A crystal ball wouldn’t make most of us rich

Buy the rumour, sell the news, goes the saying. But how much money could you make betting on stocks and bonds if you really did have tomorrow’s headlines, today?

Inspired by Nassim Nicholas Taleb’s conjecture that even blessed with a crystal ball, most investors would quickly go bust, a fun paper published this week by Victor Haghani (formerly a partner of Long-Term Capital Management) and James White (chief executive of Haghani’s Elm Partners) sought to quantify just how profitable privileged access to the next day’s news might prove:

In the 1989 blockbuster Back to the Future II, time travel enables Michael J. Fox’s nemesis, Biff, to become a gazillionaire by bringing an almanac with sports match outcomes back from the future. We thought it might be instructive, and certainly entertaining, to make a less fanciful version of this dream a reality — for a few lucky people.  

Haghani and White devised a clever experiment to test out Taleb’s hunch: 118 “young adults trained in finance” were given $50 and a copy of the front page of something called the Wall Street Journal, minus stock and bond prices, one day in advance.

The lab monkeys’ task was simple — to use their knowledge of the future to make as much money as possible by trading in the S&P 500 and a 30-year Treasury bond futures contract. (You can play the game for yourself here.)

Participants were free to use as much leverage as they liked and asked to place bets on 15 different high-volatility days over the past 15 years, five of which coincided with big employment reports, five of which coincided with Fed announcements, and the other five of which were picked purely at random.

For example:

• Maintaining easy money policy, euro dropped, modest consumer spending increase (12/14/2011)

• Orange juice futs up, surging biotech valuations, economy firmed, new homes sales surged (3/25/2015)

• Bad bank earnings, Bitcoin lower, industrial production jumped (1/18/2018)

Whether or not White and Haghani’s findings surprise you depends on how much faith you have in the investment industry generally and the four east coast US universities “with low admission rates” from which the 118 finance MBA’s were plucked:

• The average payout was just $51.62 per player, representing a weighted average return of 3.2 per cent

• Just under half of players lost money

• 16 per cent of players went bust

• Players guessed the direction of stocks and bonds correctly on 51.5 per cent of the roughly 2,000 trades they made

• Taleb was basically right (naturally, he’s already tweeted about it)

The contestants’ returns look marginally less terrible set alongside those of the roughly 1,500 people who have played White and Haghani’s game online. Among this group, the median outcome was a loss of about 30 per cent. Two in five finished with a profit and just over a third went bust.

White and Haghani attribute a lot of this poor performance to players’ haphazard use of leverage. Participants basically sucked at choosing how much capital to bet and when, to the extent that “there was little discernible logic or rationale to their trade-sizing decisions”.

“Seasoned and successful” macro traders, on the other hand, (including a former Jane Street exec and the founder of a top-ten macro hedge fund, ooooooh!) fared far better. All five finished with gains because on trade-sizing specifically, according to Haghani and White, they were “much more rational” than their younger, hotter-headed co-contestants.

The financial industry is replete with individuals and organizations constantly working to develop their own proprietary crystal balls. We hope that the experiment and results described herein convince crystal ball makers that sensible investment-sizing is essential to realizing the value of what they are trying to build.

It goes without saying that all parties would have excelled had their “crystal ball” been coloured salmon pink.

Further reading:
— News versus Sentiment: Predicting Stock Returns from News Stories (Federal Reserve Board)