Why Successful Hedge Fund Managers Can Make A Killing Without Understanding Economics

Worried trader looking at Bloomberg terminal computer screen in dark room

I’m a money manager with roots in policy economics. I worked at the US Treasury under both a Republican and a Democratic administration. I did a tour of duty at the International Monetary Fund as well. For most of the 90s, I was a sovereign debt specialist/negotiator—when emerging market debt crises were the centre of the financial universe. Since then, I’ve managed real money and fast money, mostly focusing on global macro. As a result I come at markets from both the perspective of a policy guy and a market guy, which all too often is like oil and water. My initial grounding was in sovereign credit risk and global fixed income. I am very active in currencies.

When I first came to the markets, I was taken aback by how superficial the market’s understanding of economics was. Not stupid, but superficial in the most neutral sense of the word. This was particularly true in emerging markets. It seemed that guys would have a hunch, based on price action or intuition, and then would reverse engineer a story that to them would explain what they saw or felt. In other words: the conclusion comes first and the investment hypothesis would then follow.

But these guys made money—at least, for the most part. To me, this did not compute. How did guys who didn’t even understand basic macroeconomic identities or dynamics successfully manage money? I was highly sceptical of EMH (the Efficient Market Hypothesis) well before I came to the markets. But from my first contact with animal spirits I realised that I had still vastly overestimated man’s abilities to be that textbook rational maximizer of utility.

All this got me thinking and reading. I started to consume books on technical analysis and, importantly, behavioural economics—a discipline that didn’t exist when I went to grad school. A conclusion soon started to emerge: good risk management was far more important than good ideas in money management (more on this later). And a good understanding of market psychology, positioning, and technical analysis were central to risk management.

Exploring the growing literature on behavioural economics and finance also helped me put labels on the many ways in which the standard economic and financial models failed capture the actual behaviour of economic agents. This was hugely liberating. By identifying the systematic ways in which the efficient market logic fell short, it validated much of what I was observing. The implications for the reigning ideology of the past 30 years of free, equilibrating, self-regulating markets were profound.

The aspiration of this blog is not cure the world of cognitive biases. Rather, by trying to put global macro issues and markets in a more behavioural context, the hope would be that we might be able to better recognise situations in which our biases are likely to surface so that we—whether as analyst or risk taker—can make that extra effort to try to avoid the systematic pitfalls inherent in the human condition. Not everything will have a behavioural angle to it either; I intend to splash down ideas wherever I think my background might lend itself to insight into current economics, finance, or politics.

In recent months I have become fairly active on Twitter (@mark_dow), and in recent years I have written articles and guest-blogged from time to time. But writing in my own blog is a new experience, one I am likely to take a step at a time. Not sure how it will go, or how often I’ll post. So, for those interested, please bear with me while I work things out.

Editor’s note: this post originally ran on Mark Dow’s blog on May 12, 2012.

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