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Friday, August 13, 2010
My favorite blog this week, "Why the Economy is Not Relevant to Investing", came from Million Dollar Journey authored by Ed Rempel. I came across the site as I trawled Biz of Life's Blogroll.
Ed Rempel presents a pretty forceful case. I have long thought that the mathematics of investing has a certain fuzziness about it that prevents us from getting a clear picture of what is happening in the investing world and prevents anyone from coming up with a system to "beat the market." My field in graduate school was econometrics, and, in studying mathematics and statistics and econometrics, there comes a point where you realize that people try to fit the real world into the math in a simplified fashion. Specifically, assuming the real world is linear is real convenient.
In fairness, some relationships are linear. For example, if you collect data on grade point average and hours studied, you get a fairly linear relationship. Go beyond simple cause and effect situations, however, and, again, it gets non-linear real fast.
Where's the Fuzziness?
Think about this. Suppose there is value to the stock investor of knowing GDP - the broadest measure of economic output. First off, GDP is difficult to forecast - especially at turning points. Even the Bureau of Economic Analysis (the entity that decides the economy is in a recession) can't really decide a recession is in place until sometime after the fact. Secondly, GDP is reported with a significant lag and revised twice after that! This doesn't include the periodic longer-term revisions that take place. Finally, we have to get "news" out of the information - i.e. we need to know how we differ from expectations. All of this compounds the fuzziness. But suppose we had perfect information. Suppose we knew that GDP was going to be +3.2% this quarter, an increase from 2.1% the previous quarter, and suppose we knew this on day 1 of the quarter? Would this information be valuable? I realize that stocks are affected by more, a lot more, than GDP. But this just adds to the fuzziness. For instance,if GDP ratchets higher and at the same time the Fed makes a surprise policy change, then clearly all bets are off. The reader can think of a million examples like this.
Mr. Rempel's post got me to wondering if a game using real-life info along these lines couldn't be set up and his thesis examined statistically. Suppose we draw cards and they have two pieces of info: the amount real GDP is going up (or down) this quarter versus last quarter (we're assuming we know a lot more than we really know in the real world) and the level of the S&P 500 on the first day of the quarter. As an investor, we decide to increase or decrease our allocation from 50/50. Would we be able to add value?
This easily could be extended. Add in the unemployment rate for each month of the quarter, assuming we had the perfect crystal ball. Add in Fed policy in terms of the target rate for the federal funds rate.
It seems to me that an energetic person could run with this and set up an interesting game/experiment along these lines. Maybe two or more "investors" go at it at the same time, as in the real world, adding another layer of fuzziness: people reacting differently to the same info.
Anyways, I enjoyed Mr. Rempel's post and I think he has given us and those who stay riveted to CNBC plenty to think about.