14
Feb
2016

Two kinds of crazy

Currently the newspapers are full of headlines like “Markets in Turmoil” and “Stockmarket Rout”. I find it rather odd, that economists still seem to believe that markets are rational, perhaps economics professors don’t read the newspapers or invest their own money. Instead, I wonder if the confusion comes about because there are two types of irrationality. 

The first type of crazy is that we are all irrational in predictable ways. For instance, people have irrational attitudes to risk. I like asking economists,

“if there was a linear relationship between risk and reward, why aren’t all base jumpers billionaires?”

I just can’t imagine Warren Buffett or George Soros donning a wingsuit and jumping off an icy rock in Baffin Island like this 

Aside from base jumpers, who after all, represent a small sample of society, there are other examples. Normal people actually take MORE risk to avoid a certain loss. Rogue traders at banks almost always run up huge losses because they are trying to trade their way out of trouble, but end up losing more money as they “double down”. But there are many examples of taking more risk to avoid certain loss outside financial circles. Politicians rarely resign for the original peccadillo (peccadillo means “little sin” and has been translated from Spanish to mean sexual impropriety). It is when they lie to cover things up, or claim to be for “family values” while showing hypocritical behaviour in their own affairs.

We all do things that are not in our rational self interest. The fact that there are so many books on available on amazon that help us overcome our irrationality, rather suggests that books alone can not teach you to behave in a more rational way.

The second type of irrational is genuinely unpredictable. And we find it much more uncomfortable because of the unpredictability. Some days they are almost level, the next day they are behaving erratically.  Music and films that are too predictable are boring – but music and films that are so unpredictable they make no sense are really unsettling.  Imagine if in an episode of Game of Thrones Vladimir Putin walked on to the screen, playing  “Somewhere Over the Rainbow” on the bagpipes.  It just wouldn’t make sense. So we tend to shun anything that is really unpredictable, and people who are too randomly unpredictable we tend to diagnose with psychological diseases.

we shun anything that is too randomly unpredictable

Investing is a combination of dealing with both types of crazy.

I went to an event last Monday, full of very intelligent “quantitative finance” types, programmers and computer scientists. They reminded me of alchemists, which up until the 17th century, was a respectable profession. Sir Isaac Newton, perhaps the most famous scientist of all time, made innumerable experiments trying to turn lead into gold. These quant types seems to me psychologically to be searching after the “algo” – that turns market irrationality into gold. Because the way the approach the challenge is to form a hypothesis, for example oil and gold have a co-integrated relationship, and then for an algorithm to take advantage of this. They then test the algo to see if it works. And if it does, they test it again on a second set of data (an out of sample test). I suspect that most of the time this works, but that when things get really crazy, the co-integrated relationships breakdown. And that creates more craziness, because if you are expecting people to be predictably crazy, then it turns out that they are really unpredictably crazy, they are much are harder to exploit in a systematic algorithmic way. Serious poker players hate playing against beginners, because the beginners play in an unpredictable way. I’m not against algorithms and systems, but they should be used help us to overcome our own predictable craziness.

On the other hand I am trying to exploit this second type of unpredictable craziness. Because that is where the greatest opportunity to take advantage of irrationality lies. We know that occasionally prices become wildly unpredictable. But in the end the businesses that they represent are not that unpredictable, they go through cycles, but those cycles are much more benign than the share prices reflect.  That is why Ben Graham invented the character of Mr Market, your business partner who sometimes is wildly optimistic and sometimes wildly pessimistic. You can’t systematically predict what mood Mr Market will be in, but you can take advantage of his crazy swings. 

Do your own thinking, but what I’ve been doing is buying. Two companies which seem like the price is acting irrationally. Standard Chartered and Indivior CFDs. Yes, CFDs the leveraged product where most people lose money. But I think people lose money on CFDs because they are expecting markets to be predictably irrational, whereas I have waited for a positive expectation bet from an inherently unpredictable situation. 

Indivior is a spin off from Reckitt and Benckiser involved with treating heroin addiction, which I don’t really understand. But it is trading on a low multiple (ie cheap) and spin offs are often (but not always) good investments, because it is a way for management to reward themselves. If I was going to bet on something, it seems like that might be a good heuristic to bet on something like a spin off involved with heroin addiction.

My second idea is the bank Standard Chartered, which I have followed for over a decade. In fact former management took a dislike to me, for reasons that I never found out. But I suspect it was because I was publicly critical of bank management after the financial crisis, and they found this uncomfortable (particularly uncomfortable because it now turns out I was right to be critical). But now the share price has fallen from a peak of 1950p in Nov 2010 (when the valuations was above 3x book value), to below 400p (less than half book value) earlier this week, and the management has been replaced and many of the problems have now been recognised and they have raised money, I thought it might be worth trying to take advantage of the fact that the share price has fallen so far. But I’m well aware that unpredictable crazy, has a nasty habit of becoming even more crazy (if the shares can fall to below 400p, they can fall below 200p), or even worse that the price turns out to be a reflection of the underlying business reality, and the bank really is in serious trouble. So I’m also using stop losses to limit my downside. I have to be aware that I could be wrong. And that seems to me the only way to take advantage of the second type of unpredictable crazy.

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