January 17, 2014 - Big Ideas
Here is this Friday’s installment of Avoiding Investment Strategy Flame-outs, a short book we are previewing for subscribers. With this post, the book preview is complete.
“Section 8-2 examines in detail the attractiveness of a short-term trading strategy offered in the quasi-advisory (“educational”) marketplace. Assessing this strategy entails considerable work, only to find that it is not attractive. This chapter covers more broadly the delegation of investment strategy development, ranging from following an expert’s public advice on market timing to deposit of funds for professional management. Such practices relieve investors (at a cost) of some or all of the burdens of learning, data collection/analysis, strategy design and disciplined implementation.
“However, such delegation entails agency issues (conflicts of interest). Potentially more than they want to help their readers/subscribers/clients earn exceptional investment returns:
- Media that present investing advice want subscription fees or attention to advertisements. Media company interest in the usefulness of what they present is arguably secondary to attracting attention. In general, contributors to free media also have motives that bias what they present (attracting their own subscribers or clients).
- Academics studying financial markets want employment (and tenure) and funding of future research. They therefore must attract the attention of peers and publishers. They often have no stake in whether their research findings are useful to investors. They do have an incentive to attract the attention of investors when making a transition to investment management.
- Expert equity analysts want employment by brokers and asset managers, and access to industry sources. The interests of their bosses may not always coincide with the interests of the clients of their bosses or other investors.
- Newsletter sellers want subscription fees. Getting the attention of potential subscribers is essential to their business model. They sometimes seek attention by uncritically presenting snooped, gross trading system results as an “educational” service.
- Financial advisors want advisory fees. They must attract the attention of potential clients. As with newsletter sellers, the font used for marketing copy is much larger than that used for the legal disclaimer.
- Investment managers, mutual fund managers and hedge fund managers want management fees, normally as a percentage of account balance. They have to get the account before they can debit the balance. They have to get the attention of a potential clients before they get the account.
“A common motive across the range of investment service providers is attention-seeking, which tends to drive offerors toward extreme representations (possible but low-probability scenarios, the tails of the distribution of potential outcomes). The most extreme representations offer the “holy grail” of amazingly large and reliable returns (appealing to investor greed) or the “safety of Noah’s ark” from impending doom (appealing to investor fear).
“Conflict-of-interest materiality persists because investors have great difficulty distinguishing luck from skill when outcomes involve a high degree of randomness.”