People, not markets, misprice tail risk or long shots
A market is not inefficient because people are uninformed about it, said Jeff Yass, founder and managing director of Susquehanna International Group. “It only takes two smart people competing to get the markets right,” Yass said during a seminar, sponsored by the student-led Chicago Booth Trading Group and student-led Investment Management Group, at Gleacher Center on February 28.
“Speculators will drive the market to its true price,” Yass added. “The reason this misperception about market inefficiency is so pervasive is because we are all raised to believe in democracy. I believe that each person should have a vote, but that doesn’t imply that each person’s opinion of the market has any validity.”
Yass’s presentation was followed by a question-and-answer session moderated by George Constantinides, Leo Melamed Professor of Finance, and Ralph Koijen, assistant professor of finance.
The general public finds it easier to accept something like the St. Louis Cardinals winning Major League Baseball’s 2011 World Series, despite earning the title with just a 2 percent chance of doing so, than it does a collapse in the market for mortgage-backed securities, Yass said. “They think something nefarious happened, someone cheated, there were wild speculators, or something crazy was going on.”
Those securities traded at, say, 98 percent, because a 2 percent chance existed that they would go to zero, Yass explained. “We had gone 30 years in a row laying, as a poker player would say, 50-to-1 odds,” he said. “It was not a gift from Santa. It was gamblers telling you there is a 1 in 50 chance of you losing, and I don’t want to hear any crying when you lose. You’re not entitled to that $2. You’re gambling. You may win and you may lose. And when you lose, that proves the markets are efficient.”
People, not markets, misprice tail risk or long shots happening because real probability often seems counterintuitive, Yass said. “The average person may own stocks and not know how high the probability of collapse is, particularly if you didn’t live through the Great Depression or something like 1987,” said Yass, referring to two of the worst recessions in US history.
“People make decisions based on the recent past. They underestimate how likely something really bad is. That doesn’t mean money can’t be made off of that or that the markets don’t know. It just means that some people are taking more risk than they really know they are.”
The 2008 stock market’s volatility, which proved even greater than that of the Depression, supported the conclusion of the Efficient Market Hypothesis more than any other market behavior to date, Yass said. Not even Warren Buffet was able to capitalize on the wild fluctuations that happened in the market at this time, such as that with Goldman Sachs’ shares, which shifted as much as 40 points in a day, Yass said.
“As far as I know, nobody made gigantic scores scalping stocks, even though there were enormous profits to be made,” Yass said. “As crazy as those prices were, they were perfectly rational, the same way that the St. Louis Cardinals were in going from 2 to 100 percent. In the most extreme movements in the history of financial markets, the markets remained too rational and too efficient for anybody to beat them.”
During the internet “bubble,” stocks became much more volatile than in previous generations, he said. “I remember saying, ‘I don’t know when this is going to end, but there is going to be a down draft here,’” Yass said. “‘Eventually, when it does come, everybody is going to think that these people were crazy.’ But they were not.”
It was called a bubble simply because stock prices made so many gigantic moves, he said. “That doesn’t mean there are any inefficiencies,” Yass said. “We were trading options and the internet index went down about 90 percent in six months. We went long on options, meaning we were hoping the market would fluctuate a lot, and we still lost money. We needed it to go down fast, and it went down in an orderly, rational process. It’s hard to call that a bubble, when you bet that something crazy would happen and you didn’t even win.”
“Yass illustrated today his way of taking very complicated scenarios and dissecting the parts into smaller probabilities of success or failure,” said Evening MBA Program student George Kalant, founder and co-chair of the new Chicago Booth Trading Group.
“You had individuals presenting this evening who have a deep understanding of the markets, so you would think that there is a defined answer in terms of what to expect moving forward,” Kalant said. “The irony is that everybody has different opinions. What we saw today is that there are many different methodologies that experts use to analyze the markets, which in turn makes it difficult to determine if the economy is going to get bettor or if the stock market is going to go up or down. The market, as Yass explained today, will just have to play out.”