Let’s start with a study of foreign-exchange day traders by economists at Ohio State University. They found that traders who had made money in one week take bigger bets the following week, even though those profits are due to luck rather than skill and so don’t lead to future profits.
Why do traders do this? One reason has been proposed by Elise Payzan-LeNestour at the University of New South Wales, Australia.
Rolling with the returns
Payzan-LeNestour ran experiments where subjects could choose between a safe but low-return bet, and a risky bet with good returns punctuated by big losses. Many people preferred the latter, even when the occasional losses outweighed the gains. This, she says, happens because a series of small wins tempts some people to keep betting even though they know they shouldn’t.
This is perhaps because of increased levels of a naturally-occurring chemical called dopamine in the bloodstream, which is associated with risky behaviour. Hyman Minsky’s financial instability hypothesis is the theory that economic stability is inherently self-destroying because it encourages speculation.
Furthermore, people underestimate randomness and so see skill where in fact there is only luck. Of course, it’s easy to do this when assessing our own ability, simply because we want to believe we are clever.
Just a lucky streak?
But we also underestimate randomness when assessing others’ ability. This can lead to what Adrien Vigier of the University of Oslo and Jesper Rudiger of the University of Copenhagen call “reputation traps”. Dumb luck will help some fund managers beat the market. Investors who mistake luck for skill will then entrust their money to them.
They might keep their money in the fund even when the managers’ luck runs out and their performance deteriorates. The upshot is that bad fund managers will thrive, and charge high fees. And other research this year shows there are a lot of bad fund managers. A paper from a team led by David Blake at Cass Business School finds that “the average UK equity mutual fund manager is unable to deliver outperformance net of fees”.
Waste not, want not
This means the money we pay fund managers is largely wasted. And this is a lot of money.
Ugo Panizza at the Graduate Institute in Geneva has estimated that investors around the world could save $160 billion a year if they swapped their expensive actively managed funds for cheap index trackers. In this context, some otherwise irrational behaviour described by researchers at Carnegie Mellon University makes sense. They show that people systematically avoid some information even if it is free and unbiased.
Known and unknown “facts”
Surely we should disregard irrelevant information only after considering it, rather than not bother with it at all. However, if we are prone to misinterpret information, we might really be better off without it. If we interpret a short run of good returns as evidence of skill, we might be better off not knowing about those returns.
All this raises the question: if it’s so easy to lose money, is it possible to make it?
Maybe. A paper by Chicago University’s Tobias Moskowitz shows that the prices of bets on American sports are carried along partly by their own momentum: a rising price carries on rising, and a falling one continues falling.
Look further for proof
This matters far beyond sport. Duke University’s Campbell Harvey has warned that most findings in financial economics are “likely false”. This is because if you look for enough patterns in a huge data set, you’ll find some. Those patterns might not, however, persist – in which case we might be trading on irrelevant information. To avoid this, we need to see recurring patterns in numerous data sets.
This is where another Moskowitz paper fits in. It adds to evidence that “momentum” strategies ‒ buying assets whose prices have risen – can pay off. Not only does momentum exist in US equities but also in international stocks, commodities, and currencies. Momentum appears to be a real fact about asset prices which can be traded on. Sadly, however, the evidence that other strategies beat the market is mostly much less robust.