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Thursday, March 28, 2024

Goodhart’s Law: When Investors Mistake The Distortions Of The Wall Of Money For Wisdom

Courtesy of ZeroHedge View original post here.

By One River Asset Management CIO, Eric Peters

“When a measure becomes a target, it ceases to be a good measure,” said the Englishman, stepping outside of himself. “That’s Goodhart’s Law.”

Charles Goodhart observed that central banks measured money supply, and found certain M1 growth rates to be optimal. But once they targeted that optimal range, M1 lost its value as a measure.

Market and economic actors adjusted their behavior to game the M1 system. So central bankers shifted to M2, then M3, and M4.

“Investing is obviously not a science, but if it were, we would say that you can’t act on something and observe it at the same time.” French colonialists discovered this in rat infested Hanoi, when they offered a bounty for killing rodents. To receive the reward, the Vietnamese were required to produce severed tails.

Soon thereafter, tail-less rats scurried throughout the city. The bounty hunters removed their tails and released them to the filthy sewers to breed. Boosting their bounty.

“Investors discover pricing anomalies from the past. And they pile into them, ensuring that for a time they persist.” They mistake the distortions of their wall of money for the wisdom of their observations.

They interact with the market as if they’re exogenous, when, in fact, they’ve become endogenous. “Today’s greatest example of Goodhart’s Law in action can be found in volatility markets.”

The VIX index measures the expected volatility of the S&P 500, and is calculated by multiplying expected 30-day variance by 100. As a measure of market fear, it was quite useful, until it became something that could be traded.

“The sheer size of outstanding positions in VIX futures, VIX options, ETFs, ETNs and bank volatility selling programs is such that those trading these markets can no longer separate the true measure of volatility from their own actions.”

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