Salespeople of all types are taught the doctrine of KISS: Keep It Simple, Stupid. A more specific version of this is the “elevator speech” to be used when meeting a client or prospective client in an elevator; it’s designed to be delivered quickly and simply in the time the elevator takes to go from the lobby to the client’s destination floor. Both of these approaches prize getting an intended result rather than a transmission of complete understanding.
William Shakespeare, market analyst
In his masterpiece of summing up trouble, Shakespeare has the three witches in Macbeth, Act IV, Scene I intone, “Double, double toil and trouble; Fire burn and cauldron bubble.” This may be the first literary reference to a market bubble. Notice the words “double, double.” In the investment marketplaces, a requirement for a “bubble” is great popularity-driven rivers of money flowing into a sector (e.g., dotcoms, housing, derivatives, treasuries, and high yields). Not that there is anything wrong with any of these investments in moderation, but when they enter into the phase of “double, double” or much more, there is danger of being in violation of the concept of prudence by not avoiding large losses. In handing his ruling against Harvard College in 1830, Judge Putnam intoned the famous “Prudent Man Rule,” which required a trustee or fiduciary to do those things that other men of intelligence and prudence did with their own money. This ruling created a peer-related legal concept of prudence. By definition, if there are large holdings in a security or sector, when they go down there is limited demand for the falling securities, which will lead to even greater declines.
Camp followers or market followers
In many European wars the armies were closely followed by a crowd of women; some of these were the wives of the soldiers, others pursued a more professional type of transient relationship. The wives were interested in the long-term, the second group was more interested in the action of the moment and making a quick profit. I see a parallel to the second group in some of the emerging trends today.
This week the MacArthur Foundation recognized Professor Colin Camerer from the California Institute of Technology with a Genius Grant. I am a Caltech Trustee, and as such my wife Ruth and I know and prize Professor Camerer for his leadership of a group of graduate and post-doctoral students who finished their work at other universities. Their combined study that linked blood flows in the brain to financial decisions showed that sophisticated risk-taking investors are more likely to get caught up in playing bubbles that neophytes are. (Two well-known brains who lost a great amount of their wealth in past bubbles were Sir Isaac Newton and Winston Churchill.) When I read about Colin’s success, I wrote that the victims were in effect playing the old market ploy of the ‘greater fool theory.’ My good friend and regular Wall Street Journal columnist Jason Zweig had the same conclusion. The greater fool theory works on the basis of buying and holding an investment at a price that is disassociated from reasonable value on the basis that there will be a bigger fool who will pay an even higher price. Essentially these “fools” are letting the market make their decisions for them on the belief they can identify the ultimate fool. (Not themselves, of course.) It didn’t work with tulips in the 1630s, and it didn’t work during any of bubbles we’ve seen since then.
Where is this present bubble?
Over this past week and on a recent trip to London I was made aware of investment managers who, on the basis of their back-tested data, make the claim that they can produce better-than-market results due to their timing and selection of market sector skills through the use of Exchange Traded Funds (ETFs). As with other vehicles that can be driven too fast, ETFs are based on a safer, older model that had a more prosaic basis. Having given up on selection skills in picking managers or securities, many financial institutions are opting to closely match the market through low-cost index funds. (Unless the profits on securities loans or smart intraday trading are particularly adroit, the fees charged most of the time mean that the index vehicle comes close to matching the reported index return but rarely produces the exact return of the index.) The merchandisers of securities recognized that using an index in a publicly traded security opened up opportunities for them to generate commissions, spreads, arbitrage opportunities, and margin interest; as a result, they became advocates of ETFs (bubble, double bubble). Further, hedge funds found a safer vehicle to short against the risks in their long positions.
KISS and elevator speeches seem to be working. Each week I look at the net flows into ETFs and mutual funds as produced by my old firm now known as Lipper, Inc. In these reports the volatility of the dollar flows into and occasionally out of ETFs are larger than mutual funds, even though the total size of the fast-growing ETF business is considerably smaller than the mutual fund business. This is beginning to feel like the players of the day are increasingly playing the greater fool theory. I don’t know how long this phase of the game can last.
The revenge for 2008
Diversification has become the buzz word for safety in many financial institutions. The assumption is that if one is invested in a number of different asset classes and sectors, one can’t lose it all at the same time. This belief was based on a mathematical model that showed traditionally different market sectors were not particularly well correlated. In 2008, however, almost every stock and bond around the world went down, except for treasuries and some small markets not usually held by foreigners. The spread of correlations collapsed. In reaction to this painful experience, many chose to play the market in a risk on/risk off fashion. For a lot of these players the ideal vehicle was, and is today, ETFs (double, double bubble).
A study of history may suggest that we are in the midst of a Hegelian Synthesis, where one trend creates an opposite trend and prominence of one over the other reverses. We may be heading back into a market of security selection, not index trends.
The lessons of George Washington
One of the lessons from this weekend for Ruth, myself, and some good friends of ours came from the dedication of a national library for the study of the first President. In the dedication of the library at Mount Vernon, the well-known author David McCullough said George Washington had no better than a sixth grade education, but his library and his letters showed that he learned a lot. His first military battles were defeats but he learned to be a brilliant tactician using maneuver and surprise (which my Marine Corps text books value so highly). He was a great leader of men, managing to convince his troops to stay with his ragtag army when their enlistments were up and farming season was looming. He stopped a potential army takeover in its tracks just by addressing the troops. Of all his manifold skills, the greatest of them all was his leadership.
Applying General Washington’s leadership to your portfolio
How do you avoid the group think that is surging through the use of ETFs and other index-hugging approaches? George Washington was not afraid to try different things. He found and led other generals who were more trained in the arts of war than he was. He kept his eye on his strategic goals and did not focus only on tactical moves. He endured the loneliness of command well. In the context of today’s investing world, this means picking securities and managers who are different and who are focused on the strategic goals of the account to deliver funding when needed.
Are you strong enough in your investment beliefs to escape indexing a major portion of your investment responsibilities? Share your views with me privately or publicly.
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