Understanding the world of finance is not easy. The key concepts can be so thoroughly counter-intuitive that the best way to explain them is by means of an allegory. For instance, the economics blogger, Frances Coppola, tells the tale of a mysterious shoebox to explore the idea of fractional reserve banking; while on the EconoMonitor website, a story about a far from seaworthy ship helps us to understand how traders are incentivised to undermine their own industry.
However, the best example is John Kay’s parable of the ox, which is about something even more important: the way in which the money markets – and their regulators – destroy useful information.
It starts with a true story:
- "In 1906, the great statistician Francis Galton observed a competition to guess the weight of an ox at a country fair. Eight hundred people entered. Galton, being the kind of man he was, ran statistical tests on the numbers. He discovered that the average guess (1,197lb) was extremely close to the actual weight (1,198lb) of the ox. This story was told by James Surowiecki, in his entertaining book The Wisdom of Crowds."
Kay then imagines what would have happened if livestock markets worked like money markets:
- "A few years later, the scales seemed to become less and less reliable. Repairs were expensive; but the fair organiser had a brilliant idea. Since attendees were so good at guessing the weight of an ox, it was unnecessary to repair the scales. The organiser would simply ask everyone to guess the weight, and take the average of their estimates."
A clever short cut you might think. Except that people start cheating. In order to win the guessing competition, they approach the farmer for inside information about the likely weight of the ox. More and more rules are introduced to stop cheats, but then the competition is subverted in a more subtle way:
- "Some brighter analysts realised that understanding the nutrition and health of the ox was not that useful anyway. What mattered were the guesses of the bystanders. Since the beast was no longer being weighed, the key to success lay not in correctly assessing its weight, but rather in correctly assessing what other people would guess. Or what others would guess others would guess. And so on.
- "Some, such as old Farmer Buffett, claimed that the results of this process were more and more divorced from the realities of ox-rearing."
Old farmer Buffet is, of course, a reference to Warren Buffet – the fabulously successful investor who has succeeded by actually knowing something about the companies he invests in.
Anyway, back to the parable of the ox, where by the end of story:
- "…there was a large industry of professional weight guessers, organisers of weight- guessing competitions and advisers helping people to refine their guesses. Some people suggested that it might be cheaper to repair the scales, but they were derided: why go back to relying on the judgment of a single auctioneer when you could benefit from the aggregated wisdom of so many clever people?"
As in all the best stories, there is shocking twist in the tale. But you really ought to read the whole thing first.