Saturday, September 19, 2009

Luck, Knowledge and Schiff

An article on investing in a hampered economy.

Luck, Knowledge and Schiff
By Jim Fedako

In the casino called “the market,” each new year brings another round at the gaming table. Depending on your knowledge of economics, you are either gambling on luck or investing with knowledge. If luck is your guide, you are rolling dice knowing the house will win in the end. If knowledge is your guide, you have at least a chance of coming home a winner.

Consider this standard movie scene:

A mysterious man enters a casino and begins winning at craps. As evening rolls into night, and night toward dawn, our gambler gathers fans as fast as he collects chips. Should he press his luck, but leave before luck ends, he exits the scene a legend of sorts. Should he throw the dice one time too many, a dealer collects his chips while the groupies walk away, leaving him alone with an empty glass and turned-out pockets.

Despite knowledge of probability that proves otherwise, we tend to assume that a gambler on a streak possesses something we desire. Is it luck? Possibly. But it’s likely that we attribute his success to more than just luck: we attribute it to omniscience.

Let us follow the groupies as they leave the craps table and head over to a blackjack game. Here the scene is a little different. Since blackjack is based on more than just luck, players use their own system to gain an advantage over the house. Not all systems lead to success, but unlike craps, a good blackjack player and his system (if hidden) can win in the long run.

An observer will assume that a winner at blackjack understands the essence of the game. Certainly, luck is a component, but a quick mind for mathematical calculations can slightly mitigate randomness and bring home some serious cash. Of course, if his system is too successful too fast, casino management steps in and shows the player the door.

Finally, let us move from the craps table to the poker table across the floor; a table backed by video screens displaying cable news stations. At the table we see players competing in a high stakes tournament. On the screen we see talking heads competing in a similar but different sort of contest – betting their reputations on financial predictions for the coming year. Of course, both groups of competitors will have winners and losers. But is there any difference between those at the table and those on the screen?

Professional poker has changed as its popularity has grown. Players in tournaments are no longer familiar with their opponents. Young bucks enter the sport online and quickly graduate to the tables of Las Vegas tournaments. In this mix of old and new players, a quick review of the winners reveals that luck plays a large role in selecting the champion.

Randomness rules at the poker table. While there is randomness in every sport, it appears to be the overriding factor in poker. In addition, randomness is one of the reasons that the popularity of poker as a spectator sport has recently tailed off. There are no Tiger Woods of poker, and each tournament crowns a new, relatively unknown champion.

Oh, sure, you have to understand the game being played. And you have to be able to calculate odds quickly and accurately. But since your opponents are not folks you face round after round, tournament after tournament, year after year, you no longer need to be able to read the subtle body language – the tells – of your opponents better than they read yours.

Unlike blackjack, poker players can adopt a system and use it to their advantage, without ever being shown the door. And, of course, success at poker requires the ability to calculate both the odds of the next card as well as the likely moves of all opponents. Since the game is based on an understanding of probability and (to an extent) predictable action, it can be considered a stochastic process – a process that is neither pure chance nor pure deterministic action.

There is a concept called the survivor bias. Briefly, the survivor bias says that an analysis of an event or process tends to be biased toward the survivors – or, the winners. We see the folks at the table during the final draw of poker game and assume they employ some strategy that we can also adopt with success. So we end up making errant conclusions, especially when the winners are – in essence – determined largely by random.

We look to the winning table to see how we should react under similar circumstances – we seek guidance from the supposed omniscient. And we fail by doing so.

Now, let us return our attention to the folks on screen. Like poker, financial markets are also stochastic in nature. In order to mitigate inherent randomness, analyst should view markets based on a well-developed epistemology – in this instance, an epistemology based on the science of economics.

Nassim Nicholas Taleb writes of the young bucks of finance: seemingly invincible lads who quickly rise to the top of the investment game – winners one day, losers the next. They play like our mysterious fellow at the craps table above. While they are rolling with luck on their side, everyone wants a piece of their action. Once luck runs dry, the lads are cast aside, vilified and forgotten.

However, there is more to the investment game than just luck. Or, there can be. A wise lad will invest like a poker player, using a system based on a thorough understanding of probability and likely action. Nevertheless, a black swan can ruin the run and send the lad packing.

Of course, the more cards you see, the better your odds at the card table – if you use that knowledge as
action knowledge and not just data points of information knowledge. The same holds true for investors; the more action knowledge they have, the greater their chance of success, in spite of lurking black swans.

Consider a panel of financial commentators this time last year debating the likely scenarios for 2008. Predictions are made that span the continuum of possibilities. But one man stands out: Peter Schiff. Schiff alone is predicting a sharp downturn, and his fellow panelists are smirking on the split screen.

Fast forward and Schiff is the clear winner. But we need to ask these important questions: Was Schiff’s accuracy the result of luck? Did random events conspire to support his prediction? Or, was Schiff’s accuracy based on a greater knowledge and understanding of the market and government interventions?

I would say that Schiff noted the black swan on the horizon and acted on that information. He was not (and is not) omniscient, he simply applied his understanding of economics to connect obvious data points. And he yelled “black swan” for all to hear. But most financial commentators – the talking heads – just laughed: There goes Schiff again, connecting dots and finding black swans.

While it is true that most card players have a system, the underlying factor is luck. Financial commentators also have their own system, with most systems relying more on luck than on knowledge. Yes, there was some positive news despite the downturn in late 2007. However, to connect those dots and see a likely upturn is to ignore the more ominous ones in plain view. Yet many folks were willing to bet once again on their last hand, as if a reshuffle never occurs.

Of course, luck does play a role in financial predictions. However, more times than not, luck is mitigated by the fundamentals. And Schiff based his predictions on the fundamentals, and a strong understanding of Austrian economics.

So, Schiff won. When you replay his predictions, you will see that he stated what was likely to occur and why. His reasoning is sound if you accept the Austrian approach. If you tend toward any other school of economic thought, Schiff’s reasoning is spurious at best. The fact that he won should be enough for investors to review his system. But most do not.

Unlike a poker player looking for any advantage, and willing to consider any system that wins the day, financial commentators hold onto systems because their systems are based on politics, not economics.

Was Schiff just lucky? No. Schiff won because he analyzed market data based on a comprehensive understanding of Austrian economics. And, amazingly, the house still allows financial players at the table to use his system – or any similar system.

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