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The perils of imperfect information — Pop Economics

The perils of imperfect information

by Pop on April 21, 2010

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What you don’t know can cost you money.

First, thanks to everyone who’s filled out my reader survey so far. I really appreciate the response. Since I’m all about incentives, I’m randomly picking two respondents who’ll win $10 Amazon.com gift cards. So if you haven’t filled it out yet, what are you waiting for?

So a few days ago, the SEC brought its first huge case against a major investment bank (though not technically an i-bank anymore). At the center of the controversy: Whether Goldman Sachs fraudulently misled one investor into thinking that another investor was betting the same way. It turned out that investor #2 was actually betting the opposite way, and investor #1 ended up losing nearly $1 billion.

That’s a gross simplification, and I’m not going to get into what I think the implications are for Goldman and everyone else involved. But the case does highlight one, immutable fact of the markets that applies to every economic decision you’ll ever make: Markets aren’t efficient unless everyone has all the information.

In the Goldman case, the SEC is alleging that had investor #1 known investor #2 wasn’t on its side, investor #1 would have never taken the bet. It’s kind of like how I would never trade players with John Schuerholz if I were a general manager in baseball. Schuerholz is so good at spotting talent that if he’s on the other side of the trade, you just know he’s getting the better end of the deal. (Sorry for the baseball analogy to non-watchers).

But the fact of the matter is, in almost every decision you make, your decision will be governed by how good the information you receive is. And most of the time, you won’t know everything.

Another strike against the “efficient markets hypothesis.”

It almost isn’t fair to beat up on this sucker now. I don’t think very many people believe in efficient markets anymore, save its economist creator, who will no doubt cling to his legacy until the day he dies. The theory basically says that market prices accurately reflect all known information about companies’ fundamentals. In other words, you can’t get a good deal on, say, Home Depot stock, because if there was any deal to be had, the market would have snapped it up already.

Most of the time, I rag on the efficient markets hypothesis because of behavioral issues. That is, investors don’t act rationally when they’re caught up in a bubble or frightened by a crash. So, you’ll get Pets.com stock going to incredible heights in 2000, even though there’s no apparent reason investors should be willing to pay so much for a profitless company.

But the Goldman case highlights the other problem: the informational imbalance. Goldman and investor #2 knew something that investor #1 didn’t. The SEC says that tricked investor #1 into making a bad bet.

That doesn’t happen often. Most of the market’s biggest investors do a ton of research before placing millions at stake. So unless someone’s breaking the law, they should know everything relevant there is to know before taking a position. However, that’s not always the case. Plenty of company weaknesses have been found out by intensive research of public documents. It’s not that investors didn’t think the info was relevant before the big, disastrous news story came out. It’s that they didn’t know the information was there.

Informational inefficiencies in everything you do.

You’re not immune to the phenomenon. Here are three big spots where you face an informational disadvantage.

The Markets

I won’t harp on this one too much. Mutual fund managers, hedge fund managers, investment bankers—all these guys spend thousands of hours per week trying to find mispriced investments to make a profit. You probably spend no time. If you’re smart, you just buy index funds and don’t worry about the mispricing.

The biggest mistake I see novice investors make is to go from spending no time on their investments to spending a couple hours per week on their investments and trying their hands at picking individual stocks. Because they spent no time on it before, researching a few companies for a few hours per week seems like a lot. But their informational disadvantage compared to a professional is still huge. Sure, they might get lucky or not suffer from a behavioral bias that’s hurting the professional, but I wouldn’t want to make a living doing that.

The worst part is that the underinformed investors actually have more confidence than the completely informed investors. A few Cornell school of management professors ran an experiment where one set of subjects got one point of data with which to make investment decisions and a second set got three points of data. The lesser informed set actually made investment decisions with more confidence. Until, that is, the professors let them know that there was a second set out there with more complete information.

So consider this your wake-up call: There are other investors out there who have WAY more information than you.

Your Career

Unless you work in public office (and perhaps even then), you don’t know what your coworkers make. Unless you get multiple offers from similar companies (and perhaps even then), you don’t know if you’re getting over or underpaid. For some reason, at some point in American history, employees started to equate their salaries with their self-worth. And because of that, everyone got uncomfortable talking about pay. And employers have loved that informational disadvantage ever since.

Luckily, with the advent of the internet, there are a few ways you can start to balance it out. First of all, if you are a government employee, what are you waiting for? It shouldn’t take much Googling to find a searchable database of your coworkers’ salaries. Here’s one for New Jersey. Unfortunately, the one place where salary info is transparent is probably the place where it’s the most regulated—so good luck doing something with that information.

PayScale.com
is another tool that can give you general salary information based on your position, location, and experience. Visiting the site will let you get information based on your specific situation (it costs money), but here’s a little widget that will at least let you get a general sense based on a couple variables.

But perhaps my favorite example of employees striking back at salary misinformation is at GlassDoor.com, which allows you to anonymously post salaries on specific companies. So I can see, for example, that a software engineer at Google makes $98,924 on average, where a software engineer at Yahoo makes $101,878. The info might work even better at small companies (I’m sure software engineers at both Yahoo and Google do drastically different things), though you start to sacrifice anonymity the smaller you get.

Your purchases

Of the three I’m listing, this one is probably the weakest. That’s because on most products, stores freely advertise their prices in the hopes of getting you in the door. You probably know of PriceGrabber.com, Shopzilla.com, and any number of other price aggregators.

Instead, retailers get the advantage by selling baskets of products or upselling you on a service you don’t need. Comparison shopping for a cell phone provider, for example, gets confusing when you don’t know if you need the plan that charges a daily fee for access and $0.10 per minute rates or the one that has no access fee and $0.25 per minute rates. (BillShrink.com has a great tool that can analyze your usage though.) You’ll comparison shop on the flat-screen TV, but will arrive at the store having no idea that Best Buy’s biggest margins are on the ancillary products, like HDMI cables. Best Buy’s CEO famously called customers who buy baskets of goods “angels” for helping his company make money. (The guys who bought just the discounted TV were labeled demons.)

I guess self control is the best defense against this kind of edge. But if that Cornell study holds water, an awareness of your informational deficit should at least make you a little more cautious when making decisions.

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{ 4 comments… read them below or add one }

azmyth April 22, 2010 at 12:03 pm

“Markets aren’t efficient unless everyone has all the information.”
The exact opposite is true. Markets don’t even exist if everyone has all the information. If those traders had all the information, they wouldn’t need to short stocks, they wouldn’t need to buy stocks. Everyone would know exactly what they were worth and no trades would ever take place. Differences in opinion, preference and information are the only reason why traders trade. Markets are an institution designed to gather information – they work best when information is distributed; when people in general know a lot, but the knowledge is spread across a large group.

Rob Bennett April 22, 2010 at 1:41 pm

Markets aren’t efficient unless everyone has all the information.

Thank you for saying this, Pop. Helping people understand this is the key to getting our markets working again.

The truth is that the market wants to be efficient. The market can be efficient. And we all need the market to be efficient if we are to stop our economy from going over a cliff.

But the market is not automatically efficient. People need information about how stock investing really works if they are to make the decisions they need to make for the market to be efficient. The Great Sad Irony of It All is that they cannot get that information today because those who still cling to the idea that the market is automatically efficient have not been able to acknowledge their mistakes.

Once they do, look out world! We are going to stage some economic comeback in this country! I very much look forward to that day.

Rob

K Smith April 23, 2010 at 5:32 am

The reason that so many are sitting on the sidelines is exactly what you are describing – people now know that what they didn’t know has cost them lots of money.

People didn’t know mortgages that should have never been made were used to back large dollar volumes of securities that were far riskier than advertised. The securities were insured against loss, but they didn’t know that the insurance companies did not underwrite them accurately and did not have enough to cover the losses when they went bust, which precipitated the world financial meltdown.

There is still a lot they don’t know. I suspect that most do not know that the mortgages that backed those securities continue to languish on the balance sheets of zombie banks, and that our government is in the process of moving the debt bubble from the zombie banks to pension funds.

People now know that our financial system is much more complicated than anyone ever imagined. Even the experts don’t understand it well enough to predict what will happen.

People now know that they do not know. They know that even the experts don’t know. Given the level of uncertainty, the risk of making a bet on the market is too high.

Bender April 24, 2010 at 2:40 pm

What is truly amazing, is that any institutional investor that would alter their bet based on who was on the same/opposite side of the trade didn’t get specific confirmation of that before signing on the dotted line.

I also find it puzzling (in fact I’m somewhat dubious) that these institutions would hinge their decision on whether or not Paulson was on their side of the trade. I mean did they really think that their supposed “edge” was whether Paulson was long? If so, I would think the right answer is to either (1) not enter the trade or (2) get a commitment that Paulson was long and would stay long.

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