Computers and the Internet Made the Markets Historically Stupid!

I have a degree in systems engineering and am a huge fan of technology – BUT the computer and the internet have unraveled our financial markets and made us really stupid. In fact, our unbridled adoption of these technologies has caused our markets to regress back to the days of the great Dutch tulip bubble when there was no good analysis or information, only relative speculation and emotion.

To provide some foundation for this assertion, allow me to put forward my qualifications. As mentioned above, I am and engineer, a bona fide techie who started his career building stuff like fusion reactors. I’m also an MBA and former senior partner at Robertson Stephens – the leading global technology and Internet investment bank in its day. I was a 100% enthusiast as we brought public such firms as E*trade, TeleBank, Insweb, Knight Trading, MeVC, Multex, Omega Research and PayPal – all financial services firms that used the internet to change the industry. The final highlight on my abbreviated qualifications is that I am married to a PhD who has published several books on financial markets.

So, how can it be a bad thing to have computers to run advanced financial valuation models? How can it be a bad thing to have stock trades be executed immediately on the net and only cost $5 instead of $100? How can it be a bad thing for mutual funds and individuals to be able to trade directly and anonymously for pennies on the net? How can it be a bad thing to have all public company information available for free to everyone? Of course the answer to any one of these question taken independently is: “All of these innovations were beneficial adding efficiency and leveling the playing field.”

It is when we examine the combined impact of all of this innovation on our financial markets over the last decade that we see the result was massive collective stupidity. (For those of you who would like to suggest that greed is the culprit – I will assert that that function has been constant since the beginning of time and is irrelevant in explaining the source of this crisis)

Here’s how it went down. Step 1: Introduce the computer for financial modeling. This OK at first as the models can be understood by experienced financial professionals and add real efficiency. BUT – over time the models grow in complexity as do the financial securities so the math PhD’s running the model are the only one’s who really have a clue and the experienced bankers who have judgment and broad training (Dick Fuld?) are relegated to either being silent or pretending they understand. Sounds a little like “The Terminator” – but you know it happened. The greed at Lehman was a constant – but the stupidity went off the charts.

Now let’s add the Internet. Step 2: “Free” retail stock trading via the net. The good news was added efficiency and a leveling of the playing field. This also welcomed every one of P.T. Barnum’s widows and orphans into the market regardless of training or qualifications. What a surprise that we had a bubble in 1999 – good year for casinos too. One side effect of “free” trading is that Investment Banks could no longer afford to pay brokers or analysts top dollar to provide expertise and advice – but who cared because these guys were just greedy overpaid middlemen and besides all the information an investor needed was available for free.  So out goes experienced professionals who had reputations to rely on and in comes 100% access for all to company info and analysis via EDGAR, Yahoo, Raging Bull. Great –we could all get GAAP statements on companies like Enron, Bear Stearns, Tyco, Lehman – so who needs advice.

Of course it wasn’t just the little guy who changed trading behavior – some hedge funds and mutual funds figured out that they could trade directly and cut out the middleman too. Those that didn’t figure it out were told by regulators to cut out the middleman because having a long term relationship with a broker that includes dinners and even fancy wine was clearly criminal when you could trade thru a blackbox for pennies.

My argument is simply that we embraced the sophistication, efficiency and anonymity of computers and the Internet and disposed of the judgment, experience, training and long term relationships. We did this in true American fashion without debate or consideration on the impact on markets which had been built on social contracts and trust.

As we see treasuries sold with negative yields – I hope no one would debate that we have a total collapse of trust in our financial markets. I would never argue that the solution is to abandon innovation.  However, the hands that help rebuild our capital markets will need a better understanding of the role of technology and the role of relationships in capital markets if we are to cure our historic stupidity.

Chris is the founder of Bulger Capital, before which he spent three years at Needham & Co. as a senior partner and head of technology banking. He also is a Robbie Stephens vet, having run its Boston office and its global technology banking group.

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10 Comments

  • Dear Chris, as I sit here signing Christmas cards,we send out over 1200 each year ( you’ll get one) I was so pleased to hear someone echo what I have been thinking for a long time but not as well articulated.I was a Partner @ Robbie 1989 -1995. Have a very Merry Christmas! best, Paul

  • Chris, there are some very interesting parallels between your article and a paper entitled, “Why are IPOs in the ICU?”, which was authored by Grant Thornton and may be freely available online to interested readers. Thank you for your insights. Happy holidays. – Geoff

  • Geoff,

    One of the authors of that paper, David Weild, posted a bunch of it here:

    http://www.pehub.com/25264/the-search-for-ipo-alternatives/

  • [...] Computers and the Internet Made the Markets Historically Stupid! (PE Wire) [...]

  • I disagree, and I’m not sure what you are arguing for.

    “Historic stupidity” can never be cured, as the business cycle is a permanent fixture of our human condition. It is inevitable. Given this, I would say that correlation is not causation, for many of the symptoms you have highlighted. With or without technology, this behavior (or historic stupidity) will persist.

    Look through history (again). Markets always digest new technology and behaviors. Sometimes our financial and legal structure is not prepared for radical change, and these technologies and behaviours yield a bubble. One who believes that bubbles can be prevented, quite simply, is a fool. I’m not saying you believe this or that you are a fool – what I am saying is that many are tricked by fools (legislators, financial practitioners, academics) into looking in the wrong places for the source of the problem. In the market, contracts will be broken with, and credibility will be lost by those who aren’t willing to change, as what is true yesterday is no longer true today.

    I agree with your assessment that our judgment went out the window. Confidence will be restored if the Darwinian nature of the markets to act; the old players and poor judgment of the past cycle are replaced by the new and better informed. Unfortunately, we are again trying to prevent this process, as corporate bailouts are everywhere. THIS is what will keep confidence low in the long term – as we continue to support the fools and the institutions that led us to the brink. THIS is the real tragedy.

    In all honesty, best of luck with your enterprise. Respect the business cycle, and it will respect you.

  • Greed per capital may be constant over the centuries, but markets are now composed of many more participants, and on a global scale. Total greed within the system has grown.

    I do agree with KR and you that any time we stop using judgment we are in trouble, “men of the mind” couldn’t be called such without thinking.

    Ultimately, free markets contain their own self correcting mechanisms.

  • I disagree with your premise.

    The greatest investment follies of the credit crisis were committed not by the least sophisticated investors and institutions but by the most sophisticated — the most experienced and the most well equipped to make sound judgments.

  • The ‘rush’ of having new technologies mountains of data to analyze lulled experienced investors into the trap of thinking they had all the data they needed to make aggressive bets. Believing that “the old rules don’t count anymore since it’s a new day” is a form of arrogance that is as central to humanity as greed. World War 1 was “the war to end all wars”, the New Economy changed how societies interact in ’99, the ’60′s were a new age where only individual wants mattered, Alfred Nobel though dynamite would terrorize people into peace because it was so destructive. We’re repeating the same mistakes in financial markets and, God help us, in genetic engineering.

    Hubris will get us into a whole bunch of trouble. A healthy dose of fear is a good thing.

  • I totally agree. Back in the day, equities were traded by professionals who understood fundamental valuation methodologies and considered alternate investments as comparison to equities in a calculated risk/reward scenario.

    With the democratization of trading came herd mentalities, crowd think and the flow of unvetted analysis by unqualified amateurs. I remember in 1999 how stock split announcements would raise a stock price based on the assumption that “management was bullish”. And the people who could trade cheaply traded 1 dollar for 4 quarters and assumed that those quarters were magically worth $.35.

    On the other hand, what is there to do about it? Either avoid the market altogether and find alternate investments like real estate (even now, God only made so much land and our population still keeps rising) or learn to figure out different metrics that can account for the psychological aspect of this new market dynamic.

  • Anecdotally I find your comments interesting, but empirically I don’t think they make sense. First, I think the “black box” example only works in the case of complicated hedge fund or securitized asset strategies, where the underlying mathematics are esoteric and complex. For simple equity or fixed income valuation/trading, valuation methodologies are simple enough to be understood by non-professional investors, so I don’t agree with your characterization of market participants in these asset classes being in over their heads.

    Increased market activity by “uneducated” investors could increase volatility and the dispersion of valuation “opinions”, but on the whole the market benefits from a greater number of opinions (valuation of an asset being just the aggregate result of a multitude of independent buy/sell decisions) and arms length transactions, not to mention liquidity. So in the very short-term I can agree that activity by uneducated investors can exacerbate the market over- or undershooting the “true” value of an asset, but in the long run surely this noise should more than be offset by the benefit of greater activity and price signals.

    Besides, don’t “professional” market participants (asset managers, economists, etc.) display a tendency toward “herding” around specific market projections and asset valuations? A diversity in opinions seems to me to offer a benefit in terms of the diversification of insight and independence in outlook. As Rendezvous noted, it was sophisticated participants who devised, structured and purchased synthetic portfolios of garbage debt, not the uneducated investors.

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