Smoke and Mirrors: How Wall Street Convinced You They’re Smarter

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Hello dearest readers,

It’s been months since I’ve touched this blog, and I am truly sorry. Things have been pretty hectic around here: I recently moved into a new place and for the past few months, I’ve been studying for the FINRA Series 7 exam. For those that don’t know, this is a financial certification required by law to transact in financial securities on behalf of a registered FINRA member firm (broker/dealer) who transacts on behalf of its clients. In plain english, it’s a drivers license for wall street traders and salesmen who spend their day buying and selling stocks, bonds, mutual funds, options, etc. The material isn’t particularly difficult to grasp, especially with a financial background, but there’s a lot of material to cover and that makes studying a pain in the ass.

The good news for me is that I’m one of those nerds who kind of geek-out over financial markets and securities, particularly financial innovation. There’s real beauty in the structure and complexity of a cross-currency interest rate swap, or the fact that someone had this genius idea to take your mom and dad’s mortgage, throw it into a pile of other mortgages, slice it into digestible little pieces, and sell them onto investors who want exposure to the US residential housing market. Finance is a fascinating study of human behavior, preferences, and ultimately our beliefs about the past, present, and future. It’s pretty fucking interesting.

I want to come right out and say I don’t think Wall Street is evil. Sure, there have been some bad characters throughout history, but overall Wall Street serves the greater good by making sure capital is constantly finding its way into the hands of people/companies/institutions who need it to innovate and create a better tomorrow. Maybe I’m just in a particularly good mood at the moment (and even after reading that back to myself, I may have thrown up a bit in my mouth), but I do believe the financial markets are necessary for humanity to grow.

This is the point in my blog where I hit you with the big “BUT,” and here it is: If there’s anything I’ve learned over the course of my career, it’s that investing is an art, not a science. All the numbers, the models, the charts all attempt to do one impossible thing… predict the future. Listen to me very carefully because if you don’t read another word of this post then read this, no man or machine can predict the future.

I’m reminded of a time when I was about 20, and had gone on an interview for a sales & trading analyst program at a top investment bank in New York City. I’m in a room being interviewed by two guys who look to be a few years older than I, and in an alternate universe could have easily been my fraternity brothers or the kind of bros you meet playing pick-up basketball at the JCC. The fact is, they didn’t strike me as the people sitting behind the computers making million-dollar trades that move the market. Eventually, the conversation turned toward my investing philosophy and the kind of analysis I do for my own portfolio (side note: don’t even attempt to get a job on wall street if you’re not some kind of wunderkind with a brokerage account who can talk about how much alpha you made last year and how you beat (insert hot fund manager)). It’s at this point that my ignorant 20-year-old brain, which suffers from a bad case of ‘not knowing what I don’t know,’ goes on some tangent about Black-Scholes and CAPM. Needless to say, I didn’t get the job, and years later had my moment of L’esprit de l’escalier.

The thing is, I actually know a lot about financial modeling and analysis. I could tell you all about how to pick apart a company’s balance sheet and create all kinds of financial ratios like EPS, P/E, DPS, Book to Value, Debt to Equity, etc. We could talk about using technical analysis to chart trends, look at resistance and support lines, moving averages, hell we could even talk about Fibonnacci sequences and how bizarre patterns and numbers appear everywhere and Nicholas Cage is a rogue trader who is uncovering some giant stock market conspiracy (National Treasure meets The Da Vinci Code…note to self: need to write this screenplay asap). If you want the truth though, that’s all bullshit. Every model that’s ever been created and used to identify value has one giant fundamental flaw. They all use historical data to predict the future. That’s it. When you look at your retirement account and get all hot under the collar thinking about how little you understand finance/wall street and how “those guys” are so much smarter than you and how it’s a good thing they’re defending the wall, I want you to remember this. All they do every day is plug some numbers into a “model” (calculator) that’s supposed to tell them if the price of the thing they’re looking at is going up or down, and those numbers they’re plugging into their model are based on what that thing was worth yesterday. As we’re all well aware, history has no bearing on the future (ask anyone who traded MBS in 2008). Just because something is worth X today doesn’t mean any number of things can happen and cause it to become Y tomorrow. All the “numbers” tell you the stock is going to infinity? Guess what, the CEO choked to death on a filet last night and investors are scared about leadership. A trendy apparel company has promising financials and appears undervalued? Some 16-year-old youtube star with 10 million followers murders them in her latest vlog and teen girls everywhere stop buying their shit. The stock market is fickle and based on nothing more than the irrational beliefs and opinions of people like you and me. There’s no math in the universe that can account for the kind of random irrationality humans display, even when comparing it to how irrational we’ve been in the past. It seems the greatest investors in history were the ones who merely OPENED THEIR EYES. They looked at the world around them and made “educated guesses” based on the preferences, beliefs, and opinions of society at large. I remember a story my 7th grade science teacher told our class about a guy who made a fortune investing in Volvo. He saw the advertising campaign promising a safer car, a marketing ploy no car company had used before. Then one by one, he notices Volvos appearing at his local grocery store parking lot. It didn’t take a genius to put two and two together. Even while predicting this trend correctly, his timing could have been way off. By sheer virtue of luck, he happened to buy and sell at the right times to net him a profit (but I digress). Investing is an art that favors the big thinkers, not those of us that get lost in spreadsheets looking at companies under a microscope. It’s not about numbers or models, but how we perceive the world around us.

Wall Street wants you to think what they do is difficult and quantitative. It’s how they appear important. How they keep their jobs and rationalize getting paid boatloads of money. Deep down, every banker, portfolio manager, trader, and salesman out there knows what I’ve just told you. Most are in denial and need validation, so they hold fast onto their models, even when their models turn out to be wrong. The reason the S&P 500 index is a benchmark is because 50% of all fund managers beat it and 50% fall short. Anyone who beats the benchmark consistently is doing something they shouldn’t, knows something they shouldn’t, or is just plain lucky. Don’t just take my word for it, many books and articles have been written about the rampant insider trading throughout the hedge fund community.

Deep down in places I don’t talk about at parties, I’m a financial athiest. I look around and see all these professionals out there praying to their valuation gods and reading their models like religious manuscripts. I get it, we all need faith. We need to believe that what we’re doing has purpose. That the universe and the stock market aren’t random and somewhere out there, there’s answers we still haven’t uncovered. It’s a lot easier to sleep at night when you have millions of dollars on the line if you think there’s some science or math confirming your decisions. Maybe part of me wants to believe that too, but forgive me if I remain somewhat skeptical.