The illogic of financial markets

I have worked at stock exchanges and thought many years about markets.  Much of what is said about them–even by leading economists–is rubbish.   Indeed, the salient idea is rubbish–that people can rationally select wise investments.  The logic to disprove it is straightforward, but experience is even better. We all have such experience.

Here’s a statement of the issue succinctly put by the very good Baseline Blog:

But I have one major reservation, which is that I’m not sure how good the financial advice would be. In my opinion, most financial advice floating around is worth less than nothing. To take the most obvious example: by sheer volume, the largest proportion of financial advice that exists (counting all advice that anyone gives to anyone else via any means of communication) is almost certainly advice on buying individual stocks, and the second largest is probably advice on choosing mutual funds. I am firmly in the camp that believes that whether or not stocks obey the efficent market hypothesis, it is not within the capabilities of any individual investor to identify stock trades that will have an expected risk-adjusted return higher than the market as a whole, net of transaction costs. I also believe it is not in within the capabilities of any stock mutual fund manager, and that all of the variation in risk-adjusted mutual fund performance can be explained by pure statistical variation. And even if I’m wrong about that, and there are a few exceptional fund managers out there, I don’t believe that any individual could distinguish the exceptional managers from the simply lucky ones; and even if he could, by the time he did he would be buying into a fund that had grown so big it was no longer capable of above-market returns.

It’s a point I’ve made many times in similar form with no refutation from leading institution-trained economists and others.  The real kicker is also made by the Baseline Blog.  That is, if this weren’t so…markets should solve the problem!  And I’ll take that one step further, if THAT weren’t so, then why would anyone having the capacity to invest wisely, which would be invaluable, not sell it as a commodity at extremely high markups–essentially risk free, rather than running a hedge fund, mutual fund or even their own portfolio.

It’s a fool’s game.   The pricing system simply doesn’t work.  The current global financial crisis shows just how destructive things can get when widespread belief in a myth becomes a way of life.

By the way, the same logic applies very well to starting businesses or making other key life choices.  Without global objectives that are pre-set and socially agreed, optimal selection of investment options is extremely unlikely.  That’s why rich people live in planned communities and poor people live in ad hoc ghettos.