Numberscruncher: Perfectly Imperfect Information

Written by Current Events, Numberscruncher

19990607-750-0[1]Eugene Fama is the Susan Lucci of the Nobel Prize world. He not only developed the Efficient Markets Hypothesis, which sits beneath almost every theory in finance, but he also is on faculty at the University of Chicago, a Nobel factory. Still, Fama has not received the early-morning call from Sweden. That’s too bad. The Efficient Markets Hypothesis says that market prices are accurate because everyone has the information needed to make rational investment decisions. In the real world, markets are not perfectly efficient, but they are close. The Efficient Markets Hypothesis assumption helps people try to figure out where the flaws are. (It goes without saying that those people who believe that markets are always efficient do not see the flaws and make mistakes. Fama, by the way, does not think markets are perfectly efficient.)

The Efficient Markets Hypothesis doesn’t assume that everyone involved is wise, but that there are more people with good information than bad information. The signal-to-noise ratio is high enough that the irrational and uninformed traders cancel each other out. Over the long run, this seems to be true, but there can be enormous deviations from efficiency in the short term as traders figure out who has the right information.

Two weeks ago, I gave up on Twitter. Last week, Trent Reznor joined me. Our reasons were a bit different, but they tie back to this efficient market problem. For me, it was that I wanted to learn what people were up to, but too many of the people on Twitter were up to selling get-rich quick schemes. One day, I found that about a hundred new people were following me. I used to follow everyone who followed me, but then I found that all that was ever on my Twitter page were posts like “Click this link to see how to get thousands of followers!” and “I can help you make money through new media. Click here!”  I couldn’t keep following everyone if it would make Twitter a waste of time, so I started to go through these new followers’ names to see if I wanted to follow them. It was tedious, and about 90% of them were of the “Learn how to get hundreds of new followers!” ilk. I decided that the whole thing was pointless. I signed off and never looked back.

For Reznor, the issue was that the haters took over.  “We’re in a world where the mainstream social networks want any and all people to boost user numbers for the big selloff and are not concerned with the quality of experience,” he said, and he’s right. It’s noise, and it’s chasing out the good information, giving us a short-term bubble in social media.

The social media bubble is taking place alongside a nasty and uncertain era in financial markets, and there’s some thought that the uncertainty is made worse because there is too much news but not enough good information. Like the so-called social media experts selling their “get rich through Twitter” packages who bury the tweets of Iranians trying to get the word out about the fallout of their election, ordinary investors are buried by tons of facts and opinions about the market right now. “Our brains are being reprogrammed in a way that has the potential to negatively affect people’s responses to their investments,” says Adam Bold, the CEO of the Mutual Fund Store in Overland Park, KS and the author of The Bold Truth about Investing (Ten Speed Press, 2009). He says that investors look at their 401(k) balances online, get upset, share their misery with their friends, and generally get worked up in a way that keeps them from looking at the big picture.

Once people accept the realities of the market and get the emotion out of it, the economy will turn around. And then, of course, people will get overly excited and inflate another financial bubble. And that bubble will surely burst, because signal-to-noise ratios are not steady and investors are not rational enough to filter the most accurate information every day. If you can step back from the 401(k) statement like Trent Reznor gave up Twitter, you’ll be taking a step in the right direction.