Breathes there the man, with soul so dead,
Who never to himself hath said,
“This is my own, my native land!”
Whose heart hath ne’er within him burned,
As home his footsteps he hath turned,
From wandering on a foreign strand!
If such there breathe, go, mark him well;
For him no Minstrel raptures swell;
High though his titles, proud his name,
Boundless his wealth as wish can claim;
Despite those titles, power, and pelf,
The wretch, concentred all in self,
Living, shall forfeit fair renown,
And, doubly dying, shall go down
To the vile dust, from whence he sprung,
Unwept, unhonoured, and unsung.
From The Lay of the Last Minstrel by Sir Walter Scott.
Tuesday, February 26, 2008
Monday, February 25, 2008
Love can be illustrated by a triangle, of which the first angle at the base is fearlessness. So long as there is fear, it is not love. Love banishes all fear. A mother with her baby will face a tiger to save her child. The second angle is that love never asks, never begs. The third or the apex is that love loves for the sake of love itself. Even the idea of object vanishes. Love is the only form in which love is loved. This is the highest abstraction and the same as the Absolute.
- Swami Vivekananda
Friday, February 22, 2008
The Invisible hand -- By Adam Smith.........from www.thesensexxxationalride.com
...every individual necessarily labours to render the annual revenue of the society as great as he can. He generally, indeed, neither intends to promote the public interest, nor knows how much he is promoting it. By preferring the support of domestic to that of foreign industry, he intends only his own security; and by directing that industry in such a manner as its produce may be of the greatest value, he intends only his own gain, and he is in this, as in many other cases, led by an invisible hand to promote an end which was no part of his intention. Nor is it always the worse for the society that it was no part of it. By pursuing his own interest he frequently promotes that of the society more effectually than when he really intends to promote it. I have never known much good done by those who affected to trade for the public good.
In this passage, taken from his 1776 book "An Inquiry into the Nature and Causes of the Wealth of Nations" Adam Smith set out the mechanism by which he felt economic society operated. Each individual strives to become wealthy "intending only his own gain" but to this end he must exchange what he owns or produces with others who sufficiently value what he has to offer; in this way, by division of labour and a free market, public interest is advanced.
Smith is often regarded as the father of economics, and his writings have been enormously influential. Nowadays, "invisible hand" explanations are invoked to explain all sorts of phenomena, from scientific progress to environmental degradation. In the modern context, mathematicians study "invisible hand" processes as part of Game Theory, the branch of mathematics that deals with payoffs and strategies.
Smith was profoundly religious, and saw the "invisible hand" as the mechanism by which a benevolent God administered a universe in which human happiness was maximised. He made it clear in his writings that quite considerable structure was required in society before the invisible hand mechanism could work efficiently. For example, property rights must be strong, and there must be widespread adherence to moral norms, such as prohibitions against theft and misrepresentation. Theft was, to Smith, the worst crime of all, even though a poor man stealing from a rich man may increase overall happiness. He even went so far as to say that the purpose of government is to defend the rich from the poor.
Here is a description of the way Smith imagined the universe operates:
There is a benevolent deity who administers the world in such a way as to maximise human happiness.
In order to do this he has created humans with a nature that leads them to act in a certain way.
The world as we know it is pretty much perfect, and everyone is about equally happy. In particular, the rich are no happier than the poor.
Although this means we should all be happy with our lot in life, our nature (which, remember, was created by God for the purpose of maximising happiness) leads us to think that we would be happier if we were wealthier.
This is a good thing, because it leads us to struggle to become wealthier, thus increasing the sum total of human happiness via the mechanisms of exchange and division of labour.
It is clear why Smith says that moral norms are necessary for such a system to work - in order for exchange to proceed, contracts must be enforceable, people must have good access to information about the products and services available, and the rule of law must hold.
The modern "Invisible Hand"
Nowadays, something much more general is meant by the expression "invisible hand". An invisible hand process is one in which the outcome to be explained is produced in a decentralised way, with no explicit agreements between the acting agents. The second essential component is that the process is not intentional. The agents' aims are not coordinated nor identical with the actual outcome, which is a byproduct of those aims. The process should work even without the agents having any knowledge of it. This is why the process is called invisible.
The system in which the invisible hand is most often assumed to work is the free market. Adam Smith assumed that consumers choose for the lowest price, and that entrepreneurs choose for the highest rate of profit. He asserted that by thus making their excess or insufficient demand known through market prices, consumers "directed" entrepreneurs' investment money to the most profitable industry. Remember that this is the industry producing the goods most highly valued by consumers, so in general economic well-being is increased.
One extremely positive aspect of a market-based economy is that it forces people to think about what other people want. Smith saw this as a large part of what was good about the invisible hand mechanism. He identified two ways to obtain the help and co-operation of other people, upon which we all depend constantly. The first way is to appeal to the benevolence and goodwill of others. To do this a person must often act in a servile and fawning way, which Smith found repulsive, and he claimed it generally meets with very limited success. The second way is to appeal instead to other people's self-interest. In one of his most famous quotes:
Man has almost constant occasion for the help of his brethren, and it is in vain for him to expect it from their benevolence only. He will be more likely to prevail if he can interest their self-love in his favour, and show them that it is for their own advantage to do for him what he requires of them. Whoever offers to another a bargain of any kind, proposes to do this. Give me what I want, and you shall have this which you want, is the meaning of every such offer; and it is the manner that we obtain from one another the far greater part of those good offices which we stand in need of. It is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from their regard to their own interest. We address ourselves, not to their humanity but to their self-love.
For Smith, to propose an exchange is to attempt to show another that what you can do, or what you have, can be of use to the other. When you carry out the exchange, it means the other person recognises that what you can do or that what you have is of value. This is why so much of a person's self-esteem is bound up in their job - a well-paid job is supposed to be a sign that others value your contribution and find it worth exchanging their own resources for.
How wise is the Invisible Hand?
The theory of the invisible hand is certainly persuasive, and its simplicity is also very attractive. No doubt every reader can see that it describes the way that things really work on many occasions, and, whether we find it palatable or not, we probably all recognise the truth of Smith's assertion that paying for your dinner is a more reliable way to get it than appealing to the benevolence of others.
But, even assuming all the correct conditions, does the invisible hand theory really lead to the maximisation of human economic wellbeing in some sense, as Smith asserts? This is where mathematics, in the form of Game Theory, can provide us with some insights.
The Prisoner's Dilemma
The "Prisoner's Dilemma" is a very famous "paradox" in Game Theory. It describes two people in a simple situation, acting in an informed manner, both attempting to maximise their wellbeing, and yet making choices that lead to an unnecessarily poor outcome for both.
Two people, who are suspected of being accomplices in a crime, are held prisoner in separate, non-communicating cells. The police visit each prisoner, and tell both that if neither confesses, each will be sentenced to two years in jail. However, if exactly one prisoner confesses, implicating each other, the one who confesses will get off scot-free as a reward, and the other, who didn't confess, will receive a punitive sentence of five years. If each confesses and implicates the other, both will be sentenced to three years.
What should a prisoner in this situation do? Suppose that the other prisoner doesn't confess. Then the best course of action is to confess, and go free. Even if the other prisoner does confess, it will be better to have done likewise - at least the sentence will be lower. Both prisoners will reason thus, so both will confess and end up serving sentences of three years - even though, if both had remained silent, both would have served sentences of only two years.
It may not be immediately clear what the relevance of the Prisoner's Dilemma is to Smith's theory of the Invisible Hand. In fact, it has a number of implications for economic behaviour.
The temptation to default
We can think of the prisoners as being asked to decide whether to keep a contract they have made with each other (remain silent) or to default (confess and betray the other). Similar choices have to be made all the time in economic society. When two people freely agree to exchange goods or services to their mutual benefit, each must decide whether to try to cheat the other by defaulting, or handing over counterfeit goods, or whether to act in good faith and risk the other party defaulting. Obviously, both parties are better off if neither default than if both default - after all, we suppose they willingly contracted with each other - but each would like to get something for nothing, and each is afraid the other will feel the same. The result may well be that the parties are unable to carry out the exchange as arranged, and both lose out.
The reason we don't see this behaviour too often is because we live in a society where courts can enforce contracts. This reduces the fear of the other party defaulting, and makes it easier to hand over goods ahead of receiving whatever is to be exchanged for them. In illegal exchanges, for example, receiving stolen goods, default is more common, and rather difficult for criminals to guard against.
Enforcing laws of contract requires cooperation and resources from someone else - in democratic societies, the courts on behalf of the government and the people. But courts and prisons and police cost money and most of the costs fall on people who were not party to the contract in the first place - who are therefore paying for a service that doesn't directly benefit themselves. Such courts fall into the category of "public good" - we are all better off in a society where the rule of law is upheld - but are not created and maintained by any invisible hand mechanism. Courts are set up deliberately to carry out a public good; and, although they may not always work the way they are intended to, there is nothing unintended about their use to enforce contracts.
Subsidy-seeking
In a democratic society, there is a strong temptation for "special-interest" groups to form and lobby the government to provide tax-payers' money to the group in the form of subsidies. Politicians find the prospect of buying the loyalty of the group attractive, and the group sees the prospect of getting other people's money for nothing. Clearly, everyone would be better off if no one sought subsidies - by definition, subsidies are only needed for unprofitable activities, that is, activities that other people do not value sufficiently to pay their own money for. However, if other people seek and gain subsidies, anyone who doesn't bother trying to do the same for themselves will end up subsidising others while receiving no subsidies themselves. This fear may force large numbers of people to spend their time lobbying the government for subsidies, rather than simply engaging in more profitable activities - a classic example of the Prisoner's Dilemma, and one over which no court has jurisdiction.
A very similar situation occurs regarding monopolies. Since pretty much every producer is a consumer, it is probably to everybody's benefit overall if no producers attempt to raise prices by monopolising their market; however, attempting to enforce a monopoly can be very attractive to individual producers. Smith rather sardonically observed that
People of the same trade seldom meet together even for merriment and
diversion, but the conversation ends in a conspiracy against the public or some
contrivance to raise prices
Arrow's Theorem
Arrow's Impossibility Theorem says that, in a certain sense, it is impossible to produce a consistent group preference by aggregating individual preferences. It is normally stated in terms of votes and elections, and, in this format, says that is impossible to use information about individual voters' preferences to decide what is "the will of the people". Every voting system in current use throws up anomalies, such as "flip-flops", which occur when a third candidate enters the race and overturns the group preference between the other two candidates (think of Ralph Nader in California, splitting Al Gore's vote and handing George Bush the election).
The "will of the people"
Again, the relevance to allocation of public goods is not immediately obvious - until you recall that an essential part of the invisible hand process is that producers respond to an single signal that is meant to be an aggregate of all signals by consumers. Arrow's Theorem is often interpreted as saying that there is no consistent way to aggregate the preferences of individuals to give a single preference which can be regarded as the preference of society - or "the will of the people".
An economic version of the flip-flop could occur if a majority of customers would prefer to buy Product X to Product Y, but some of that majority actually like Product Z even better (the equivalent of splitting the vote); the producer may end up producing Product Y even though more people would have liked Product X, and presumably it would have been more profitable to produce it. If this happens, then the invisible hand cannot be said to have worked to maximise economic wellbeing.
In a centralised society a few individuals make decisions on how to spend everyone's money and direct everyone's effort.
How far does the invisible hand reach?
How economic systems work and what can be done to improve them is still very much a live area of research for economists. Mathematicians are currently grappling with the implications of game theory for all sorts of social choice, in particular, what meaning, if any, can be attached to the expressions "the will of the people" and "the public good".
The results of such analyses will not be the only factor in deciding whether societies move towards or away from laissez-faire economics ("laissez-faire" means "let alone" and is shorthand for leaving things to the invisible hand). Political will, whether the world becomes more peaceful or less, and the practicality of any alternatives will also be factors. Alternative systems tend to require much more intervention and more stringent rules. In the real world, such rules automatically introduce more and more opportunities for mistakes and corruption, which might mean that another system, even if better in principle, would be worse in practice.
Perhaps the strongest reason for leaving the allocation of effort and reward to the invisible hand is that when it misappropriates goods, it is likely to be on a small scale. More centralised methods of allocating goods are more prone to corruption and waste. Smith described people given the spending of other people's money thus:
..being the managers of other people's money than of their own, it cannot
well be expected that they should watch over it with the same anxious vigilance
with which partners in a private copartnery frequently watch over their own.
Like the stewards of a rich man, they ... consider attention to small matters as
not for their master's honour and very easily give themselves a dispensation
from having it.
It is useful to remember the context in which Smith developed his theories - that of a heavily planned and rather dictatorial society, where some individuals were above the law and others were effectively without any rights. In a centralised society a few individuals make decisions on how to spend everyone's money and direct everyone's effort. As Smith said
It is the highest impertinence and presumption, therefore, in kings and
ministers to pretend to watch over the economy of private people, and to
restrain their expense...They are themselves always, and without exception, the
greatest spendthrifts in the society.
In this passage, taken from his 1776 book "An Inquiry into the Nature and Causes of the Wealth of Nations" Adam Smith set out the mechanism by which he felt economic society operated. Each individual strives to become wealthy "intending only his own gain" but to this end he must exchange what he owns or produces with others who sufficiently value what he has to offer; in this way, by division of labour and a free market, public interest is advanced.
Smith is often regarded as the father of economics, and his writings have been enormously influential. Nowadays, "invisible hand" explanations are invoked to explain all sorts of phenomena, from scientific progress to environmental degradation. In the modern context, mathematicians study "invisible hand" processes as part of Game Theory, the branch of mathematics that deals with payoffs and strategies.
Smith was profoundly religious, and saw the "invisible hand" as the mechanism by which a benevolent God administered a universe in which human happiness was maximised. He made it clear in his writings that quite considerable structure was required in society before the invisible hand mechanism could work efficiently. For example, property rights must be strong, and there must be widespread adherence to moral norms, such as prohibitions against theft and misrepresentation. Theft was, to Smith, the worst crime of all, even though a poor man stealing from a rich man may increase overall happiness. He even went so far as to say that the purpose of government is to defend the rich from the poor.
Here is a description of the way Smith imagined the universe operates:
There is a benevolent deity who administers the world in such a way as to maximise human happiness.
In order to do this he has created humans with a nature that leads them to act in a certain way.
The world as we know it is pretty much perfect, and everyone is about equally happy. In particular, the rich are no happier than the poor.
Although this means we should all be happy with our lot in life, our nature (which, remember, was created by God for the purpose of maximising happiness) leads us to think that we would be happier if we were wealthier.
This is a good thing, because it leads us to struggle to become wealthier, thus increasing the sum total of human happiness via the mechanisms of exchange and division of labour.
It is clear why Smith says that moral norms are necessary for such a system to work - in order for exchange to proceed, contracts must be enforceable, people must have good access to information about the products and services available, and the rule of law must hold.
The modern "Invisible Hand"
Nowadays, something much more general is meant by the expression "invisible hand". An invisible hand process is one in which the outcome to be explained is produced in a decentralised way, with no explicit agreements between the acting agents. The second essential component is that the process is not intentional. The agents' aims are not coordinated nor identical with the actual outcome, which is a byproduct of those aims. The process should work even without the agents having any knowledge of it. This is why the process is called invisible.
The system in which the invisible hand is most often assumed to work is the free market. Adam Smith assumed that consumers choose for the lowest price, and that entrepreneurs choose for the highest rate of profit. He asserted that by thus making their excess or insufficient demand known through market prices, consumers "directed" entrepreneurs' investment money to the most profitable industry. Remember that this is the industry producing the goods most highly valued by consumers, so in general economic well-being is increased.
One extremely positive aspect of a market-based economy is that it forces people to think about what other people want. Smith saw this as a large part of what was good about the invisible hand mechanism. He identified two ways to obtain the help and co-operation of other people, upon which we all depend constantly. The first way is to appeal to the benevolence and goodwill of others. To do this a person must often act in a servile and fawning way, which Smith found repulsive, and he claimed it generally meets with very limited success. The second way is to appeal instead to other people's self-interest. In one of his most famous quotes:
Man has almost constant occasion for the help of his brethren, and it is in vain for him to expect it from their benevolence only. He will be more likely to prevail if he can interest their self-love in his favour, and show them that it is for their own advantage to do for him what he requires of them. Whoever offers to another a bargain of any kind, proposes to do this. Give me what I want, and you shall have this which you want, is the meaning of every such offer; and it is the manner that we obtain from one another the far greater part of those good offices which we stand in need of. It is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from their regard to their own interest. We address ourselves, not to their humanity but to their self-love.
For Smith, to propose an exchange is to attempt to show another that what you can do, or what you have, can be of use to the other. When you carry out the exchange, it means the other person recognises that what you can do or that what you have is of value. This is why so much of a person's self-esteem is bound up in their job - a well-paid job is supposed to be a sign that others value your contribution and find it worth exchanging their own resources for.
How wise is the Invisible Hand?
The theory of the invisible hand is certainly persuasive, and its simplicity is also very attractive. No doubt every reader can see that it describes the way that things really work on many occasions, and, whether we find it palatable or not, we probably all recognise the truth of Smith's assertion that paying for your dinner is a more reliable way to get it than appealing to the benevolence of others.
But, even assuming all the correct conditions, does the invisible hand theory really lead to the maximisation of human economic wellbeing in some sense, as Smith asserts? This is where mathematics, in the form of Game Theory, can provide us with some insights.
The Prisoner's Dilemma
The "Prisoner's Dilemma" is a very famous "paradox" in Game Theory. It describes two people in a simple situation, acting in an informed manner, both attempting to maximise their wellbeing, and yet making choices that lead to an unnecessarily poor outcome for both.
Two people, who are suspected of being accomplices in a crime, are held prisoner in separate, non-communicating cells. The police visit each prisoner, and tell both that if neither confesses, each will be sentenced to two years in jail. However, if exactly one prisoner confesses, implicating each other, the one who confesses will get off scot-free as a reward, and the other, who didn't confess, will receive a punitive sentence of five years. If each confesses and implicates the other, both will be sentenced to three years.
What should a prisoner in this situation do? Suppose that the other prisoner doesn't confess. Then the best course of action is to confess, and go free. Even if the other prisoner does confess, it will be better to have done likewise - at least the sentence will be lower. Both prisoners will reason thus, so both will confess and end up serving sentences of three years - even though, if both had remained silent, both would have served sentences of only two years.
It may not be immediately clear what the relevance of the Prisoner's Dilemma is to Smith's theory of the Invisible Hand. In fact, it has a number of implications for economic behaviour.
The temptation to default
We can think of the prisoners as being asked to decide whether to keep a contract they have made with each other (remain silent) or to default (confess and betray the other). Similar choices have to be made all the time in economic society. When two people freely agree to exchange goods or services to their mutual benefit, each must decide whether to try to cheat the other by defaulting, or handing over counterfeit goods, or whether to act in good faith and risk the other party defaulting. Obviously, both parties are better off if neither default than if both default - after all, we suppose they willingly contracted with each other - but each would like to get something for nothing, and each is afraid the other will feel the same. The result may well be that the parties are unable to carry out the exchange as arranged, and both lose out.
The reason we don't see this behaviour too often is because we live in a society where courts can enforce contracts. This reduces the fear of the other party defaulting, and makes it easier to hand over goods ahead of receiving whatever is to be exchanged for them. In illegal exchanges, for example, receiving stolen goods, default is more common, and rather difficult for criminals to guard against.
Enforcing laws of contract requires cooperation and resources from someone else - in democratic societies, the courts on behalf of the government and the people. But courts and prisons and police cost money and most of the costs fall on people who were not party to the contract in the first place - who are therefore paying for a service that doesn't directly benefit themselves. Such courts fall into the category of "public good" - we are all better off in a society where the rule of law is upheld - but are not created and maintained by any invisible hand mechanism. Courts are set up deliberately to carry out a public good; and, although they may not always work the way they are intended to, there is nothing unintended about their use to enforce contracts.
Subsidy-seeking
In a democratic society, there is a strong temptation for "special-interest" groups to form and lobby the government to provide tax-payers' money to the group in the form of subsidies. Politicians find the prospect of buying the loyalty of the group attractive, and the group sees the prospect of getting other people's money for nothing. Clearly, everyone would be better off if no one sought subsidies - by definition, subsidies are only needed for unprofitable activities, that is, activities that other people do not value sufficiently to pay their own money for. However, if other people seek and gain subsidies, anyone who doesn't bother trying to do the same for themselves will end up subsidising others while receiving no subsidies themselves. This fear may force large numbers of people to spend their time lobbying the government for subsidies, rather than simply engaging in more profitable activities - a classic example of the Prisoner's Dilemma, and one over which no court has jurisdiction.
A very similar situation occurs regarding monopolies. Since pretty much every producer is a consumer, it is probably to everybody's benefit overall if no producers attempt to raise prices by monopolising their market; however, attempting to enforce a monopoly can be very attractive to individual producers. Smith rather sardonically observed that
People of the same trade seldom meet together even for merriment and
diversion, but the conversation ends in a conspiracy against the public or some
contrivance to raise prices
Arrow's Theorem
Arrow's Impossibility Theorem says that, in a certain sense, it is impossible to produce a consistent group preference by aggregating individual preferences. It is normally stated in terms of votes and elections, and, in this format, says that is impossible to use information about individual voters' preferences to decide what is "the will of the people". Every voting system in current use throws up anomalies, such as "flip-flops", which occur when a third candidate enters the race and overturns the group preference between the other two candidates (think of Ralph Nader in California, splitting Al Gore's vote and handing George Bush the election).
The "will of the people"
Again, the relevance to allocation of public goods is not immediately obvious - until you recall that an essential part of the invisible hand process is that producers respond to an single signal that is meant to be an aggregate of all signals by consumers. Arrow's Theorem is often interpreted as saying that there is no consistent way to aggregate the preferences of individuals to give a single preference which can be regarded as the preference of society - or "the will of the people".
An economic version of the flip-flop could occur if a majority of customers would prefer to buy Product X to Product Y, but some of that majority actually like Product Z even better (the equivalent of splitting the vote); the producer may end up producing Product Y even though more people would have liked Product X, and presumably it would have been more profitable to produce it. If this happens, then the invisible hand cannot be said to have worked to maximise economic wellbeing.
In a centralised society a few individuals make decisions on how to spend everyone's money and direct everyone's effort.
How far does the invisible hand reach?
How economic systems work and what can be done to improve them is still very much a live area of research for economists. Mathematicians are currently grappling with the implications of game theory for all sorts of social choice, in particular, what meaning, if any, can be attached to the expressions "the will of the people" and "the public good".
The results of such analyses will not be the only factor in deciding whether societies move towards or away from laissez-faire economics ("laissez-faire" means "let alone" and is shorthand for leaving things to the invisible hand). Political will, whether the world becomes more peaceful or less, and the practicality of any alternatives will also be factors. Alternative systems tend to require much more intervention and more stringent rules. In the real world, such rules automatically introduce more and more opportunities for mistakes and corruption, which might mean that another system, even if better in principle, would be worse in practice.
Perhaps the strongest reason for leaving the allocation of effort and reward to the invisible hand is that when it misappropriates goods, it is likely to be on a small scale. More centralised methods of allocating goods are more prone to corruption and waste. Smith described people given the spending of other people's money thus:
..being the managers of other people's money than of their own, it cannot
well be expected that they should watch over it with the same anxious vigilance
with which partners in a private copartnery frequently watch over their own.
Like the stewards of a rich man, they ... consider attention to small matters as
not for their master's honour and very easily give themselves a dispensation
from having it.
It is useful to remember the context in which Smith developed his theories - that of a heavily planned and rather dictatorial society, where some individuals were above the law and others were effectively without any rights. In a centralised society a few individuals make decisions on how to spend everyone's money and direct everyone's effort. As Smith said
It is the highest impertinence and presumption, therefore, in kings and
ministers to pretend to watch over the economy of private people, and to
restrain their expense...They are themselves always, and without exception, the
greatest spendthrifts in the society.
Monday, February 18, 2008
We see a star and admire its glitter,
the twinkle catching our eye,
and all through our lives,
we only see the twinkle,
whenever we see the star.
We know but fail to see,
that all it takes to be a star,
is an unending fire.
A fire thats beneath the surface,
the fire that made it the star it is.
And had we seen the star this way,
we might as well have woken up to the fact,
that the only thing separating us,
from being the star,
is the lack of fire in our hearts.
the twinkle catching our eye,
and all through our lives,
we only see the twinkle,
whenever we see the star.
We know but fail to see,
that all it takes to be a star,
is an unending fire.
A fire thats beneath the surface,
the fire that made it the star it is.
And had we seen the star this way,
we might as well have woken up to the fact,
that the only thing separating us,
from being the star,
is the lack of fire in our hearts.
- An excerpt from 'Joker in the Pack'
Sunday, February 17, 2008
Friday, February 15, 2008
“Remixing is about taking something that already exists and redefining it in your own personal creative space, reinterpreting someone else’s work your way. [It’s about] taking an idea and making it suitable for a whole new audience.” — Matt Mason, THE PIRATE’S DILEMMA
“Entrepreneurs look for gaps in the market. Pirates look for gaps outside of the market. By thinking like pirates, people grow niche audiences to a critical mass and change the mainstream from the bottom-up.”
Never let your trading profits turn into a loss
This is a simple enough rule that everybody applies without thinking about. When a floor trader first told me about it I dismissed him as being overly cautious. I continued to make the mistake of selling out my winners and keeping my losers. As a young trader, my mistakes could be overcome; as I get older, the mistakes are more difficult to overcome.
Let's go through the process of placing a trade to illustrate how I manage to maintain a profit in it. When I make a decision to buy or sell a futures or a stock, I also figure out how much I am willing to risk on the trade.
Let's say I want to buy 100 shares of IBM at $124 per share. I figure out that I will put in a stop order at around the $121 level. The actual number is something like $120-7/8. Whole numbers and even fractions are where the public enters the markets; I stay away from public orders.
There might be a lot of public orders resting at $121 to buy the stock, but all the orders to buy at that price won't be filled. If they are all filled at $121, there's a reason why informed insiders would be willing to sell all the public wants to buy at the $121 level. My selling out my position at $120-7/8 would be warranted because the price of the stock should drop pretty drastically after all the public orders to buy at the 121 support level are taken out.
Let's go back to the original scenario, where I buy stock at $124. I now enter an order to stop out my position at $ 120-7/8. At $120-7/8 I am taking a $3-1/8 risk. If the price does not drop to my stop price, then I must wait patiently for it to go up. The rule that cautions me not to let a profit turn into a loss tells me that once the price of the stock goes above my purchase price I must get rid of it if and when it starts to show a possibility of a loss.
(The rule does not tell me to get out of a winning position if it shows a profit!). If the price reaches a high of $124-1/8, I must be willing to let it go at $124 if it ever dips back there. At $ 124-1/4 I must sell it if it gets back to $124. If it shoots up immediately to $130, I must sell it if it gets back to $124!
However, strict adherence to the rule is impractical for two reasons. The first reason is that markets never go straight up or down. If you bought a stock at $124, you can't realistically expect it to go straight up without any backing action. The second reason is that the cost of commissions to the outsider is too high relative to the minimum fluctuations. If commission costs are $50 for a one-sided execution on a 100-share trade at $124, the stock price would have to go up to $125 before you would break even. If you got out of the trade at the same price you went in, you would wind up a loser.
In this example I used a trailing $3-1/8 point stop, or whatever dollar amount I was willing to risk on that type of trade. That is, if the stock trades up to a high price of $125, I would move my stop up to $121-7/8, risking $3-1/8. If the stock trades up to $126, I would move my stop up to $122-7/8, still risking 3-1/8.
The subjective judgment comes in once the stock trades at or above $125. Here I would risk a potential loss of $2-1/8 from my original entry position of $124; at $126 I would risk a potential loss of $1-1/8 from my original entry position of $124. I am making a distinction between potential losses from entry price and the potential loss from the high move. The first case is oriented towards trading equity, independent of market action.
In the second case, the profit valuation is based on trading equity plus a portion of the paper profits dependent on the high of the market's up move. My main objective is to preserve my initial equity. If I can maintain control of my equity, I will have greater control over market risks to my paper profits.
In either case -- a $125 high or a $126 high -- I would risk losing part of my equity. According to Rule 4, any deterioration of trading equity is not acceptable, so with the entry price at $124, my exit point must be at $124 if the trade goes against me. The problem concerns the definition of a loss. At what price level or time span, relative to the entry level of my trade, do I have a loss?
When you put on a trade, the potential loss must be taken out of your trading capital. If you buy stock at $124, you place a stop at a lower price. The difference between the entry price and the stop loss price is your potential loss.
When the trade you have put on starts to show a profit, at what point do you consider the paper profits a part of your trading capital that you can use to gauge potential losses? If the stock you bought at $124 is now at $130 and you still have the open position, you now have a paper profit of $6; on 100 shares of stock you show a profit of $600. At what point do you consider this $600, unrealized as it is, to be part of your trading capital?
This is hard to determine, and since you are dealing with capital, it isn't a question of mere semantics. If you consider your trading capital to be original capital less the paper profit, then you can let the price of the stock dip all the way back to $124 before you start to worry about a deterioration of your trading capital.
If, on the other hand, you consider the $600 paper profit to be part of your trading equity, then once the price dips below $130, you will have sustained a loss. I settle on something in the middle when the price appreciates to a level where my position cannot be taken out at a loss if the trailing stop order is executed -- I take half of the paper profits, as marked by the extreme of the move and use that as a stop point, give or take a few fractions. That is, with the initial entry price of $124 and a high swing of $130, I would place my stop at around the halfway mark -- somewhere slightly below $127: $ 126-7/8 or $ 126-3/8. This is a rule of thumb to preserve some sort of profits. The actual stop price might be closer to the lower range of some important chart support point.
I have always chosen the halfway mark as a balance. At a one-half retracement back, you have an even chance of being wrong or right. A one-third retracement back would be giving the market too little leeway in reactions. The market often retraces one-third, only to resume its original direction. If you unload your position at a one-third retracement, you would be selling prematurely out of a bullish move. On the other hand, a two-thirds retracement would be offering the market too much of your profits. I have often found that if the market backs two-thirds, it is too weak to rally much. If this situation occurs, then it is a good idea to close out your positions.
Whatever frame of reference you use to determine whether market retracements have affected your profits, you must do it systematically. You can't consider a dip below the high of the swing to be a loss of profits on one trade and a dip to the halfway mark of your paper profits to be an erosion of profits on the next trade.
A systematic approach to valuing market losses is crucial in evaluating future market trends. The permutations of the markets are infinite and random, whereas the methods of analyzing the markets are finite and must be systematic. Your goal as a successful trader must be to make the market less random and less infinite.
Excerpt from Stock Market Trading Rules: 50 Golden Strategies by William F Eng.
"Ideas are usually rejected out of turn for being too 'something' — too fast, too unproven, too far beyond the corporate image. 'Too something' is a reactionary description used to take the edge off ideas that are strong, bold, and a little scary at first sight. Your challenge is to help people discover a means, harmonious with the culture, to accept your concept."
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