Money carries no passport, but it slides through almost any border. It flies no flag, but it is welcome in almost every nation. It speaks no language, but when it talks, everyone listens. But for all its passe-partout appeal, money has more enemies than friends. And the biggest threat is probably is the financial industry itself.
“Don’t worry,” the bright young man at a London private banking told us, “we maintain the highest levels of professionalism and use the most sophisticated tools of modern portfolio management.”
That was just what we were worried about. What follows is a lament…and a complaint…about the current state of people in the financial métier: they have been disabled by their own theories…handicapped by their own greasy trade.
We were impressed by the man in front of us. Handsome, well-dressed, well spoken in three different languages, he had spent years learning the principles of economics, finance and business management. His palaver to prospective clients was flawless. Yes, he said, the research department is keenly searching for alpha…but it knows that 80% of performance comes from careful asset allocation, which the bank’s strategists have calculated based on risk/return analyses going back a hundred years. The expected return from Japanese equities over the next five years, for example, will be precisely 7.56%…but with an anticipated volatility of 20.43%.
But then we learned that we didn’t have to live with volatility. The firm’s analysts have done extensive research, he explained; they’ve been able to find many different asset classes that had equal and opposite volatilities.
When Japanese stocks bob in one direction, for example, the firm’s Ultra-leveraged Macro Opportunity Hedge fund weaves in another.
Just throw the mathematicians a bone; they’ll figure out how to put these things together so that you can optimize your return while minimizing your risk. Then, according to the math whizzes’ calculations, you could find yourself with a 90% probability that your $100 investment will grow to somewhere between $292 and $132 in year 10. This, it should be mentioned, is a “nominal” value. Even if the target is hit, the $132 may not even buy you a cup of coffee in London. It barely buys you one now.
So many numbers… 6s and 7s…5s and 4s…every number the Arabs ever invented is brought into service. But what do they really mean?
“Can you tell us what the price of oil will be next week,” we began to torment our interlocutor. “Or, how about the dollar?”
“Of course not.”
“Then, how can you make projections ten years out…on investments, all of which will be greatly influenced by the price of oil, the strength of the dollar, inflation rates and completely unforeseeable events?”
“Well, these are not predictions. They are projections, based on many years of experience. Our researchers are the best in the business, with degrees from Harvard, MIT and Oxbridge. Of course, no one knows what the future will bring…but these projections are the best output of modern portfolio management.”
Pointing to a helpful chart supplied by the investment firm, we continued our interrogation:
“In the last 6 months, Merrill Lynch has had to write down an amount equal to almost half its book value? UBS has written off 40%. If these financial engineers were really able to project earnings and risk out to 2 decimal places, how come they couldn’t protect themselves from this blow up?”
They ought to give special parking places to anyone who studied business, economics or finance in the last 30 years. Higher education has lowered their I.Qs. Years of toil in academia have weakened their vision and taken the common sense right out of them.
A blind man could have seen the blow-up in sub-prime coming. But somehow, the geniuses missed it. What went wrong? The disabling infection may be understood by looking at how the hot shots handle risk. Of course, they don’t really have any way of knowing what real risk is; no one can know the future. For all we know, a plague will wipe us all out in the next three weeks. None of us knows what the price of oil will be next week…or next year…or 10 years from now. Nor do any of us know what real risks the oil market faces. War…weather…technological advance…who can say?
But rather than admit that it just didn’t know…the financial industry embarked on a staggering series of myths and conceits that must have taken the gods’ breath away.
Since they couldn’t know real risk, they substituted volatility as a proxy, which is a little like getting an inflatable doll to take your wife’s place at a dinner party; the conversation may be dull, but at least she won’t contradict you.
Once they had shut up risk, they could say whatever they wanted. They could pretend that price movements, for example, were like natural phenomena. It was absurd and everyone knew it. Prices depended on what people thought; volcanic eruptions did not. But Richard Fama put forward the Efficient Market Hypothesis in the 1960s as if he had stolen the gods’ fire. He claimed market data could be treated as if they were random fluctuations. If an earthquake had stuck Rome only twice in the last 100 years, the ‘risk’ of an earthquake was only 2%. For all they know, the streets of the Eternal City will rock and roll every day for the next 200 years…but this little subterfuge gave their mathematicians something to work with. Then, looking at price patterns as if they were seismic records, they could make all sorts of fantastic simulations…and come up with fancy new products, such as a Highly Leveraged, Sub-prime Debt Portfolio. Using historical norms, they pressed the junk credits together like potted meat and — in a miracle that would have floored Jesus – transformed it into Prime A.
But it was all nonsense. The prices thought to be random weren’t random at all, but the consequence of practices, ideas, and institutions built up over centuries. Change the circumstances…and the numbers changed too. As Soros puts it, markets are ‘reflexive.’ In our words, prices are neither fixed nor random…but subject to influence. For example, it was observed that stocks outperformed bonds over the longterm. Stocks for the Long Run was the title of a best-selling investment book in 1994, which argued that stocks would make you rich if you held them long enough. This long-term reward was in return for investors’ willingness to take short-term risks; they called it the risk premium…which they defined, again, as volatility. Stocks were down in some periods, but always up over the long term. Thus, for a person who could wait, there was no risk at all.
By 1999, no truth was more obvious: stocks would make you rich. By then, the whole financial world was alight…stocks had risen three times since 1994 – to over 11,000 on the Dow by the end of the year. Now, it was time to pour on the gasoline. Another best-seller appeared that year: Dow 36,000.
No one seemed to notice that those data points that convinced investors that stocks were such a great investment were registered when people thought stocks weren’t so great. For much of the stock market’s history, investors had demanded higher dividend yields from stocks than they got from bonds – to make up for the risk. And they had rarely paid more than 20 times earnings. Yet, in 1999, the p/e ratio of the S&P rose over 32 – about twice the long term average. Circumstances had changed; the insight was no longer valid. And the fire went out.
The Dow may still go to 36,000, probably when a cup of coffee goes to $132. Last we looked, it was almost 10 years later and the Dow was back to where it ended 1999. During this time, too, the dollar has lost about 30% of its purchasing power…so the investor who believed in stocks for the long run is down about a third.
To be continued…
Markets and Money