflect information, than anybody with the slightest information edge can get a huge gain. This is also a good explanation of why such a situation dosn't occur in real life. There's an equilibrium at work - the moment the market slides towards inefficiency, somebody is going to try and take advantage of it. Everybody thinks they have the advantage, even though only half of them do. Hence, the paradox: the market is rational only because most of its players are distinctly irrational.

-- IndependentGeorge - 27 Sep 2005

oh boy, this is still over my head--although it's a big help.

I started trying to learn economics about a year ago, using THE ECONOMIC WAY OF THINKING by Heyne (which is supposed to be great, and in fact seems great) but learning economcis, along with learning how to draw, has been put Severely on hold.

At least I am at the point where I semi-grasp the last paragraph--the fact that a Perfect No Information situation can't last.

Also, I'm pretty sure I do grasp the fact that the market is rational because the players are irrational, to some degree.

I read a terrific line on why you can't beat the market, and why most money managers don't beat the market, either: no one can predict the future.

That was enormously helpful to me, and whenever I talk to someone who is engaged in active trading (who is not a professional) I think: Are you completely and totally irrational?

Or is it me?

I'm usually pretty sure it's the other guy.

-- CatherineJohnson - 27 Sep 2005

Have you seen writeups of Swenson's new book? (He's the legendary Yale guy, the one who's averaged a 16% return on the Yale trust fund for 20 years.)

He's articulate & persuasive. Says forget mutual funds.

-- CatherineJohnson - 27 Sep 2005