The Error Cycle

Society is now so busy highlighting errors that it does not realise that it is repeating itself.

Everybody makes an error. It is a process of learning. Some errors are small, some big and some generational. Beyond a generation, a new cycle of errors and learnings starts, which is similar but not the same.

The Dow Index and after

In 1884, Charles Dow made the index and in 1984 the society started to trade a future on it. One can see a century long cycle of instrument evolution. Instruments launch and comprehension has a lag as traders and investors speculate, adapt and take risk. It is this risk which generates profits and losses.

1929 happened forty five years after the Dow index was launched. Societal interpretation of the Great Depression without Dow levels might seem like an incomplete case study. 45-50 years brought indexing into main stream. If 1984 is considered the other milestone of leverage derivatives, the complete picture might be visible near 2030. At 2010, we are half way through this journey, marginally aware of what leveraging can do to a portfolio and society.

As we proceed to the next twenty five years to complete our comprehension of what we created till 1984 we are going to see some paradigm shift. We are already witnessing a shift in intellectual and academic focus. It is less on idealising the profit cycle or positive of the creation cycle but more about glorifying errors. Off course it is all done elegantly.

Academic criticism can be scathing. Sometimes I feel lucky to be a practitioner and not a academician, but that’s an elusion. Read behavioural finance and you will see the who’s who of practitioners crucified (ok, that is a harsh word) for their judgement.

Repeating past errors

All this debate of behavioural finance junking 200 years of economics, efficient-inefficient collusion and Mandelbrot calling the bell curve nonsense all at the same time is not a coincidence. We are witnessing the down leg of the error cycle.

The error and the risk associated with instruments and creations of the past are today’s breaking news. So, if behaviourologists assume that they possess the truth and they have overcome gaps they should live and wait to see how gaps and errors of behavioural finance gets glorified 50 years after it was first mooted in 1972. Another interesting aspect is that all these errors talk overlaps because glorification has an element of noise or feedback loop as Robert Shiller put it. Society is now so busy highlighting errors that it does not realise that it is repeating itself.

Market cap driven

The investment world is based on market capitalisation (mcap). Increase in value of mcap is increase in profits. The benchmark that we follow or the indices which tell us we are relatively richer or poorer are mcap-oriented.

Fund performance gets compared to the same benchmark.

In the first part of the error cycle, where past creations were glorified, mcap was worshipped. Now in the second part of the cycle, we as a society are bringing the same idea down. Mcap investing, intrinsically is linked with buying higher and selling lower. If what goes up gets bigger weightage in the benchmark this is what it means.

On the other hand the loser or the underperformer loses market cap and gets lower weightage in the index or benchmark. If as a society we invest more in the winner as it outperforms and pushes up and less in the loser as it underperforms and pushes lower for more than 100 years than behaviourologists are correct regarding societal tendency to push winners higher and vice-versa.

This behavioural finance refers to as representativeness and momentum investing. This societal error is the reason why we know Buy-Hold without a Sell. This is the error why our risk return understanding is minimal. Rather than reducing our performers (winner) in our portfolio we increase them and we kick out the losers. This is also why we do not look at markets at March low to buy but in October high to get in.

Even if the errors are glorified and take more than the necessary sound bits this is the time for celebrating mistakes. Orpheus mooted the idea of performance cycles in March this year in a paper published at the Kyoto University. Performance cycle is a solution or reward against momentum or mcap investing. Even if behavourologists (being in the same camp) may disagree. This agreement should resolve in 2030 when this error cycles ends.

ORPHEUS RESEARCH AT REUTERS – UNITED KINGDOM

ORPHEUS RESEARCH AT REUTERS – USA

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