Jevon’s Paradox and the Long Tail of Investing

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Here is one possibly useless idea for you to chew on for the rest of the day. We’ve said before that the defining trend of the 20th century was the centralization of power and energy. This favoured big institutions… especially big government and big oil. All of that is under stress as the world becomes more competitive. Big is out. Little is in.

But what about money? Hasn’t it too, become centralized in the 20th century? By centralized, we really mean equitized and marketized and digitised. Hasn’t globalisation made it easier for money to move to and fro seeking yield, through a centralized network of trading systems? And hasn’t this very mobility of capital actually reduced the size of the returns you can expect to find?

We had the thought the other day because we read the words “efficient global capital markets” somewhere in the newspaper and instantly thought of 19th century British economist William Stanley Jevons and his eponymous Jevon’s Paradox.

Jevons showed that the more you use something (in his day, coal), the more you increase demand for that thing. Increased efficiency in finding or getting energy from say, coal or oil, did indeed lead to greater demand. After all, when you’re getting more energy from it and finding more of it to begin with, you’d be a fool not to use more.

The irony, Jevons, pointed out, is that increased efficiency led to a higher rate of depletion. The more you use something, the faster you exhaust its supply. It’s a feed-back loop of sorts, with the net effect of depleting a resource more quickly the more efficiently you use it. Just think of how the second half of the bottle of wine always goes more quickly than the first half. Or how the second bottle of wine goes more quickly than the first, and you’ll grasp the gist of the idea.

Now, how does this apply to capital markets? Well, there is no doubt that globalisation has expanded the number of investment opportunities you have, your resource base. Icelandic bonds, commodity currencies, American mortgage- lenders…the world is your investment oyster. But wait, there’s a grain of sand to consider.

Information about all these new opportunities is also widely available. Usually using the Google is enough to give you a good lead. Rare are the glaring opportunities where you can find an undiscovered stock at an incredible value, or buy a dollar’s worth of earnings for fifty cents. So your opportunities may have expanded in sheer numbers, but so has the number of investors you are competing with for the same market-beating returns.

There’s probably some kind of new-fangled Daily Reckoning law in all of this, in which the expansion of investment vehicles leads propotionally/arithmetically/gemoterically to a shrinkage in the total return. But we’ll leave that up to our un-official Law Giver, Bill Bonner.

What we think this means is that the globalisation of investment markets resembles the Long Tail Wired Magazine editor Chris Anderson described in his book The Long Tail. There are fewer big hits but a mot more niches. You get fewer huge winning stocks but a lot more smaller, respectable returns.

Perhaps this explains why hedge funds have become so popular. Hedge funds are good at exploiting a wealth of niches in order to produce a total return that beats the market. But the vehicle itself is a concession that the really huge returns…well…they just aren’t there in a market where everyone has access to good information and cheap capital. Information and capital are great levelers.

So what does this mean for you as investor? Well, it doesn’t mean there aren’t any big returns left. It just means you have to work harder to find them.

You’ll find them in sectors or asset classes where information is less than perfect and not widely dispersed to the public. The Australian gold mining industry is one sector that comes to mind. Small cap stocks are an asset class that also comes to mind, which is why have lately taken to analyzing small businesses again, because it is one place we think you have an advantage of Henry Paulson and the Goldman Sachs Alpha Fund.

In other words, in markets where not everyone has the same information (because, by its nature, the information is hard to get), you have a chance to discover value that other investors haven’t, simply because they don’t know about it and can’t be bothered to look that hard.

Another example might be Indian stocks. There are thousands of listed stocks, but less than a few hundreds that analysts actually cover. The analysts cover large stocks that can accommodate cross-border money flows.

But what about all the small, healthy, growing businesses? They are simply too small to get anyone’s attention. And that, we would suggest, is good thing. It’s exactly where you should be looking. The fact that these stocks are so hard to find is what makes them so worth looking at. Smaller is better. Big is lazy.

Of course, it would be much easier if we could just all buy the same 15-20 big companies, own them for about twenty years, and live of the proceeds once its time to sell and retire. But that too, is a naïve financial myth, fit for children and bedtime stories, not for serious investors with a retirement to play for And it too, will be forcibly discredited by a crash, at which point it will be good to have some capital on hand. You’ll want to be a buyer.

By the way, we officially downsized ourselves, selecting a small flat in a building with 10 units. We trade a little privacy for a much lower rent payment. The cash is compensation for the blow to our vanity, which was probably over-due for a correction anyway.

Dan Denning
The Daily Reckoning Australia

Dan Denning
Dan Denning examines the geopolitical and economic events that can affect your investments domestically. He raises the questions you need to answer, in order to survive financially in these turbulent times.
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