Wednesday, April 30, 2008

Adam Smith Was Not in the Prediction Business

Not knowing momentum's causes should not prevent us from acting. Followers of Adam Smith understand that markets work in invisible and unfathomable ways. There's a lot we don't know-a reality that effective advisors and investors accept, even embrace. Momentum sure seems real in the data. The question is what we should—or shouldn't—do about it.”

So says Gene Fama in his ‘The Big Mo’ in the 1 May issue of Financial Planning of New York (HERE).

Adam Smith knew how markets worked. They weren’t ‘invisible and unfathomable’. That’s a gross exaggeration. We can explain what happened after it has happened, or is happening in the abstract.

But what is ‘invisible and unfathomable’ is the future. Markets do not work in isolation from human behaviours. Our ability to predict how humans – all of them involved – will affect outcomes of myriad of transactions is severely limited, if not beyond us.

That’s where Gene Fama and his like come in. People with money want to make it work to give them more. Somebody wins and others don't whatever anybody predicts but whether anybody actually knows beforehand is doubtful.

Unfortunately, finance and its associated fields are not an exact science. It’s like predicting where a number of electrons are and will be next. You can’t be sure where they are or were, other than we know they are somewhere.

But if you can persuade investors that you know better than most others where their money is likely to increased, you can make a living, if your best guess is better than your rivals. Given that some ‘best guesses’ match what actually happens (sadly, many more do not), profits flow, fees are earned, and the investors and their advisers bask in their success. The others leave frustrated.

It’s the same with ‘investors’ who succeed in predicting the winners at the race track. One horse will win a race whatever (even whether) anybody bets.

All this has nothing to do with Adam Smith, who was not concerned with which tradesman, artisan or shopkeeper succeeded each week. He wasn’t in the prediction business; his task was to understand how the business of markets worked, leaving the winners and losers for them to discover for themselves, as they would whatever anybody wrote about them.

Trying to take economics, finance, horseracing or politics beyond that is ambitious, but lucrative if your clients' 'win' more often that they 'lose'.


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