Economics for One

The Well of Infinite Depth

In high school calculus I remember learning about an equation for a 3-dimensional shape whose walls stretch to infinite, but whose volume is limited. Imagine that! It’s like a flower vase that stretches from the earth to the moon, and off to the stars, but which only holds a cup of water.

It’s really neat in theory.  But it doesn’t hold up in the real world.

A lot of economic theories are like that.  They assume that the financial world is infinitely deep, and that their actions are just a tiny part of that. And they may even work—so long as most people don’t use them.

One example is index funds.  Index funds attempt to mirror the market by holding a set of securities in the same proportions as the market.  The theory is that the market incorporates all known information, and represents the best understanding of relative values, and so you cannot own any better portfolio than the overall market.  (The counter-argument is that the market really represents a voting system, and often includes a great deal of emotion.  And there are plenty of examples of stocks rising or falling for reasons that have nothing to do with the underlying value of the stock.)

But if everyone owned index funds, who would be left to set the relative prices?  As more and more people subscribe to index funds, the number of people who are setting the prices goes down, until eventually (in the absurd) a single person is setting relative prices while the rest of the world just follows that person’s allocation.

There are many more examples of financial theories that break down as their adoption rate goes up.  And it’s worse for the better theories.  When people realize they can get an edge, their method, theory, or whatever, quickly spreads through the financial community, thus violating the premise that most of the market is not using it.

So what is the solution?  Two parts:

  1. Don’t rely on theories that require you to be a small part of the market.  Instead use approaches that are independent of how much of the stock or how much of the market you own.
  2. If you do find a trading edge that requires you to own a small part of the market — keep it to yourself!

And finally, if you find that the market is following a theory like this, be prepared for a breakdown, and position to take advantage of it.

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1 Comment so far

  1. Steve November 26th, 2009 5:45 pm

    I like your comments.

    You mention, your calculus class. Well consider feedback from an electronics class. It seems, the economic model can be considered a feedback. I think it should be called positive as opposed to negative. But, anyway too much feed back will cause oscillations, or instability in general. The Fed can be called a controlling response, hopefully usually applying a damping effect. The index funds as you posed should be analagous to a voltmeter, but it isn’t as it is applying a feedback.

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