Too Much Information

Could it be that the current financial crisis was caused by too much information, not too little? James Surowiecki writes in this week's The New Yorker about more data not making investors any smarter.

Another related issue that I've thought about is the unintended consequences of too much information. The market has always been about arbitrage in one form or another. It's about finding investments that are mispriced and betting that eventually the market will correct the pricing. Value investing, the Graham/Buffet model is to find investments that are undervalued and betting that their value will rise. Shorting stocks is about finding investments that are overvalued and betting their value will fall.

On a more micro level, before the advent of electronic trading, traders on the market floor could make money by arbitraging the difference between bid and ask prices, the spread. Before electronic trading, spreads could be quite high but now, for a highly-liquid investment, spreads are mere pennies.

In the 1960s, Edward Thorp started one of the first hedge funds, Princeton/Newport Partners. He developed mathematical models to find arbitrage opportunities in the market. His fund returned over 15% a year for 19 years. The problem he ran into, and this is key, once others figured out what he was doing and started doing the same thing, the arbitrage opportunities evaporated. The mantra is - arbitrage only works if you know something others don't.

Online trading, complex computer programs that can sift through gigabytes of data, the instantaneous spread of information on the internet, have all combined to eliminate most opportunities to arbitrage.

So what is a large institutional investor to do to gain an advantage over other investors?

The answer is found in the wreckage of our current financial crisis. Create new trading instruments that are complicated, hard to analyze and hard to value. And finally, believe that you are better than others in figuring out to make money with them.

The institutions that created and were trading CDOs and CDSs (forms of credit derivatives) had a vested interest in not making the market transparent. If they believed that they knew more about the market than their competitors then they had the opportunity to make more money.