Wednesday, December 03, 2008

I'll Take the Giants Plus the Points

I've long suspected that "investing" in the stock market was far more like gambling than most of us like to believe. And now this piece by Michael Lewis seems to confirm at least some of my suspicions. (For the record, I've read Lewis's Liar's Poker (referenced in the article) and I can testify that my reaction to it was precisely the one Lewis intended me to have.)

What has always bothered me about the market is that there is no necessary connection between the value of a stock and the quality of a company. Sure, there are broad correlations. But these correlations are anchored in the correlations that investors draw in their minds between the price of a stock and the quality of a company--correlations which may or may not track the truth of the matter. And if, for whatever reason, millions of investors decide that is a great company, you can be sure the value of the stock will rise no matter what the facts are on the ground. So when you buy a stock, you are betting that over time, people will think that the company is a good one.

Moreover, in the world of derivatives investing--the kind of thing that has driven the large investment banks over the last 20-plus years--there is even less of a relationship between an actual institution and the security being purchased. Invest in, say, mortgages and you are thereby assuming the combined debt of thousands of home"owners" and betting on the chances that they will pay off their loans. The greater the risk, the greater the possible reward. Sure sounds like gambling to me.

The truly amazing thing about Lewis's piece (and Liar's Poker) is that it reveals the sheer lack of understanding that those involved with such investing have of what they are doing. I have a Ph.D., albeit not in economics, and I have a very difficult time understanding what the hell is going on with these kinds of securities. As far as I can tell, it's all a bunch of smoke and mirrors designed to get people to get people to hand you their money.

Conversely, I'd argue strenuously that Vegas linemakers--those who set the point spreads for betting on sports--know exponentially more about what they are doing than the typical lackey working at an investment bank. That may sound outrageous. But its outrageousness, such as it is, is only a function of the outrageousness of much investment banking--not the lack of information available to sports bettors.* The linemakers may make it very difficult for you to beat them. But at least you are working with cogent information when you are trying to do so. Frighteningly, the same cannot be said of the house of cards that is our financial system.

*Also "for the record" the extent of my sports betting consists of a few horse races growing up (via my parents until I was of age) and various party pools. I have never bet on a football game against the spread in Vegas, online, or through Vinny the bookie. Not that there's anything wrong with that . . .

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