The Paradox of Friction

Economic friction is everything that keeps markets from working according to the textbook model of perfect competition: Distance. Cost. Restrictive regulations. Imperfect information. In high-friction markets, customers don’t have many suppliers to choose among. Owning a factory — or a store with a good location — counts for a lot. It’s hard for new competitors to get into the game. The marketplace moves slowly and predictably. Low-friction markets are just the reverse. New competitors crop up all over, and customers are quick to respond. The marketplace is anything but predictable.

— Inc. Magazine 06/01/1996

Adam Smith wrote about economic friction in terms of trade barriers – such as taxes and tariffs – in his master work, An Inquiry into the Nature and Causes of the Wealth of Nations. It is an old idea.

Economic orthodoxy regards a reduction in economic friction as an increase in efficiency – usually a good thing – and, by the work of economists such as Vilfredo Pareto (1848 – 1923) we come to the idea of a Pareto Optimality wherein:

Pareto efficiency, or Pareto optimality, is a state of allocation of resources in which it is impossible to make any one individual better off without making at least one individual worse off.

Pareto optimalities are, however, rare in the real world (the capital markets may be the exception) and most economists would agree that Pareto’s biggest contribution was the construct of the “Pareto Gain” where a marginal movement toward an optimality creates net gains for market participants. We know it as a “win-win”.

Pareto, though, was also a sociologist and did not claim that a market in an optimal state added to the well-being of society in every case. We’ll leave Pareto’s controversial social writing for another discussion.

Shut Up And Take My Money

I think about such things and, God knows, it’s a waste of time – but, as Russ Roberts might say, a lovely waste of time. In today’s economy, though, perhaps keeping friction factors, efficiency and, ultimately, productivity in mind we can better our lot in life.

Recently a Jimmy Johns was opened close to my house. I had never ordered from them prior to then. I installed their app, ordered a sandwich and, as advertised, it was delivered “freakishly fast.” Their app stores my order history and now I can compete the entire sales cycle from order to delivery in roughly 10 minutes. I’ve done it many times now.

Amazon differentiated itself when it introduced “1 click”  purchasing. In doing so it removed about some 4 steps in placing an order from the traditional eCommerce site.

Domino’s Pizza has given us the ability to simply text a pizza emoji and your favorite pizza (I have significant trouble calling it “pizza” but, whatever) will come hot and fast to your home.

Twitter is working on a 1 click order system for nested ads that pop up in one’s stream.

I can go on and on. The number of these kind of apps are almost too numerous to count.

In economic terms, all this technology does represent significant reduction of friction and increase in efficiencies: Efficiently Separating People From Their Money For Impulse Purchases.

Is it a Pareto gain? At the risk of sounding like a “get off my lawn” Luddite, I’m thinking not.

Young adults, with a mountain of student loans and the crush of having to reconcile the future with a public Keynesian legacy in the trillion$, would be well served by more, rather than less, friction of this sort.

Meanwhile, most people – and millennials in particular – think it’s really cool. It is – until one overlays the time value of money on it.

As investors we like all of this. It’s fuel for sales. And Wall Street has a raft of new “stories” that tell us things like a coffee vendor is now really a technology play. Now that’s a win-win – especially for the sell side.

As a side note, I read this week that in 1950 the average household prepared 90% of their food. Today that has dropped to 50%. If you bemoan that we’re becoming an economy of people selling each other burgers, we’re on that trend.

Pareto Babies And Bath Water

Since near the middle of the recent bull run, the outcry for passive management (there really is no such thing) and ETF investing has increased in volume to the point that, near the end of 2014, paying management fees placed you in a very special class of boob – at least from the perspective of many economists and most financial journalists.

I know that one year does not a trend make but if you’re a 60/40 (70/30) portfolio “allocator”, you’ve been outperformed by cash YTD.  I won’t go on again with the faults I see in Modern Portfolio Theory. I will say that many late comers that put their money in an MPT strategy won’t have the discipline to stay in. We see this every time the market plateaus or goes into a bear trend.

Like buying through Amazon, retail traders, 25 year old portfolio managers, and asset gathering investment advisors can buy a large swath of the market with one click through ETFs. It’s an efficiency we didn’t know in days of yore. On the other hand, the market structure tilt from so much money undermines price discovery of individual stocks. Just look what happened to biotechs last week if you need proof.

Now, from the standpoint of the health and the pricing component of efficient capital markets, I disagree with most economists that ETFs are in any way efficient other than reducing buyer friction. Because I love markets I don’t like what ETFs do to them.

As a money manager, however, one cannot help but embrace the price inefficiencies caused by the influence of ETFs on the market’s structure.  That, though, is a two edged sword in the short run and riding the volatility can rattle one’s nerves. But alpha gets built on price inefficiency.

No matter if you’re a value or growth investor, this is where the gold is. Keep your watch lists current and set your alerts. Then wait for your price.

How I Did This Week

The portfolio was up about 30 bps and has been more or less flat for the last 3 week. The grind is hard. I have a feeling it’s going to stay tough for a while.

So many people are looking for a year end rally. I have no idea. The market tends to move on the path of greatest frustration. All we can do is watch.

Please pass the Xanax. I think there’s a Pareto gain in that.





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