31 Oct 2024 In My Adverse Selection Era
For those of you who are unaware, the title of this blog is in some way an allusion to a Taylor Swift meme, and I’m honestly not sure I’m even using it correctly. Writing on the internet can be hazardous.
I’m not really here to talk about Taylor Swift, but let’s imagine a scenario: You are waiting to go into one of her concerts, surrounded by thousands of others doing the same, and someone comes up to you with an offer: “For $200, a bargain relative to the price of the ticket you’ve bought for this show, my firm SwiftStream is offering investors an opportunity to share in Taylor’s quest to buy back her original catalog.”
A couple of things here: 1) I hope you would turn this down as an obvious fraud due to…a random person trying to sell you an investment at a concert. But 2) even more important than the concert context clues is the actual nature of the offer.
In other words, why in the world would Taylor Swift or anyone associated with her business dealings be wanting your $200? For that matter, what could Taylor Swift possibly want with your $200,000?
This is all very silly of course. Taylor has re-recorded her own music and hopefully no one ever tries to sell you an investment product at a concert. But behind this silly illustration is one of the more overlooked and misunderstood concepts in finance: Adverse Selection.
Adverse selection is basically the answer to the question, “Why is someone approaching me out of the blue selling this thing or proposing this trade?” Well, they are approaching you because of information asymmetry—they know much more about the trade or product than you—and because of that fact it’s exceedingly unlikely that you will get what you want from it, and exceedingly likely that they will. There are rare exceptions, but as a general rule, avoid these products and trades.
Here’s an example of adverse selection: A couple of years ago, a well-known real estate firm was going around my old neighborhood—a neighborhood rich with information asymmetry due to the age and income levels of many of its residents—offering quick, cash closes on their homes. We were about to sell our home anyway, and though I had no intention of selling to this firm, I was curious to know what they would offer. And the actual, real-life signed offer I got hand-delivered to my office was 32% lower than what we ended up selling it for by placing it on the market two weeks later.
Here’s another example: The reason there are so many salesmen selling permanent life insurance and structured notes (etc.) is not because permanent life insurance and structured notes are good insurance and investment products for those buying them, but because they are great products for the companies (and salesmen) selling them! And what’s worse, you’ll get tons of “information” in the disclosures relating to these products, but they are little more than complex exercises in obfuscation. In some ways it’s worse than no information, because it gives a false sense of knowledge and understanding.
Here’s another example: Periodically, folks who are of a certain income or wealth will get pitched by startups seeking to raise money (like the Taylor Swift example above). But again, it is important to ask, “Why you?” If the company has a great business idea, then why have they not been able to get funding from venture capital firms whose entire business model revolves around funding possibly good ideas? And if they have a great business, why do they need to dilute their equity by seeking small lot investments in a new offering? As Agustin Lebron says in his book, “The profitable trades that exist in the world are either (a) the ones you’re intimately involved in running, or (b) the ones that are inaccessible to you. There is no (c).”
Look. There’s rarely, if ever, perfect information symmetry. Any sale or trade will tend to have slightly more uncertainty on one side than the other. But the point of this whole blog is to help you realize that it’s extremely important to avoid situations where the asymmetry is largely stacked against you. It is important to develop a healthy skepticism of cold and/or complicated pitches that are seeking you out for no obvious reason. And it’s important to be humble. As Matt Levine says, “People selling financial products love investors who think they are sophisticated.”
Do those three things, and you can avoid your adverse selection era!
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