There is a dirty little secret haunting Wall Street. And that secret is: amateur stock pickers outperform the experts more than 90% of the time. This performance of amateurs vis-à-vis experts in stock picking was in fact the touchstone of James Surowiecki’s 2004 best-selling book, "The Wisdom of Crowds." But Surowiecki’s evidence raises a troubling question in today’s news climate: if the S&P 500 or the Wilshire 5000 outperforms the experts – why the hell are these self-styled experts getting million dollar bonuses? Are there are a few geniuses that really really deserve the big money, super-geniuses so to speak? Surprisingly, the answer seems to be no.
A couple of facts from Surowiecki: (1) "Between 1984 and 1999...almost 90 percent of mutual-fund managers underperformed the Wilshire 5000 Index..." or to put it another way, their clients would have been better off investing in funds which simply buy these indexes; (2) "The numbers for bond-fund managers are similar: in the most recent five-year period, more than 95 percent of all managed bond funds underperformed the market."
Ah, you say, but what about those 5 – 10% of mutual fund managers and bond fund managers who do outperform the average. Aren’t they the ones who run the big funds and make the big big money? Actually, no. As Surowiecki writes:
"Nor was there evidence that even if most experts were not very good at forecasting, a few titans were excellent." He cites Wharton professor J. Scott Armstrong who surveyed expert forecasts and analyses in a wide range of fields and wrote: "I could find no studies that showed an important advantage for expertise."
These findings led Armstrong to formulate what he calls his "seer-sucker theory:"
"No matter how much evidence exists that seers do not exist, suckers will pay for the existence of seers."
But this raises a troubling question: suckers may pay for seers, but investment banks are not suckers. What are they paying for if not for seers? If there really are no "experts" on Wall Street, if you really are better off picking stocks based on the Wilshire 5000 or the S&P 500, then how do you earn a million dollar bonus? I’ve been thinking about this, and would like to offer an hypothesis for your consideration.
My hypothesis is that these traders actually do earn their big bonuses by trafficking in a very subtle, ethereal and dubious commodity: inside information that does not violate the law.
What does that mean? Surely all trading on insider information violates the law? Well, no, it doesn’t. As the Wikipedia article on insider trading puts it:
Not all trading on information is illegal inside trading, however. For example, while dining at a restaurant, you hear the CEO of Company A at the next table telling the CFO that the company's profits will be higher than expected, and then you buy the stock, you are not guilty of insider trading unless there was some closer connection between you, the company, or the company officers.
The hypothesis that I would like to put forward is that the million dollar bonuses paid on Wall Street are not paid for stock pickers or "experts" who can outperform the average – as mentioned, studies show this is "fool’s gold," that such experts simply don’t exist. What earns the big bucks, instead, are the old boy networks, the Skull and Bones connections, and above all, the Kabuki arts of sharing inside information without breaking the law.
What I am suggesting is that what earns Wall Street investment bankers the very large coin is exactly the same skill and art that earns Washington lobbyists the very large coin: the skill of using one’s old boy network to achieve "gray" goods, walking right up to illegality and stopping one hair breadth short. In other words, offering Senator X millions of dollars in campaign contributions, but scrupulously avoiding any mention of any special interest in pending legislation – until the lobbyist plays golf with the Senator later that afternoon after the fundraiser is over.
So what do you think? Do you agree with my theory that these guys actually earn these bonuses but in a dubious way? Or do you think the studies are wrong and that there are "experts" that can consistently make money on their smarts alone?