Private Wisdom, General Ignorance

Equity Private is posting again. That is the cause for some celebration. Her creativity have obviously been refreshed by an absence from the blogosphere (what an ugly word) and she has some acerbic gems at the moment. My favourites:

My own disposition is towards limited market efficiency--prices reflect all sufficiently scrutinized information, subject to sufficiently saturating capital. This implies two major sources of pricing error:

1. Insufficient distribution of material information.
2. Insufficient capital applied by those in possession of material information.

This seems so obviously true that I wouldn't remark on it but for the sheer prevalence of the opposing view - unlimited market efficiency, aka not long enough out of business school disease. As we move further into the crunch, 2. is becoming an important driver of investment opportunities, so one might hope that the wisdom of the doctrine of limited efficiency will become more readily apparent.


Ms. Private then goes on to discuss those strategies (such as buying AAA yielding Libor + 40) that appear to generate alpha, i.e. return without risk.

The correct response to investment strategies that appear to generate abnormal returns but are of such complexity to defy understand is not to invest. Or, to emphasize the commenter of earlier fame [Alea]:

If you couldn’t determine the conditions under which the transaction would lose money, you didn’t execute.

Follow that? If you don't understand what you are buying, don't buy. Quite simple. Or so you would think.

Cheap debt does not cause losses. Being on the wrong side of information asymmetry does. When structures are complex, falling back to a careful look at incentives often is the best (and only) behavioral prediction mechanism.

So true. But, just as with '86 Lafite vs. the '85, just because something is obviously worse doesn't mean that some people won't buy it.