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Monday, 27 February 2012

Why There’s Never Been A More Dangerous Time To Invest

Facing the Big Guns

Tadas Viskanta, who writes and curates the excellent Abnormal Returns, recently penned an equally excellent article entitled There Has Never Been A Better Time To Be An Individual Investor. In this he cogently sets out a list of reasons why investing is cheaper and easier than ever before while caveating that our innate biases work against us when investing.

While agreeing with every word of the article, I think there’s danger for anyone executing anything other than the suggested default option of a low cost, globally diversified, occasionally rebalanced portfolio. Active private investors are engaged in an arm’s race with the securities industry and most of the big guns are facing the wrong way. The problem is that darned scientific method, which is why there's also never been a more dangerous time to invest.

Barking Up The Wrong Paradigm

The development and acceptance of behavioral finance, the basic tenet of which is that we suffer from implicit mental biases which cause us to behave irrationally in the vicinity of money has taken place over an extended fifty year period. Probably it’s only been really accepted as investment orthodoxy in the last decade when cognitive dissonance with neoclassical economics on a grand scale has set in. Failing to foresee the greatest implosion in financial history will do that to a paradigm.

Even in the long wilderness of old style rational economics businesses still developed ways of exploiting human behavioral biases. This wasn’t based on any directed process of systematic analysis, but was a hit and miss evolutionary process as firms figured out what worked and what didn’t. The notorious unwillingness of financial firms to provide simple, easily comparable products almost certainly stems from this type of approach (see: Finance: Where The Law Of One Price Doesn't Apply) – hell, they even apply this to the humble index tracker and promptly manage to confuse our brightest and best, as we saw in Intelligence Can Seriously Damage Your Wealth.

Look around and we can find examples of this type of exploitation lying around like seashells on the seashore. Take credit card offers, for instance, where we’ve seen that worse up-front offers are preferred to better long term ones by triggering peoples’ hyperbolic discounting biases (see: Putting Down The Credit Cards). And, as we saw in the Secret of a Healthy, Wealthy Life, examples like this are everywhere, purely limited by the time and money researchers have to spend looking for them.

A Scientific Approach

Now this has been happening at a time in which behavioral bias was only dimly understood, practised by odd men in white coats in dingy laboratories in the hours of darkness … well, maybe not quite, but the research sure wasn’t in the mainstream. Evolutionary processes such as the ones that created us, or the ones that corporations have used to develop their behavior triggering products are economically wasteful, and tend to take a long time: they’re basically development by trial and error and will tend to involve a lot of the latter and a large number of the former.

Human ascent to the shaky top and precarious position as lords and masters of all we survey has been characterised by two distinct periods. Most of history involved us in trial and error experimentation without much idea of what we were doing or why. This gave us a lot of religions and lots of wars, although the wars were usually about religion, but not much in the way of discernable economic progress or freedom from drudgery.

But somewhere in the last millennium, under the influence of thinkers like Francis Bacon, Galileo, and Isaac Newton, we developed a different way of proceeding: what we now refer to as the scientific method. Regardless of your views on science in general the scientific method is now pervasive in society, and for good reason: it’s a far more economically efficient way of making progress than the previous approach. Instead of randomly wandering around guessing we develop hypotheses and target our research, abandoning it before we exhaustively try out every option, when it becomes clear the original idea is wrong. Well, that’s the theory – in practice what we do is nowhere near that efficient, but it’s still a darn sight more effective than the alternative.

Consumer Biases and Exploitation

Prior to the general appreciation of the behavioral biases that accompany our every living breath the ability of financial firms to exploit our behavioral weaknesses was limited to the relatively simple ways they could find through evolutionary happenstance. Sometimes they figured out how to make money out of peoples’ cognitive biases, but mainly they just threw money around in the hope that it would stick. However, what do you think they’re going to do when they realise that there’s science behind these traits and you give them the best minds and vast quantities of investment dollars to start looking at them?

Suddenly firms aren’t limited to randomly finding ways of extracting money from people but have the opportunity to systematically develop products and solutions based on hard research. And they do. What’s worse about this is, that as Ryan Bubb and Alex Kaufman have shown in Consumer Biases and Firm Ownership, companies which don’t exploit these biases will actually have to charge higher up front fees, because they won’t have the additional income stream that accrues from the exploitation of these biases. And, of course, what’s the default option for most people when given two offers, one with a higher up-front cost but which is cheaper in the long run?

So what we have here is an imbalance. On one hand we have behavioral biased consumers and investors, who aren’t generally governed by hard economic reality, and on the other we have profit maximising corporations who see their role as to make as much money for their stakeholders as possible, usually by staying within the legal boundaries which, as we saw in Frankenstein's Corporations, are pretty loosely defined anyway. As this paper by Mei, Wu and Zhou indicates, it’s perfectly possible to exploit these tendencies without doing anything illegal at all:
“Conventional wisdom suggests that smart money’s speculation tends to make the market efficient by offsetting the foolishness of some investors. This paper provides a new counterexample. Smart money may actually create “market inefficiency”, by driving asset prices away from their fundamental value, rather than forcing asset prices to converge to their fundamental values. This possibility poses a new challenge for regulators. As the manipulator relies on neither inside information nor visible actions (other than trading), his manipulation is difficult to be detected and ruled out.”
Index Tracking Bias

We shouldn’t even think that the humble index tracking fund is immune to the clever manoeuvring of the securities industry. It’s now well established that so-called synthetic Exchange Traded Funds are often backed by derivatives from counterparties underpinned by collateral with only the most tenuous relationship to the actual assets being tracked. Even simple physical ETFs, which actually hold the securities they track, often engage in lending programmes which could ultimately mean an unexpected risk exposure for investors.

The idea that we’re in an arms race against a better equipped, better funded and far less moral enemy isn’t one that most private investors take on, but they should. Despite our manifest deficiencies we aren’t without our own weapons – the behavioral weaknesses of the financial industry itself. We can fight a successful guerrilla war by refusing to engage in a pitched battle on their terms: trade rarely, go where they don’t go and never, ever believe you have to react in seconds or even minutes and hours. When High Frequency Trading algorithms can execute faster than you can blink you’re wasting your time, your money and throwing away your intellectual advantage: faster is not better.

As Tadas Viskanta says:
“Most investors would be well served in investing in a low cost, globally diversified portfolio that they systematically re-balance and occasionally revisit. The upside is that this sort of investment process is, as we said, now cheaper and easier than before. In the end no one knows what the markets will do, but the vast majority of investors can do more by doing less.”

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