Sunday, February 22, 2009

Why your investment adviser can't advise the world

As stock markets around the world continue to plummet, most investment advisers are telling their long-time clients to stay put and wait for a rebound. With the world overflowing with newly printed (actually, electronically created) money waiting to be invested, a rebound might come despite sentiment that is now so extremely negative.

But the problem with investing (as opposed to saving) is that it is primarily a social phenomenon (rather than an individual one) and therefore has some of the characteristics of both a Ponzi scheme and a zero-sum game. Our savings usually go these days into bank accounts that are insured. The value doesn't fluctuate or rather fluctuates very gradually upward with each interest payment. No matter how many people choose to open savings accounts or CDs at a bank, your principal can neither go up nor down. (The interest payment you receive, however, might go down if too many people flood the bank with money that it cannot deploy profitably in the form of loans.) And, even if some choose to save in part through the purchase of, say, jewelry, gold coins or land, we insure these against loss and liability. Their market price can't be controlled, but loss from theft, damage or lawsuit can be. And, only a fool would think to put all of his or her savings into any one of these alternatives to bank accounts.

The same things can't be said for what most people call investments. Here people were advised to pile into the stock and bond markets with all of their savings. And, in these markets it is essential that there be people who continuously bid for what we have chosen to invest in in order for its value to increase or at least be maintained. Hence, investing is a social phenomenon. A sharp investment adviser will put his or her clients into the next profitable thing early and then have them sell to the latecomers before the trend reverses. And who are the latecomers? Some of them are undoubtedly people put into the same investment by other investment advisers who see the next profitable thing only somewhat later than our aforementioned sharp investment adviser. As each new cohort of investors piles into an investment, the early ones have an opportunity to bail out. This is what I mean when I say investing has some resemblence to a Ponzi scheme. The new investors pay off the original investors by buying their assets at a higher price.

Now, some will complain that if there is overall continuous growth in the economy, the latecomers will make money as the economy continues to expand. There is some truth to this, and yet the fabulous expansion of the world economy in the 20th and early 21st centuries hasn't prevented wide swings in markets that have made paupers of the latecomers. Whether that growth can continue is an open question since we are facing mulitple resource limits and the headwind of climate change.

But setting aside the growth question, we can still see that the social aspects of investing make it far more hazardous than what we call saving. For if a lot of people decide all at once to sell assets similar to what we ourselves own, they can create a panic that leads to much lower prices. And, that, of course, is what we've seen in the past several months.

But not everyone is poorer for this happening. There are short-sellers who have been making gobs of money. Those are the people that remind us of the zero-sum aspect of investing. They only make money if we who are in the market lose it.

The current market meltdown makes clear that the risks faced by amateur investors were much higher than they were told. Professional investors understand the risks better (but not much better, it seems!). Investing is really a form of gambling. If you go into a casino and lose your money, you will, of course, be disappointed. But you shouldn't be surprised. Unprepared, many amateur investors were surprised by recent events.

The upshot is that the vast majority of people are not fit to participate in the casino of investing. Their talents lie elsewhere. We are about to return to a world where a much smaller group of people risk capital in the stock, bond and commodity markets, people who can afford to or at least think they can afford to do so. For everyone else it will be back to the staples of savings: bank accounts, savings bonds, perhaps some gold coins, silverware, jewelry or a little land.

And, what of all those people who are currently being told that they should hang on for a rebound in the market? Well, it might very well come. And, if it does, will they be counseled to sell after a 20 or 30 percent rise? And, if they take such advice, it will turn out like every other socially-driven market move. Some will act first--perhaps from a special premonitory insight--and reap the rewards. Others will follow in successive waves. It is logistically impossible for everyone can sell at once because, as in every Ponzi scheme and zero-sum game, there has to be someone to sell to.

Unfortunately, there is a bell curve that describes the success of financial advisers just as there is in every other profession. This has less to do with talent than with the structure of the investment game. If your doctor tells you to eat right, exercise and get plenty of rest, it's advice that every one of his or her patients can profit from. But if everybody acted at once on the basis of one adviser's counsel, the investment game wouldn't work. And, that's why your investment adviser will never be able to advise the world.


SoapBoxTech said...

What amazes me is how many people could not, or cannot, grasp the basic common sense in what you've discussed here. Ignorance is only bliss when times are good.

Rice Farmer said...

Of course there are winners and losers, but the one thing that mitigated that and at least gave everyone the hope of coming out ahead was the infinite-growth economy. That increased the size of the pie and left a few crumbs for some, if not all, of the latecomers. (Nevertheless, I think your thesis still holds.) And of course infinite growth made it possible (or seemingly possible) for everyone to pay back their debts plus interest.

Now, however, growth has been stifled. But investment gurus will advise people that "now is the time to buy," and we'll see the same thing played out, only worse.