When stupidity pays

If you want to understand stock markets, it’s better to read the sports pages than the financial pages of the dead trees. Here’s the wisdom of Arsene Wenger:

If you give success to stupid people, it makes them more stupid sometimes and not more intelligent.

This is a fine description of an important reason why markets are inefficient – it’s noise trader risk, originally described in Brad De Long’s classic paper (pdf).

He showed that the principle “survival of the fittest” does not apply to stock markets. Quite the opposite.

Imagine that stupid investors have driven a share’s price up “too far.” Efficient market theory says smart investors will step in and sell the stock short. Smart investors will therefore make money, at the expense of stupid investors. Eventually, stupid investors will lose money to smart ones, ands thus leave the market.

Brad showed that this theory was wrong. Smart investors won’t always short an over-priced stock, because they’ll fear that stupid investors could get even stupider, and drive the price even higher. [insert cliché from Keynes here].

This will cause share prices to be more volatile than their “fundamentals.”

Stupid investors will profit from this, in three ways:

1. Volatile stocks earn higher returns than less volatile ones. So there’s a tendency for stocks which stupid investors hold to do well, thus making money for them.

2. As stupid investors make money, they’ll become more confident, and so will take bigger positions, on the basis of the same crack-brained thinking that made them money; this is what Arsene had in mind.

3. Because stocks generally give good returns over the long run, these bigger positions earn good money.

The stock market, therefore, illustrates the wisdom of Ecclesiastes: “The race is not to the swift, nor the battle to the strong, neither yet bread to the wise, nor yet riches to men of understanding.” The difference is that it’s not “time and chance” that happeneth to cause this, but the very structure of markets.

So, here’s my question. Could we apply this story to other walks of life, to show that stupidity drive out smartness in other professions? My strong suspicion is: an emphatic yes. Tell me I’m wrong.

Comments

[Paul Davies]

Novel writing?

[Paddy Carter]

journalism, surely

[Tim Worstall]

"Could we apply this story to other walks of life, to show that stupidity drive out smartness in other professions? My strong suspicion is: an emphatic yes. Tell me I’m wrong."

Wrong? How can you be? Ever met a politician?

[Simstim]

Football club chairmen?

[dearieme]

I remember after the '97 election hearing a Commons debate with Hague, Lilley, Brown and Blair: three clever chaps and the P.M. How has Brown stuck it so long?

[Paket Shop Hermes]

For career, dare not say what improvement. Because have been jobs, and although some of his about go hard, but not really is successful, recently came to a new company, is very hard, I went for business, and then give me the opportunity to learn, also let I good effort.