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Six Questions to Help You Evaluate Investment Gossip.
The other investor leans closer, looks you straight in the eye and says, “Don’t repeat this to anyone.See that money manager over there?He doesn’t know how to trade.I wouldn’t put your money with him.”Despite our pretenses of rationality, we gossip, some of us all of the time.We may call it something else, networking, for example, but we gossip and we use the information we pick up to make investment decisions, to decide which investment managers to hire and which to fire.It is another question entirely whether this is a good idea.
Gossip may have less than no value.At least, that is what a recent scientific study suggests.John Tierney writes in the New York Times, “…researchers at the Max Plank Institute for Evolutionary Biology and the University of Vienna gave 10 Euros apiece to 126 students and had them play a game that put them in a dilemma.On each turn, the players would be paired off, and one of them was offered a chance to give 1.25 Euros to the other.If he agreed, the researcher added a bonus of .75 Euros so that the recipient ended up gaining 2 Euros.
“If the first player refused to give the money, he’d save 1.25 Euros, but if others found out about his miserliness, they might later withhold money from him.As the game progressed, with the players changing partners frequently and alternating between the donor and recipient roles, the players were given information about their partners’ past decisions.
“Sometimes the donor was shown a record of what the partner had done previously while playing the donor role.The more generous this partner had earlier been toward other players, the more likely the donor was to give him something.Sometimes the donor was shown gossip about the partner from another player.When the partner was paid a compliment like spendabler spieler!—generous player! –the donor was more likely to give money.But the donor tuned stingy when he saw gossip like ‘uber geizkragen’—nasty miser.”
So far, so dull. But then the study turns interesting.“In a couple of rounds, each donor was given both hard facts and gossip.He was given a record of how his partner had behaved previously as well as some gossip—positive gossip in one round, negative in another.
“The donor was told that the source of the gossip didn’t have any extra information beyond what the donor could already see for himself.Yet the gossip, where positive or negative, still had a big influence on the donor’s decisions, and it didn’t even matter if the source of the gossip had a good reputation himself.On average, cooperation increased by about 20% if the gossip was good, and fell by 20 percent if the gossip was negative.”
Notice that the people in the study are making decisions based on information they know or should know is useless.At least, they have been told that the information is redundant.Unless they believe the researcher is lying to them, their behavior makes not sense.
John Tierney calls this the Chico Mark paradox.In the movie “Duck Soup” Chico tries to pass himself off as Groucho.Margaret Dumont protests that she just saw Groucho leave the room.Chico asks, “Who are you going to believe, me or your own eyes?”The available evidence suggests that many of us are more willing to believe the guy who’s talking than our own eyes.Why, exactly, would someone behave this way?
Perhaps we believe because gossip is a way of bonding with other people and other people are important. Like dogs, we are pack animals and, in many ways, our pack is more important than we are.Trading gossip is a way of telling friend from foe.People who give you little verbal gifts are your friends, members of your pack.The people who don’t are not.The people who keep you out of the loop are your foes, not members of your pack, bad.I believe that is hardwired into us, encoded in our DNA somehow is the conviction that it is more important to have friends than to be right.
Still, the pack isn’t as important to some people as it is to others.Have you noticed how many successful investment managers are jerks, if not ********?This may not be an accident.A jerk is more likely to ignore the opinions of others than you or I.We may hate him, but he’s making money.This strongly implies that you and I would be better off ignoring investment gossip.
This also implies that the quants that ignore such information, whether they are jerks or not, are probably right.Certainly, that is the right thing to do in the game Mr. Tierney describes above.
On the other hand, information is under no obligation to reside in the rigid categories and data sources that quants find so reassuring.Information is where you find it.Bizarrely, and I am not making this up, computers are learning to gossip.“Gossip protocols” are rigid set of rules by which computers pass information to each other.As the name suggests, the protocols are modeled on human gossip.More traditional computer protocols pass the information to some central network node, which passes the information on to other computers in a pattern that may resemble a loop or a tree.In contrast, a computer in a network following a gossip protocol will pass the information on to whatever other computer happens to be listening at that moment.This works.The information will rapidly saturate the network.Think computer viruses, except here the contagion is part of the system.
The analogy suggests that gossip can be useful.Even better, the points at which the analogy breaks down suggests rules as to when gossip can be useful and when not.
First, are you capable of evaluating gossip strictly on its economic merits?If you can’t, and there is no shame in not being able to do so, then ignore the gossip.
Second, is there anything you can do with the information?If I tell you that Hedge Fund manager ‘Jack Stack’ is a racist, sexist pig, what are you going to do with that information?If Jack runs a large investment firm, there may be investment implications here or, at least, operational and legal problems.On the other hand, if he works alone or in a small group, that information is probably of no investment value.In which case, you would do well to forget these alleged facts and move on to something important.
Third, does the gossip duplicate known information?As the study from the Max Plank Institute suggests, rumors about an investment manager’s track record are worse than useless; that information is already in the manager’s track record.On the other hand, if the rumor does not duplicate known information, it could well be important.For example, gossip about an investment manager’s performance that his disclosure documents do not expose might be extraordinarily important.
Fourth, can you confirm or deny the gossip?If you can, then confirm or deny or ignore it, but don’t let it remain gossip.Continuing the example above, confront the investment manager and see if he will confirm or deny the rumor.Then track down the investment manager’s previous employers, employees and coworkers and see if you can get them to confirm or deny the rumor.
Fifth, how reliable is the gossip source?U.S. courts do not generally permit hearsay.This is a good rule as information degrades as it passes along a network.A good investment rule of thumb here is, therefore, if you can’t trace the gossip back to someone who actually saw the event, you are wasting your time.Even then, you may not be able to trust them.There is a large literature about the reliability of eyewitness testimony.The unfortunate conclusion is that it is not very reliable.When Sam tells you that Jack’s undisclosed track record is awful, you need to pin him down.Did he actually see the documents himself?And you need to pin him down in a way that won’t threaten him.Act like a district attorney and Sam will defend himself and you will have no way of telling whether or not he is telling you the truth.
Sixth, do you have more than one independent source of information?If Susan tells you that she saw Jack’s undisclosed track record, too, you are probably closer to the truth.But if Susan is just repeating what Jack told her or if Susan got it from a friend of a friend, you are probably not learning anything new.Remember the Iraqi weapons of mass destruction?If the newspaper reports I have read can be trusted, no western intelligence agency had evidence that such weapons existed.This is not surprising, considering that there turned out not to be any.But, based on no evidence at all, the various agencies argued that such weapons might exist.Based on those intelligence reports, President Bush eventually argued that he knew for a fact that Iraq had weapons of mass destruction.The fact is that several opinions based on no data are not better than one opinion based on no data.Unfortunately, several opinions can be strangely comforting, even when they are gibberish.
And what do you get if the gossip passes all of these tests?You get a fact, perhaps true, that you can use in your analysis. If you have done your work well, you get a small information advantage, you get an edge.Profits can be made from this.
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"If your mother says she loves you, check it out." --Old reporters' motto; also our motto. Copyright (C) 2005, 2006, 2007, 2008, 2009 Fred Gehm. All rights reserved.