Tuesday, October 13, 2009

Capital Misallocation

So after the last decade of bubbles and other capital destroying behavior we get this Wall Street Journal article.

Apparently, high-frequency trading is on the rise.

According to the article, there is now an increased focus by money managers on the short-term.

It also points out money managers have increased short term focus much of it related to heightened interest in high-frequency trading. This extremely rapid form of trading now makes up roughly two-thirds of the volume in equities.

For equities, over the past 30 years or so, we've gone from an average holding period measured in years to an average holding period measured in months. The rise of high-frequency trading sure isn't going to help reverse that trend.

Recently, Buffett and Bogle and 25 others signed a letter with the title Overcoming Short-termism, calling for new incentives to discourage short-term trading practices in favor of long-term investing. Less casino capital; more patient capital. It appears to have been all but ignored so far.

In fact, at least based upon the Wall Street Journal article, the response of Wall Street seems to be the exact opposite of what the letter recommends. From the letter:

"Risk-taking is an essential underpinning of our capitalist system, but the consequences to the corporation, and the economy, of high-risk strategies designed exclusively to produce high returns in the short-run is evident in recent market failures."

The letter goes on to say that "market incentives to encourage patient capital, is likely to be the most effective mechanism to encourage long-term focus by investors. Capitalism is a powerful economic and societal force which, if properly directed, can have a hugely beneficial impact on society at all levels. By enlisting natural market forces and establishing incentives for market actors to modify their respective behaviors..."

To me, the Wall Street Journal article on high-frequency trading says, in effect, that the instincts of many on Wall Street is to completely ignore the spirit of that letter. They're now engaging in strategies that involve even more hyperactive short-term trading.

The Seinfeld episode where George Costanza finally implements an effective strategy to overcome his innately terrible instincts comes to mind. The title of that episode happens to be "The Opposite".

Well, those with similarly ineffective instincts might learn a thing or two from the episode.

"If every instinct you have is wrong, then the opposite would have to be right." - Jerry Seinfeld speaking to George in "The Opposite"

So maybe instead it's time for some on Wall Street to adopt George's strategy.

"A job with the New York Yankees! This has been the dream of my life ever since I was a child, and it's all happening because I'm completely ignoring every urge towards common sense and good judgment I've ever had. This is no longer just some crazy notion, Elaine, Jerry. This is my religion." - George Costanza Speaking to Elaine Benes and Jerry Seinfeld in "The Opposite"

Who knows, it just might work.

It's not just instincts, of course.

Much of this problem is systemic and cultural.


Related post: Buffett & Bogle: Overcoming Short-termism

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