Disclaimer - this was going to be a long and mostly boring post. But once I got to the end, I realized I had a really awesome and badass point. Just wanted to give you a heads up.
You know something that fascinates me? Traffic. When I'm sitting in traffic in the mornings, I'll try to put away my inevitable rage from driving down I-95 during rush hour in Philly by thinking about how traffic moves.
Mostly because efforts to convince my wife to lean out the window and offer unsolicited but honest fashion and beauty advice to strangers have been unsuccessful.
The thing that fascinates me about the flow of traffic is an analogy that I came up with when I was first learning about how the stock market operated. It's overly simplified and mostly wrong, but it was how I first started thinking about how awesome the flow of traffic can be from a theoretical perspective.
So here's the analogy:
Each lane is like a different stock or fund. You can only see so far down the road, and a lot of times, that short line of sight can prove to be wrong. You don't know which lane will be the fastest, and your goal is to reach your destination in the quickest way possible. Thus, you must shift lanes when you think it would benefit you most. In terms of our analogy, switching lanes would be roughly equal to selling out of one stock and buying into another one. In this way, reducing time spent driving effectively equals increasing portfolio value.
An interesting thing about traffic, though, is that there are CLEAR sections of the highway where it is absolutely beneficial to be in one lane versus another, which is where the finance analogy really starts to break down. For example, leading up to an exit, it is in your best interest (assuming your goal is to get to your destination asap) to be in the exiting lane for as long as possible. But immediately after an exit, when new cars are entering the highway, it is in your best interests to be as far away from those entering cars as possible. Thus, you have to merge over a few lanes in a very short distance in order to get to the most beneficial lane.
Knowing that there is a clear way to advantage of a situation is called arbitrage in finance. If there's an obvious mis-pricing of a stock, an arbitrageur (someone who engages in arbitrage) will try to profit by exploiting that mis-pricing. It's obviously more complicated than this, but it serves our purposes here. Finance theory says that arbitrageurs will exploit this mis-pricing to the point where the stock comes back in line with its fundamental value, thus erasing that mis-pricing.
So, I was sitting in traffic yesterday, because some jerk-face decided to crash his car into another car so badly that at the very beginning of rush hour, there was already a 45 minute delay (how dare he?). And I was driving about 20-25 mph down the road in the lane leading up to an exit while everyone else was stopped dead. Just before the exit, I merged and ended up saving myself a good 15 minutes of sitting. I started thinking about how I was an arbitrageur. But why was it that no one else was taking advantage of this "obvious mis-pricing"? There were maybe one or two, but not enough to completely erase the advantage, like what would happen in a financial setting.
Then I laughed cynically to myself, realizing from the middle finger of the guy I cut off to merge over that, well, I was just driving like an asshole. Apparently, morality has a place in society after all - serving as the deterrent for dick-like behavior.
But what does that say about the world of finance?