“The fool doth think he is wise, but the wise man knows himself to be a fool.” – William Shakespeare, As You Like It
When you are choosing to be an investor, you are choosing to expose yourself to the baser nature of human beings, and the market does bring out that animal spirit from many of its participants. You will see the triumph of entrepreneurship over harsh conditions of the economy, but you will also see the desperation that drives many to play unfairly and to deceive others in the pursuit of monetary gains.
What the efficient market, behavioural theory and many other investment theories do not teach you is the fact that there are various characters that play in the market. Regardless of the presence of asymmetrical and insiders’ information, some enter the market as pure of thought and as trusting as a fresh born doe, unthinking of the Jabberwockies that they might encounter.
There will always be someone who knows more than you do, whether they would take advantage of you depends on their moral compass and savvy.
Your spider-sense should be tingling when you have passionate, emotional shareholders tweeting the same name over and over again, or dodgy stockbrokers touting the shares’ worth. Two maxims to keep in mind: gentle ladies do not need to advertise their worth like the ladies of the night; and as John Hempton of Bronte Capital said, securities sellers sell securities – not companies.
|Type Prisoners Dilemma||Optimal Strategy||Examples|
|One time no knowledge||Betray partner||Predator Prey (Buyer beware)|
|Infinite repetition||Be loyal first time, return in kind thereafter||Super co-operators (Ants and human ingenuity, contracts, on-going business model)|
|Repeated process BUT expected by one side of business to end soon||Prey on others altruism naiveté until they catch on||Devious ant, Bubble market, short term business model (Travelling salesman)1|
Unsophisticated investors are slow to realise when they have been deceived. This vulnerability leaves them to be exposed to the kind of Prisoners Dilemma exampled above. From ‘hot’ commodities to the next ‘break-through’ biotech, the promise of a sure thing, a lottery ticket fogs even the most reasonable minds. If you study the above table, I am sure a few companies’ names and instances come to mind.
People are not entitled to profit and growth. But they are entitled to honesty and respect. ¹
A business that is about to collapse will have an increased level of deviousness. There is a great pressure for insiders to portray to outsiders that the business is still progressing at the same pace, at the expense of the future health of the company. The management is “rewarded for shifting profits or sales growth up front, at the expense of either outright cannibalising the future or shifting the risk to a later date and off balance sheet”¹.
Investing with Uncertainty and Potential Asymmetric Information
|Easy for others to estimate||Hard for others to estimate|
|Easy for you to estimate||Tough to beat the markets||They’re the Sucker|
|Hard for you to estimate||Sky Masterson’s Dad, You’re the Sucker||Buffett’s reinsurance sale California Earthquake Authority2|
The table above shows investing with uncertainty and potential asymmetric information, otherwise known as ‘Who is the sucker’? Perhaps it wouldn’t be a surprise to you to know that some IPO firms understate the non-observable market price of pre-IPO shares to manipulate the value of stock options.
According to a study conducted by Anthony J. Amoruso and Joseph D. Beams, “during the height of the IPO bubble, CEO pay was associated with the undervaluation of stock options by IPO firms. The discretion varies with the relative mix of cash versus stock-based compensation. Firms with higher cash compensation tend to undervalue the unobservable market price of pre-IPO shares, leading to lower option values and a lower likelihood of reporting in-the-money options. Firms with greater stock-based compensation understate stock volatility resulting in lower measures of the time-value component of options”.
In short, this means that firms “attempted to disguise the true value of CEO pay when making IPOs. By disguising the value of options granted to the CEO, outsiders were not aware of the actual cost incurred and the true value of the company”.3
From Paul Scott, “A brief comment on what seems to be a trend at the moment for junior resource stocks to issue positive newsflow, and then immediately raise funding from a deeply discounted placing on the back of the share price spike.”
He continued, “so small shareholders need to realise that you are the cannon fodder to get the share price up, whilst other people get in on the discounted placings, and can flip their stocks for an instant profit at your expense”.
Having given those few examples, I would love to say that it is an efficient market. To be able to claim, by all means, information will be arbitraged and everyone has a fair access to the market and therefore, profit – and largely, it is.
However, we all live in the real world. All of us understand that a number of company reports are at best, make-believe fairy tales, and not even well-written ones at that. We all can see that CEOs are often susceptible to deviousness in desperate times; and suspect that some analysts or brokers may pander more for the institutional investors than what is right.4
So, be critical, be suspicious, be alert – the market has made many fools out of reasonable people. There is no way that a private investor may guard against all of these deceptions, to be able to identify all tricks, crooks and scum-bags. Nothing I can say would help, only bitter experience would be our best teacher so that we have a ‘nose’ for these kinds of things. We did not immerse ourselves into the world of investing just to be made a fool of.
The best practice to protect ourselves is to have a good safety margin; the riskier the investment, the greater the discount. Lets not be reckless in our decisions, hurrying into the position for fear of missing out. Most of all, make sure we research well. Common sense, I know – but how many of us actually do it satisfactorily?
Should I caution, ‘buyers beware, sellers be sure’? It is not that simple. Should I remind that ‘not all that glitters is gold’ – but how can we always tell? What about this, ‘a fool and his money are soon to be parted’?
All I can do is dredge up one last old saying in the hope that there will be a few less fools, including myself, in the market tomorrow; ‘if it is too good to be true, it usually is’.
“The Entitlement Paradox”; Russell Sears, Canadian Institute of Actuaries, Casualty Actuary Society, Society of Actuaries; 2013.
Capitalism and Society: “Investing in the Unknown and Unknowable”; Richard Zeckhauser, Vol. 1, Issue 2; 2006.
“CEO compensation and the reported value of stock options in initial public offerings”; Anthony J. Amoruso, Joseph D. Beams; 2014.
“Strategic distortions in analyst target prices in the presence of short-term institutional investors”; P.Balinski, K.Stathopoulus and M.Walker, Cass Business School; 2014.