Thursday, March 5th, 2009
one hand clapping

It has become fashionable during the Great FallNew York Times | William Safire did his usual good job of lexicographic musing on what we should call the mess we are in. to make lists of those who have caused us all of this grief; we are all natural athletes when it comes to playing the blame game.  The odd thing is my list is headlined by a group that is rarely mentioned in any stories or postings of the type.

In one of the most famous utterances in the history of comics, Pogo said, “We have met the enemy and he is us.”  As an investment professional, I must say that I feel that way too.  One theme of this series on incentivesthe research puzzle | This is the seventh episode, the last was on our predicament of being “optioned out.” is that many investment products are sold, not bought — and for all of the wrong reasons.

However, those on the “buyside” — at mutual funds, hedge funds, endowments, and the like — are not rubes.  In fact, if Adam Smith were around, he’d expect that as a group they would do more than their fair share of work to make the “invisible hand” do its thing.  Yet, they not only didn’t do their business to make the market work as theorized, they happily bought all manner of toxic sludge.  To focus on the main event first:  We can question consumers caught up in the housing and refi crazes; the government functionaries that goofed up; the hapless rating agencies; and the geeks and studs on Wall Street for their parts in the disaster, but without the insatiable demand for the crappy paper, the securitization market would have been like Popeye without the spinach and we wouldn’t have had much of a crisis at all.

It is part of a distressing pattern.  The number of investment professionals has exploded over the last twenty years, yet it seems like less real work is being done now.  Short time horizons, narrow fields of vision regarding possible outcomes, and superficial approaches to due diligence and analysis are predominant.  As with other industries that have peaked and fallen, there may have just been more good years than were optimal for keeping the ken keen.

My former teaching partner, Tim Nantell, responded to a recent market failure by asking the simple question, “Could it be that analysts don’t analyze?”  The answer too often — and many times because of misplaced incentives — is “yes.”  Making mistakes is part of investing, but if we are to have faith in the market, those errors can’t end up being as one-sided as they have become in every corner of the investment world.

According to Nantell, some finance professors are also self-flagellating these days, thinking that it must be their fault that the students that they taught have made such basic mistakes in concert.  If they cop to their part in grade inflation, I’ll give them a pass on the big picture.  It’s my “guys” that screwed up.

In response to my absolution (and maybe to soothe my guilt), once again Nantell tried to shift the blame:  “The client is the problem.”  Now there he is right.  The expectations of the average client are totally out of whack with the realities of what the market is and what it provides in the way of returns, causing firms to play to their misdirected instincts and at the same time providing an open field for charlatans.  In the process, the investment industry and the investment profession have abandoned many principles and responsibilities to keep the money rolling in.  Yes, Tim, the problem is the client, but the fault once again lies with my kind; we are charged with improving that client’s financial approach instead of bowing to it in the hopes of getting rich.

And so, leaping from Pogo to Adam Smith to Zen, what is the sound of one hand clapping?  Without the “hand” that properly-incented market players can provide, we are left far away from enlightenment about whether theory can translate into sound practice, and find ourselves out in the wilderness.  Even if there were any applause, we couldn’t hear it.

The philosophical engine will get warmed up once again in the last posting of this long series, coming soon.