Supply-Side Economics Lesson No. 18
Memo To: Website Students
From: Jude Wanniski
Re: Thinking About Markets (August 17, 1993)
[I'm getting many questions relating to the efficiency of markets, which are always under attack by those who insist that markets are basically inefficient and must be managed. How do we know a market is efficient? I spend a lot of my time thinking about markets and have written a thing or two in recent years that may stimulate discussion. The following client letter from 1993 is one of my favorites, inspired by a fellow named Jack Traynor and his jar of beans. In coming weeks, I'll run some other pieces on the subject that I find in my files. As usual, questions and comments are most welcome.]
It first occurred to me nearly 20 years ago that there really isn't much of a difference between the market for goods and the market for ideas. Superior goods and superior ideas survive the test of the marketplace. New entrants are constantly trying to elbow their way into the commercial and political bazaars. Most initiatives fail early on, and of those that succeed early on, most fail over a longer run. All growth, including political growth, is the result of risk-taking. All success, in a sense, is the result of early failures. These are fairly broad generalities, and I developed them to a degree in The Way the World Works, but there is no end to what can be learned about markets, which is one of the reasons Polyconomics continues to thrive as we quietly celebrate our 15th Anniversary.
A few months ago, at a gathering of financial types at the Wigwam resort near Phoenix, I learned something very important about markets from Jack Traynor, former editor of the Financial Analysts Journal, a man who has been thinking about markets far longer than I. Traynor just happened to mention that, when he taught finance, he would pass ajar of beans among his students and ask them to guess the number. The guesses would vary wildly, but always, when the number guessed in total was divided by the number of students guessing, the result was within 3% of the correct number, he said. As there were 52 of us assembled, and a bowl of peppermint candies on the table, we tried the experiment. A low guess of 32 was recorded, a high of 71. The median guess was 46, the mean was 45. The correct total was 46, a number only one of the 52 had guessed.
This is a reminder that the essence of portfolio theory goes back to the old adage, "Don't put all your eggs in one basket." In this case, the more students available to guess the number of beans in the jar, the more reliable the forecast. At the Wigwam discussion, I pointed out that Traynor's experiment provided a proof of democracy. Years ago I suggested to William F. Buckley, Jr., that while he was smarter than any of 100,000 people he might interview on a New York street corner, their collective wisdom would dwarf his, which he could see if only the means could be found to tap into it — which is, of course, what we do in the electoral process. If a way could be found to have 100,000 people guess the number of beans, there is zero chance a Buckley or Einstein could consistently outguess them. In coming to this conclusion, the history of civilization has passed from oligarchical and monarchical forms of governance to more and more refined forms of democracy — which have extended the number of policies decided by democratic means, and also broadened the electorate to include as many "guesses" as possible.
Two great religions that have been among the longest to survive in the marketplace are western, both incorporating the philosophical identity of the "Good Shepherd," who will leave the entire flock to round up the one stray sheep. The difference between Christianity and Judaism is that the former is evangelical, the latter is not — which means the Jewish flock is self-contained and, theoretically, the Jewish shepherd only leaves the flock to round up Jewish sheep. It is no coincidence, though, that Christ and Moses were of the humblest origins, the one born in a stable, the other abandoned in the bulrushes. History wants us to learn this particular lesson about the marketplace, i.e., the best investments may at first look like the worst. In the Christian faith, we're even told there were three wise men who traveled a great distance to add the infant to their portfolios.
There are two world-class investors I know, who sit side by side in the hedge fund they manage. They've both achieved remarkable returns in the dozen years IVe known them, but the older of the two has been the more successful. The only stylistic difference I've detected is that the older man casts a wider net. Several years ago I asked the younger man why he doesn't invest in airline stocks, and he said he'd lost so much money over the years in airlines that he decided to blot them out of his vision. The older man told me that he too had lost fortunes on airlines, but things might change. In the last three years, the difference in performance between the two can be accounted for almost entirely by Southwest Airlines, which the older man bought heavily before it left the stable.
There are two century-class investors I know, men who finance entire companies. In this case, the younger man had been the more successful, and he indeed cast a wider net, but in recent years has been overtaken by the older. The stylistic differences I observed in this period were distinctive. The younger man provided financing for myriad enterprises, often it seemed favoring every entrepreneur who came into his field of view, perhaps on the theory that the few mega-successes would offset the failures. The older, more patient man would scrutinize a great many possibilities, but sometimes go for years without making a fresh investment. His investments were few, but spectacular, a pearl in every oyster. The other major difference between the two, which has had a telling effect, is that the younger man through his streak worked for an institution, which eventually cramped his style. The older man worked for himself, free to be patient.
In the political marketplace, the United States remains the wonder of the world, the kind of place where a babe born in a log cabin can grow up to be one of the greatest political leaders in recorded history, perhaps the greatest. Because we don't know which kid in which log cabin will look the best in the portfolio of history, we have to be attentive to all the kids in all the log cabins. Who would have thought a washed-up, "B" movie actor and a washed-up football player would team up in the 1980s to pull the country out of its tailspin? For the same reason, we can't dismiss the possibility that a particular man or woman who looks washed up at the moment will come roaring back. It is especially the people at the bottom of the pile, those who feel they have little or nothing to lose, who will take the biggest chances. The turnaround situation in politics or commerce yields the greatest gains. Chrysler Corp. was a dead duck in 1978. Richard Nixon, who was history in 1962, would not stay buried then or now. In 1987, I thought Alan Greenspan was absolutely the worst choice in the world to be Fed Chairman. He has proven since that he was a dandy choice. With that kind of experience, how can I give up so soon on President Clinton? George Mitchell? Even Ross Perot?
The thought jumped out at me late last month when Carol Moseley-Braun, the first black woman elected to the United States Senate, a liberal Democrat from Illinois, burst into the news. The issue involved the logo of the United Daughters of the Confederacy, which included a Confederate flag. For more than a hundred years, the club had been coming to the Senate every 14 years for renewal of the patent, and the Senate had routinely complied. This year, Sen. Moseley-Braun killed the request in the Judiciary Committee by a 13-2 vote, on the grounds that the flag represented a banner of slavery, slavery being the only reason the Confederacy was formed. Sen. Jesse Helms brought the issue up on the Senate floor and Republicans and Dixiecrats joined to reverse the committee vote. A distraught Moseley-Braun thereupon informed her colleagues she would not accept their reversal. The debate with racial overtones began heating up, until Sen. Robert Bennett, a freshman Republican from Utah, put a stop to it — enlisting Senate Minority Leader Bob Dole and others who, like him, had voted with Helms, to reverse themselves on a motion to reconsider. I watched a tape of the episode in its entirety on C-SPAN and I realized Dole and Bennett had officially buried the OOP's Southern Strategy, which for a quarter century had been conceding the black vote to the Democrats. I also thought about Jack Traynor and his jar of beans, and a political marketplace that would inspire the people of Illinois to send a black woman to the U.S. Senate, to close a chapter of American history and begin another. A male black Senator might not have done it, as the issue would have been confused by the battlefield, and manly arguments over the valor of the young men who fought under the stars and bars.
Investors in the political or financial marketplace are advised to cast wide nets. I remember Irving Kristol telling me years ago that of all the people he meets, as a class he enjoys portfolio strategists the most, as they cannot afford closed thinking and therefore have lively minds. You can make myriad investments in myriad opportunities, or be agonizingly selective. But it doesn't make sense to rule out opportunities in advance — like airline stocks, or Democrats, or black politicians, or junk bonds, or liberals, or businesswomen, or politicalwomen, or Mexicans or Chinese. There's no telling which knock will be opportunity, so you really have to answer all of them.