The Stock Market and Perceptions of Risk

Two articles of note about the stock market came to mind today. The first is “Beyond Value Investing: How I Realized the Internet Bubble was a Pyramid Scheme” by Bob Hiler. Hiler’s argument is that the internet bubble is a new form of the pyramid scheme - a distributed pyramid scheme in which no one person or group can be blamed, instead a bunch of individual actors, acting in their perceived best interest, created a pyramid which eventually came crashing down. Hiler suggest the following 4 characteristics of a pyramid and then demonstrates how each one of them worked in the internet bubble.

  1. Pyramids Tout A Revolutionary High-Return Strategy.
  2. Pyramids Have New Investors Transfer Money to Old Investors.
  3. All “Levels” Of The Pyramid Sell The Same Stuff To Each Other.
  4. Pyramids Make Competition a Good Thing.

Finally he concludes that we were all duped into thinking that the internet was selling opportunity instead of an actual product. Based on how many Time cover stories I remember reading from just a few years ago I have to agree that opportunity was in the air.

Could this have been avoided? We all like to believe that we are immune to the hype of commercialism, whether it be ignoring the latest ad for cola or deciding for ourselves what is a good investment. Unfortunately there is too much information for any of us to digest. Even the so-called experts aren’t always right. For that I cite an excellent piece by Malcolm Gladwell from the New Yorker “Blowing Up: How Nassim Taleb turned the inevitability of disaster into an investment strategy

Taleb is an investor in options. He buys stock options on both sides of the fence, betting that the market will go up or it will go down, and eventually it will go so far that his options will make a lot of money.

What Empirica has done is to invert the traditional psychology of investing. You and I, if we invest conventionally in the market, have a fairly large chance of making a small amount of money in a given day from dividends or interest or the general upward trend of the market. We have almost no chance of making a large amount of money in one day, and there is a very small, but real, possibility that if the market collapses we could blow up. We accept that distribution of risks because, for fundamental reasons, it feels right.

For Taleb there will be a day when everything moves dramatically or unthinkably and that will be the day he makes his money. On normal days nothing much happens or he loses money. But he knows that someday the unthinkable will happen and the other “rational” people who invest in the stock market will cause a bust or a boom that can’t be justified and he will be waiting to cash in.

I’m thinking to myself that this is a strategy I need to use. Maybe I should have become a broker. But fundamentally it undermines our notion of rationality. Sometimes the unthinkable happens and it cannot be avoided.