Tuesday, June 12, 2012

Can you spare a dollar?

I'd almost be confident in saying that at some point in everyones lives, and by everyone I mean the usual - wealthy white westerners, we have had the thought 'if just everyone in the world gave me a dollar, all my problems would be solved and they wouldn't even notice the lost dollar.' or something like it.

Of course it amounts to nothing more than wishful thinking, we quickly recognise that although a dollar is nothing much to the people that possess them in plenty, it is too arbitrary for us to be designated as the recipient. It is too unfair to ever happen in real life.

And yet it happens, it happens all the time. You are giving not just a dollar up to somebody arbitrarily but many dollars, potentially thousands.

I'm talking of course about fund managers, finincial planners, finance experts, investment firms, managed funds etc. The entire industry exists and is sustained, propegated and well compensated for one reason and one reason only: confidence.
Confidence. noun 1. full trust; belief in the powers, trustworthiness, or reliability of a person or thing: We have every confidence in their ability to succeed.

Not expertise. There is no evidence of expertise, there is almost no history of expertise, the expertise is simply arbitrary. Or post-hoc, we entrust our money to them therefore they are experts not they are experts therefore we entrust our money to them.

The vast bulk of 'mum & dad' invesotors' (a tautology if ever I heard one) funds are accrued passively through supperannuation (401k plans in the US, and I'm sure Europe and Japan have their local equivalents) and these funds have to go into some kind of 'super-fund' of which deregulation in Australia saw the number of which massively increase once superchoices came into effect and then rapidly decrease to be dominated by industry super funds.

What made the difference? Not expertise, just fees. Low fees. You would be amazed at how mythical the notion of finance expertise is.

For example, the majority of fund managers, people who look at the sharemarket every day, read the Wall Street Journal, meet in the morning with other experts, have doctrates in advanced mathemagicalness and have six monitors on their desk are outperformed consistently by index funds.

Index funds just try and imitate as closely as possible the share market as a whole. It requires no real expertise and costs far less generally than having a fund manager manage your funds.

Let that thought explode in your mind for a while. Most fund managers would have performed better if they had not performed at all. If they had not attempted to pick winners or time the market or even manage risks.

And yet we trust these very people with their poor track records with sums of money that are supposed to determine our quality of life in our twilight years. It is not uncommon for example for an investment bank or managed fund to retain a staff member on $100,000 a year, plus a $20,000 signing bonus, plus a $100,000 annual (or staying) bonus simply for staying in the job. And yes the job is horrible, but consider that they are paid this despite their average customers superannuation balance being $50,000 (and shrinking).

This works because it is scalable, that is one fund manager can manage a thousand clients funds. One decision effects 1000 people, they don't need to make 1,000 decisions. But it doesn't work because they don't do a good job. They don't do a good job because they don't know what they doing. Not only do they have no-idea what they are doing, they often have no-idea they have no-idea what they are doing.

For example, there is a compelling and beguiling theory called 'efficient market theory' or 'efficient market hypothesis' that says the market is basically this huge supercomputer that efficiently determines the correct price of everything in it, and doesn't make mistakes. I personally am a fan of EMT in terms of thinking that their is no information produced by the market that can be exploited for personal gain. I'm not a fan of EMT when it is interpreted as 'the market can't make mistakes.' EMT should liberate you from the absurd notion that you need to read the Wall Street Journal to keep up to speed with the market. I'm not a fan when it is used to disregard phenomena such as asset-bubbles.

Proponents (indeed Authors) of EMT, don't like the traditional Keynsian explanation of bubbles - markets are driven by emotions. Because they will correctly point out that 'emotions' are not an explanation. But it is better to say 'markets are driven by emotions so who knows what the fuck they will do' than to say 'blah blah blah mathematical model therefore = confidence.' or as Nassim Nicholas Taleb puts it 'it is better to be approximately right, than wrong with infinite precision.'

The problem is taxi-drivers. Estimate the percentage of Taxi-drivers that are bad drivers despite their extensive hours on the road. Now estimate the number of taxi-drivers that would describe themselves as good drivers. I'm going to guess that typical responses to this exercise are 90% and 90%. How does this disparity occur? Well the figures are probably incorrect, but can we concieve that the disparity arises because the very criteria we use to evaluate somebody else as a bad driver is the exact criteria they may use to evaluate themselves as a good driver.

Thus thusly, what I would use to describe somebody as an incompetent investor is if they earned top marks in a finance degree. Precisely the thing that gives them confidence in their own abilities. And confidence is the mistake, and why it is not just arbitrary to redistribute our wealth to them, but probably misguided.

This post was inspired by the Address to the Princeton Graduates by Michael Lewis author of 'Moneyball' and 'Liars Poker'. Lewis pointed out that as long ago as the 80's the practice of hiring people into finance to handle millions of dollars of other people's money based on a subjective view of their intelligence was thought of as a winning strategy.

Lewis was shipped to the London office of Salomon Brothers as a bond salesman. Despite his lack of knowledge, he was soon handling millions of dollars in investment accounts. In 1987, he witnessed a near-hostile takeover of Salomon Brothers but survived with his job. However, growing disillusioned with his work, Lewis quit the firm at the beginning of 1988 to write this book and become a financial journalist. The first edition was published October 17, 1989.
This isn't a once off mistake, it's common practice. Driven by confidence, not expertise. Confidence in Wall Street, confidence in experts, confidence in regulators and business practice, confidence in higher education, confidence in academia, confidence in economic theory, confidence in consumers, confidence, confidence, confidence.

The whole system is based on trust, and it probably has to be. I am not one of those moron's that thinks dropping the gold standard and switching to 'legal tender' as a system of money (*cough* Zeitgeist *cough*) was too much trust. I mean commerce is if nothing else a system of trust. I am simply saying the trust is being abused.

I have a degree in marketing, so I know that if you have somebody from the bodyshop say 'this cream will moisturise you skin and make you feel good' dressed in a hemp t-shirt and jeans made by adults in a developing economy under fair trade conditions, a person is less likely to buy the product when approached by a woman with no qualifications in a lab coat in Myers saying 'blah blah blah anti-ageing science = rejuvination'. In just the same way the people we should trust our money too, the people like Warren Buffet and Benjamin Graham before him who say 'I don't pretend to understand it, I just buy what I know when the price is right.' are cast aside in favor of 'we have 17 risk managers calculating Beta's to determine the optimum portfolio to diversify away your risk and blah blah blah derivatives = higher returns at lower risks' that shouldn't be trusted with $1 let alone thousands and millions. The government probably needs to step in and regulate away our tendency to be impressed by scientificness and repulsed by honesty and epistemic humility.

But still, next time you find yourself wishing everybody would just give you a dollar for no reason, consider a job in finance. And next time a hobo asks you if you can spare a dollar, you may as well make them your fund manager. They will probably lose less. Alcohol and Cigarettes tend to perform well in recessions.

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