Thinking and Financial Accountability

Robert Kramer contributes: “Thinking and Financial Accountability: A (not yet) Rightfully Unequal Burden”:

A common error in thought, though not an unexpected one, is for a person to use one or several pieces of data as a marker for another piece of data, as in, for an outcome. For example, in the medical community, researchers look at biological markers (genetic make-up, etc) as they relate to different diseases, with the idea that those markers are predictive. In some cases markers and outcomes are correlated. This process is often a good thing. However, there are a few important issues concerning correlation: one is that correlation does not mean causation, and two is that correlation does not mean correlated all the time. So even when markers are present and positively correlated to outcomes, there are many times when the outcome does not occur despite the marker being present, and many times those doing the research still do not know (and sometimes cannot know) why the correlation is there in the first place. Many hedge fund strategies are based on, or use correlation (via multivariate regression, etc) to select portfolios or to look for combinations of events occurring simultaneously to determine entry and/or exit points for various financial instruments.

We think in terms of correlation all the time, even when we don’t realize it. We look at a graduate of a particular school or institution and immediately correlate that to some level of future success. This thinking, despite sometimes usefully stream-lining the understanding of our world, can also restrict our analytical process — because, at its core, this type of thinking is biased. How many successful (however you define it) people have you known, heard of or read about that did not receive an Ivy League education? How many received Ivy League education and went on to failure? In these situations, we are using one piece of data, place of education, as a marker for success. Although this makes it easier for us to not have to think about and analyze the virtually unlimited number of potentially relevant other data points that could impact the outcome success, it may also be limiting our worldly understanding and our ability to make the most effective judgments and decisions for ourselves, our businesses and our families. I have heard it suggested that humans developed this way of thinking in order to categorize the world for survival, so as to not get eaten by Saber-toothed tigers and such. While this makes sense, today’s world is more complex and often doesn’t lend itself to that type of quick categorization, especially when it comes to investing. Think about the statements, derivatives are bad, mutual funds are bad, college graduates are smart. Context matters, and understanding the context of complicated systems takes more effort. Don’t get me wrong, though. If you come face to face with a bobcat or some other aggressive-looking wild animal, I still suggest you run like hell.

The point is there is a lot of information out there, and it takes a healthy mind, a fair dose of skepticism, and an ability to seek out, recognize and give up old, unfounded, pre-existing thought processes, beliefs and biases in order to understand today’s complex systems, solve ‘unsolvable’ problems, find better methods, and create more robust processes. In short, to use a religious term, it takes a fair amount of agnosticism to be creative. Creativity implies new methods, lower barriers to entry and less rigidity. It means doing things differently. And to do things differently, there needs to be either the will and the need, or the will and the want (plus ability). Usually, in my experience, the will and the need have been the big precipitators. And the process of solving problems means, with as agnostic a mind as possible, sifting through as much information as possible to determine that which is actually relevant (and not merely academic) for solving real-world problems.

There is so much information that exists in the financial realm that it can be challenging to determine what information is good and what is bad. The real question is, what information serves your purpose, and what information does not serve your purpose? Irrelevant information is hard to ignore sometimes, especially if it is what your school, boss, or some other ‘expert’ has instilled in you. Is fundamental financial information good or bad, or is technical information good or bad? We all like to think that we think for ourselves, but it takes a courageous person to continually question their beliefs and knowledge and to admit how little they actually know. In my opinion, acknowledging anything else is both ignorance and arrogance. (For example, compare your ‘knowledge’ of the world today to an ancient Greek’s ‘knowledge’ of their world, and remember that the ancient Greek also believed they ‘knew’ their world better than the generations before them.)

What I am saying is that knowledge is only valuable given its utility (disregarding knowledge for the sake of intellectual enjoyment). And we have the ability to manipulate knowledge to our own ends, especially if it is knowledge that relatively few others have the ability or desire to understand. For example, Long Term Capital Management went under (and was subsequently bailed out) by using a trading strategy based around faulty knowledge – that knowledge being the probability of how often some form of big, financial shock event can or will occur. If the chances of that event occurring are 1 in 700 million, then why not leverage your fund 50-1 or 100-1 (hypothetical figures) and go all in? But when that assumption, that knowledge is wrong, and the real odds of that event occurring are 70-1, then it becomes much more likely that your fund and all of your clients’ money have effectively been vaporized. Keep in mind that the real odds of this kind of event can never be known, only hypothesized about. And this begs the question, what types of knowledge do current mutual funds, hedge funds, or any other fiduciary funds use in an attempt to achieve their desired outcomes? And if you are invested, have you analyzed their process?

The great thing about scientific thought, though, is that knowledge is only known until it is not known anymore, until new knowledge arrives that replaces the old. It is not absolute. Hypotheses are never proven, only supported. In statistics, we “reject the null of no value.” Rejecting a null hypothesis (one that states there is no relationship among the variables being studied) means we look at data, run some analysis, and ultimately cannot conclude that there is no relationship between the variables. This is very different than definitively proving a relationship between the variables. In effect, statisticians say “there appears to be a relationship between these variables, we cannot say there is no relationship, and we are confident about this conclusion at the X% level.” Meaningful science and medical research decisions are based on this type of analysis, and so are financial ones.

This is why the caution has to be made in understanding that correlated relationships are not, by default, permanent. Whether you are a fund manager or investing for your own account, if you see (hypothetically) that every time AAPL (Apple) goes up, so does BBBY (Best Buy), you might be able to trade off this information. Would you build a hedge fund business around knowing this? Speaking in terms of correlation, you do not know if AAPL is causing BBBY to go up or vice versa. You also do not know if there is some third factor, unknown to you, that is causing both of them to go up or down at the same time (a process known as confounding). Maybe there’s some big institutional investor who buys and sells those two stocks, triggering individual traders to hop on and off the bandwagon when the big boy comes to town. If you are going to develop a fund around finding and exploiting correlations, then you need to have a lot of smart, mathematically-minded people working continuously to keep finding new ones from which to profit, and you have to do it better and faster than the other funds out there doing the same thing. In this case the fund manager’s edge would be their understanding of the mathematics and their ability to do it faster. David Harding comes to mind.

If you are a mutual fund, and base decisions on fundamental analysis, then your success is driven by the quantitative and qualitative analysis of that fundamental information. There are mutual funds out there that perform well. The problem with fundamental information, however, is that it is not the only information the leads to or is related to price changes in financial instruments. I worked as a broker, and we were pushing Citigroup (great fundamentals!) when it was at $99/share, before it went down to $2/share, and it was being pushed for most of that time, justified via dollar cost averaging strategies – same with Bank of America (then at $44/share) and a host of other company-preferred stocks. So if you are a mutual fund manager, does it not seem like there should be more to your investment strategy than merely looking at information that sometimes is and sometimes is not correlated to price movements? How do they control the losses? But mutual funds do have an edge, and for most of them, their edge is inertia. If enough people believe in something, it becomes a self-fulfilling prophecy. If the mutual fund industry can get enough people to believe that they have it right, then money will pour into mutual funds, creating buying pressure, and potentially keeping stock prices moving up (at whatever rate). This performance is then used a confirmation of the validity of that faulty process. It would be interesting to see how the markets would change if we all decided tomorrow that we do not believe in mutual funds anymore.

I am not saying mutual funds do not have their place. What I am saying is that all organizations and individuals who manage money have a responsibility to analyze their processes to make sure that those processes are useful in achieving the best interests of their clients at all times. We have gotten to the point where in politics, it’s all about the politician, in business it’s all about the corporation and in finance it’s all about the fund and/or manager. What about the people who these institutions were set up to help in the first place..? Should there be individual accountability on the part of the retail investor? Of course, but when the game seems largely rigged to begin with (think Goldman Sachs, Lehman Brothers, WorldCom, LTCM, many existing mutual funds, etc), the responsibility and accountability of the individual is less than that of the organization with the fiduciary responsibility, because the individual often cannot (and shouldn’t be required to) compete in that game. And it is not everyone’s responsibility to be a master at everything. If I am sick, I am not going to medical school in order to try to heal myself, as my skill set might be engineering. If the flight is grounded, I am not going to run out to become an engineer to fix the wing if my skill set is in sales. We have processes and systems for all of that. We, as individuals, cannot be all things and have ultimate accountability in all situations. Our world cannot work effectively that way. We can have reasonable accountability to due our due diligence, but if someone puts them self out there as a doctor, and lies about their credentials, they are accountable for the consequences of their actions. It is not an excuse for the doctor for me to say to the victimized patient, well, you should have went somewhere else.

Nassim Taleb tells a story about the accountability of an architect in ancient times: if a man lives in a house designed by an architect, and that house falls down and kills the man, the architect is put to death. Harsh or not, the point is accountability. I go to the architect because I do not have that skill set. When did we get to the point of allowing organizations to harm us with no consequences under some thinly-veiled rationale of, well, it’s legal, or, well, what can I do? If anything (and probably a lot of things) we, the mass public, are guilty of apathy. Focused, driven people and organizations are always going to achieve whatever they want, regardless of consequences, if they are competing against the apathetic. We as a society have become apathetic intellectually and emotionally, and have allowed other individuals and organizations to operate with much more impunity than is beneficial for society as a whole, often times secretly (lobbyists, backdoor deals, etc) or overtly supported by government (think, bailouts). Was I the only one who was furious at these?

What if we held mutual funds and hedge funds responsible for their losses to the investor? Force fund managers to be, metaphorically, the architects Nassim Taleb described. Require mutual funds to keep cash reserves to offset poor investment choices – make them do what their marketing machines hype them to do, which is to provide growth or preservation of capital. Same with hedge funds. How are they getting paid, while you are taking all the risk? And watermarks don’t mean **** if a manager loses most or all of a client’s invested money. There are hedge fund managers out there (read the Market Wizards books) whose client-agreements included the fund manager being responsible for all fund losses. Imagine that. A fund manager who took responsibility for his process and promise to his clients, while still lucratively participating in the U.S. capitalist structure and profiting from good business. This exact arrangement may or may not be feasible for all investment vehicles, but the accountability pendulum needs to shift back in the direction of those who are in a position of fiduciary responsibility. Some may argue that fund managers are not in that position, and to those people I would say, make it their responsibility — they’re the ones holding themselves out there as experts. Your retirement account will thank you.

Unfortunately we have allowed this current system to be acceptable – through our apathy, by continuing to not adequately question it, and by not holding those individuals and organizations accountable. They are not all bad, obviously, and I wish not to diminish those brilliant traders and managers who are smart and doing things right and getting rewarded deservedly and handsomely for doing so. But the rules of the game need to be changed to set up the odds (protections) in favor of the clients and the people as a whole, and not those at the tip of the spear.

Carl Sagan said: “We have … arranged things so that almost no one understands science and technology. This is a prescription for disaster. We might get away with it for a while, but sooner or later this combustible mixture of ignorance and power is going to blow up in our faces.” Think about this as it relates to our current financial community, and ask yourself what the implications could mean for your own personal economy.

Thanks Robert for the contribution.

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