Essay: "Being Ignorant the Hard Way"

"Beware of the man who works hard to learn something, learns it, and finds himself no wiser than he was before. He is full of murderous resentment for people who are ignorant without having come by their ignorance the hard way." - Kurt Vonnegut

If you're a big corporation, and you want to defraud your shareholders by withholding information, there are two basic ways to do it.  The first, and most obvious, is to just withhold the information.  The second, and more devious, is to obfusticate.  You bury relevant information in complicated documents.  You hide it in the fine print.  You disclose so much information that people give up instead of reading it all.

Although not many people realize it, the fraudsters at Enron followed the latter strategy.  Malcolm Gladwell wrote an article called "Open Secrets" in which he described how Enron had, technically, publicly disclosed all of their accounting shenanigans.  He points out that in 1998, when Enron's share price was $40, a group of Cornell business students carefully poured through Enron's public filings and determined that Enron was pursuing a risky strategy and manipulating its earnings.  The marked Enron down as a sell, years before the company went bust.

Pretty smart right?  Well, no.  Becuase Enron's stock peaked in August 2000 at $90 a share. In 1998, Enron might have been nothing more than a Ponzi scheme, but it was just about the best stock you could buy.  Those Cornell kids were so smart they were stupid.

What does this mean?  Well, I'm sure if you're an unreflective free market enthusiast, there's a way to explain it away somehow.  But however you dress it up, it strikes to the heart of market capitalism.  The name of the game when you're investing is not to be "right", it's to make money.  We're all trying to retire while we can still live a little, here, not to get bragging rights.  And it seems to suggest that being smart and doing research is pretty pointless.

If any of those Cornell students decided to short Enron back in 1998, they would have lost their shirts. It wouldn't have mattered that they turned out to be right in the end. So what if they got an "A" on their paper? They would be broke.

In fact, I worked (briefly) on a lawsuit involving some of these issues.  Google "Fairfax hedge fund lawsuit" if you're curious. Basically, the plaintiff corporation alleged that a hedge fund shorted its stock when it identified what it thought were accounting irregularities.  When the share price of the plaintiff continued to rise, the fund allegedly became desperate and began to smear the plaintiff.

You can easily see how this could happen.  Imagine a fund had shorted Enron in 1998.  How desperate would they be when the share price hit $60?

Anyway, the point is that the price of shares is driven by the decisions of ordinary people who are reacting to rumours, not crunching a lot of numbers. The market is a casino on the deepest level.  And that's what we need to remember. We need to be humble about our ability to predict market returns based on our reseach.  All the work the Cornell students did was great. The danger comes if they took a huge bet based on that work. Such a bet would have wiped them out.

It's easy to be seduced by your own research, to think you've figured things out.  We have somehow convinced ourself that we can iron out the wrinkles of life, cut out all of the chaos, but this has led us to being terrible, as a society, with risk.  We've seen that with the failure of banks and even whole countries.  All of these problems had different proximate causes but they all fundamentally arose because extremely sophistiacated individuals simply did not comprehend and accept that we live in a world where unexpected things can and do happen.  In doing so, they made those disasters more likely to happen, and bigger when they did.

The solution is not better modelling, or different assumptions, or more work. We need to change our whole starting position.  We need to admit we do not know, and cannot know, what is going to happen in the future.  The solution is to be humble, on the deepest level, and to be prepared for serious contingencies.  In particular, large actors like countries and banks need to have enough money in case their projections turn out to be flawed. The future is a grey land, always shifting, and it does not necessarily belong to us.

It must be hard for people like those hard-working Cornell students to admit that they can't predict the future much better than someone much stupider and lazier than them.  No one likes to believe that the work they do is pointless.  But it's even harder to lose all your money.

(I recommend checking the book The Black Swan by Nassim Nicholas Taleb if you're curious about this issue.)