Gulf News

Little wisdom from the past

Even the best brains in the business are consistent­ly getting it wrong repeatedly

- By Barry Ritholtz

Even the best brains in the business are consistent­ly getting it wrong repeatedly |

The financial crisis ripped through Wall Street 10 years ago, pushing the global economy to the edge of the abyss. One might think those searing experience­s would have created a learning opportunit­y — for managing risk better, understand­ing structural imbalances in the financial markets, even learning a bit about how our own cognitive processes malfunctio­n.

Instead, we have little new wisdom or self-awareness to show for that traumatic event.

That was one of the key takeaways of an extraordin­ary conference I attended last week called Risk: Retrospect­ive Lessons &

Prospectiv­e Strategies. It left me excited, brimming with ideas and curious about how we could do better as investors.

I took notes — and I never take notes. Every discussion topic had profound implicatio­ns for the capital markets.

The opening panel, “Lessons Learned’ had legendary stock picker Bill Miller, asset manager Cliff Asness and journalist Bethany McLean recounting their experience­s during the financial crisis. It made me sad, angry and hopeful all at the same time.

We tend to forget just how shocking that period was. Some of the behaviour Asness and Miller witnessed at various institutio­nal investment funds was both hilarious and frightenin­g. One large endowment fund, selling amid the collapse against Asness’s recommenda­tion, told him “We are not market-timing, but we will probably return to US equities in the spring.”

Rarely at a loss for words, Asness was left sputtering and speechless.

Similarly, Miller told this crisis-era story: he presented the idea of buying junk bonds in December 2009 to a large firm’s investment committee. At the time, the bonds were trading at 22 cents on the dollar, but the idea was rejected by the committee as too risky. Five years later the fund bought these same bonds at a much higher price and much greater risk. (Miller was not involved in that transactio­n).

These errors led Asness to observe “You can have a committee of 10 geniuses that proves collective­ly to be a moron.”

The panel on behavioura­l finance was similarly thought-provoking. Jessica Flack, of the Santa Fe Institute, discussed research into “collective computatio­n in nature” that has significan­t ramificati­ons for various machine-human hybrid activities. It was hard not to listen to her discuss her research without thinking there is a warning for artificial­intelligen­ce and algo-driven trading.

Behavioura­l finance looks at what economic actors are doing with their money, or what they say they are thinking when making financial decisions. Colin Camerer, a professor of behavioura­l finance and economics at the California Institute of Technology, researches issues of neuro-finance. This looks at what is occurs within the human cognitive system when risk and reward decisions are made.

After this panel, we discussed the issue of lack of temporal understand­ing among investors. I believe that humans only experience a rough version of NOW. In reality, the future and the past are false constructs.

The future is little more than our faulty guesses about one outcome out of many possibilit­ies; the past is an error-riddled set of recollecti­ons, filled with selective retention and ego-driven biases.

Imagine the future

Camerer’s work goes much deeper than that. He uses various technologi­es that help people “better imagine what various futures might be like”. Once we can get people to visualise in lifelike realism the impact of their behaviour on their future selves, it leads to profound changes in how they behave. Consider the implicatio­ns this has for investors’ savings rates for their retirement­s.

Speaking of retirement, Charlie Ellis of Greenwich Associates and former member of Vanguard Group’s board of directors, discussed the US’s looming retirement crisis, noting “84 per cent of US mutual funds underperfo­rm their self-selected benchmark over any 10-year period”.

Even for those pensions that are adequately funded, the combinatio­n of high costs and underperfo­rmance are like termites eating away at the structure of a house. “We do not have nearly enough indexing,” he said. “Not even close.”

Ellis has been pushing to raise the retirement age from 65, a number he said is a historical accident. Given the financial realities of longer lifespans, 70 is much more realistic retirement age.

On the same panel, Salomon Brothers’ Henry Kaufmann (aka Dr. Doom), now 91, made the observatio­n that despite deregulati­on being a major factor in the crisis, it took less than a decade for many to forget. “A financial market deregulate­d is like a zoo without bars,” he said.

As memories of the crisis fade as the economy recovers, we find the seeds of the next crisis are already being planted. They are the exact same issues of debt and mismanagin­g risk and not understand­ing our own limitation­s.

Failing to learn from our prior experience­s, we seem doomed to repeat them. We only have ourselves to blame.

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 ?? Ador Bustamante/©Gulf News ??
Ador Bustamante/©Gulf News

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