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Structural Misinformation in Financial Markets

Recent events have brought attention to misinformation, both during the pandemic and with the geopolitical conflict and war. But misinformation has always been present in financial markets and often disguised as analysis. It was just impossible to differentiate between actual information and misinformation due to nature of markets.

Efficient markets leave little room for profit above what passive investing can offer. Asymmetric information and, more importantly, misinformation, have played a key role in a game where profits cannot be easily made if there are no losses by making the markets inefficient. The zero-sum game is true in a structural way in all derivative markets and also true in the case of stock market speculative trading.

I have never paid much attention to claims of celebrity fund managers about their approach, or methodology, to markets offered post hoc as a justification of a long success record.

Why? Because given a large pool of investment managers and traders and by virtue of a statistical distribution, some of them will be found at the right tail even for extended periods of time. However, it could have been luck or specific market conditions where the random strategies they used were successful.

I have written an article about a fictional fund manager, Felix Grandluckmeister, about the role of luck in investing and trading.

CTAs are another example: due to special conditions in futures markets and primarily a rising bond market for several decades, they managed to make significant gains for about two decades before their performance plunged near noise levels. Crowded markets and no barrier to entry also played major roles in the annihilation of CTA returns as a group but those are just some of the factors that point to misconceptions about trading and investing caused by misinformation mainly.

In my opinion, below are three major sources of misinformation:

  1. Technical analysis and the naïve view that price and volume can provide an edge.
  2. Macro analysis and frequent use of dual-axis charts.
  3. Popular articles and books with post hoc claims for the reasons of high performance.

Technical analysis is indistinguishable from astrology. What may provide an edge is using technical analysis in ways to generate idiosyncratic edges. Those edges can be hardly replicated because trading and investing are much more than the methodology used to generate signals: risk and money management play a decisive role in performance. In fact, naïve application of technical analysis and backtesting of these methods have contributed to a massive wealth transfer from uninformed users to professionals.

Macro analysis is indistinguishable from tasseography. The economic, political, social and investment conditions are dynamic and always different. The past cannot forecast the future.

There are also those cute stories about investment styles and methodologies. In fact, those are non-falsifiable theories. Professionals know well that if there are no losers, nowadays called bagholders, they cannot make huge profits. It is rational then to assume they will never disclose their true edges. Even when they do, there is no way of confirming performance was due to some edge. Therefore, the information is useless and I don’t distinguish between useless information and misinformation although this can be perceived as an extreme stand.

I have written before in a book that if someone gives the exact same trading strategy to 10 traders, they will produce 10 different performance records and differences may be extreme. Especially in the fund management space where there can be transactions outside of regular exchanges, there may be huge differences due to timing, liquidity and many other factors.

Misinformation has been one of the modes of operation of the financial industry. Only the fact that one group of analysts claims the central bank won’t hike rates while another group claims they will hike ten or more times, this already amounts to structural misinformation.

Misinformation in financial markets is structural only by virtue of fact that analysts can have diametrically different views causing cognitive dissonance to market participants. On the other hand, it is necessary for the markets to exist and function.

The conclusion is that all edges are idiosyncratic attempts to deal with structural misinformation and luck plays a significant role in performance. Post hoc narratives of success have little value, can be even misleading, or part of misinformation.

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Disclaimer:  No part of the analysis in this blog constitutes a trade recommendation. The past performance of any trading system or methodology is not necessarily indicative of future results. Read the full disclaimer here.

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