Published in Discourse (St. Lawrence Institute), Summer 1997, pp. 40-41
Of Play and Money
by
Pierre LemieuxWhat does it take to be a successful speculator? If anybody, Victor Niederhoffer should know.[1] Over the last two decades, he has made a fortune speculating on all kinds of financial markets all over the world, out of his base in New York and Connecticut. He was branded the most successful fund manager in 1994.
But in these memoirs of a speculator in his early fifties, Mr. Niederhoffer tells us that humility is a cardinal virtue in his business. He would rather speak of his failures, like when he lost 25% of his assets in one tense hour during the dollar debacle of March 1995. He is often on the verge of financial catastrophe, just as his grandfather, a small-time speculator in stocks, was wiped out in 1929 -- with a lot of larger speculators.
Indeed, not all speculators make money, and the lucky ones don't make money all the time. Niederhoffer's mentor and former employer, George Soros, has been earning a 35% annual return for three decades, but his Quantum Fund lost money in 1996. Speculating consists in buying low and selling high, but the problem is to know when is low and when is high.
What is the proper education for a speculator? In this book, we follow the young Niederhoffer from his childhood in Brighton Beach, Brooklyn, in a family of modest means whose head was a New York City policeman, to his college days in Harvard, and his Ph.D. in Finance at University of Chicago. What we discover is an education based on a rich mixture of play and gambling, music and rhythms of life, science and analysis, and competition.
The first shock, perhaps, comes from realizing how much importance the author attributes to play and gambling. His whole childhood looks like a succession of sports events, games, and gambles. But then, it was not wasted fun, as he was taught from a young age, especially by his father (an omnipresent figure), to learn lessons from all experiences.
The book's most intriguing chapter compares market ups and downs with movements in Beethoven's symphonies or Bach's sonatas. Although some of this is written tongue in cheek, the main point lies in the parallelism between rhythms of life in general and speculation in particular.
Now, speculation is more than gambling and music. The speculator performs crucial economic functions and provides a homeostatic mechanism for balancing supply and demand. This ceases to be true when everybody runs with the crowd, but the ensuing bubble can only last so long. At some point in time, contrarians like Niederhoffer will bring the followers back to reality. Hence, the idea of the speculator as a contrarian, which is a watermark of this book.
How does the successful speculator recognize reality, and forecast market evolution, better than others? One economic answer, related to the theory of efficient markets, is that he cannot, except by gambling and sheer luck. The alternative economic answer is that the speculator is a Kirznerian entrepreneur who discovers and knows things that others do not. Another type of answer comes from financial "technical analysis," which Mr. Niederhoffer rightly discounts as having no scientific basis. Like other gurus' pronouncements, such gadgets have no more predictive power than the Delphic oracles of two millennia ago.
Niederhoffer argues against the efficient market, or random walk, hypothesis: "There is always a market somewhere where divergences can be rectified. But the problem is to recognize a divergence." Markets do show regularities that are amenable to scientific and statistical analysis. Many examples are produced -- like, for example, the statistically significant observation that years ending by "5" tend to be bullish in stocks, while years ending by "7" have fallen in the bearish camp.
Yet change is a constant feature of markets, and many speculators have been wiped out gambling on a repeat of October 1929 or October 1987. The good speculator understands the deep motives that run the world and can analyze scientifically their changing impacts. Everything is connected. When winds blow more softly in the Pacific, the ocean will warm, anchovy harvests in South America will suffer, supply of poultry and cattle feed will be reduced, and the Niederhoffers of this world will rush to buy grains before their prices jump.
The competitive spirit is another ingredient in the education of a speculator. Niederhoffer's book is full of parallels between speculation and competitive sports -- including squash, in which the author was a North American champion. Competition on financial markets is modeled as an ecological system, but this is probably where Niederhoffer is the weakest. Although he is aware of the danger, the predator-prey model dangerously obscures the difference between a shark eating a small fish, and the advantages of voluntary exchange in human society.
Finally, we don't know what it takes to be a speculator, except that it is related to the range and richness of life experiences and learning, from chess and sex to family life. In any event, the author had warned us that if he did have a recipe to make a fortune in speculation, he would not be foolish enough to reveil it. Like inside information, a good recipe would loose its power once known.
Does Mr. Niederhoffer actually have a recipe? Probably not. Virtues like a scientific mind, individualism, and self-reliance are necessary, but not sufficient, conditions to prosper as a speculator. They are also general conditions of the good life, as we learn in this brilliant book, written in lively style by one of the most learned businessmen of our times.
1. Victor Niederhoffer, The Education of a Speculator (New York: Wiley, 1997).