Wednesday, July 29, 2009

Bubbles at the speed of light

A friend of mine, trained in physics, once told me that he never expected to be in a profession where the speed of light was a limiting factor. That profession was finance, and this article by Paul Wilmott explains why (and also explains why the author is worried): computerised stock-market transactions now take place at speeds limited only by computer hardware and communication systems. But I was particularly struck by the closing paragraph:

Buying stocks used to be about long-term value, doing your research and finding the company that you thought had good prospects. Maybe it had a product that you liked the look of, or perhaps a solid management team. Increasingly such real value is becoming irrelevant. The contest is now between the machines — and they’re playing games with real businesses and real people.

I wrote something extremely similar in the last paragraph of a blog post some time ago:

Once upon a time, you decided whether or not to buy a stock by comparing its price with the earnings of the company, estimating the dividends you would get, and comparing with other investment options. Somewhere along the way, the goal of investment changed into something rather different: buy a stock in the hope that its price will rise, and sell it. It doesn't matter if it is ridiculously overvalued: if the market is going up, buy. What exactly was wrong with the old model, and how many mutual fund managers actually looked into the strengths of the companies in their portfolios before putting their customers' money into them?

Wilmott doesn't talk about mutual funds, but to date his is the only article I have read that raises the question of investing for long-term sustainability. His NYT article talks about how bubbles grow and burst. It seems clear to me that most mutual fund managers feed (and feed on) bubbles, rather than look at the long term. It is not clear to me that, even today, investing with a long-term perspective in a sound company is a bad thing to do.


gaddeswarup said...

This does not answer your question :Identifying and Popping Bubbles: Evidence from Experiments, but there is some advice like "Bubbles are also less common with more experienced traders - this is one of the strongest findings. Don't get too excited about this, however, it's experience with bubbles that counts not just trading experience."

km said...

Time to roll back the 56K modems, eh?

//I love to harass financial planners by asking them why I shouldn't just invest in a no-load, low-cost Index fund and save all the commission fees. The look on their faces is *priceless*.

gaddeswarup said...

Tossing around at 4 in the morning found this which may be more relevany but I cannot understand it;

Ramanan said...

Absolutely. In fact Mutual Fund Managers try to pump up stock and commodities price near the year end, so that they show a book profit and get a handsome bonus. That is my 2-cents. May I request you to have a look at an article on Commodities Market Bubble by a favorite Economist of mine named Randall Wray ? It is here