Moral Hazard

CLICK HERE for an excellent interview on the Charlie Rose show with David Einhorn, a very successful hedge fund manager who made substantial profit by understanding market distortions.

He outlines a point that most people do not understand:  the unseen or unanticipated effects of attempts to regulate the complex markets in the world. His main point is that the market is a rough and tumble place and that laws and regulations provide false “cover.” People are lulled into NOT doing their homework and make mistakes, some of them enormous, based on this moral hazard.

I further agree with Einhorn in his statement that he does “not believe that markets are efficient.” For the less knowledgeable about modern portfolio theory, I need to clarify that he is not saying that markets don’t work. He is reacting to a mathematical theory regarding market behavior that anyone with a degree in Finance will tell is basic to the theory of diversification across multiple securities that optimally balances risk and reward. This “efficient market hypothesis” forms that basis for this structural approach to investing.

EMH (efficient market hypothesis) assumes that all knowledge about the market is incorporated instantaneously in prices and that no specific investment advantage can be possible with market research. To the uninitiated to the theory, many people think this is ridiculous. To the “initiated” it is considered gospel. Einhorn’s departure from the theory in his statement that he believes that markets are not efficient is very significant and it is worth noting.

I, too, think that the EMH is a mathematical tool, a simple model, that bears little resemblance to the actual market. The reality, in my opinion, is that the market is not perfectly efficient; it incorporates information at varying rates and varying penetrance across market participants. In this way, the market does incorporate errors. People make mistakes. Sometimes, especially when normal market signals are skewed by manipulation, the market can make very large, almost systemic errors. These errors are represented by market crashes once reality sets in.

An efficient market in my opinion is one that minimizes mass errors. The error correction mechanisms of the unrestricted market is the most efficient means possible to see stability (as defined by the absence of mass disturbance.) In this way, government regulation of the market in nearly all instances represents market interference. It chiefly works through this moral hazard that Einhorn discusses. People assume safety where it is not. They therefore do not mamage risk properlyand set themselves up for larger than necessary downsides.

The best way I can explain this moral hazard is to consider a very rough part of town, a very dangerous high-crime area of town. Nearly everyone understands this idea (most towns have such an area). Now, think about walking through such a dangerous place. If you proceed with the assumption that the police have complete control over the neighborhood, then you act differently. You conduct yourself with less attention to your surroundings. As such, your safety is in jeopardy. The police, no matter how good and efficient, cannot guarantee safety. Crime happens.

The truly smart person who has to enter this section of town will act accordingly relative to their safety. They will protect themselves. They may do it in any number of ways:  private security, arm and train themselves, etc. The clear point is that they make a clear assessment and plan their business given the security concerns. This is the free market. People protect themselves. They do not assume that somebody else will do it for them.

A well-armed society is a polite society.

ADDENDUM

CLICK HERE for another excellent description of moral hazard.