Quote & Thought of the Day, 2010/10/15

“Financial markets are a collection of arguments. The less transparent the market and the more complicated the securities, the more money the trading desks at big Wall Street firms can make from the argument. The constant argument over the value of the shares of some major publicly traded company has very little value, as both buyer and seller can see the fair price of the stock on the ticker, and the broker’s commission has been driven down by competition. The argument over the value of credit default swaps on subprime mortgage bonds — a complex security whose value was derived from that of another complex secruity — could be a gold mine.”

-Michael Lewis, The Big Short (1), pg 79

The Big Short is a really fun book to read (as long as you don’t mind the occasional profanity) and it also does a very good job of explaining a lot of what happened during the subprime meltdown that started hitting the stock market, bond market, banks, and big Wall Street firms starting in about 2007.

No matter what type of market you’re talking about, the biggest issues come down to people. In the passage above, Lewis explains why markets where you can make insane amounts of money also carry insane amounts of risk, because the potential gains (and losses) come from some people not knowing — or maybe knowing more — than other people know.

I’ve known people who have asked me about playing in the futures markets, and I’ve told them what my parents told me when I asked as a child about the futures markets (2): the futures markets are a really good way to lose a lot of money really fast.

But if you look at how fast prices can go up in the futures markets, it looks like there’s an insane amount of money to be made. And there is. And the futures market can go down just as fast, based on things you might not know about, like changes in the currency exchange rates, changes in expected crop yields, a bad weather forecast during planting time, changes to our government’s regulations, changes to other government’s regulations, or even transportation issues like a problem with railroads, rivers, ports or availability of large cargo ships.

In general, if there’s a place where people are telling you there’s an insane amount of money to be made, always look carefully because there’s probably an insane amount of risk too and almost certainly there’s something you don’t know or aren’t being told. It’s like a poster I got years ago titled “Murphy’s Laws of Combat”. One of the laws from that poster which as stuck in my head over the years is “The easy way is always mined.”

Also “The important things are always simple,” and “The simple things are always hard.”

 

(1) Michael Lewis, The Big Short, copyright 2010, W. W. Norton & Company Inc., Isbn 978-0-393-07223-5

(2) No, I was not some financial prodigy as a child. Grain futures markets affect how much we can sell our wheat for locally. So one of the local radio stations carries hourly updates on the grain futures markets and my dad always listens at least once every weekday. It wasn’t until I was in college that I realized most places in the U.S. don’t have a radio station you can check on the hour and hear what the financial markets are doing.

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