Bad Trades as a Macro Parable

There are two types of bad trades.  The first is the mode-mean trade where the mode is positive the mean zero or negative.  One shouldn’t make this kind of investment, because at best it simply adds noise to one’s portfolio.  The net return to the passive investor can be especially negative because often they mistakenly overpay for management, not anticipating the drawdown, and the agent does not payback old profits when this is all revealed. Such trades are common in financial markets, and savvy investors are very aware of them.  Junk bonds, writing out-of-the-money options, hurricane insurance, are good examples.

Another type of bad trade is where losses are expected initially, but supposedly it’s just a learning curve or scale issue, and eventually once all the ducks are in a row the positive cash flow supposedly appears.  These are more common, as with any high frequency trading strategy that burns transaction costs, not realizing that those close-to-close returns used in the back tests weren’t realistic estimates of feasible net fill prices.

The more money an investor has tied up in such trades the lower their total return over the long run. You can try to avoid them, but a better priority is to simply identify them and flush them when they reveal themselves. That is, getting out of bad investments is probably the single most important thing an investor can do,as opposed to finding alpha, which is simply much harder.

Our economy has many such bad trades going on at any one time, and the sooner these are abandoned, the quicker people will reallocate their time towards something that actually costs less than its revenue.  Consider guarantees to farmers, which supposedly allow farmers to withstand the vagaries of weather, ensuring our very survival.  We have policies that encourage producer cartels, direct payments via subsidies, paying farmers to not farm, disaster aid, insurance subsidies, and export subsidies and import tariffs. So now farmers who suffered from the recent drought directly get fully insured payments, and those who avoided it get the revenue from higher prices.  This isn’t helping us become more efficient farmers.

Then we have clean energy, education, defense, high-speed rail, all costly investments that potentially will pay off big eventually, but in practice are subverted by special interests into a focus on producers not consumers.  If the negative present value were revealed via the negative cash flow at market prices, an efficient response would be to reallocate capital and labor. Instead, these activities are propped up under the hope that mere time will allow some sort of critical take-off point in future productivity.

Many like to deride the short-term nature of markets, but the long-term rationalizations of top-down industrial planning is much worse.  It’s not like our non-market economy is allocating capital like Berkshire Hathaway, rather just a series of patches to problems created by prior programs.

The best way to increase productivity is to stop doing things that have negative NPVs because these have massive opportunity costs, and this is best reflected by the true discounted cashflow sans government in its myriad forms. Obviously this is a pipe dream, but it’s an example of the way government can help the economy and reduce spending simultaneously.

There would be some costly adjustments, but as they say, when you are in a hole, stop digging. What is prudence in the conduct of every portfolio can scarce be folly in that of a great kingdom.

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About Eric Falkenstein 136 Articles

Eric Falkenstein is an economist who specializes in quantitative issues in finance: risk management, long/short equity investing, default modeling, etc.

Eric received his Ph.D. in Economics from Northwestern University , 1994 and his B.A. in Economics from Washington University in St. Louis, 1987

He is the author of the 2009 book Finding Alpha.

Visit: Eric Falkenstein's Website

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