Mind of The Market
Risk means “getting hurt when it hurts to get hurt the most” — Cliff Asness, AQR Capital Management
Over the years, capitalism has emerged a somewhat imperfect but longer lasting economic order. Key to the success of capitalism has been the institution of free markets and the economy these markets create. One of the frustrations in learning about finance and economics is the fact that a lot of modern financial literature today strays away from common sense and simple explanations towards a more technical and numerical description of finance. Sometimes, it takes a teacher that can simplify seemingly complex concepts to kindle a love of learning. However, it is upto the student to meet the teacher half way. I will try my best to explain markets on the basis of my experiences with them.
This article traces the origins of markets, provides an overview of present day financial markets, imagines the future of markets and provides solutions to improve markets and capitalism itself to create a fairer and less unequal human world.
What Markets Are All About
There is a small joke you often hear about markets — “ no one can figure out the markets and the weather although not in any particularly order”. My personal take on this statement is that trading or investing was never about figuring out the markets but it was about discovering your own vices as a human and finding a way to be the best version of you.
Many hedge fund managers, stock and currency traders have wrestled with the market and have had periods of stupendous success followed by abysmal declines. There is no single strategy that has outperformed the broader market forever. Ultimately, the market changes it’s mind and a previously successful strategy is turned on it’s head.
However, some have created extraordinary wealth. George Soros, a hedge fund manager, recently donated roughly $18 billion of his wealth to philanthropic endeavors. However, one thing common amongst all of these players has been the fact that their activities in the financial markets forced them to reflect on their character. Ray Dalio, manager of the largest hedge fund in the world Bridgewater Associates, went one step ahead. Not only did he pen down his lessons in a recently released book titled “Principles” but also codified his principles in algorithms to run his hedge fund and manage people employed by the fund.
Think of markets as a mirror and your life as a fleeting image cast upon it.
The Little Prince And His Imaginary World
I grew up a Gujarati in Western India. My community ‘the Gujaratis’ were mercantile and seafaring people. In fact, the word ‘market’ originated from the Latin ‘Mercatus’. It goes without saying, therefore, that trade and commerce are the dominant means of earning a livelihood for Gujaratis.
Whenever my father uttered the word ‘market’, it would conjure images, in my mind, of sand dunes and people sitting under canopies. In Arabic, markets are called ‘Souks’ and in Persian ‘Bazaar’.
Growing up, I remember the Gujarati version called ‘bajaar’ very often. I often ask myself “How do you eliminate an integral part of your childhood?” The answer, I soon found, is you can’t. The imaginary world just grows larger until it completely engulfs you.
The origins of markets can be traced back to 3000 BCE where zoning laws confined markets to a particular place. A market is a place (physical or virtual) where people gather to buy and sell goods at a mutually agreed value called ‘price’. If a buyer buys from one market and sells in the other at a higher price, that transaction is called ‘arbitrage’ and the buyer an ‘arbitrageur’.
One of the first words I learnt was ‘price’. The price is the value at which goods are exchanged. It could reflect the intrinsic value of things such as what the good would be used for. Intrinsic value may or may not be the same as the price at which the good exchanges hands. Gold is used for industrial purposes and jewelry which gives it its intrinsic value but a price can also me made up of an extra value depending on perception of value. The word perception is very important because as I discovered most things in life are percpetion and not the truth. The ability to separate the two comes through personal experience.
Traders can also be named ‘market makers’. They make money off the difference between the price they buy (bid) and the price at which they sell (ask) the same good. The profit margin is also called a ‘bid-ask’ spread’.
The market, to me, always had a mind of its own. Also, a heart of its own which isn’t always rational but which keeps the flow of trades going on nonetheless. Much like human nature which has a logical side and a whimsical streak. Think of markets as a giant social experiment in human psychology and you soon figure out that there are some rules but they don’t always apply.
Math and The Modern Markets
Financial markets are places (exchanges or OTC markets) where stocks, bonds, money, commodities, derivatives, currencies and cryptocurrencies are traded.
Stocks also known as shares or equities represent ownership in a company and it’s holders (shareholders) are rewarded by a share of profits (either in the form of dividends of price appreciation or both). Bonds are loans given to a company which carry a fixed interest rate which has to be paid before shareholders can receive dividend.
Money markets are usually interbank markets where central banks and other banks lend each other money for a day or a short term and charge interest for the funds.
86% of currency trade is in Dollars. However, currency or foreign exchange markets allow trading around the clock 24/7
Derivatives are contracts that derive their value from an underlying financial asset such as stocks, bonds, commodities or currencies. Structured derivative markets are called futures markets which have fixed contract sizes (called lots). Unstructured markets are called forward markets. In both cases, irrespective of the financial asset involved, the forward or future market price reflects the participants perception of the future i.e. some expect the price to go down (short sellers) while others expect the price to go up (traders who go ‘long’).
Whenever a market maker or a middle man/intermediary is involved, the market is known as an exchange. When two parties directly trade with each other, the market is known as an Over The Counter (OTC) market.The largest market in the world is the currency market:
- Foreign Exchange (FX/Currency) market ($ 4 trillion a day)
- Over The Counter (OTC) derivative markets ($630 Trillion to $1.2 quadrillion),
- Global debt ($199 trillion),
- Broad money (cash, notes and deposits — $81 trillion),
- Global GDP ($78 trillion),
- Equity markets ($70 trillion),
- Gold ($7.8 trillion),
- Commercial real estate ($7.6 trillion),
- Private Equity ($2.5 trillion),
- Crypto currencies ($173billion) and
- Venture Capital ($100 billion).
Many say data is the new gold. To me, it was always gold. Decisions made on the basis of fundamental value are known as investment decisions while those made with short term gain in mind are trading decisions. Decisions made for pure profit without any fundamental reason are classified as gambling while educated guesses are speculations. Trades performed using information obtained through insiders (which is illegal) is known as ‘Insider Trading’.
There are roughly 280 stock markets in the world with roughly 37 countries not having an individual stock exchange. Several countries have multiple stock exchanges. The number of stock markets are more than the number of countries in the world indicating the depth and breadth of free markets across the world and the need for capital and liquidity so much so that alternative trading venues known as Private Markets and Dark Pools have emerged to create a small club of limited market participants who do not wish to trade in the broader markets.
Dark pools are private markets mostly run by international banks that allow trades in large blocks. These private markets emerged in 1980’s and are known as dark pools because of the absence of visibility into its operations.
In the USA, there are approximately 45 alternate exchanges mostly dark pools which are growing in volume every day.
Private markets involve private trades (buying and selling) of existing investments to private equity firms, hedge funds or other alternative investors. An alternative investment is an investment other than stocks, bonds and cash.
High Frequency Trading (HFT) and Algorithmic Trading
High Frequency Trading emerged in the 1980’s and involves trades executed by computer programs at extremely high frequency and within seconds to take advantage of price movements that occur over seconds of time. Both algorithmic and HFT are performed by computer programs. High Frequency trading is a subset of Algorithmic Trading
Unpredictability begets risk and risk begets return. Risk is a term that is universally understood but not universally mastered.Math and algorithms have created an alternate breed of currencies that are incredibly disruptive but also rife with speculation. In October 2017, Bitcoin surpassed $6000 and the total market capitalization of cryptocurrencies touched $174 billion. An incredibly frothy market with a very high degree of risk.
Lessons From The CEO of NASDAQ
One of my idols in the world of finance has been Adena Friedman, CEO of NASDAQ. NASDAQ is an exchange younger than the NYSE but more technology focused. NASDAQ computerized the trades that the traders at NYSE used to perform manually. I met Adena at Washington University in St. Louis on October 19.
One of the key observations she made was the declining trend in the number of companies going public or Initial Public Offerings (IPO’s) in the stock market. She attributed that decline to many factors including the availability of private capital through venture capital and private equity that allows companies to stay private longer so that they can be ready for the intense scrutiny and extensive disclosures of a public offering (every quarter) later.
When a company decides to take money (capital) from the general public including small investors and big institutions, it is said to have gone public using an Initial Public Offering. Once a company goes public, its shares are traded in a “Secondary Market”. Prior to that, the IPO is listed on the “Primary Market”
The side effect of lesser IPO’s means lesser options for the small investor to invest in. Also, IPO’s have a significant positive effect on employment which was the result of one study by the SEC.
Going public also results in short term thinking as the management has to focus on quarterly earnings resulting in long term trade offs. Today, public companies are hounded by fears of litigation, activism, disclosures etc.
Looking Towards The Future
The present involves virtualization of markets. The future will be virtualization of market participants. This will raise an ethical dilemma that could push retail investors further to the fringes. It would provide a push towards low cost FinTech players which will allow retail investors access to sophisticated algorithms at a lower cost.
The future of markets, therefore, is tied to one word- ‘talent’. In the world of algorithms and machine learning, the key difference would be superior pattern recognition using big data and therefore better predictability. Already, there is a gap between demand and supply of data scientists pointing to the future demand for jobs.
It All Comes Down To Mindset
Arguably, free market economics has come to shape global economics more than any other economic order. Central to this order is the fact that the market is wise. Atleast in the long term. However, this system is not without it’s flaws. Sometimes, these flaws can be thought of as inhuman. Market manipulation by nefarious actors has resulted in ruining thousands of retail investors.
Over the years, I have heard many arguments about why capitalism is flawed and why we need a different economic order. Wealth disparities are constantly increasing — the rich are getting richer and the poor are becoming poorer and the top 1% account for 45.2% of global wealth:
However, it is also true that as per World Bank estimates, nearly 1.1 billion people have moved out of extreme poverty since 1990. In 2013, 767 million people lived on less than $1.90 a day, down from 1.85 billion in 1990.
Frankly speaking, I don’t have all of the solutions and I believe that individually, none of us has. Or if somebody does, I don’t know about how a new economic order can emerge without creating more chaos, disruption and anarchy. I am not a blind proponent of capitalism. Rather, I would love to see a new economic order that is fair for all.
Some might say digital currencies are the new solution, others going back to barter economics and sharing resources equally. Universal Basic Income (UBI) and going back to the gold standard have been suggested by many. However, none of the solutions, on its own, is capable of supporting a new economic order. Collectively, they will suffer from as many flaws as the current system. What is clear is that there is a need for a global debate on reducing inequality- a claim that is almost universally accepted. This debate becomes more important in the light of technological changes.
The other lesson that my personal experience has taught me is that we can change, starting this very second, our mindset. Money occupies a central position in our lives and sometimes ranks higher than love, health, family and relationships because WE allow it to. I have heard many stories of siblings forging signatures to rob other siblings of their wealth for personal gain, Ponzi schemes invented to rob the common man of his life’s savings and so on. These stories may sound inhuman to many but may be considered smart ways to get rich by some. This is because we may not be able to get rid of all the bad actors in society or get rid of human vices. It’s almost impossible to do so. Perhaps, because just as darkness is the absence of light, vices help us truly understand the value of virtues. Rather late but mostly through experience.
At the end, I leave you with 3 different ways to change your mindset:
- Think of money as a means to an end and not an end in itself.
- Don’t compare yourself with others. Ultimately, the competition is only with yourself.
- Put others before yourself in almost everything you do.
These principles cannot be implemented overnight but only through personal experience. It’s also possible you may not be able to achieve any change mentioned above but trying is half the battle won. Collectively, we may succeed in tilting the balance towards the greater good. Maybe, that’s all that is needed.