Fishing for perfect markets

By Savvas Savouri of Toscafund Asset Management

I have spent many hours impressing upon students this sad reality. Whilst in theory forecasting using good fundamentals should be enough to deliver success, in practice financial markets are stubbornly imperfect and favour bad techniques. To make this point I go fishing for analogies.

To set a scene, I ask the audience to imagine watching a Polynesian fisherman going about his work. Having waded into the clear blue water of the South Sea’s, he confidently holds a spear above his head and takes aim. With this imagery in mind I then ask the students to reflect on his fundamental technique. Why for instance is the trajectory of his aim not in the direction of where the fish appears to be. My point to them is ‘good’ forecasting does not confuse perception with reality. We consider the three judgements the fisherman is making; one based upon simple physics, another basic maths and the other behaviour theory. Using these in isolation the fisherman will fail, combine them and he will return home with a good return from his efforts.

Our good fisherman is aware the position of the fish is distorted. He may not know the precise science that because light travels at different speeds through air and water it kinks or refracts, but is aware of this distortion all the same. The second element our fisherman contemplates is momentum. He can see the fish is in motion and is aware it will have moved by the time the spear arrives. The third simultaneous judgement our Polynesian fisherman makes is the survival instincts of the fish. If it has not already been made aware it is being stalked by the shadow cast over it, it will certainly become conscious of a threat from the ripples set in motion by the harpoon entering the water.

Despite the complications, with painstaking teaching and practice the ‘good’ fisherman will not go home empty handed. His family is sure to be well fed, and he will impart to his sons the skills he had learned from his own father a transfer of knowledge that almost certainly has gone on for generations. Across our Polynesian fishing village bad fisherman have long vanished; Darwinian logic having seen they have. The population of the village has even steadied to reflect sustainable fishing levels. We have in effect a perfect market. Reaching this point I caution that financial markets have never reached this perfect state. To illustrate what I mean I return to the ‘perfect’ fishing village where only ‘good’ fishermen are at work.

I ask the student to assume ‘bad’ fishermen hadn’t been eliminated by Darwinian evolution and congest the waters around our good fishermen. Their presence introduces not only complications to our good fisherman but a threat to their very survival. Not simply are the spears being thrown wildly around in such a random way they are a danger to our good fisherman, they are causing chaos in the waters. Where fish once moved sedately in calm waters they are now darting around in panic, and so more challenging targets for even the best of our ‘good’ fishermen. Matters are worse still for our good fishermen. Many fish have moved away from their preferred coastal water habitat into deeper, colder and more tidal waters; from one inhospitable place to another. Moreover, through their sheer weight of numbers, the bad fishermen are spearing ever more fish as the good fisherman return home empty handed. Before long fish numbers plummet and order in the fishing village has turned upside down. Whilst the families of ‘good’ fisherman go hungry, ‘bad’ fisherman boast of their successes, convinced they were good rather than lucky. I end my lecture with these words, “welcome to the imperfect world of investing, if you want perfect markets forget finance go fishing in the south seas”.