"And the dilettante who “trades for fun” will be eaten alive by a firm with a much better model of a) the world and b) the dilettante themself."
This is maybe true in a zero-sum game such as commodity futures markets, but not necessarily true in what can be a positive (or negative) sum game such as stock markets. The amateur may generate less return than a professional, but often not, once the professional's fees are taken into account.
Then again, the number of professionals who underperform index funds is remarkable.
No, this is a naive take. the firms are still getting your alpha (returns beyond a suitable index). In which case you beat the index, then by all means keep doing it
> I’m reminded of the story of Richard Feynman in academia6. His colleagues who kept their office doors closed made progress on their research in the short-term, but hit stumbling blocks. Those who kept their doors open didn’t seem to make much progress initially, but eventually outpaced the “closed door” scientists. They had new ideas and research directions based on all the interesting conversations they were having with others.
This was part of my keys to success when I worked in high tech. I sat with different people in the cafeteria, struck up conversations with different people at the coffee counter, learned what they did, touring their labs ... when I had difficulties, I knew where to find resources.
Interesting. Similar experience here, but soon after meeting everyone, got sidetracked into company politics and then lost interest in the whole ordeal and left.
> The Efficient Market Hypothesis is one of the core concepts taught in Finance 101. The Efficient Market Hypothesis is a lie. The person that better understands the nature of a small sliver of the world (e.g. Apple’s share price) will make more money than others.
... and in the process they'll bring the market closer to a perfectly efficient one.
This is a pretty small nitpick, but I feel like this is one of several "takedowns" I've seen of the EHM which seems like it's only really 'refuting' the absolute strongest form of the principal - a sort of "Perfectly Efficient Market Hypothesis" - which I'm not sure anyone really believes, while actually affirming the general concept behind the hypothesis.
The EMH isn't an absolute rule, but it just seems like basic sense, in line with the rest of the advice here: if you think you've got some killer trade that's going to make you a ton of money, it's possible you're right, but it's also very likely that the market's price accounts for something you aren't pricing in yourself.
In my view it's not a ironclad "you can never make a winning trade", but it's an important reminder towards humility and I think deserves better than to be called (literally) a bold-faced lie.
Absolutely. The Efficient Market Hypothesis relies on people spotting it's a lie in order to be true, and unless you have a real (non-imaginary) edge or are dealing in an illiquid market, the chances are it *is* true for you. If somehow you're right and it's a lie in your particular circumstance, you better be quick, because it probably won't be long before it goes back to being true.
In my view, the EMH can only be true at a high, coarse grained level...and the EMH can only be true at a high, coarse grained level, if it false at a fine grained level. Trading activity exploiting short-term opportunities is the mechanism that creates long-term efficiency.Coarse grained market efficiency is the result of fine grained inefficiency.
It is a lie the Ivory tower academics like to tell themselves why they are only pulling in a university salary and not making a killing in the markets. Despite being an economics or finance professor.
Avoids a lot of awkwardness at parties:
"Say Steve, if you know so much about economics, how come you are not doing much better than a University salary?"
"Well I will tell you, it is not me who is the sucker! It is those 5 sigma fools like Warren Buffett, making billions, who are the suckers! Because they have no clue just how lucky they are!"
This seems like a you thing, a weird vendetta against economics professors.
Economists and traders have wildly different skill sets and are doing wildly different things. Economists almost universally don't want to be traders, they want to be economists. They want to write a paper examining data on how a minimum wage increase in Puerto Rico impact labor force participation (or whatever). It's just wildly different as an occupation than trading, and your model of them as incompetent/jealous losers seems to say more about your personal hang ups than it does about the profession.
As a group, economics and finance professors should outperform though. They don't. So they had to invent a theory that conveniently explains why nobody could outperform.
Macro economists are also embarassingly terrible at making predictions.
You are comparing a group (economics or finance professors) against a winner from another group (Warren Buffett). Fair comparison would be group vs group. Among the people who tried to be the next Warren Buffett, what is the typical result?
The EMH is an entirely correct and accurate description of the behaviour of systems with certain properties; where people go wrong is in trying to generalise it to real-world systems that don't have those properties.
And they're right to do that. There's an opportunity cost to being a professional trader, if you don't pay which you won't outperform ETFs. That's what EMH is really saying.
1. Trading costs are incredibly important, and the more money you're investing the larger they are (since buying and selling big positions moves the market).
2. Finding inefficiencies is possible, but it takes work, which costs money. To find inefficiencies you need to be paying a bunch of smart people lots of money, which means you need to be trading big positions to make enough profit to make their wages worthwhile.
So a fancier version of the EMH states that inefficiencies do exist but are incredibly hard to profitably trade. Inefficiencies can only be traded profitably if you take a small position, but you need to take large positions in order to justify the expensive process of hiring people to look for those inefficiencies.
Professionals are usually able to distinguish between trading and investing. They invest in various markets - usually a combination of index funds and special opportunities where they think they have an edge in judging the managers. And they trade in markets where they built their own edge, and these may have nothing to do with their index funds or other long germ investments.
Dunking on the strong EMH in a well-reasoned way is often virtuous, in the same way it’s virtuous to dunk on the null hypothesis. No-one believes it, but it can be useful to quantify your views by using it.
Maybe this fits into the model, but markets are not all equally efficient. Starting a local accounting firm, corn farm, or construction company, are all pretty easy as you are competing against the people in your town. An engineering/manufacturing/tech startup is really hard as you compete on a global market but can grow really fast in the unlikely event you happen to be the best in the world.
My favorite phrasing of the EMH is "you can't beat the market". Maybe Warren Buffett can beat the market, maybe Augustin Lebron can beat the market, hell maybe the average junior trader at a random investment bank can beat the market. But you're just a random idiot, and any trade so obvious that you can see it is either not a good trade or has already been fully exploited by the professionals.
"Isn't the GameStop thing kinda fake? They weren't out to stop the masses revolting, they just ran out of money to fund T+2 or something"
Robinhood ran out of capital to fund T+2 at the volume needed for the desired GameStop purchases and put the brakes on those trades. Yep.
The Robinhood customers screamed (and a bunch of folks floated conspiracy theories ...), but there wasn't much Robinhood could do short term.
I view this as a "leaky abstraction" problem. The T+2 requirement had always been there, but the customers were (almost uniformly) unaware of it because NOT requiring the customers to understand this sort of thing is one of the features of a brokerage house. Then the fact that it was there couldn't be hidden and people got upset.
From the typical customer's viewpoint, this did seem like the rules had changed, though.
I'd bin it slightly differently and add something like "your understanding of the rules may be incomplete" as a risk, but I still think including it in the risks bucket is correct.
That's not how the US equity market works. Cash in customer's account with a retail broker protects the broker from customer default. The retail broker still trades T+2 with other brokers, so the other brokers are exposed to the retail broker defaulting and this is what stopped Robinhood back then
I don't get it, is this painting the American 30-year mortgage as a bad deal for the buyer? I've always thought of it as a subsidy, after all isn't that Freddie Mac & Fannie Mae whole deal: taking the side of the bet that nobody would?
It is painting the 30-year mortgage as a bad deal for the buyer.
Clicking through the link gives a flavor of this belief: "So the default life path for the ~2/3 of Americans who own their homes is to borrow a bunch of money to double-down on a bet they didn’t even want to make in the first place, and it’s coupled with an interest rate option."
The link then elaborates on all the ways that the mortgage correlates badly with what people SHOULD want. One example being that because of the leverage one can need to move and be unable to sell the house without declaring bankruptcy. "Maybe folks shouldn't want to make that bet?" is part of the argument against 30-year mortgages.
He also points out that some of the losses are socialized, which can make the bet a sane gamble for individuals, but maybe a poor idea for society.
IF the price of your house stays the same or goes up then things are fine. With 10% down then a 10% drop in the price of the house can wipe out all your equity PLUS some more because the seller typically pays the real estate broker's commission.
NOTE: Please don't take this summary as agreement with the argument.
Instead through part of the article. Basically he's saying that if it wasn't subsidized, there's no way buyers would be getting 30 year loans. Most consumer good loans are based on how long you use it, which is more like 5 to 10 years. By giving 30 year loans, most people have less flexibility to move than is ideal, especially if they lose a job during a recession. That is often when their house value goes down as well.
Because of the subsidies, home ownership does make sense, but he argues we should sunset the subsidies.
"By giving 30 year loans, most people have less flexibility to move than is ideal"
If the author was going for a "it's good for the individual but bad for society" I think that's a cop out. It's a book about trading after all, society be damned.
To clarify, the argument I was quoting was from Byrne Hobart, who the author of the book review is citing. I am not sure what Agustin Lebron's believe is. I wouldn't be surprised if he recommends traders to rent because the liquidity of that is more valuable than the small investment earnings. But I haven't read the book in question, and the book review author doesn't make it clear.
I was aware of that but it's good to clarify nonetheless.
You can always sell a property with a mortgage. Renting just leaves you exposed to the market. Also, "moving whenever you want" is not the superpower they make it sound. Move a couple of times, specially across cities/states and you'll spend as much as whatever you calculated the difference between rent/purchase was.
Disagree; 30 year loans exist in many countries where they're not artificially subsidised the way they are in the US.
What doesn't exist outside the US is 30-year fixed rate loans. Nobody would write a 30 year loan at fixed interest if it weren't subsidised by Fannie and Freddie.
The subsidy makes it positive EV, but it's still a massively risky bet in multiple ways so the Sharpe is quite bad (though like the reviewer mentioned, there may be intangible payoffs that improve it so ymmv).
All this book demonstrates is that trading is a wasteful economic activity.
The derivative nature of modern trading makes it a useless economic activity. Modern trading is almost entirely based on trying to read the actions of other actors within the market rather than trying to discover something that is True, no matter what anyone believes, about the world.
If the point of our capital market was truly to efficiently allocate capital, we would pass a law requiring all trades be made public in real time. People who have discovered a true piece of information that confers advantage don’t need to keep that information secret to profit.
This is a nice idea. People often say that the function of the market is to transmit and collate information about the value of things that is widely distributed and opaque. But the finance industry now absorbs vast quantities of our excess capital.
So what the finance bros are saying is that they can't effectively communicate information amongst themselves without using billions of dollars!
Perhaps all that money could be saved if they just came for a writing bootcamp with Scott, and learned to blog a bit better.
(Perhaps all that money will be saved by TraderGPT, which will be able to distribute financially-salient information to all instances of itself at virtually zero cost.)
Or perhaps the finance bros are right, and communication is just fundamentally, irreducibly hard. So hard that when the world achieves industrialisation and excess production, the thing it ends up having to invest its money in is massive expensive systems (like markets) for distributing information.
What both of you are missing is that markets are efficient at communicating information not just because they send signals, but because they also align incentives. And they align incentives because people are investing resource for profit. Scott can write the most beautiful blog ever about the importance of wheat in the USA next year, but the only resource he is investing is his time. A trader is putting his money where his mouth is, and hence helping discover the valuable uses for money.
"Greed isn’t good, per se. It is honest. You know where you stand with greed. You never wonder if greed has an ulterior motive, because it’s already the most ulterior motive there is. Greed feels no temptation to corruption, because the thing it would do if it were corrupt is precisely what it’s doing anyway."
“ A trader is putting his money where his mouth is”
If only, my internet friend, if only.
Traders famously put other people’s money in places, and not always where their mouths are. The mistake you’re making here is the same mistake that policy wonks make: assume the execution goes right, this is what policy X will do.
You raised the issue of incentives, and then you wished it away!
Writing is hard, understanding is hard. Especially when some people depend on it being hard.
Putting money in makes it less hard. You can think the bettor is right and update. Or you can think the bettor is wrong, put your money up, win, and make the rest of the world think more your way, i.e. they update.
Writing a blog piece means you have to read it, understand the points the blogger is making (complete with digressions), understand their biases etc. and then maybe update based on that. It can work better, but it's more work.
Yep. My last paragraph was written flippantly, but meant seriously. We should take seriously the possibility that communication is the hardest thing that human beings do, and wasting billions of dollars on it... isn't actually a waste of money.
It's a bit like marketing. I read somewhere that a lot of executives think they waste half of the marketing budget, but they don't know >which< half, and cutting the wrong half is a good way to lose market share.
The first bit seems more about trying to discover true things that other people don't know, where the "other people don't know" part produces a lot of the mind games.
But as the review goes on, it does sound like a paean to athletes, devoting their minds and bodies and souls to being better than everyone else. (As opposed to aiming for some specific goal.)
> If the point of our capital market was truly to efficiently allocate capital, we would pass a law requiring all trades be made public in real time.
I think that for e.g. publicly traded companies, this is roughly the case? I would assume that most trade by volume happens at the stock exchange and is public knowledge.
> People who have discovered a true piece of information that confers advantage don’t need to keep that information secret to profit.
Yes, but in many cases they can profit longer by keeping their information secret. If I have exclusive knowledge of the exact amount of gold in some publicly traded mining claim, then I can profit once by buying shares at a lower price than their worth and reveal my knowledge. Or I can keep the knowledge secret and sell the my shares at for more profit if their price rises above their worth.
I think that trading is -- at first -- a clearly positive sum activity. If one wants to buy bitcoins (say to spend on weed), it is clearly beneficial for the customer if arbitrage happens so that the price at the local exchange reflects the global price. Funding start-ups seems also clearly pro-social (at least if the start-ups make the world better).
However, I think that the rewards of trading are not always in proportion to the amount of benefit to society. Take high frequency trading. If stock exchanges were to execute trades in bunches at a frequency of 1Hz, would anything of social value be lost? I doubt it.
More generally, I think arbiters and market-makers clearly have diminishing social returns. Knowing that a the market price for something is about 10$ and not 5$ or 20$ is a valuable to society. The additional social gains of knowing that the market price is precisely 9.81$ are much smaller.
I agree with you that competitive modelling likely involves little modelling of the physical reality and mostly modelling of other market participants and their models. Being correct about the yields of a future gold mine or the profitability of a gaming console under development will give you earnings on a time scale of years. Having an accurate model of how market participants will act can give you earnings on a timescale of days to microseconds.
This is of course a Red Queen race, with the trading companies investing human genius into figuring out how their competitors will act. One does not have to be a commie to wonder if this is the best way society can use very smart people.
I also think that models being mostly based on other models you get weird and unstable dynamics. "Greater Fool", bubbles, etc. And when the bubble bursts, some of the very same finance institutions which previously lobbied for minimal oversight will call themselves To Big To Fail and cry for taxpayer money to save the industry cascade effects and save all the pension funds. (My take: if you run a financial institution and do not hedge against the risk of another financial institution going bankrupt, you are not doing your job and deserve to be dragged down with them. And pension funds should invest in something less volatile than the stock market.)
I would argue that smart people, like most people in general, do respond to incentives, including incentives set by society implicitly or explicitly.
"Comrade Doctor, society requires you to work on creating nuclear weapons against the enemies of our glorious $ideology" is a classical commie (or perhaps fascist) thing, but saying "we give some smart people the opportunity to use some taxpayer money to figure out things which are not of immediate interest to private enterprise" is one incentive which influences where some of the smart people end up which most people would not call communism. (Not that academia is without its problems, but the position that the state should not subsidize research seems a minority position.)
> Why did I write this book review? To test my intellectual mettle. I could easily have posted this book review elsewhere, but no, I wanted to see how I stack up against other ACX Book Review contest participants.
Well, you had a bit of edge here in getting your review published. It's true these are people using their belief in rationality to literally pay rent, but it's also not an unfamiliar relationship.
SSC and LessWrong have been a frequent topic of conversation at Jane Street for a long time, going back to the late oughts. Eliezer Yudkowsky and Robin Hanson gave a talk there on AI safety in 2011(?)
Jane Street even used to advertise on SSC.
This is all to say, good going (The book review is also excellent!)
To be fair,Jane Street probably didn't learn their rational approach to risk management from SSC/LW. That likely came from one of the founders' stints on a nuclear submarine. In fact, an earlier book review in the series had some familiar ideas in it as well: https://astralcodexten.substack.com/p/your-book-review-safe-enough
I don't have all of the details here but AFAICT SBFs primary problem was that he allegedly committed fraud? Maybe you can cast that in terms of failing to learn good risk management but I think the simpler explanation is that he was just crazy. He didn't appear to run his company as I would've expected a JS alum to.
Which feels like something only a person without long term experience would do. Playing that bet every time it comes up is a guarantee of ending up with nothing. Double-or-nothing even on 99% odds will eventually bankrupt you, if you do it enough times.
I don't think SBF was crazy. I think he had huge individual financial incentives to lean heavily into the philosophy he already had about risk management. It had worked out well for him so far, so he kept updating to accepting even more risk. What he needed was someone with more actual experience to rein in his worst tendencies (and also help him set up the company better).
I haven't been paying attention, but I don't think I could name other JS alumni off the top of my head. Which I interpret to mean that the vast, overwhelming majority are not high-profile fraudsters.
(The version of the SBF story that I recall was that he put in some time there, but left while still very junior because he thought he had better ideas. And it turned out, aside from one idea (the Japan arbitrage), he was wrong. And he valued his image more than he valued his integrity, leading to fraud.)
More interestingly than risk management, sbf et al were also *terrible* market makers (Alameda was losing money despite *owning the exchange*. That is some unbelievably bad trading right there).
(Of course JS itself is quite profitable, but I suspect that's based more on their recruitment advantage (they have really good PR for hiring) and tech infrastructure (most HFs have surprisingly bad tech and it might help that they spend so much on engineering).
I believe Alameda was successful at market-making for a time (though I lack hard data). Crypto market-making has become much more competitive in recent years, as more of the major trading firms have entered the market. Many crypto MM firms, like Alameda, were successful by being relatively early into a retail-heavy market. It's just gotten a lot harder in the past few years.
The problem is that rather than winding down, Alameda pivoted to longer-term investing. The huge downside risk was obvious to many. You can read tweets from Alameda execs all throughout this transition and they seemed to actually have convinced themselves they had a special talent for making leveraged long bets on crypto\s. I can't make this stuff up.
> The Efficient Market Hypothesis is a lie. The person that better understands the nature of a small sliver of the world (e.g. Apple’s share price) will make more money than others.
> Modern financial markets are exceedingly competitive. This means that the bigger you think your edge is, the more likely it is that you’re wrong.
...isn't that a statement of (a form of) the efficient market hypothesis?
The amount that markets are efficient is neither 0% nor 100% (nor, in many cases, even close to either of those), thus making both of those true at once.
People do make money with edge, but even more people falsely think they have edge and lose money.
Or the people make money using edge, they still think they have edge, but they've lost it because others have discovered it and have already traded all of it away.
This is called "bad luck".
It's a better statement of the EMH.
The strongest form of the EMH (which no one uses except as a strawman) is that no one can ever make money because all the edge has already been traded away.
A looser and more applicable form is that the market is really good at discovering edge, the larger it is and the more generally applicable, the faster it is discovered. Once the edge is discovered it is very quickly traded away. You may discover a fleeting edge, but it won't be for long, and it requires a lot of effort (and some luck) to do so. Sooner or later you will mess up by thinking you still have edge when you don't. So don't bet the farm on your new edge.
If most people believe the market is efficient, then the market will not be efficient.
The definition EMH theorists use is that since most people aren't able beat the market, it is efficient. Which is pretty self evident.
But that doesn't mean it isn't impossible for some people to beat the market. Just like it isn't impossible for some people to become a world class tennis player.
Since it is a lot easier to argue that Rafael Nadal's tennis success isn't some 5 sigma freak accident compared to for example's Warren Buffett's investing success, nobody is arguing "the efficient tennis hypothesis". And Nadal is really a clueless tennis player that got insanely lucky and by pure freak accident made all the right moves.
I suppose humans will have to get a lot older, so that eventually some 300 year old's investing success is a 9 sigma event, and EMH proponents will finally throw in the towel and say "fine it is because of skill that he did that!".
Although that 300 year old would have to start all over again multiple times due to the nature of compound interest.
> Lebron views trading as an act of creativity, a way to make the world, in one small way, a better place through creating efficiencies in markets.
I'm curious to hear other takes... but to me, this feels like the epitome of motivated reasoning.
Yes, market efficiency is a *good thing* for the obvious reasons. But there's opportunity cost to so much effort to eke out gains for the benefit of so few, there's economic risk introduced by the exposure to cascading strategy failures, there's direct harm caused by encouraging poor investments, and (perhaps worst of all) there's a reinforcement of *money* being the best measure of status. I find it hard to believe Lebron's view is not net-negative to society.
Taking a myopic view, sure, I can understand how getting into trading is a reasonable, and even good choice for someone to make. But it seems *so* wrong to me to use that view to make statements about what's good for the world. There's a better equilibrium society could enjoy: let's call that good instead.
Interesting! When I read that paragraph, I thought about the advent of long distance trading, with the invention of seagoing vessels, and how it was far and away the most valuable activity that a human being could commit themselves to even given the enormous chance (66%+ per voyage for some routes, especially manilla -> acapulco!) of death at sea and the total loss of the entire investment
it seems inherently evident that moving goods from a place where they are less valuable, to a place where they are more valuable, generates additional value for society
nowadays, the analogous activity appears to be moving liquidity from a place where it's less valuable to a place where it's more valuable
i feel like the transition from long distance trading to this new kind of trading was gradual enough that i'm not exactly sure where it crossed the origin, or even if it ever did
surely if this kind of investing weren't actually valuable for society, we wouldn't be willing to pay people to perform it? right? or something?
i know you're saying it's more that we're deep into diminishing returns on this kind of trading, not that this kind of trading is valueless
but, if we just halved the number of people engaged in this kind of trading, wouldn't the effect be... something about liquidity being so much harder to come by that a lot of value would be lost? or do you think it's that all these extra traders mean liquidity must be getting misallocated based on bad cycles of traders' impressions of other traders' impressions of other traders etc.?
> if this kind of investing weren't actually valuable for society, we wouldn't be willing to pay people to perform it? right? or something?
A free market will *absolutely* pay people to do things that are net-negative to society. The existence of drug dealing, gambling and Ponzi schemes seem sufficient to prove this.
> do you think it's that all these extra traders mean liquidity must be getting misallocated based on bad cycles of traders' impressions of other traders' impressions of other traders etc.?
That is my strong intuition.
And besides, the market today already fails to provide sufficient liquidity / investment for many human development projects, which government policies and programs step in to address.
err, in all of those other cases there *is* value being provided, it's just that there's a very, very horrible short term vs long term perverse incentive thing going on
except ponzi schemes ofc which is just fraud, and we treat it as such, it's not possible without people getting tricked into thinking there will be future value when there won't
like, someone needs to want drugs in order for drug dealing to exist, and when someone deals drugs to someone else, it's very easy to understand where the increase in 'value' comes from, it's easy to point at the drug user and say "yup, his gained perceived value"
with trading like this otoh, it's harder to point at the customer, but i think it's like, anyone who ever takes out a loan, right? stock traders allow corporations to easily leverage their stock to gain liquidity and a line of credit which provides huge value to those corporations that wouldn't exist if the market for stock weren't enormous... and i feel like the same must be true of most other financial instruments, that somewhere down the line someone is getting value, and the brokers take a cut of that value
in order for high frequency traders who develop strategies like this to earn a living, 'value' must be getting created. i don't care if it's the kind of value that satisfies society spiritually or the kind of value that addicts society to consumerism or drugs or the kind of value that society wants to eliminate at all costs, there must be some form of value being created by this activity... right?
like, in order for it to be the kind of activity that we ought to frown upon as, not merely economically counterproductive, but economically *empty*... where is their pay coming from?
i guess the obvious answer is that it's theft, that they're taking money from morons. maybe the economy grows swiftly enough that the bottom 50% of investors still end up averaging a positive return anyway? so the situation is stable?
> in order for high frequency traders who develop strategies like this to earn a living, 'value' must be getting created. i don't care if it's the kind of value that satisfies society spiritually or the kind of value that addicts society to consumerism or drugs or the kind of value that society wants to eliminate at all costs, there must be some form of value being created by this activity... right?
Oh, I think I misunderstood you. I totally agree with this. Market making, and developing financial products more generally, definitely creates value.
"in order for high frequency traders who develop strategies like this to earn a living, 'value' must be getting created... right?"
Not at all. The traders are getting money from somewhere, so someone is paying them. But that person could be mistaken about the value they're getting.
I don't know enough about American markets to comment, but the Chinese stock market has given me a nice perspective. It's been described as a massive vacuum cleaner, sucking money up from the middle classes to the connected, and that's been our experience. The market has boomed over the last couple of decades. But we just lost money, and everyone else we know who does individual investment has lost money. Money was made by the people with enough political pull to get licenses, IPOs, etc. Along the way, the brokers/traders made money. So there was a net transfer of assets from low-wealth people to high-wealth people (total wealth remaining constant, but a net negative for society, I think); along the way, the traders took a cut (so the high-wealth people got less money than was extracted from the low-wealth people).
The traders facilitated the transfer, so your argument would have to be that that facilitation was valuable. That's not a proposition I'd agree with.
The US stock market seems to work precisely as described above. People who are not traders, nor have the time, inclination, or resources to become traders, but want a sporting chance of rescuing their savings from inflation are de-facto forced to hold stocks; their wealth is then periodically harvested by the elite, under the guise of "crashes" (which the elite can afford to hedge against.)
I think the motte here is just that the opportunity costs of so many smart people devoting their considerable talents to trading exceed the benefits of a marginal improvement in market efficiency. With maybe a side order of traders capturing most of the surplus they generate. (In the counterfactual where the traders were building mars rockets instead they may be creating more total value but capturing less of it for themselves)
I guess you don't have any idea how selfish this sort of narrative actually is. The main reason many PhDs go into these areas is that the system has no way of valuing the good work you want them to be doing. If you want to allocate talent to where you and others can benefit more, put money where your mouth is and also advocate for better treatment of scientists.
> In the counterfactual where the traders were building mars rockets instead
I think this kinda overstates how many traders there are and understates how hard it is to build Mars Rockets. Even relatively huge hedge funds are a fifth the size of SpaceX (and an even smaller fraction of a bigtech) in terms of headcount. And while there's a lot of smart people there, they do have specific talents and I'm not sure the marginal employee at DE Shaw would make a great rocket engineer.
Incidentally, this is why governments are inefficient. With a large investment, it would be easy to improve national GDP. But, very difficult to capture enough of the benefits.
Regular trading is still enormously more valuable than stock trading. It's just gotten a lot easier and safer, what with planes and trains and better boats. But any tourist town can tell you how important a missed ship is.
I used to believe this until I worked in tech for a few years. The marginal software engineer at a bigtech or even medium sized company also does nothing useful (adding bloatware or tests for minor features is common at best, and is done quite slowly), as seen by software working increasingly badly over the last ten years.
The contribution of a hedge fund to the world is smaller in a way (since to some degree it's a second degree improvement), but the marginal employee there is a lot more effective. I think it balances out to HFs being slightly better.
I appreciate this perspective, and agree there are problematic inefficiencies in a lot of SWE work.
But I'm not sure what your disagreement is? Yes, the marginal economic value of a trader may often be higher than if that same labor was applied to software engineering. But that doesn't justify claiming additional effort put into creating market efficiencies is good for the world.
Someone has to keep corporations efficient? If literally everyone invested in index funds, then corporations would effectively be owned by funds that have minimal administrative staff and would just rubber stamp everything the CEO demanded. Board of directors would be stacked by friends of the CEO.
So a well run long term oriented hedge fund can add a lot of value, despite only making zero sum trades. Keeps those CEO's on their toes, and makes sure there are enough independent directors out there with skin the game.
Agree with you (mostly) on short term high frequency trading.
Sure, I agree to some degree… but the degree is important.
Traditional hedge funds now have over $5T in AUM. Related (very rough) numbers:
* That’s 5% of global market cap of globally listed companies
* Over 3x compared to 2010 levels, and over 20x 2000
* It’s very hard to calculate, but that likely translates to 100’s of billions in fund profits and management fees.
On top, there’s even far more money being made in the financial sector tracked outside of this, which are also activities that are also (nominally) creating liquidity and efficiencies. BlackRock alone has almost $9T AUM.
These numbers are not commensurate with the good being done in the world. It’s the *blanket sentiment* that trading is good for the world that has allowed so many people to justify this situation, and makes it so much harder to draw the line for what’s too much.
It’s too much. We need a perspective of trading that makes this easier to say.
"On top, there’s even far more money being made in the financial sector tracked outside of this, which are also activities that are also (nominally) creating liquidity and efficiencies. BlackRock alone has almost $9T AUM."
I'm not sure what you mean by this. BlackRock's AUM by and large isn't being traded actively, it's being invested by institutions and retail investors. The purpose isn't to create liquidity or efficiencies, it's to grow assets.
I think you may be underestimating how much staffing index funds have. Vanguard has move that more than 60 people doing “investment stewardship.” For places like Vanguard (more than $3 trillion under management) or BlackRock (more than $9 trillion under management), the cost of an additional 60 staff is trivial.
Having a team dedicated to investment stewardship means that you are unlikely to turn into a rubber stamp for whatever the CEO's of the companies you invest in want to do. The reason is that you've embedded the job of pushing back against this into the structure of your organization. Therefore, I don't think there is any real chance that index funds with investment stewardship teams are going to role over for CEO's.
It's much harder to make that prediction about hedge funds, because hedge funds don't seem to talk about investment stewardship.
Also people gravitate towards the funds with the lowest costs, so they will be directly incentivized to keep their costs as low as possible.
Finally the whole point of index funds are that they generally don't form a firm opinion on any one stock. Which would be necessairy when actively monitoring management of a firm.
I read the posting you linked to, although not the underlying paper (which I don't have access to). I don't think it stands up to scrutiny very well:
1. Voting
To begin with, the differences in voting are fairly small. In cases where ISS disagrees with management, index funds vote with management 54.3% of the time and non-index funds vote with management 47.3% of the time. If following ISS recommendations is the goal, the main take away from this is that both types of funds are really bad at it.
Furthermore, it's not clear how robust the results are. In Figure 1, Dimensional Fund Advisors appears near the lower left corner. Most of the DFA funds are not index funds because they attempt to track asset classes, rather than attempting to track indexes which in turn attempt to track asset classes. If the study had compared passive to active funds, rather than index to non-index funds, DFA would appear near the bottom right of the chart. This suggests that the difference in voting might disappear, or at least be smaller, if the study had compared passive to active funds.
So why does DFA score so much higher than Vanguard? DFA says that the number of “engagements” (investor-speak for talking to a company) is about 1/3 of Vanguard's, which suggests that they have less staff dealing with investment stewardship than Vanguard. However, they do have a lot to say about their commitment to ESG, which is short for Environmental, Social, and Governance. Vanguard, on the other hand, seems to care primarily about the corporate governance part of ESG.
All this suggests that the issue is policy differences, not staffing. ISS makes proxy voting recommendations based on ESG criteria. The difference between DFA and Vanguard could be entirely due to Vanguard choosing to vote with management on environmental and social issues.
Indeed, if you agree the position that the ISS recommendations are always correct, as the study implicitly assumes, then you shouldn't be worried about index funds not hiring enough staff. Rather, you should be upset that they are hiring any staff at all to decide how to vote proxies, rather than just following the ISS recommendations 100% of the time.
Your claimed, if I understood you correctly, that index funds pay less attention to corporate governance than other investors, and that the reason for this is lack of staffing. The voting portion of the study provides no support for either of those claims.
2. Engagement
The requirements for filing Schedule 13D are described in Regulation 13D-G in the Code of Federal Regulations, and an intent to “actively engage with firm management and affect firm policy” is not mentioned there at all. A fund has to file Schedule 13D if it acquires 5% or more of of a company for the purpose of changing or influencing control of the company, or if it acquires 20% or more of a company regardless of its reasons for acquiring the stock. The authors tell us that index funds never file Schedule 13D, while non-index funds do, but I'd guess that non-index mutual funds *almost* never file Schedule 13D. Without knowing how often, or why, non-index funds file Schedule 13D, I don't think we can draw any meaningful conclusions.
Comparing companies with based on the amount of stock held by index funds is problematic because companies that appear in an index are going to be different from companies that don't. For example, Russian companies have approximately zero percent of their stock owned by index funds because Russian companies were removed from the major indexes after the invasion of Ukraine. But if you compare a sample of Russian companies to a sample of U.S. companies, and find a difference, there could be many explanations. The cause could be different laws, different regulatory regimes, cultural differences, or even the sanctions that led Russian companies to be dropped from the indexes in the first place. You can't assume that any differences you discover are caused by index funds not holding Russian stocks.
The preceding paragraph posits that there is a difference, but the authors write that, “when index funds hold more of a firm’s stock, the number or type of proposals that are tabled at annual shareholder meetings do not change.” If the lack of difference were evidence of anything, it would be evidence that index funds are equally as effective as other investors.
Your claim, as I understand it, was that index funds are *less* effective than other funds, and this portion of the study provides no support for that claim.
3. Divestment
It is true that index funds won't sell a stock because of dissatisfaction with management. The authors state that selling out a position, “possibly drives the share price down,” and it seems likely that management would like to avoid a lower share price.
Suppose a bunch of investors sell a stock because they don't like the company management. Let's assume that the corresponding buyers also aren't thrilled with company management, and are only willing to buy because the stock is being offered at a lower prices than before. If half the market is owned by index funds, then there will be fewer sellers because index funds won't be selling, but there also will be fewer buyers because the index funds won't be buying, so the price should be the same. To put it another way, stock prices are set by active investors, so the existence of index funds doesn't affect stock prices. (There are some qualifications on this last statement, but I don't think they matter here.)
Suppose a CEO stacks the board of directors with his friends and relatives. In a world with no index funds, a bunch of investors are unhappy with this, and the CEO is punished with a lower stock price. In a world with index funds, the CEO is faced with the same lower stock price, but he is also stuck with a bunch of index funds which continue to hold the corporate stock and express their displeasure with management by voting against it every time they get a chance. The divestment argument leads to the conclusion that index funds are good for CEO accountability. The study authors claim the opposite of this, probably because of faulty reasoning on their part.
You mention the case where “literally everyone invested in index funds.” If that actually happened, there would no longer be a price discovery mechanism, and the claim I made in the preceding paragraph about “the same lower stock price” would no longer be valid because there is no way to reason about stock prices under such a scenario. All I can say is that if you don't have a price discovery mechanism, you have bigger problems than a lack of CEO accountability.
Differences are small in voting because most matters are routine. The important ones are only a minority of items being voted on.
Also what matters is not just staffing, but competent staffing. The best way to select for this is by having funds invest actively, with the most effective ones getting largest and having the most influence. Have the people who can boss around the CEO being selected by the market, and not by some random HR manager at an index fund.
As for your divestment argument, if there is a steady selling of the stock because of incompetence, it depresses stock price performance. Because there are still plenty of active funds, it opens up the company to an activist shareholder who can make a compelling argument why management needs to go, and the board of directors needs to be shuffled. This is mainly why CEO's care about stock performance. Because options can be priced downwards.
This form of activist investing, which is increasingly common, is not something generally initiated by index funds.
In case you are not convinced, you can sink your teeth into this paper:
It's very clear that the OP doesn't think that getting rid of markets is good. He's arguing that the remuneration received by traders is vastly higher than the amount of "good" they provide to society. I would characterize the sentiment as analogous to drug dealers. Sure, your local weed guy is providing "value" by taking a personal risk to provide entertainment to some and relieving the suffering of others. But, we can make this market better through competition and economies of scale (in other words, gang violence and cartels).
Lebron's paean to the power of trading rings absolutely hollow when you consider/know some profitable trades are net bad for society, simply because some things which lead to human flourishing can't be accurately modeled, and pursuing things only for economic gain can in fact destroy the underlying value of what gets traded. Finance people get so much social status through the money they make; you don't need to give them additional status by arguing what they do is virtuous as well.
"When the share price is down is when layoffs happen."
This sounds plausible as a rule of thumb, but right now I mostly see the opposite. This year, practically all of the largest tech companies have had major layoffs, and most of them have hit new all-time highs for their stock price.
I think the point is about timing. Stock price falls -> layoffs happen -> stock price rises (although looking at the largest tech companies is probably the wrong sample set and in many cases the stock price does not match the previous highs in a short time period). If you lose your job and need liquidity, you may be forced to sell your stock at the low prices and miss out on the recovery. Whether you should follow this advice depends on your personal financial situation, risk-tolerance, etc.
Sounds like an interesting book, sort of a financial-trading-themed "11 Rules for Life". I do notice how it sort of transitions from "discovering truths about the world that no one else knows" though "the importance of modeling people and what they know" into "the nobility of agonas and the purifying flames of competition". Which is actually one of the things I dislike about financial trading - it feels like a hideously inefficient protocol that's laid waste to the best minds of the last few generations. Kind of like proof-of-work, but running on human ambition rather than GPUs. But I suppose money is a form of power, and allocation of power is an important problem, and it's not like there's ever been a shortage of people competing to drain off tiny bits of power for themselves by doing services for people with power.
I rather like the review's style. Efficient, concise, and still showing signs of a personality underneath. I do get the impression that the reviewer has an axe to grind with the vague rationalist/EA/ACX community, but it seems like a small axe, more of a hatchet, really.
To me it felt like a correct attitude towards the community, but maybe that's because I have basically the same one. Except for silly use of the word "irrational" towards committed relationships or scientific stubbornness, that's kinda cringe.
I believe that this book is a good, insightful description of how financial trading works. I'm a bit more skeptical about the applications to non-trading life. It made me think of this comedy clip:
The comedian watches the Chris Voss Masterclass in being a negotiator, and comes to the conclusion that it's less a class than a documentary about a madman who treats ordinary interactions with service workers like a hostage negotiation...
” This seems to be why there is little innovation in government: talented engineers are treated as second-class citizens in research labs, so they work for Stripe and OpenAI instead. Similarly, one can attribute the lack of innovation in hospitals to doctors holding all of the institutional power. Often, all a hospital needs to save lives is simple practices that other businesses figured out long ago, but the hubris of MDs prevents this from happening. ”
I don’t understand this part. It starts off talking about government and then immediately mentions ”research labs” which suggests that the meaning is that no one ever invented anything in a government run research facility, which isn’t true (and which isn’t ”government” anyway). Also, doctors don’t hold all of the institutional power in hospitals. No one is prevented from coming up with an idea for an innovative hospital and suggesting that if they like.
As for checklists, I see that in healthcare (at least in the UK NHS) has implemented them on par with aviation – short, concise, relevant and life saving.
Whereas other businesses often use them like a parody and actually makes things worse. For example, they make multiplate page checklist that takes too long to fill, or requires them to fill when the job is complete or populate with irrelevant questions.
Healthcare is very hard and improving it is much harder than most writers realize. There is another book in Scott's list that talks about healthcare specifically (by Mark Britnell) and that was much better, although a little bit dry.
My father worked for a state government engagement program where he lead a team porting standard manufacturing management practices (lean manufacturing, root cause analysis, six sigma) to healthcare providers and hospitals. Based on his stories, can confirm that "Often, all a hospital needs to save lives is simple practices that other businesses figured out long ago" is definitely true.
Some problems he worked on:
1. Extra/missing doses of medications. Mistakes were often caused by nursing shift changes, intra hospital patient relocations, and routine surges in nursing demand.
2. Leaving equipment in the body during surgery, especially surgical gauss used to control bleeding.
3. Patient gets the wrong procedure. One patient had an incorrect appendage amputated because the radiologist's medical school used an "X" written on the appendage to mean "no, don't cut this off" and the surgeon's school used "X" to mean "yes, cut this one off".
Sure, employees in hospitals make mistakes. What intrigues me is the claim that other businesses ”long ago” figured out how to stop their employees from making mistakes. As a consumer, I apparently don’t often come in contact with those businesses. Maybe I am not rich enough?
Besides, as your own story illustrates, hospitals do employ standard procedures to improve patient safety.
"What intrigues me is the claim that other businesses ”long ago” figured out how to stop their employees from making mistakes."
These are really interesting topics, but yes business practices can definitely change how many mistakes employees make on average and and how much each mistake impacts the final product.
Had a friend involved in phlebotomy operation and they got way better results by simply matching the most experienced technicians to the donors with the most difficult veins. It was a simple change but they operated for decades on a much worse FIFO model.
> Lebron argues that we need stories here. Edge is expressed in stories: an edge does not exist without a clear mental representation of that edge. Pure linear algebra does not suffice.
My model is that Rentech & friends *are* what makes this true. If your edge is just linear algebra, Simons and his quant army figured it out years ago, and you need a compelling non-mathematical story to overcome this barrier.
> Similarly, one can attribute the lack of innovation in hospitals to doctors holding all of the institutional power. Often, all a hospital needs to save lives is simple practices that other businesses figured out long ago, but the hubris of MDs prevents this from happening.
Doctors often hold much less institutional power than the author thinks… the doctors I know often feel tightly constrained by government and business interests, whose collective decisions are made primarily by individuals without medical training.
I am compelled to comment on the really excellent execution of this review. You can feel how the reviewer strives to communicate the main points of the book, through the lens of what the ACX audience would appreciate. They do so briskly and concisely, which avoids the length problems some other reviews in the contest have had. They interject a few personal asides and connections to related subjects, but not in a way that distracts or takes over the review. They give clear real-world examples of each concept.
Overall, I'm left with the feeling that the review itself is "dense" in meaning. I think I would derive a lot of value from closely reading each section and paragraph, considering their implications and how they relate to my own life. That's an impressive feat for a book review.
Other book reviews we've seen so far might be more entertaining, or their topics more interesting. But I'm currently feeling like I have to give this one a top vote based on the strength of execution. I'd love to see more reviews written like this.
I have invested almost exclusively in hedge funds and CTAs for roughly thirty years now and I have found your review really very interesting, clear and relevant.
I am going to read the book and I am going to forward your review to all the money in managers in my portfolio.
The apprenticeship analogy is fantastic. Well, actually it’s not really even an analogy. I recently started at a fund and am effectively an apprentice. I’m doing the infrastructure and learning. Eventually I will do the infrastructure + analysis. Then analysis + decision making. Then mostly decision making
Interesting how this review makes me uncomfortable, and unwilling to ever participate in market trading or try to apply market-based reasoning to my life. I hate competing with anyone over anything, and I just want to remain in my comfort zone and do things I know and like.
> The Efficient Market Hypothesis is one of the core concepts taught in Finance 101. The Efficient Market Hypothesis is a lie. The person that better understands the nature of a small sliver of the world (e.g. Apple’s share price) will make more money than others.
> Modern financial markets are exceedingly competitive. This means that the bigger you think your edge is, the more likely it is that you’re wrong.
> “Evolutionary thinking applies quite directly when thinking about the evolution of markets. Having an edge in a mature market means understanding the world better than other traders, even ones who are already highly skilled. In fact, the marginal trader in modern financial markets is quite sophisticated and skilled indeed.”
This section is quite confusing to me, as this is basically what an economics professor teaching Finance 101 to econ majors will say when describing the EMH. There might theoretically be inefficiencies you could exploit, it's just that if you think you found one, it's far more likely that you are mistaken (often for the exact reasons described immediately after this section) than that you are correct. (To be precise, it's not just about having an edge--the edge has to be big enough to give you a better percent return compared to what you have to invest, and it has to compensate for any additional risk, in order to "violate" EMH).
Later, it even says this:
> If you think your costs are negligible relative to your edge, you’re wrong about at least one of them.
Which again seems to capture the spirit of the EMH (arguably even the strong form if taken literally, although this whole review seems to be written as if cheating is not an option, so we'll say the semi-strong form) as commonly expressed.
Re:the last bit, academic research is also a genuine apprenticeship, and which was one of my favorite parts of it (though the flipside is this is also why bad advisors are so damaging)
>“Residential real estate has historically returned significantly below equity markets over long time horizons”
Sure, but if I got to the bank to get a 300k loan for a house, I'll get it at a very low interest rate (at least until this year), considerably below inflation. If I got and ask for a 300k loan to leverage myself into buying ETF, I kinda expect to be laughed out of the office.
"And the dilettante who “trades for fun” will be eaten alive by a firm with a much better model of a) the world and b) the dilettante themself."
This is maybe true in a zero-sum game such as commodity futures markets, but not necessarily true in what can be a positive (or negative) sum game such as stock markets. The amateur may generate less return than a professional, but often not, once the professional's fees are taken into account.
Then again, the number of professionals who underperform index funds is remarkable.
In that case you're no longer trading, but doing 'proper' investing.
And indeed, with long term investing you can beat the professionals, as they often have a quarterly time horizon, while you can have one of years.
No, this is a naive take. the firms are still getting your alpha (returns beyond a suitable index). In which case you beat the index, then by all means keep doing it
Great review. I'm going to buy the book.
I have to admit that every time i read Lebron, I thought of LeBron.
This was such a good book.
You all may enjoy my interview of the author: https://www.dwarkeshpatel.com/p/agustin-lebron
Oh yes we will. Listening now!
thanks for sharing.
> I’m reminded of the story of Richard Feynman in academia6. His colleagues who kept their office doors closed made progress on their research in the short-term, but hit stumbling blocks. Those who kept their doors open didn’t seem to make much progress initially, but eventually outpaced the “closed door” scientists. They had new ideas and research directions based on all the interesting conversations they were having with others.
You are thinking of Richard Hamming: https://gwern.net/doc/science/1986-hamming#open-door-policy
For those wondering, the Bayesian cite is "Bayesian estimation and the Kalman filter" https://core.ac.uk/download/pdf/82197354.pdf
Thanks for the comment!
II was unfamiliar with the Feynman story, but was wondering if I should mention that Hamming had said something similar :-)
This was part of my keys to success when I worked in high tech. I sat with different people in the cafeteria, struck up conversations with different people at the coffee counter, learned what they did, touring their labs ... when I had difficulties, I knew where to find resources.
Interesting. Similar experience here, but soon after meeting everyone, got sidetracked into company politics and then lost interest in the whole ordeal and left.
> The Efficient Market Hypothesis is one of the core concepts taught in Finance 101. The Efficient Market Hypothesis is a lie. The person that better understands the nature of a small sliver of the world (e.g. Apple’s share price) will make more money than others.
... and in the process they'll bring the market closer to a perfectly efficient one.
This is a pretty small nitpick, but I feel like this is one of several "takedowns" I've seen of the EHM which seems like it's only really 'refuting' the absolute strongest form of the principal - a sort of "Perfectly Efficient Market Hypothesis" - which I'm not sure anyone really believes, while actually affirming the general concept behind the hypothesis.
The EMH isn't an absolute rule, but it just seems like basic sense, in line with the rest of the advice here: if you think you've got some killer trade that's going to make you a ton of money, it's possible you're right, but it's also very likely that the market's price accounts for something you aren't pricing in yourself.
In my view it's not a ironclad "you can never make a winning trade", but it's an important reminder towards humility and I think deserves better than to be called (literally) a bold-faced lie.
Absolutely. The Efficient Market Hypothesis relies on people spotting it's a lie in order to be true, and unless you have a real (non-imaginary) edge or are dealing in an illiquid market, the chances are it *is* true for you. If somehow you're right and it's a lie in your particular circumstance, you better be quick, because it probably won't be long before it goes back to being true.
"Lie" is a bit strong.
In my view, the EMH can only be true at a high, coarse grained level...and the EMH can only be true at a high, coarse grained level, if it false at a fine grained level. Trading activity exploiting short-term opportunities is the mechanism that creates long-term efficiency.Coarse grained market efficiency is the result of fine grained inefficiency.
It is a lie the Ivory tower academics like to tell themselves why they are only pulling in a university salary and not making a killing in the markets. Despite being an economics or finance professor.
Avoids a lot of awkwardness at parties:
"Say Steve, if you know so much about economics, how come you are not doing much better than a University salary?"
"Well I will tell you, it is not me who is the sucker! It is those 5 sigma fools like Warren Buffett, making billions, who are the suckers! Because they have no clue just how lucky they are!"
This seems like a you thing, a weird vendetta against economics professors.
Economists and traders have wildly different skill sets and are doing wildly different things. Economists almost universally don't want to be traders, they want to be economists. They want to write a paper examining data on how a minimum wage increase in Puerto Rico impact labor force participation (or whatever). It's just wildly different as an occupation than trading, and your model of them as incompetent/jealous losers seems to say more about your personal hang ups than it does about the profession.
As a group, economics and finance professors should outperform though. They don't. So they had to invent a theory that conveniently explains why nobody could outperform.
Macro economists are also embarassingly terrible at making predictions.
You are comparing a group (economics or finance professors) against a winner from another group (Warren Buffett). Fair comparison would be group vs group. Among the people who tried to be the next Warren Buffett, what is the typical result?
That is not really a fair comparison.
I also did not compare only Warren Buffett against all economists and finance professors.
The EMH is an entirely correct and accurate description of the behaviour of systems with certain properties; where people go wrong is in trying to generalise it to real-world systems that don't have those properties.
Believers in the EMH just invest in index funds rather than trying to do trading for themselves... not the approach of a professional trader!
And they're right to do that. There's an opportunity cost to being a professional trader, if you don't pay which you won't outperform ETFs. That's what EMH is really saying.
A couple of other points worth noting:
1. Trading costs are incredibly important, and the more money you're investing the larger they are (since buying and selling big positions moves the market).
2. Finding inefficiencies is possible, but it takes work, which costs money. To find inefficiencies you need to be paying a bunch of smart people lots of money, which means you need to be trading big positions to make enough profit to make their wages worthwhile.
So a fancier version of the EMH states that inefficiencies do exist but are incredibly hard to profitably trade. Inefficiencies can only be traded profitably if you take a small position, but you need to take large positions in order to justify the expensive process of hiring people to look for those inefficiencies.
Professionals are usually able to distinguish between trading and investing. They invest in various markets - usually a combination of index funds and special opportunities where they think they have an edge in judging the managers. And they trade in markets where they built their own edge, and these may have nothing to do with their index funds or other long germ investments.
Dunking on the strong EMH in a well-reasoned way is often virtuous, in the same way it’s virtuous to dunk on the null hypothesis. No-one believes it, but it can be useful to quantify your views by using it.
Exactly! I copy pasted the paragraph to make the same comment. Glad you made it before me!
Efficient Market Hypothesis:
Maybe this fits into the model, but markets are not all equally efficient. Starting a local accounting firm, corn farm, or construction company, are all pretty easy as you are competing against the people in your town. An engineering/manufacturing/tech startup is really hard as you compete on a global market but can grow really fast in the unlikely event you happen to be the best in the world.
My favorite phrasing of the EMH is "you can't beat the market". Maybe Warren Buffett can beat the market, maybe Augustin Lebron can beat the market, hell maybe the average junior trader at a random investment bank can beat the market. But you're just a random idiot, and any trade so obvious that you can see it is either not a good trade or has already been fully exploited by the professionals.
>No luck finding this story via Google or ChatGPT, but I think I’m getting the details broadly correct.
Because it wasn't Feynman, it was Hamming. See, "You and your research"
(edit: scooped by Gwern)
Isn't the GameStop thing kinda fake? They weren't out to stop the masses revolting, they just ran out of money to fund T+2 or something
"Isn't the GameStop thing kinda fake? They weren't out to stop the masses revolting, they just ran out of money to fund T+2 or something"
Robinhood ran out of capital to fund T+2 at the volume needed for the desired GameStop purchases and put the brakes on those trades. Yep.
The Robinhood customers screamed (and a bunch of folks floated conspiracy theories ...), but there wasn't much Robinhood could do short term.
I view this as a "leaky abstraction" problem. The T+2 requirement had always been there, but the customers were (almost uniformly) unaware of it because NOT requiring the customers to understand this sort of thing is one of the features of a brokerage house. Then the fact that it was there couldn't be hidden and people got upset.
From the typical customer's viewpoint, this did seem like the rules had changed, though.
I'd bin it slightly differently and add something like "your understanding of the rules may be incomplete" as a risk, but I still think including it in the risks bucket is correct.
What? If the customer has settled cash, there is no reason the broker shouldn't be able to make a trade with that cash.
That's not how the US equity market works. Cash in customer's account with a retail broker protects the broker from customer default. The retail broker still trades T+2 with other brokers, so the other brokers are exposed to the retail broker defaulting and this is what stopped Robinhood back then
I don't get it, is this painting the American 30-year mortgage as a bad deal for the buyer? I've always thought of it as a subsidy, after all isn't that Freddie Mac & Fannie Mae whole deal: taking the side of the bet that nobody would?
It is painting the 30-year mortgage as a bad deal for the buyer.
Clicking through the link gives a flavor of this belief: "So the default life path for the ~2/3 of Americans who own their homes is to borrow a bunch of money to double-down on a bet they didn’t even want to make in the first place, and it’s coupled with an interest rate option."
The link then elaborates on all the ways that the mortgage correlates badly with what people SHOULD want. One example being that because of the leverage one can need to move and be unable to sell the house without declaring bankruptcy. "Maybe folks shouldn't want to make that bet?" is part of the argument against 30-year mortgages.
He also points out that some of the losses are socialized, which can make the bet a sane gamble for individuals, but maybe a poor idea for society.
IF the price of your house stays the same or goes up then things are fine. With 10% down then a 10% drop in the price of the house can wipe out all your equity PLUS some more because the seller typically pays the real estate broker's commission.
NOTE: Please don't take this summary as agreement with the argument.
Instead through part of the article. Basically he's saying that if it wasn't subsidized, there's no way buyers would be getting 30 year loans. Most consumer good loans are based on how long you use it, which is more like 5 to 10 years. By giving 30 year loans, most people have less flexibility to move than is ideal, especially if they lose a job during a recession. That is often when their house value goes down as well.
Because of the subsidies, home ownership does make sense, but he argues we should sunset the subsidies.
"By giving 30 year loans, most people have less flexibility to move than is ideal"
If the author was going for a "it's good for the individual but bad for society" I think that's a cop out. It's a book about trading after all, society be damned.
To clarify, the argument I was quoting was from Byrne Hobart, who the author of the book review is citing. I am not sure what Agustin Lebron's believe is. I wouldn't be surprised if he recommends traders to rent because the liquidity of that is more valuable than the small investment earnings. But I haven't read the book in question, and the book review author doesn't make it clear.
I was aware of that but it's good to clarify nonetheless.
You can always sell a property with a mortgage. Renting just leaves you exposed to the market. Also, "moving whenever you want" is not the superpower they make it sound. Move a couple of times, specially across cities/states and you'll spend as much as whatever you calculated the difference between rent/purchase was.
Disagree; 30 year loans exist in many countries where they're not artificially subsidised the way they are in the US.
What doesn't exist outside the US is 30-year fixed rate loans. Nobody would write a 30 year loan at fixed interest if it weren't subsidised by Fannie and Freddie.
The subsidy makes it positive EV, but it's still a massively risky bet in multiple ways so the Sharpe is quite bad (though like the reviewer mentioned, there may be intangible payoffs that improve it so ymmv).
All this book demonstrates is that trading is a wasteful economic activity.
The derivative nature of modern trading makes it a useless economic activity. Modern trading is almost entirely based on trying to read the actions of other actors within the market rather than trying to discover something that is True, no matter what anyone believes, about the world.
If the point of our capital market was truly to efficiently allocate capital, we would pass a law requiring all trades be made public in real time. People who have discovered a true piece of information that confers advantage don’t need to keep that information secret to profit.
This is a nice idea. People often say that the function of the market is to transmit and collate information about the value of things that is widely distributed and opaque. But the finance industry now absorbs vast quantities of our excess capital.
So what the finance bros are saying is that they can't effectively communicate information amongst themselves without using billions of dollars!
Perhaps all that money could be saved if they just came for a writing bootcamp with Scott, and learned to blog a bit better.
(Perhaps all that money will be saved by TraderGPT, which will be able to distribute financially-salient information to all instances of itself at virtually zero cost.)
Or perhaps the finance bros are right, and communication is just fundamentally, irreducibly hard. So hard that when the world achieves industrialisation and excess production, the thing it ends up having to invest its money in is massive expensive systems (like markets) for distributing information.
What both of you are missing is that markets are efficient at communicating information not just because they send signals, but because they also align incentives. And they align incentives because people are investing resource for profit. Scott can write the most beautiful blog ever about the importance of wheat in the USA next year, but the only resource he is investing is his time. A trader is putting his money where his mouth is, and hence helping discover the valuable uses for money.
Yep. Scott as usual put it best:
"Greed isn’t good, per se. It is honest. You know where you stand with greed. You never wonder if greed has an ulterior motive, because it’s already the most ulterior motive there is. Greed feels no temptation to corruption, because the thing it would do if it were corrupt is precisely what it’s doing anyway."
“ A trader is putting his money where his mouth is”
If only, my internet friend, if only.
Traders famously put other people’s money in places, and not always where their mouths are. The mistake you’re making here is the same mistake that policy wonks make: assume the execution goes right, this is what policy X will do.
You raised the issue of incentives, and then you wished it away!
Writing is hard, understanding is hard. Especially when some people depend on it being hard.
Putting money in makes it less hard. You can think the bettor is right and update. Or you can think the bettor is wrong, put your money up, win, and make the rest of the world think more your way, i.e. they update.
Writing a blog piece means you have to read it, understand the points the blogger is making (complete with digressions), understand their biases etc. and then maybe update based on that. It can work better, but it's more work.
Yep. My last paragraph was written flippantly, but meant seriously. We should take seriously the possibility that communication is the hardest thing that human beings do, and wasting billions of dollars on it... isn't actually a waste of money.
It's a bit like marketing. I read somewhere that a lot of executives think they waste half of the marketing budget, but they don't know >which< half, and cutting the wrong half is a good way to lose market share.
The first bit seems more about trying to discover true things that other people don't know, where the "other people don't know" part produces a lot of the mind games.
But as the review goes on, it does sound like a paean to athletes, devoting their minds and bodies and souls to being better than everyone else. (As opposed to aiming for some specific goal.)
> If the point of our capital market was truly to efficiently allocate capital, we would pass a law requiring all trades be made public in real time.
I think that for e.g. publicly traded companies, this is roughly the case? I would assume that most trade by volume happens at the stock exchange and is public knowledge.
> People who have discovered a true piece of information that confers advantage don’t need to keep that information secret to profit.
Yes, but in many cases they can profit longer by keeping their information secret. If I have exclusive knowledge of the exact amount of gold in some publicly traded mining claim, then I can profit once by buying shares at a lower price than their worth and reveal my knowledge. Or I can keep the knowledge secret and sell the my shares at for more profit if their price rises above their worth.
I think that trading is -- at first -- a clearly positive sum activity. If one wants to buy bitcoins (say to spend on weed), it is clearly beneficial for the customer if arbitrage happens so that the price at the local exchange reflects the global price. Funding start-ups seems also clearly pro-social (at least if the start-ups make the world better).
However, I think that the rewards of trading are not always in proportion to the amount of benefit to society. Take high frequency trading. If stock exchanges were to execute trades in bunches at a frequency of 1Hz, would anything of social value be lost? I doubt it.
More generally, I think arbiters and market-makers clearly have diminishing social returns. Knowing that a the market price for something is about 10$ and not 5$ or 20$ is a valuable to society. The additional social gains of knowing that the market price is precisely 9.81$ are much smaller.
I agree with you that competitive modelling likely involves little modelling of the physical reality and mostly modelling of other market participants and their models. Being correct about the yields of a future gold mine or the profitability of a gaming console under development will give you earnings on a time scale of years. Having an accurate model of how market participants will act can give you earnings on a timescale of days to microseconds.
This is of course a Red Queen race, with the trading companies investing human genius into figuring out how their competitors will act. One does not have to be a commie to wonder if this is the best way society can use very smart people.
I also think that models being mostly based on other models you get weird and unstable dynamics. "Greater Fool", bubbles, etc. And when the bubble bursts, some of the very same finance institutions which previously lobbied for minimal oversight will call themselves To Big To Fail and cry for taxpayer money to save the industry cascade effects and save all the pension funds. (My take: if you run a financial institution and do not hedge against the risk of another financial institution going bankrupt, you are not doing your job and deserve to be dragged down with them. And pension funds should invest in something less volatile than the stock market.)
"One does not have to be a commie to wonder if this is the best way society can use very smart people."
Only commies believe society has the authority to control what smart people do.
I may have phrased things non-optimally, here.
I would argue that smart people, like most people in general, do respond to incentives, including incentives set by society implicitly or explicitly.
"Comrade Doctor, society requires you to work on creating nuclear weapons against the enemies of our glorious $ideology" is a classical commie (or perhaps fascist) thing, but saying "we give some smart people the opportunity to use some taxpayer money to figure out things which are not of immediate interest to private enterprise" is one incentive which influences where some of the smart people end up which most people would not call communism. (Not that academia is without its problems, but the position that the state should not subsidize research seems a minority position.)
> Why did I write this book review? To test my intellectual mettle. I could easily have posted this book review elsewhere, but no, I wanted to see how I stack up against other ACX Book Review contest participants.
Well, you had a bit of edge here in getting your review published. It's true these are people using their belief in rationality to literally pay rent, but it's also not an unfamiliar relationship.
SSC and LessWrong have been a frequent topic of conversation at Jane Street for a long time, going back to the late oughts. Eliezer Yudkowsky and Robin Hanson gave a talk there on AI safety in 2011(?)
Jane Street even used to advertise on SSC.
This is all to say, good going (The book review is also excellent!)
To be fair,Jane Street probably didn't learn their rational approach to risk management from SSC/LW. That likely came from one of the founders' stints on a nuclear submarine. In fact, an earlier book review in the series had some familiar ideas in it as well: https://astralcodexten.substack.com/p/your-book-review-safe-enough
AFAIK the currently best-known Jane Street alums are... SBF et al.
Leads one to wonder, are they illustrative of that firm's approach to risk management?
I don't have all of the details here but AFAICT SBFs primary problem was that he allegedly committed fraud? Maybe you can cast that in terms of failing to learn good risk management but I think the simpler explanation is that he was just crazy. He didn't appear to run his company as I would've expected a JS alum to.
SBF was also on record as being pure risk neutral, going in for a 51% double or nothing bet even if you were betting the whole world.
Which feels like something only a person without long term experience would do. Playing that bet every time it comes up is a guarantee of ending up with nothing. Double-or-nothing even on 99% odds will eventually bankrupt you, if you do it enough times.
I don't think SBF was crazy. I think he had huge individual financial incentives to lean heavily into the philosophy he already had about risk management. It had worked out well for him so far, so he kept updating to accepting even more risk. What he needed was someone with more actual experience to rein in his worst tendencies (and also help him set up the company better).
I haven't been paying attention, but I don't think I could name other JS alumni off the top of my head. Which I interpret to mean that the vast, overwhelming majority are not high-profile fraudsters.
(The version of the SBF story that I recall was that he put in some time there, but left while still very junior because he thought he had better ideas. And it turned out, aside from one idea (the Japan arbitrage), he was wrong. And he valued his image more than he valued his integrity, leading to fraud.)
More interestingly than risk management, sbf et al were also *terrible* market makers (Alameda was losing money despite *owning the exchange*. That is some unbelievably bad trading right there).
(Of course JS itself is quite profitable, but I suspect that's based more on their recruitment advantage (they have really good PR for hiring) and tech infrastructure (most HFs have surprisingly bad tech and it might help that they spend so much on engineering).
Only partly true.
I believe Alameda was successful at market-making for a time (though I lack hard data). Crypto market-making has become much more competitive in recent years, as more of the major trading firms have entered the market. Many crypto MM firms, like Alameda, were successful by being relatively early into a retail-heavy market. It's just gotten a lot harder in the past few years.
The problem is that rather than winding down, Alameda pivoted to longer-term investing. The huge downside risk was obvious to many. You can read tweets from Alameda execs all throughout this transition and they seemed to actually have convinced themselves they had a special talent for making leveraged long bets on crypto\s. I can't make this stuff up.
My impression is that they swerved in large part because they stopped being able to reliably make money in market making though
That's the part I said was true.
> The Efficient Market Hypothesis is a lie. The person that better understands the nature of a small sliver of the world (e.g. Apple’s share price) will make more money than others.
> Modern financial markets are exceedingly competitive. This means that the bigger you think your edge is, the more likely it is that you’re wrong.
...isn't that a statement of (a form of) the efficient market hypothesis?
The amount that markets are efficient is neither 0% nor 100% (nor, in many cases, even close to either of those), thus making both of those true at once.
People do make money with edge, but even more people falsely think they have edge and lose money.
Or the people make money using edge, they still think they have edge, but they've lost it because others have discovered it and have already traded all of it away.
This is called "bad luck".
It's a better statement of the EMH.
The strongest form of the EMH (which no one uses except as a strawman) is that no one can ever make money because all the edge has already been traded away.
A looser and more applicable form is that the market is really good at discovering edge, the larger it is and the more generally applicable, the faster it is discovered. Once the edge is discovered it is very quickly traded away. You may discover a fleeting edge, but it won't be for long, and it requires a lot of effort (and some luck) to do so. Sooner or later you will mess up by thinking you still have edge when you don't. So don't bet the farm on your new edge.
If most people believe the market is efficient, then the market will not be efficient.
The definition EMH theorists use is that since most people aren't able beat the market, it is efficient. Which is pretty self evident.
But that doesn't mean it isn't impossible for some people to beat the market. Just like it isn't impossible for some people to become a world class tennis player.
Since it is a lot easier to argue that Rafael Nadal's tennis success isn't some 5 sigma freak accident compared to for example's Warren Buffett's investing success, nobody is arguing "the efficient tennis hypothesis". And Nadal is really a clueless tennis player that got insanely lucky and by pure freak accident made all the right moves.
I suppose humans will have to get a lot older, so that eventually some 300 year old's investing success is a 9 sigma event, and EMH proponents will finally throw in the towel and say "fine it is because of skill that he did that!".
Although that 300 year old would have to start all over again multiple times due to the nature of compound interest.
> Lebron views trading as an act of creativity, a way to make the world, in one small way, a better place through creating efficiencies in markets.
I'm curious to hear other takes... but to me, this feels like the epitome of motivated reasoning.
Yes, market efficiency is a *good thing* for the obvious reasons. But there's opportunity cost to so much effort to eke out gains for the benefit of so few, there's economic risk introduced by the exposure to cascading strategy failures, there's direct harm caused by encouraging poor investments, and (perhaps worst of all) there's a reinforcement of *money* being the best measure of status. I find it hard to believe Lebron's view is not net-negative to society.
Taking a myopic view, sure, I can understand how getting into trading is a reasonable, and even good choice for someone to make. But it seems *so* wrong to me to use that view to make statements about what's good for the world. There's a better equilibrium society could enjoy: let's call that good instead.
Interesting! When I read that paragraph, I thought about the advent of long distance trading, with the invention of seagoing vessels, and how it was far and away the most valuable activity that a human being could commit themselves to even given the enormous chance (66%+ per voyage for some routes, especially manilla -> acapulco!) of death at sea and the total loss of the entire investment
it seems inherently evident that moving goods from a place where they are less valuable, to a place where they are more valuable, generates additional value for society
nowadays, the analogous activity appears to be moving liquidity from a place where it's less valuable to a place where it's more valuable
i feel like the transition from long distance trading to this new kind of trading was gradual enough that i'm not exactly sure where it crossed the origin, or even if it ever did
surely if this kind of investing weren't actually valuable for society, we wouldn't be willing to pay people to perform it? right? or something?
i know you're saying it's more that we're deep into diminishing returns on this kind of trading, not that this kind of trading is valueless
but, if we just halved the number of people engaged in this kind of trading, wouldn't the effect be... something about liquidity being so much harder to come by that a lot of value would be lost? or do you think it's that all these extra traders mean liquidity must be getting misallocated based on bad cycles of traders' impressions of other traders' impressions of other traders etc.?
> if this kind of investing weren't actually valuable for society, we wouldn't be willing to pay people to perform it? right? or something?
A free market will *absolutely* pay people to do things that are net-negative to society. The existence of drug dealing, gambling and Ponzi schemes seem sufficient to prove this.
> do you think it's that all these extra traders mean liquidity must be getting misallocated based on bad cycles of traders' impressions of other traders' impressions of other traders etc.?
That is my strong intuition.
And besides, the market today already fails to provide sufficient liquidity / investment for many human development projects, which government policies and programs step in to address.
err, in all of those other cases there *is* value being provided, it's just that there's a very, very horrible short term vs long term perverse incentive thing going on
except ponzi schemes ofc which is just fraud, and we treat it as such, it's not possible without people getting tricked into thinking there will be future value when there won't
like, someone needs to want drugs in order for drug dealing to exist, and when someone deals drugs to someone else, it's very easy to understand where the increase in 'value' comes from, it's easy to point at the drug user and say "yup, his gained perceived value"
with trading like this otoh, it's harder to point at the customer, but i think it's like, anyone who ever takes out a loan, right? stock traders allow corporations to easily leverage their stock to gain liquidity and a line of credit which provides huge value to those corporations that wouldn't exist if the market for stock weren't enormous... and i feel like the same must be true of most other financial instruments, that somewhere down the line someone is getting value, and the brokers take a cut of that value
in order for high frequency traders who develop strategies like this to earn a living, 'value' must be getting created. i don't care if it's the kind of value that satisfies society spiritually or the kind of value that addicts society to consumerism or drugs or the kind of value that society wants to eliminate at all costs, there must be some form of value being created by this activity... right?
like, in order for it to be the kind of activity that we ought to frown upon as, not merely economically counterproductive, but economically *empty*... where is their pay coming from?
i guess the obvious answer is that it's theft, that they're taking money from morons. maybe the economy grows swiftly enough that the bottom 50% of investors still end up averaging a positive return anyway? so the situation is stable?
but i don't feel like that's a good answer
> in order for high frequency traders who develop strategies like this to earn a living, 'value' must be getting created. i don't care if it's the kind of value that satisfies society spiritually or the kind of value that addicts society to consumerism or drugs or the kind of value that society wants to eliminate at all costs, there must be some form of value being created by this activity... right?
Oh, I think I misunderstood you. I totally agree with this. Market making, and developing financial products more generally, definitely creates value.
"in order for high frequency traders who develop strategies like this to earn a living, 'value' must be getting created... right?"
Not at all. The traders are getting money from somewhere, so someone is paying them. But that person could be mistaken about the value they're getting.
I don't know enough about American markets to comment, but the Chinese stock market has given me a nice perspective. It's been described as a massive vacuum cleaner, sucking money up from the middle classes to the connected, and that's been our experience. The market has boomed over the last couple of decades. But we just lost money, and everyone else we know who does individual investment has lost money. Money was made by the people with enough political pull to get licenses, IPOs, etc. Along the way, the brokers/traders made money. So there was a net transfer of assets from low-wealth people to high-wealth people (total wealth remaining constant, but a net negative for society, I think); along the way, the traders took a cut (so the high-wealth people got less money than was extracted from the low-wealth people).
The traders facilitated the transfer, so your argument would have to be that that facilitation was valuable. That's not a proposition I'd agree with.
The US stock market seems to work precisely as described above. People who are not traders, nor have the time, inclination, or resources to become traders, but want a sporting chance of rescuing their savings from inflation are de-facto forced to hold stocks; their wealth is then periodically harvested by the elite, under the guise of "crashes" (which the elite can afford to hedge against.)
"The market has boomed over the last couple of decades."
False. The Shanghai index was higher in 2007 than it is today.
Ponzis are analogous to a drug -- they sell hope. E.g. https://en.wikipedia.org/wiki/Sergei_Mavrodi was hailed as a hero by a surprising number of people.
I think the motte here is just that the opportunity costs of so many smart people devoting their considerable talents to trading exceed the benefits of a marginal improvement in market efficiency. With maybe a side order of traders capturing most of the surplus they generate. (In the counterfactual where the traders were building mars rockets instead they may be creating more total value but capturing less of it for themselves)
I guess you don't have any idea how selfish this sort of narrative actually is. The main reason many PhDs go into these areas is that the system has no way of valuing the good work you want them to be doing. If you want to allocate talent to where you and others can benefit more, put money where your mouth is and also advocate for better treatment of scientists.
> In the counterfactual where the traders were building mars rockets instead
I think this kinda overstates how many traders there are and understates how hard it is to build Mars Rockets. Even relatively huge hedge funds are a fifth the size of SpaceX (and an even smaller fraction of a bigtech) in terms of headcount. And while there's a lot of smart people there, they do have specific talents and I'm not sure the marginal employee at DE Shaw would make a great rocket engineer.
Incidentally, this is why governments are inefficient. With a large investment, it would be easy to improve national GDP. But, very difficult to capture enough of the benefits.
Regular trading is still enormously more valuable than stock trading. It's just gotten a lot easier and safer, what with planes and trains and better boats. But any tourist town can tell you how important a missed ship is.
I used to believe this until I worked in tech for a few years. The marginal software engineer at a bigtech or even medium sized company also does nothing useful (adding bloatware or tests for minor features is common at best, and is done quite slowly), as seen by software working increasingly badly over the last ten years.
The contribution of a hedge fund to the world is smaller in a way (since to some degree it's a second degree improvement), but the marginal employee there is a lot more effective. I think it balances out to HFs being slightly better.
I appreciate this perspective, and agree there are problematic inefficiencies in a lot of SWE work.
But I'm not sure what your disagreement is? Yes, the marginal economic value of a trader may often be higher than if that same labor was applied to software engineering. But that doesn't justify claiming additional effort put into creating market efficiencies is good for the world.
Paraphrasing Churchill, markets are the worst form of economy management, except for all those other forms that have been tried.
Someone has to keep corporations efficient? If literally everyone invested in index funds, then corporations would effectively be owned by funds that have minimal administrative staff and would just rubber stamp everything the CEO demanded. Board of directors would be stacked by friends of the CEO.
So a well run long term oriented hedge fund can add a lot of value, despite only making zero sum trades. Keeps those CEO's on their toes, and makes sure there are enough independent directors out there with skin the game.
Agree with you (mostly) on short term high frequency trading.
Sure, I agree to some degree… but the degree is important.
Traditional hedge funds now have over $5T in AUM. Related (very rough) numbers:
* That’s 5% of global market cap of globally listed companies
* Over 3x compared to 2010 levels, and over 20x 2000
* It’s very hard to calculate, but that likely translates to 100’s of billions in fund profits and management fees.
On top, there’s even far more money being made in the financial sector tracked outside of this, which are also activities that are also (nominally) creating liquidity and efficiencies. BlackRock alone has almost $9T AUM.
These numbers are not commensurate with the good being done in the world. It’s the *blanket sentiment* that trading is good for the world that has allowed so many people to justify this situation, and makes it so much harder to draw the line for what’s too much.
It’s too much. We need a perspective of trading that makes this easier to say.
"On top, there’s even far more money being made in the financial sector tracked outside of this, which are also activities that are also (nominally) creating liquidity and efficiencies. BlackRock alone has almost $9T AUM."
I'm not sure what you mean by this. BlackRock's AUM by and large isn't being traded actively, it's being invested by institutions and retail investors. The purpose isn't to create liquidity or efficiencies, it's to grow assets.
I think you may be underestimating how much staffing index funds have. Vanguard has move that more than 60 people doing “investment stewardship.” For places like Vanguard (more than $3 trillion under management) or BlackRock (more than $9 trillion under management), the cost of an additional 60 staff is trivial.
Having a team dedicated to investment stewardship means that you are unlikely to turn into a rubber stamp for whatever the CEO's of the companies you invest in want to do. The reason is that you've embedded the job of pushing back against this into the structure of your organization. Therefore, I don't think there is any real chance that index funds with investment stewardship teams are going to role over for CEO's.
It's much harder to make that prediction about hedge funds, because hedge funds don't seem to talk about investment stewardship.
60 staff is nowhere near enough to monitor thousands or tens of thousands of stocks.
In practice they do rubber stamp a lot.
https://www.unpri.org/pri-blog/do-index-funds-monitor-their-portfolio-firms/7865.article
Also people gravitate towards the funds with the lowest costs, so they will be directly incentivized to keep their costs as low as possible.
Finally the whole point of index funds are that they generally don't form a firm opinion on any one stock. Which would be necessairy when actively monitoring management of a firm.
I read the posting you linked to, although not the underlying paper (which I don't have access to). I don't think it stands up to scrutiny very well:
1. Voting
To begin with, the differences in voting are fairly small. In cases where ISS disagrees with management, index funds vote with management 54.3% of the time and non-index funds vote with management 47.3% of the time. If following ISS recommendations is the goal, the main take away from this is that both types of funds are really bad at it.
Furthermore, it's not clear how robust the results are. In Figure 1, Dimensional Fund Advisors appears near the lower left corner. Most of the DFA funds are not index funds because they attempt to track asset classes, rather than attempting to track indexes which in turn attempt to track asset classes. If the study had compared passive to active funds, rather than index to non-index funds, DFA would appear near the bottom right of the chart. This suggests that the difference in voting might disappear, or at least be smaller, if the study had compared passive to active funds.
So why does DFA score so much higher than Vanguard? DFA says that the number of “engagements” (investor-speak for talking to a company) is about 1/3 of Vanguard's, which suggests that they have less staff dealing with investment stewardship than Vanguard. However, they do have a lot to say about their commitment to ESG, which is short for Environmental, Social, and Governance. Vanguard, on the other hand, seems to care primarily about the corporate governance part of ESG.
All this suggests that the issue is policy differences, not staffing. ISS makes proxy voting recommendations based on ESG criteria. The difference between DFA and Vanguard could be entirely due to Vanguard choosing to vote with management on environmental and social issues.
Indeed, if you agree the position that the ISS recommendations are always correct, as the study implicitly assumes, then you shouldn't be worried about index funds not hiring enough staff. Rather, you should be upset that they are hiring any staff at all to decide how to vote proxies, rather than just following the ISS recommendations 100% of the time.
Your claimed, if I understood you correctly, that index funds pay less attention to corporate governance than other investors, and that the reason for this is lack of staffing. The voting portion of the study provides no support for either of those claims.
2. Engagement
The requirements for filing Schedule 13D are described in Regulation 13D-G in the Code of Federal Regulations, and an intent to “actively engage with firm management and affect firm policy” is not mentioned there at all. A fund has to file Schedule 13D if it acquires 5% or more of of a company for the purpose of changing or influencing control of the company, or if it acquires 20% or more of a company regardless of its reasons for acquiring the stock. The authors tell us that index funds never file Schedule 13D, while non-index funds do, but I'd guess that non-index mutual funds *almost* never file Schedule 13D. Without knowing how often, or why, non-index funds file Schedule 13D, I don't think we can draw any meaningful conclusions.
Comparing companies with based on the amount of stock held by index funds is problematic because companies that appear in an index are going to be different from companies that don't. For example, Russian companies have approximately zero percent of their stock owned by index funds because Russian companies were removed from the major indexes after the invasion of Ukraine. But if you compare a sample of Russian companies to a sample of U.S. companies, and find a difference, there could be many explanations. The cause could be different laws, different regulatory regimes, cultural differences, or even the sanctions that led Russian companies to be dropped from the indexes in the first place. You can't assume that any differences you discover are caused by index funds not holding Russian stocks.
The preceding paragraph posits that there is a difference, but the authors write that, “when index funds hold more of a firm’s stock, the number or type of proposals that are tabled at annual shareholder meetings do not change.” If the lack of difference were evidence of anything, it would be evidence that index funds are equally as effective as other investors.
Your claim, as I understand it, was that index funds are *less* effective than other funds, and this portion of the study provides no support for that claim.
3. Divestment
It is true that index funds won't sell a stock because of dissatisfaction with management. The authors state that selling out a position, “possibly drives the share price down,” and it seems likely that management would like to avoid a lower share price.
Suppose a bunch of investors sell a stock because they don't like the company management. Let's assume that the corresponding buyers also aren't thrilled with company management, and are only willing to buy because the stock is being offered at a lower prices than before. If half the market is owned by index funds, then there will be fewer sellers because index funds won't be selling, but there also will be fewer buyers because the index funds won't be buying, so the price should be the same. To put it another way, stock prices are set by active investors, so the existence of index funds doesn't affect stock prices. (There are some qualifications on this last statement, but I don't think they matter here.)
Suppose a CEO stacks the board of directors with his friends and relatives. In a world with no index funds, a bunch of investors are unhappy with this, and the CEO is punished with a lower stock price. In a world with index funds, the CEO is faced with the same lower stock price, but he is also stuck with a bunch of index funds which continue to hold the corporate stock and express their displeasure with management by voting against it every time they get a chance. The divestment argument leads to the conclusion that index funds are good for CEO accountability. The study authors claim the opposite of this, probably because of faulty reasoning on their part.
You mention the case where “literally everyone invested in index funds.” If that actually happened, there would no longer be a price discovery mechanism, and the claim I made in the preceding paragraph about “the same lower stock price” would no longer be valid because there is no way to reason about stock prices under such a scenario. All I can say is that if you don't have a price discovery mechanism, you have bigger problems than a lack of CEO accountability.
Differences are small in voting because most matters are routine. The important ones are only a minority of items being voted on.
Also what matters is not just staffing, but competent staffing. The best way to select for this is by having funds invest actively, with the most effective ones getting largest and having the most influence. Have the people who can boss around the CEO being selected by the market, and not by some random HR manager at an index fund.
As for your divestment argument, if there is a steady selling of the stock because of incompetence, it depresses stock price performance. Because there are still plenty of active funds, it opens up the company to an activist shareholder who can make a compelling argument why management needs to go, and the board of directors needs to be shuffled. This is mainly why CEO's care about stock performance. Because options can be priced downwards.
This form of activist investing, which is increasingly common, is not something generally initiated by index funds.
In case you are not convinced, you can sink your teeth into this paper:
https://www.nber.org/system/files/working_papers/w26543/w26543.pdf
"Our findings regarding voting decisions are consistent with those
reported by four other current empirical studies. Three studies—one by Ryan
Bubb and Emiliano Catan; another by Patrick Bolton, Tao Li, Enrichetta
Ravina, and Howard Rosenthal; and a third by Davidson Heath, Daniele
Macciocchi, Roni Michaely, and Matthew Ringgenberg—document that, in
general, index funds tend to vote in a more pro-management way than other
investment fund managers.165 Furthermore, a fourth study by Alon Brav, Wei
Jiang, Tao Li, and James Pinnington finds that the votes of index funds are
more pro-management than other investment managers in contested
elections, another context in which vote outcomes are important for corporate
managers.
166 The results of these studies are all consistent with and reinforce
the deference predictions of our incentive analysis.
B. What the Big Three Do Not Do
We now turn to discuss five types of stewardship activity that the Big
Three generally do not undertake. The activities on which we focus are (i)
monitoring business performance, (ii) influencing director identity; (iii)
submission of shareholder proposals to facilitate changes favored by the
index fund’s own governance principles, (iv) contributing to corporate governance reforms by filing comments regarding SEC rulemaking and
amicus briefs in precedential litigation, and (v) taking on lead plaintiff
positions in consequential securities cases."
Plenty of countries have experimented with doing away with markets. The outcomes have been universally horrendous, but let's call that "good" instead.
It's very clear that the OP doesn't think that getting rid of markets is good. He's arguing that the remuneration received by traders is vastly higher than the amount of "good" they provide to society. I would characterize the sentiment as analogous to drug dealers. Sure, your local weed guy is providing "value" by taking a personal risk to provide entertainment to some and relieving the suffering of others. But, we can make this market better through competition and economies of scale (in other words, gang violence and cartels).
Lebron's paean to the power of trading rings absolutely hollow when you consider/know some profitable trades are net bad for society, simply because some things which lead to human flourishing can't be accurately modeled, and pursuing things only for economic gain can in fact destroy the underlying value of what gets traded. Finance people get so much social status through the money they make; you don't need to give them additional status by arguing what they do is virtuous as well.
"When the share price is down is when layoffs happen."
This sounds plausible as a rule of thumb, but right now I mostly see the opposite. This year, practically all of the largest tech companies have had major layoffs, and most of them have hit new all-time highs for their stock price.
I think the point is about timing. Stock price falls -> layoffs happen -> stock price rises (although looking at the largest tech companies is probably the wrong sample set and in many cases the stock price does not match the previous highs in a short time period). If you lose your job and need liquidity, you may be forced to sell your stock at the low prices and miss out on the recovery. Whether you should follow this advice depends on your personal financial situation, risk-tolerance, etc.
Sounds like an interesting book, sort of a financial-trading-themed "11 Rules for Life". I do notice how it sort of transitions from "discovering truths about the world that no one else knows" though "the importance of modeling people and what they know" into "the nobility of agonas and the purifying flames of competition". Which is actually one of the things I dislike about financial trading - it feels like a hideously inefficient protocol that's laid waste to the best minds of the last few generations. Kind of like proof-of-work, but running on human ambition rather than GPUs. But I suppose money is a form of power, and allocation of power is an important problem, and it's not like there's ever been a shortage of people competing to drain off tiny bits of power for themselves by doing services for people with power.
I rather like the review's style. Efficient, concise, and still showing signs of a personality underneath. I do get the impression that the reviewer has an axe to grind with the vague rationalist/EA/ACX community, but it seems like a small axe, more of a hatchet, really.
To me it felt like a correct attitude towards the community, but maybe that's because I have basically the same one. Except for silly use of the word "irrational" towards committed relationships or scientific stubbornness, that's kinda cringe.
I like this explanation. This explains why trading is so popular.
I believe that this book is a good, insightful description of how financial trading works. I'm a bit more skeptical about the applications to non-trading life. It made me think of this comedy clip:
https://www.youtube.com/watch?v=AwueQ-Mbdb8
The comedian watches the Chris Voss Masterclass in being a negotiator, and comes to the conclusion that it's less a class than a documentary about a madman who treats ordinary interactions with service workers like a hostage negotiation...
I laughed. Thanks for sharing
Desinit in piscem mulier formosa superne.
” This seems to be why there is little innovation in government: talented engineers are treated as second-class citizens in research labs, so they work for Stripe and OpenAI instead. Similarly, one can attribute the lack of innovation in hospitals to doctors holding all of the institutional power. Often, all a hospital needs to save lives is simple practices that other businesses figured out long ago, but the hubris of MDs prevents this from happening. ”
I don’t understand this part. It starts off talking about government and then immediately mentions ”research labs” which suggests that the meaning is that no one ever invented anything in a government run research facility, which isn’t true (and which isn’t ”government” anyway). Also, doctors don’t hold all of the institutional power in hospitals. No one is prevented from coming up with an idea for an innovative hospital and suggesting that if they like.
>"No one is prevented from coming up with an idea for an innovative hospital and suggesting that if they like."
Counterpoint: Certificate of Need laws
As for checklists, I see that in healthcare (at least in the UK NHS) has implemented them on par with aviation – short, concise, relevant and life saving.
Whereas other businesses often use them like a parody and actually makes things worse. For example, they make multiplate page checklist that takes too long to fill, or requires them to fill when the job is complete or populate with irrelevant questions.
Healthcare is very hard and improving it is much harder than most writers realize. There is another book in Scott's list that talks about healthcare specifically (by Mark Britnell) and that was much better, although a little bit dry.
My father worked for a state government engagement program where he lead a team porting standard manufacturing management practices (lean manufacturing, root cause analysis, six sigma) to healthcare providers and hospitals. Based on his stories, can confirm that "Often, all a hospital needs to save lives is simple practices that other businesses figured out long ago" is definitely true.
Some problems he worked on:
1. Extra/missing doses of medications. Mistakes were often caused by nursing shift changes, intra hospital patient relocations, and routine surges in nursing demand.
2. Leaving equipment in the body during surgery, especially surgical gauss used to control bleeding.
3. Patient gets the wrong procedure. One patient had an incorrect appendage amputated because the radiologist's medical school used an "X" written on the appendage to mean "no, don't cut this off" and the surgeon's school used "X" to mean "yes, cut this one off".
Sure, employees in hospitals make mistakes. What intrigues me is the claim that other businesses ”long ago” figured out how to stop their employees from making mistakes. As a consumer, I apparently don’t often come in contact with those businesses. Maybe I am not rich enough?
Besides, as your own story illustrates, hospitals do employ standard procedures to improve patient safety.
"What intrigues me is the claim that other businesses ”long ago” figured out how to stop their employees from making mistakes."
These are really interesting topics, but yes business practices can definitely change how many mistakes employees make on average and and how much each mistake impacts the final product.
Had a friend involved in phlebotomy operation and they got way better results by simply matching the most experienced technicians to the donors with the most difficult veins. It was a simple change but they operated for decades on a much worse FIFO model.
Are all people named Lebron competitive?
LOL
Xd
> Lebron argues that we need stories here. Edge is expressed in stories: an edge does not exist without a clear mental representation of that edge. Pure linear algebra does not suffice.
My model is that Rentech & friends *are* what makes this true. If your edge is just linear algebra, Simons and his quant army figured it out years ago, and you need a compelling non-mathematical story to overcome this barrier.
Sounds like a comment (Lebron's) from someone with a poor understanding of linear algebra.
Sincerely,
Trader that has made hundreds of millions of dollars with mostly linear algebra.
> Similarly, one can attribute the lack of innovation in hospitals to doctors holding all of the institutional power. Often, all a hospital needs to save lives is simple practices that other businesses figured out long ago, but the hubris of MDs prevents this from happening.
Doctors often hold much less institutional power than the author thinks… the doctors I know often feel tightly constrained by government and business interests, whose collective decisions are made primarily by individuals without medical training.
I am compelled to comment on the really excellent execution of this review. You can feel how the reviewer strives to communicate the main points of the book, through the lens of what the ACX audience would appreciate. They do so briskly and concisely, which avoids the length problems some other reviews in the contest have had. They interject a few personal asides and connections to related subjects, but not in a way that distracts or takes over the review. They give clear real-world examples of each concept.
Overall, I'm left with the feeling that the review itself is "dense" in meaning. I think I would derive a lot of value from closely reading each section and paragraph, considering their implications and how they relate to my own life. That's an impressive feat for a book review.
Other book reviews we've seen so far might be more entertaining, or their topics more interesting. But I'm currently feeling like I have to give this one a top vote based on the strength of execution. I'd love to see more reviews written like this.
Yes! Voting for one of these reviews is going to be hard this year.
I have invested almost exclusively in hedge funds and CTAs for roughly thirty years now and I have found your review really very interesting, clear and relevant.
I am going to read the book and I am going to forward your review to all the money in managers in my portfolio.
Hello, I am a long time investor specialized in hedge funds and CTA.
I found the Laws of trading book review really very, very interesting, clear and relevant.
I am going to buy the book and I am going to forward the review to all the hedge fund managers I have in my portfolio.
My congratulations to the reviewer.
> but the hubris of MDs prevents this from happening
This is one of those “if everyone would just...” drive by statements.
Everyone will not just. Your brilliant idea is not so brilliant if you can’t figure out how to accommodate human nature.
The apprenticeship analogy is fantastic. Well, actually it’s not really even an analogy. I recently started at a fund and am effectively an apprentice. I’m doing the infrastructure and learning. Eventually I will do the infrastructure + analysis. Then analysis + decision making. Then mostly decision making
Interesting how this review makes me uncomfortable, and unwilling to ever participate in market trading or try to apply market-based reasoning to my life. I hate competing with anyone over anything, and I just want to remain in my comfort zone and do things I know and like.
> The Efficient Market Hypothesis is one of the core concepts taught in Finance 101. The Efficient Market Hypothesis is a lie. The person that better understands the nature of a small sliver of the world (e.g. Apple’s share price) will make more money than others.
> Modern financial markets are exceedingly competitive. This means that the bigger you think your edge is, the more likely it is that you’re wrong.
> “Evolutionary thinking applies quite directly when thinking about the evolution of markets. Having an edge in a mature market means understanding the world better than other traders, even ones who are already highly skilled. In fact, the marginal trader in modern financial markets is quite sophisticated and skilled indeed.”
This section is quite confusing to me, as this is basically what an economics professor teaching Finance 101 to econ majors will say when describing the EMH. There might theoretically be inefficiencies you could exploit, it's just that if you think you found one, it's far more likely that you are mistaken (often for the exact reasons described immediately after this section) than that you are correct. (To be precise, it's not just about having an edge--the edge has to be big enough to give you a better percent return compared to what you have to invest, and it has to compensate for any additional risk, in order to "violate" EMH).
Later, it even says this:
> If you think your costs are negligible relative to your edge, you’re wrong about at least one of them.
Which again seems to capture the spirit of the EMH (arguably even the strong form if taken literally, although this whole review seems to be written as if cheating is not an option, so we'll say the semi-strong form) as commonly expressed.
Re:the last bit, academic research is also a genuine apprenticeship, and which was one of my favorite parts of it (though the flipside is this is also why bad advisors are so damaging)
The audiobook of Laws of Trading is currently free for Audible members.
>“Residential real estate has historically returned significantly below equity markets over long time horizons”
Sure, but if I got to the bank to get a 300k loan for a house, I'll get it at a very low interest rate (at least until this year), considerably below inflation. If I got and ask for a 300k loan to leverage myself into buying ETF, I kinda expect to be laughed out of the office.
"The markets are a very scary place, and you are in an existential arms race with your competitors."
I read "scalpy" and only when re-reading that paragraph I noticed. Seems even more fitting.