Asymmetrical Information

Question: Why is information available to everybody worthless? Could you explain this one to me? Is it because, once the information is available to lots of people, it gets incorporated into the price, or for some other, more esoteric reason?

No, that's it: any information anyone already has is already priced in. Since you can't make any money off of it, you won't pay for it.

I'm not sure that "research available to everyone is worthless." I know this is a commonplace belief among economists; that known information is already priced into the market. But this ignores the differences of individual skills in combining and analyzing this information.

Analogy: chess. Chess is a game of complete information (unlike, for example, poker.) But no one would say that a view of the chess board is of no value, or that everyone who has this view will do equally well at playing the game.

The whole perfect-market hypothesis seems to me to suffer from the belief that information is a much simpler kind of commodity than it in fact is.

Great post. Fascinating article in WSJ. I would encourage everyone to read it in full, particularly if you are a little mystified by a lot of the corporate finance news that is out there these days. This is a good “back to first principles” analysis.

David, the efficient market hypothesis is easy to poke holes in – the theory simply seems wrong to me. The problem is that there is so much data that seems to support it. Beating “the market” consistently is almost impossible to do. There are some shortcomings in a lot of the studies that have been done, but I don’t want to get into all that – I’d be writing for hours.

Your chess analogy intrigued me. I’d offer a different twist on it. Let’s say it’s you and I that are playing chess (or you and Megan, or anybody vs anybody), and all information (and advice) is available to both of us. At anytime we can go to the Internet and download advice from Gary Kasparov, Bobby Fisher, or Deep Blue on what move we should make next. We are going to play to a lot of draws. Under such circumstances what is the information really “worth”.

I rarely have much good to say about the investment banking community, but the fact is that there are some very smart and talented people who have intimate knowledge about these companies’ balance sheets and income statements. They know what drives their profits and have a pretty good idea of how sustainable they are. This information gets distributed to people like me (simply because I use their brokerage services or because they are trying to get my business), and through trial and error I figure out who’s good and who’s not. This winds up in the price of the stock. Information is constantly changing, but this is rapidly incorporated into the price.

One theme of the article is that Wall Street is a selling machine – it’s how they make money. They go to great lengths to get market share, including hiring those who have exhibited great skill in “combining and analyzing information”. Then, they essentially give it away to try to entice me to buy from them. The resulting stock price is never perfect, but determining which ones are wrong, whether they are too high or too low, and by how much is a tough thing to do.

Perhaps I can offer another twist on this debate. Imagine two surgeons. One is a complete moron, the other a genius. Without knowing which is which, do you think you could tell one from the other based on the results of their surgical work? Now apply the same test to investment managers. One's a moron, the other a genius. If you looked at their respective portfolios in detail, but didn't know who's running it, could you tell the moron from the genius? Essentially, the question before the house is: Does talent exist on Wall Street, and if it does, how confident are you that you could identify it?

What's wrong with Wall Street research is in the first sentence: "The incentive for the brokerages is to sell a product." Brokers are supposed to bring buyers and sellers together, facilitating a transaction.

The basic story of 'full-service brokerage' is: "You need to know what to invest in to meet your goals of maximimizing profit with a given amount of risk. We know how to do this, and will tell you how to do it, for free! Oh, btw, any time you trade your stocks, we'll make money, regardless of what happens to you, but that will never influence what we tell you."

The way to reform this is to require a big statement at the beginning of all research: "This firm's economic interests is not served by you getting rich. It is served by you making trades. When they recommend that you buy something, suggest that instead of paying them a commission, you'll cut them in for a share of the profit, assuming you make one. Then, when they refuse to share the risks with you, ask yourself why you should trust their advice when they don't."

Comments are Closed.