Rethinking Finance: A Manifesto for Change
The following is excerpted from a white paper by James Montier, a member of the asset allocation team…
The following is excerpted from a white paper by James Montier, a member of the asset allocation team for GMO. To read the full paper, click here.
1. Practice of Finance
All practitioners should be required to take a financial version of the Hippocratic Oath, with an emphasis on doing no harm. They should also avoid becoming “slaves to some defunct economist” to borrow Keynes’s phraseology. Far too frequently, ideas flow out of academia and are seized upon by those in pursuit of profit because they serve their own ends, rather than the ends of the client.
Practitioners should abandon their obsession with optimality. One of financial theory’s lasting contributions to the world of financial practice is the concept of optimality. I don’t believe that the optimal can exist in an ex ante sense without the aid of a crystal ball. Of course, ex post, it is trivial to construct an optimal portfolio. However, since I’ve yet to encounter an investor armed with a fully functioning crystal ball, I would suggest that we need to abandon the pursuit of the optimal, and instead aim for robustness. Ex ante optimality is inherently fragile: it is only optimal for your best guess of the future.
Let us forsake the false deity of volatility as a measure of risk. Risk isn’t a number. It is a far more complex and multifaceted concept. Risk is the permanent impairment of capital. As I have written many times before, there are three routes to the permanent impairment of capital: (i) valuation risk (buying an overvalued asset); (ii) fundamental risk (real business risk); and (iii) financing risk (including leverage, overcrowding, etc.). Thinking about risk across these different dimensions should help protect against some of the most common ways of damaging capital.
We should all treat financial innovation with skepticism. As J.K. Galbraith noted, “The world of finance hails the invention of the wheel over and over again, often in a slightly more unstable version.” All too often, financial innovation is just thinly veiled leverage.
When engaged in the use of models, know the limits of those models, and don’t try to game them. I fear that this may prove to be impossible, illustrated by the scorpion, who, having found a turtle willing to transport him across a river, stings the turtle halfway across, saying “It is just my nature.”
We must focus on the long term, and not get caught up in the short term. Of course, as Keynes argued, “It is the long-term investor, he who most promotes the public interest, who will in practice come in for the most criticism…For it is the essence of his behavior that he should appear eccentric, unconventional and rash in the eyes of average opinion.”
We should avoid getting bogged down in the details. The risk of missing the wood for the trees seems to be a perennial problem for most investors. Einstein once said “If you can’t explain something to a 6-year old, you don’t understand it yourself.” To me, all finance concepts should be able to pass this criterion. Time and again, complicated jargon and dense mathematics are used to baffle and bamboozle.
All investors should be required to study the history of financial euphoria. It never ceases to amaze me how little we learn from one crisis to another. Galbraith noted “the extreme brevity of financial memory.” The details of each bubble may change but the underlying patterns (usually involving some nasty combination of illiquidity and leverage) don’t.
We had seen instruments like CDOs before. During the junk bond boom of the late 1980s, they were collaterized bond obligations (CBOs).
We should all learn to engage in what is pompously described as event horizon scanning. In plainer English this translates to looking out for predictable surprises, or becoming a black swan hunter. Of course, the timing element of predictable surprises makes them hard to deal with. Not only do you need the skills necessary to engage in this activity, you also require the patience to stand aside when the world is going mad (but making lots of short-term profit in the process).
2. Regulation/Policy and Finance
When it comes to policy, central bankers and regulators have much to learn. First and foremost, central banks should “lean against the wind,” rather than be cheerleaders for manias. Bursting bubbles in their early stages is likely to be far less damaging in the long term than allowing them to go full term and then trying to mop up after the burst.
Central bankers and regulators must also learn that markets aren’t efficient. They shouldn’t expect the market to do the “right thing.” Hence, they should be wary of inferring too much from market prices, including risk measures.
Mark-to-market based accounting suffers from similar problems. Capital adequacy should be contra-cyclical not pro-cyclical. Surely this is a “no-brainer”: ensure that reserves are built up in good times to provide for the bad. A simple indicator such as credit growth as the basis of capital adequacy shouldn’t be beyond the ken of regulators.
It really shouldn’t need to be said. But as with all regulators, financial regulators should guard against regulatory capture and industrial self-serving bias. Letting banks use their own models to assess risk and capital requirements was always going to end in tears. Yet once again, Basel III seems to have been, at least partially, formulated by the banks!
Finally, regulators should try to learn the correct lesson from the GFC. It seems as if the lesson learnt has been that investors had too much equity in their portfolios in the run-up to the GFC. Of course, this isn’t the correct lesson to take away. It wasn’t that funds had too much equity (and equity-like risk) in their portfolios; it was that they had too much expensive equity. Ironically, the regulators are now encouraging funds to own too much expensive fixed income, sowing the seeds for a future crisis no doubt!
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