Thursday, January 27, 2011

A new post by James Kwak, an old rant by me

James Kwak has an excellent post on rational maximizing, but while the whole thing is worth reading, this passage jumped out at me:
I say this is interesting because, on the one hand, I accept the random walk studies (and I personally believe I have no ability to predict where any security price is going tomorrow), but on the other hand I think that any idea that markets have fundamental levels is flawed. For example, housing prices are still falling. Some people try to predict how far they will fall by looking at the Case-Shiller Index and figuring out where the long-term trend line will be. But how do you look at a chart and figure out what the right value is? What if there has been something different about the market over the last one hundred years from the market today? It’s really a fool’s errand.
Kwak's objection reminded me of a similar problem I had with the book, "Lifecyle Investing," by Ian Ayres and Barry Nalebuff, one that finally made my head explode:
No one can possibly know what's going on here! We can get some smart people making good guesses about long term stock performance, but these guesses are based on data from a century's worth of secular upheavals. A list that includes the Great Depression, two world wars, a post-war reconstruction, the cold war, China becoming a major player, boomers entering the market, boomers leaving the market and huge changes in regulation, technology and business practices.

What's happening now never happened before. What happened before never happened before. What happened before what happened before never happened before. We have no precedents. People are recommending forty-year investment strategies using models based on data from markets that haven't gone twenty years without a major secular change.
I have great respect for economists, but, more so than any other field I can think of, they are shooting at moving targets and sometimes I get a bit nervous about their aim.

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