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Do as I say, not as I do Samuel Brittan: The Financial Times 02/01/04 Around this season I look for a book to recommend to a proverbial nephew who does not intend to take an economics exam or become a practitioner, but who wants the equivalent of a popular science book. This time I recommend a recent book on the related subject of stock markets, namely A Mathematician Plays the Market by J A Paulos (Allen Lane). Here I am however somewhat in the position of the nephew myself. For, as readers will be all too aware I have spent my career in the "first half" of the Financial Times and never been a financial markets commentator. Hence I stand to learn as much as the nephew when the author explains matters such as "Beta Values", which quantify past volatility. He also explains very well notions such as the (very badly named) chaos theory which have newly entered the social sciences and which require more than a dictionary definition. Paulos covers all this ground with simple arithmetic and very little algebra. The proliferation of numerical illustrations does not make the book easy bedside reading. But the reader will not lose much if he takes the author's word for most of the arithmetic, provided he does an occasional spot check himself. But I must warn that he does not explain how to pick winning stocks or even to spot highs and lows in the equity market. Indeed it is only a slight oversimplification to say that his view on how to play the market is: "Don't". Almost on the last page he lists four basic maxims: Don't succumb to hype and vaporous enthusiasm. Even if you do, don't put too many eggs into one basket. If you violate even this last maxim, at least ensure against sudden drops with put options, which are options to sell at a given price. Even if you neglect all the rest, at least don't buy on margin. But now comes the irony. Prof. Paulos has an enviable reputation for explaining elementary logic and mathematics to ordinary readers in earlier books such as A Mathematician Reads The Newspaper or Innumeracy and Its Consequences. Yet he himself used a small unexpected legacy to buy WorldCom shares on their way up at $47 per share. He followed the market upwards; and, even when it turned, continued to buy in the hope that he was picking up a recovery bargain. He even tried to recoup his losses by buying on margin near the final debacle. He adds that his experience is applicable to many other stocks such as Yahoo!, AOL-Time Warner, Enron "or perhaps the generic symbols WOE or BANE". The only explanation he can give of why he disobeyed his own maxims is the word "addiction" - he is not inclined to be his own financial psychologist. It is enough to make one wonder about the slogan of Tony Blair the British prime minister, "Education, education, education". It should also to make me ponder my own dictum that what the public needs is not courses in economics but an introduction to the elementary arithmetic of risk and probability, which Paulos himself has provided in spades. We should not laugh at the saying "Do what I say, not what I do." In his teachings Paulos flirts with Efficient Market theory. This can be stated in many forms. The most realistic version is that it is almost impossible to outperform the market systematically. In this modest form it accepts that markets overshoot and bubbles occur; but it denies that an expert or government official has the ability to spot these deviations consistently beforehand, however wise they are after the event, or lucky on particular occasions. In financial discussions you often hear how about Ms.X or Mr.Y who has had a consistently good record in beating the market indices. Paulos shows how such "successful" analysts can emerge purely by chance. Of 1,000 analysts, roughly 500 might be expected to outperform the market next year. Of these another 250 might be expected to do so well for a second year and 125 in the third. Continuing the series we might expect to find one analyst who does well for ten consecutive years by chance alone. But will she do better in the 11th year? Your guess is as good as mine. The Efficient Market Hypothesis does not imply that financial market operators should retrain as fishermen or market gardeners. To begin with, investors have varying requirements. A strategy based on most likely average behaviour may not suit a fund with a lumpy liability due in 15 years time; and individuals will have their own rates of future discount, depending not only on temperament but on family circumstances. Paulos points to a more subtle problem. If everyone believed that all publicly available information were already reflected in security prices, nobody would bother to do any fundamental research; and the market would not be fed the information it requires for "efficiency.". Thus if the efficient market theory is true it is false; and if it is false it is true, rather like the paradox of Cretan who said all men were liars. He exaggerates, however, how many people are required to make markets approximately efficient in his limited sense. Surely it requires only a few specialists who are not content to be free riders on the theory to set the ball rolling in the right direction. It reminds me of a seemingly innocent remark made by a Cambridge professor in what was supposed to be a revision class for the laggards. He asked if it was really necessary for people to go from shop to shop comparing prices to make competition work. He concluded that it would be enough if a few people behaved in this unattractive way and the rest of us were more laid back. What investment strategy should a person follow who does not believe that he can beat the market? The conventional advice is to invest in a broadly spread indexed fund. Indeed a pin would do as well so long as it pricked often enough. Unfortunately even this modest advice is too optimistic. For it supposes that the only assets are equities and that these fluctuate around an upward trend. This feature dates back only to the 1950s when the cult of the ordinary share began. In the previous half century US equities, taking one decade with another, struggled to keep pace with inflation, and in the UK they fell well behind it. A genuinely diversified portfolio would cover not only equities but fixed interest securities, Treasury bills and much else, and would include a heavy loading of buildings and land which make up about half the national wealth. Indeed there is a question about how far it should be a national as distinct from a worldwide portfolio. Devising the appropriate weights would tax the finest City brains. The relative values of these broad classes of assets are probably subject to long cycles lasting several decades. These long cycles are difficult enough to explain after the event, let alone predict in advance. With these cautions in mind I looked back at one occasion in which I publicly "argued with the market". This was in a column on May 13, 1999 entitled Nonsense on Stilts when the Wall Street equity upsurge was in full flood and Fed chairman Greenspan had dropped his earlier warning about "irrational exuberance". Of course I was not original but following the lead of a minority of analysts such as Tim Congdon who scorned "this crazy boom". There were two factors which tempted me into this unfamiliar territory. The first was that surveys of equity analysts showed expectations of 13 to 14 per cent annual rises in corporate earnings. The trend growth of US Nominal GDP is around five per cent; and if any component continues to grow faster than the total, compound interest alone suggested that it would eventually swallow almost the whole of GDP, if a revolution did not intervene first. Secondly, the shape and size of the 1990s boom almost exactly mirrored that of the 1920s before the Great Crash of 1929. This time the crash came in 2000. But the equity market did not fall nearly as much and the Dow Jones has now recovered over two thirds of the lost ground to a level which some analysts still regard as overvalued. Some part of the credit for the more moderate reaction this time round must go to Chairman Greenspan who acted to prevent the dot.com bust and loss of confidence following September 11 from becoming a general economic rout. And unfashionable though it may be to say so some credit also goes to political leaders, including President Bush, who have allowed their budgets to swing into deficit, although not necessarily realising that you can have too much of a good thing. The real test will come however in the response of the world economy if and when the dollar comes tumbling down a good deal further han it has already. How do these events link up with my earlier discussion of investment strategy? Even had it been proper to do so, it would have been far from easy to make money from my suspicions of the late Wall St. boom. It is one thing to believe that a trend cannot continue and another to know when it will come to an end and whether it will gradually fizzle out or be abruptly punctured. And what should I have sold? The dollar, Wall St, the Nasdaq index? And how far ahead? Taking a bearish view of the market is itself risky, as market scepticism can only be a matter of probability rather than certainty. Above all, the fact that I was right on the last unsustainable boom does not mean that I will spot the next one. It may have very different origins and require someone of a totally different temperament to spot. All these considerations make a powerful case for basing macroeconomic policy, as well as personal investment, as much as possible on rules and as little as possible on supposedly brilliant perceptions or intuitions - which is involved in the vain search for "another Keynes" . But - as the first British chancellor to put his faith in rules, Nigel Lawson, discovered, and as the second chancellor of such inclinations, namely Gordon Brown, is now discovering - it is much easier to make the case for such rules than to decide what form they should take and how to apply them.
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