Munger Has The Better View

Recently Warren Buffett expressed his view that Goldman Sachs had acted appropriately in relation to the ABACUS 2007-AC1 deal, essentially stating that he could not understand the public’s consternation with the activities of the investment banking firm.

His partner, Charlie Munger, expressed a different view, that is, that there is a difference between behaving legally and behaving ethically — and that a business should not simply follow the former.

I believe that this time Mr. Munger has it right and Mr. Buffett has it wrong. The distinction between Mr. Buffett’s view and the view expressed by Mr. Munger is important - both on a market scale and on an individual scale.  The distinction in views explains why Wall Street doesn’t think Goldman (and other banks) did anything wrong and Main Street does - emphatically.  Main Street wins this argument hands down.  I will leave it up to the banks to learn or not learn₁.  My focus is on risk management in doing your business.

In our country ethical behavior and honest behavior are mutually inclusive. Societal norms dictate the standard for ethics and honesty. In ours “fundamental fairness” is that standard.

To act in a manner which we do not consider to be fundamentally fair is to behave dishontestly₂.  If you do that, we will not trust you and if we don’t trust you we will not deal with you. If we will not deal with you then - there you go.

I am not going to pick on Mr. Buffett to make my point further.  Rather I will use a leading character from a movie about Wall Street.

Hence the following Observation:

·        Gordon, you were wrong bud

This is an observation I have been working on for some time.  Given developments the past few weeks I thought this was the time to make this Observation. In doing so I am not commenting on current events but on an important underlying theme.

Honesty, rather than fear and greed, is the human characteristic that runs our markets. True fear and greed exist and effect markets and financial decisions but they don’t run our markets, honesty does. Why do I say that? It’s very simple, almost sounds trite, but is nevertheless bedrock true.

Honesty builds trust between individuals and trust is the keystone to successful interaction between individuals in a functional sophisticated society. Where trust is absent societies are dysfunctional.  In those societies markets either do not exist or are dysfunctional themselves and little used.  Our markets are the largest and most successful in the world because historically they have been trusted to be more honest (read that fundamentally fair) than any other market in the world.

So are we honest and if so, why? The answer is that we are, at least in our society.  Honesty is a societal norm in our country (and in some others as well).  Individuals learn societal norms as they grow up.  Our brain records those societal norms in its long term memory and draws on them when confronted with decisions on future actions.  There are distinctly different physiological reactions which occur in the brain relating to actions that conform to societal norms versus those actions which violate societal norms.

FMRI studies have confirmed that there are two parts of the brain₃ that are stimulated (neuronal activity) causing pleasure when a person conforms to a societal norm (or observes someone else doing so).  There actually is a physiological explanation for why you feel good when you turn a wallet you happen upon into the lost and found knowing that the owner will never know that you did it let alone reward you. The same physical phenomenon occurs to you when you learn someone else has turned in that wallet.

Well if this is the case how do we explain the dishonest acts that occur, especially the numerous little acts of dishonesty that are carried out every day by everyday people.  We don’t know for sure yet. We do know that certain portions of the brain₄ are stimulated (giving a negative feeling of discomfort) when a person violates a societal norm (or observes someone else doing so). Those portions of the brain are not stimulated by perceived trivial acts of dishonesty (such as refilling a drink at a convenience store after taking one sip, as opposed to taking a refill after downing the entire drink).  Why significant dishonest acts occur is way beyond the scope of this Observation, but for now just consider that a psychopathological condition may be involved in those acts.

The takeaway from this Observation is that beginning early in our lives we learn the norms of our society.  Brain physiology causes us to store that information and react to the observance/violation of our societal norms on a positive-pleasure/negative-discomfort basis.  People like things that make them feel good and dislike things that do the opposite. Our society has as a norm the concept of honesty (fundamentally fair behavior) and therefore the vast majority of our acts are honest. Simply put we pursue pleasure. This actually helps us as social beings. Honesty promotes trust which in turn allows the individuals in our society to interact with each other successfully and in sophisticated ways.  Each act of honesty builds this trust and each dishonest act tears some of it away.

As for our markets, unless you want to concede first place to someone else (and if you do you are no friend of mine), you should remind yourself of this concept₅ periodically and support efforts by individuals, groups, associations and governments to promote honesty₆. Caveat emptor will not suffice as the ethical standard in any society that wants to have successful financial markets.

You may also wish to consider the foregoing in managing your risk.

1.       I would, however, caution them and Mr. Buffett against the continued use of the word “bet” in their statements about their activities.  Webster’s dictionary may include as a description something that would not be related to gambling, horse racing, craps, roulette or other games typically played at the track or in casinos.   Most Americans, however, associate the word “bet” with behavior that is not associated with investments or investing, speculating or gambling yes, but not investing.  I know what they mean but I am confident that neither the banks nor Mr. Buffett want people to “get the wrong idea”, that is, that someone is playing a hunch with enough money to have nine zeros in the figure before you get to the decimal point.  Surely there would be more intelligent evaluation before they acted in their investment decisions with that kind of money than their action in placing a bet at the track or at a roulette table. Nobody places a billion dollar bet at the track or in a casino, nobody.  Why bets of that size might risk bringing down the house. My comment to the banks and Mr. Buffett is, if you don’t like what is going into the Financial Reform bill now, keep using the word “bet” and see what happens.

2.       Definitions of “honesty” invariably contain the words “fair” or “fairness.”

3.       The nucleus accumbens and caudate nucleus.

4.       Certain specific areas of the prefrontal cortex. The studies to date indicate a positive correlation between the subject’s perception of the probability of punishment for violating a social norm and the stimulation causing mental discomfort. This may explain the “trivial” violation exception discussed above.

5.       Psychological studies have confirmed that individuals who are reminded of the societal norm of honesty thereafter increase their propensity to choose the “honest” alternative when confronted with a decision about future action.

6.       Another societal norm is that group approval or disapproval of our actions is important to us.  In our society the approval or disapproval of our peers is very important and is a significant motivating factor in our decision making process.  Transparency in financial markets amplifies the ability of the “group” to view and evaluate the actions of individuals (and groups, associations, corporations, etc.) in those markets.  Because we care what people think, the positive response to conforming to societal norms is promoted by transparency. We know in advance that people “will look and they will see.”  Therefore, transparency promotes honesty which in turn... (well you can see where this goes).

Never Again! Really? The Devil You Say.

The forthcoming adoption of a financial reform bill in Congress prompted me to republish an Observation I made at the height of the financial crisis.  Here is my Observation:

Last week [the week of September 29, 2008] I was asked to explain one comment in my latest Observation. That comment was that “we all had a hand in it.”  By “it” of course I meant the present economic conundrum.  By “we” I meant to include the population at large.

I was then asked to explain my reasoning and I gave the following explanation:

We are all subject to certain cognitive imperfections.  One of them directly impacted us when the real estate bubble burst and that same imperfection impacted us when the tech bubble burst. The imperfection is:

People have an irrational, compulsive and subconscious belief that a trend will continue far beyond what would be justified by a historical statistical analysis.  They are then unpleasantly surprised when the “trend” ends and things revert to the mean.  Hence the following previous Observation I made over a year ago (when the market was still hot):

·        Yes but this time it’s different

It never is.

Why do you think they named it the “mean?”

Maybe because of the harsh way you can be re-taught an old lesson when something reverts to it.

-          06/18/2007

Ok how does all of the foregoing apply to our present situation [October 2008]?  When real estate began to “take off” (late 90’s) and that market condition continued until the general public perceived it as a trend this “cognitive bias”, called “recency” or trend continuance, took over. People began to buy real estate with the conviction that values would continue to go up. They simply reasoned that if the property turned out to be more than they could afford they could sell it at a profit. That outlook changed the way they perceived the risk of borrowing money (remember that I said in an Observation that when the “possibility” of making a large profit comes in the room a cognitive bias causes “probability” to head for an exit -05/27/2008).

Ordinary everyday people began to take risks that they simply did not perceive as real. What began as a trickle became a torrent the longer real estate continued to appreciate. People began to believe that it was ok to, shall we say, fib on loan applications. They also saw logic in NINJA loans.  Yes that’s how far logic strayed. All of us were aware of what was transpiring.¹   We simply did not perceive how short the trend would last and how far and extensive the damage would be.

Then the trend ended and now -

          We know how mean the mean is.

Of course the lending and financial industries had a hand in it - they encouraged and facilitated this to go on.

People say that we should learn from this and never let it happen again.  Well I am all for that but my hope is balanced by the simple fact that contrary to a precept of classic economic theory we are not “rational” when it comes to economic decisions.  Our shortcomings are embedded in our DNA. 

The best strategy in my view is to remember our shortcomings and do our best with those in mind to avoid repeating our economic mistakes.

In 1991 I read an article by Chris Argyrs in the Harvard Business Review, Teaching Smart People How to Learn.  The upshot of this article is that when events turn out badly we tend to engage in “defensive reasoning”, i.e. blame others for the outcome.² This very effectively keeps us from learning from past experience.  In order to keep history “repetition” to an absolute minimum we need to avoid the onset of defensive reasoning and instead focus on the one thing we had and will have control over which is, our own conduct.  That is why in my previous Observation I said “Whining that it was someone else’s fault isn’t going to help.”

Regulate yes, but don’t be foolish enough to think it will never happen again. Lewis Black, the satirist (03/20/2007 Observation), is no doubt going to have a field day with these peccadilloes.

1. Even those of us that owned property but did not refinance, take out a second mortgage, line of credit or trade up were yelling “run, baby, run – who cares if the kids can’t buy a home.”

2. The more intelligent the individual the more pronounced the onset of defensive reasoning – blaming someone else for a negative outcome. As observers, it is not uncommon for us to be surprised when we observe people we consider to be extremely intelligent, well educated and experienced in the matter at hand to fail to “get it” and insist on proclaiming an argument that no one else is buying.  This I believe explains the reaction many have had to the denials coming from some on Wall Street.

            -10/06/2008

Oh! So Now You are Sorry?

Last week Messrs Prince and Rubin, formerly of Citigroup, testified before a government commission looking into the financial meltdown.  Having lived through the “experience” I thought I might share some of my earlier Observations.

·        Separating the Truth from Fiction

“Of all the offspring of Time, Error is the most ancient, and is so old and familiar an acquaintance, that Truth, when discovered, comes upon most of us like an intruder, and meets the intruder’s welcome.”

            Charles Mackay – Scottish Philosopher

If you don’t understand something ask for an explanation. If the explanation doesn’t make sense, then ask for clarification.  If it still doesn’t make sense the problem is not you or your capacity to understand. It’s that “it” doesn’t make sense. 

Implying that people who “don’t understand” are dense is a common persuasive tactic of people who themselves don’t actually understand (or worse).

The problems we often encounter are not caused by our lack of mental capacity, but by our willingness to go along with such an implication.

            -03/24/2008

·        Demigod (Demon)

Corporate culture has a negative aspect I would like to address.  I call it the deification (often later demonization) of senior executives.  These folks are not demigods (or demons).  They are not smarter (or vice versa) than before they got promoted (appointed, whatever) and their intelligence and acumen does not vary with the fortunes of the firm.  They are humans just like the rest of us.  Nonetheless this process goes on constantly, often the result of actions by their subordinates.

We are neither unintelligent nor uneducated and don't help ourselves or the firm by buying into the process I have described.

We should overcome the temptation to do so.

          - 07/07/2008

·        Standards do serve a purpose

When the justification is that we have to because “well everybody else is doing it and we have to stay competitive” then it’s time to take a deep breath and remember what happened to …..

          -09/08/2008

·        What happened (11/05/2007)

Here is my take:

People (yes that means everybody) tend to overestimate the accuracy and precision of their knowledge and that often leads to overconfidence and a lack of perception of the amount of risk they are undertaking in making financial decisions. This in turn tends to burn them from time to time and it kick starts the law of unintended consequences hurting others.

10/01/2008 Supplement: Senior executives in financial firms, quasi governmental entities (Fannie, Freddie), and regulatory authorities listened to and accepted the explanation (by senior but subordinate experts) of the “risks incurred” for various proposed offerings and undertakings.  The senior executives and those making a proposal were far too confident that the analysis of the risk/reward balance on the proposal was based on accurate and complete underlying data. That is a classic and oft repeated mistake.  This led to tragic overconfidence and the assumption of a level of risk that was unknown and unprecedented sending the law of unintended consequences off on a gallop.

But make no mistake we all had a hand in this. Whining that it was someone else’s fault isn’t going to help.

          -09/29/2008

·        Prognostication is a four letter word (and so is overconfidence)

I was all set with a different Observation for today but then a financial guru testified before Congress on Thursday.  I read a transcript of part of his testimony and I just could not resist.

What he said was:

It was the failure to properly price such risky assets that precipitated the crisis. In recent decades, a vast risk management and pricing system has evolved, combining the best insights of mathematicians and finance experts supported by major advances in computer and communications technology. A Nobel Prize was awarded for the discovery of the pricing model that underpins much of the advance in derivatives markets. This modern risk management paradigm held sway for decades. The whole intellectual edifice, however, collapsed in the summer of last year because the data inputted into the risk management models generally covered only the past two decades, a period of euphoria. Had instead the models been fitted more appropriately to historic periods of stress, capital requirements would have been much higher and the financial world would be in far better shape today, in my judgment.

What he meant (in plain English) was:

They thought they had it figured out but they didn’t and it turned out to bite everyone on the....*

Overconfident Prognosticators, all of them, including the “guru” (and you know what I think of those guys).

You may wish to reread my 03/31/2008 (“worse than a lollygagger”) and 05/19/2008 (“…use your head Fred…”) Observations. If you don’t have them I will send them to you. I already sent them to the “guru.”

*reminds me of when I was young and used to set off firecrackers with my buddies.  Once we set off several hundred in a row without a failure.  Then one of didn’t go off after being lit.  Georgie Wade stuck his head over the darn thing; it flared up and burnt his eyebrows off.

            -10/27/2008

Behavioral Finance and Economics - Hingsight Bias - Knew or Should Have Known

Recently I testified as an expert witness in an arbitration involving retail stock-brokerage activity.  My client asked that I attend the hearing and observe the testimony of the other witnesses as a prelude to my testimony.  In doing so I was constantly reminded of the cognitive distortion called Hindsight Bias and an Observation I wrote several years ago as an in-house counsel.  I reproduce that piece:

·        Hindsight Bias Revisited

Hindsight bias: The natural tendency of an individual to overweight the probability that an event would occur after being told that the event had occurred.

The most common allegation I see in an arbitration is "knew or should have known."  Often the resolution of "should have known" is the deciding issue.  Its resolution also involves the involuntary and subconscious application of the principle of "Hindsight Bias" by arbitration panel members.

When you judge risk about the future, you judge it with foresight and objectively. When panel members judge risk, they judge it with hindsight and not so objectively (using Hindsight Bias).

Panel members are effectively asked to step back into the past and through the use of their imagination attempt to the judge probability of something occurring (in the then future) when they already know "it" did occur. In their attempt, try as they might not to, they may overweight the probability.

You may wish to keep the foregoing  in mind while managing your risks. 

  -10/30/2006

Don't Stop Managing Your Risk Just Because You Have a Dispute

“I was never ruined but twice - once when I lost a lawsuit, once when I won one.”

                                                      -Voltaire

I write these Observations to help you manage your risks as intelligently as possible.  Nevertheless sometimes problems and disputes over those problems arise.

So when you have a dispute over a problem don't you want to control its outcome (i.e. manage that risk as well)?* 

When your dispute ends up in litigation or arbitration and you finally turn it over to the arbitration panel or jury to decide you, at that point, give up total control over your fate.  Think about potential panel or jury members and how well you will know them. Why would you give up that degree of control over the resolution of your dispute to total strangers? Here is a link to a recent federal appellate court decision which I think dramatically tells us what unforeseen events may occur once we do turn over that control (in this case at least three times).  I do not cite this case for any proposition other than the line from the movie Forrest Gump "You never know what you're gonna get." Now for the link: 

http://pacer.ca4.uscourts.gov/opinion.pdf/091038.P.pdf *

Think about about mediation, you do, after all, retain control during the entire process. You are not alone in controlling the outcome but then you never are in arbitration or litigation. When you are mediating a dispute you are actively managing your risk.  Not so in the other forums - as I said when your evidence is in and the arguments are over and you turn your case over to a panel, judge or jury all risk management ceases. You better hope that a good jury, judge or panel showed up for your case and the bad ones somehow went to a case on the other coast.

* my thanks to my acquaintance Marc Dobin, a securities lawyer in Jupiter Florida, for a recent blog post which alerted me to this case. Marc's blog can be found at http://lawyersfromjupiter.blogspot.com/

Behavioral Finance and Economics - Reciprocal Altruism and Homo Economicus

“Economic Humankind” is, according to classic economic theory, made up of individuals who possess the attributes of unbounded (1) free will, (2) self-interest and (3) rationality.  I reserve for another day an Observation on “unbounded rationality” and today take a short look at the concept in classical economic theory that we are selfish and self maximizing (unbounded self-interest).  Dr. Michael Shermer, in his book The Mind of the Market: Compassionate Apes, Competitive Humans and Other Tales from Evolutionary Economics, describes the moral emotion of “reciprocal altruism” or “I will scratch your back if your scratch mine” – to which I politely add, “or if not take a hike.”  This moral sense of fairness is hard wired into our brains and according to Dr. Shermer, present in all humans and primates tested for it.  It was developed during our formative years as “hunter-gathers” as a means of self preservation of the tribe but has continued to exist even now that we, in the words of Dr. Shermer, have morphed into “consumer-traders” in a large society. As I stated this reciprocal altruism trait has been repeatedly confirmed, more specifically, in a test dubbed the “Ultimatum Game” by behavioral economists.  In the game participants are paired up and one of each pair is given $100 with a condition.  That person is ordered to propose a split of the funds between her/himself and their game partner. If a proposal to split the money in a particular fashion is accepted by the partner then each get their agreed upon proportion.  If the proposal is not accepted then neither gets any portion.

Classical economic theory would tell us that no matter what the proposal is (assuming it was not 100 to zero) the trading partner will, without exception, accept.  The reasoning is that the partner is a Homo Economicus and will not turn down free money (no matter how small or disproportionate the share).
Results of the game in operation show that anything less than a 70 -30 split is usually rejected.  You are not surprised.  Now why would that be?  Well no doubt you have concluded that less than a 70-30 split is not viewed as fair.  No kidding. But although fairness is not a concept in classic economic theory - it is in human psychology - the moral emotion of “reciprocal altruism.” See your conclusion is really the operation of this trait and by the way it’s a reflexive action not a reflective one which once again means it’s invocation is subconscious and compulsive (don’t know it and can’t help it).

You may wish to consider the foregoing as further evidence that psychology matters when analyzing how an investor may confront economic dilemma. In addition you may wish to consider whether something you did or propose will be analyzed by others as being fair and if it’s not whether the moral emotion of reciprocal altruism will have an effect on the evaluation of your proposal (or historical action)*.
*For those of you in the dispute resolution business I bet you can see several important implications.
As a postscript today I thought I would give you the following link to Paul Krugman’s article in a Sunday edition of the New York times.   http://www.nytimes.com/2009/09/06/magazine/06Economic-t.html?_r=1&em

Financial Plans and "Flexibility"

We can learn a lot about improving our financial plans and the financial plans and advice we give our clients from Leo Tolstoy and Robert Burns.

War and Peace – The Novel

In Tolstoy’s view (extensively expressed in the novel) history was not created by great men or significant events. Rather history was the result of the interaction of millions of individual chains of cause and effect too small to be analyzed independently.The principle “great men” in the novel, Napoleon and Czar Alexander, may have believed they were in charge of their destiny but in fact they were caught up in the same web of circumstance as the rest of us.

In addition, Tolstoy emphasized the irrational motives for human behavior and hence the total unpredictability of unfolding events.  A central premise of the novel was that Napoleon never intended to invade Russia but was drawn into it and did not comprehend the forces that led him to do so.

Tolstoy linked wisdom not to innate logic or reason but to an acceptance of the foregoing state of affairs.  In Tolstoy’s view General Kutuzov, the leader of the Russian forces opposing Napoleon’s invasion, emerged as a great leader not because he developed a logical battle plan and then demanded that everyone follow it as events unfolded.  Rather, Tolstoy explained, Kutuzov’s genius lay in the fact that he was willing to adapt to the flow of events and think on his feet. In General Kutuzov’s experience each stage of a battle turned out to be vastly different from what was expected (by everyone). Based on his experience Kutuzov devised very flexible battle plans and allocated his resources accordingly.  Kutuzov often slept through battles after they began, leaving to his lieutenants the ability to react to changing circumstances. Kutuzov eventually defeated Napoleon.

Well I don’t recommend that you go to sleep but I do recommend that you “be (Tolstoy) wise” and accept the fact that you cannot predict what will happen in the future (both in the markets, in your personal lives  or those of your clients).  Build in flexibility to your financial plans and the advice you give your clients.  Then you can be a modern Kutuzov.

My point:

Don't build a plan based on an anticipated future and then change the plan when the future does not turn out as anticipated. Build your plan to take as many contingencies as possible into account.  It's the difference between a great plan and an ordinary plan - between winning and losing.

Robert Burns, the national poet of Scotland wrote a poem which eloquently describes our human dilemma.  I reproduce a part of it below.

“To a Mouse” by Robert Burns

"But, Mousie, thou art no thy lane,
In proving foresight may be vain;
The best-laid schemes o' mice an 'men Gang aft agley,
An'lea'e us nought but grief an' pain,
For promis'd joy!

Still thou art blest, compar'd  wi' me
The present only toucheth thee:
But, Och! I backward cast my e'e.
On prospects drear!
An' forward, tho' I canna see,
I guess an' fear!"

Behavioral Finance and Economics- Comparatives

People are funny in many ways. Here is one which may be of interest to you.  We can’t decide if we want something unless we see it in a comparative context.  We have a compulsive desire to compare before deciding.  We want to compare things that are easy to compare. On the other hand we dislike (and avoid) comparing things that are not compared easily. Marketing folks know this tendency all too well and manipulate us with it.  For example take the three levels of gasoline at the pump. Depending on underlying conditions (such as supply and profit margin on each octane) the price spread is sometimes altered to have two closer in price. That price spread then gives us an impulse to buy one of two octanes (not uncommonly the highest priced gasoline and if not then the second highest price gasoline).   Another example occurs frequently in a men’s store when shopping for ties¹.  They inevitably bring out three ties, two basically red and one blue.  The vast majority of us will select one of the red ties.  Reverse things and we will pick a blue one.  Marketing folks insert a third choice in our selection and purposely make the third choice similar to one of the other choices but slightly inferior in terms of value.  This choice is actually called the “decoy” in marketing circles.
   
This propensity is a good example of the operation of a judgmental heuristic or mental short cut.  It is also a reflexive (and not a reflective) mental process.

You may wish to consider the foregoing in the future in managing your risk². 

1.  This does not apply when women are looking at shoes in which case no marketing techniques are necessary.  There is no truth to the rumor that "must buy shoes" is a subliminal message sent out over "muzak" in the women's shoe department of Nordstrom.
 2.  In July 2008 an Organization called The Edge Foundation, Inc. held a symposium taught by three preeminent scholars in Behavioral Economics, Richard Thaler, Sendhil Mullainathan and Daniel Kahneman (the winner of the 2002 Nobel Prize in Economics). The attendees included founders of firms such as Amazon and Google. The symposium lasted several days with a seminar on one topic presented each day. The seminar on the first day was presented by Dr. Thaler on the topic of "Libertarian Paternalism: Why it is impossible not to nudge". A quote from Dr. Thaler in this symposium sums up his message: "If you remember one thing from this session, let it be this one: There is no way of avoiding meddling. People sometimes have the confused idea that we are pro meddling. That is a ridiculous notion. It's impossible not to meddle. Given that we can't avoid meddling, let's meddle in a good way." Along with Cass R. Sunstein, Dr. Thaler is the author of a book entitled: Nudge: Improving Decisions About Health, Wealth, and Happiness.

The Evolution of the Customer Complaint - Portfolio Evaluation Tools

Since 1979 the financial services industry has been undergoing a paradigm shift from transactional business to what is called managed money. That shift has accelerated within the last few years. Most full service firms today engage in managing assets far more than in transactional business. The dramatic rise in the popularity of the Registered Investment Advisory firm (to say nothing of the hybrid firms now being created) only confirms this trend.  True transactional business is alive and well, primarily with online discount houses. There will always be a small portion of the business that will be transactional in nature but the lion’s share going forward will be in asset management.

On that basis I think we can safely expect that customer complaints and arbitrations in the future will focus on the acquisition and maintenance of an investment portfolio. This focus may be on the portfolio itself or its components. Therefore, I believe that virtually everyone associated with the financial services industry should develop a working knowledge of what can be loosely characterized as portfolio evaluation tools. If you are an investor you should also become acquainted with them as well, whether you pick your own investments or let someone else manage your assets. I have composed a short list to get you started.*

You may wish have to have some familiarity with:

Standard Deviation – in the financial services industry, a measure of systematic and unsystematic risk of an investment or portfolio.

Beta – a measure of the volatility of a stock or portfolio against a benchmark index.

R-squared – a statistical tool used to determine the relevance of Beta.

Alpha (Jensen Index) – a tool to measure the risk adjusted performance of a diversified portfolio.

Sharpe Index or Ratio – a tool to measure the risk adjusted performance of an undiversified portfolio.

Sortino Index – a modification of the Sharpe Ratio using downside variance only.

Treynor Index – another tool to measure the risk adjusted performance of a diversified portfolio.

Duration – a tool useful in measuring the volatility of bonds versus changes in interest rates.

Value at Risk - a tool that calculates the maximum loss expected (or worst case scenario) on an investment, over a given time period and given a specified degree of confidence.

You may also wish to be familiar with the interrelationships some of these tools have (e.g. R-squared and Beta).  I don’t think that you necessarily have to know how to do the actual calculations but rather have sufficient familiarity to know the appropriate circumstances for the use of a particular tool and the significance of the results of its application.

Google is a good place to start your education.

*For the brokers reading this, I know you know this material already; however, many other persons associated with your industry (including your clients) do not and should.  For those of you in the dispute resolution business these tools add new dimensions to concepts such as suitability or the nature and extent of a duty owed to the client.

A Piece of the Continent

Why hasn't top line growth occurred in American businesses. Perhaps we should revisit John Donne's famous essay. Cutting costs by firing people has consequences which cannot be avoided by anyone. In an effort to eliminate losses businesses have been reducing costs.  A material part of that effort has come in the form of what is referred to as “RIFs” or reductions in force.  On the face of it (except for those personally affected) it sounds like a good idea. Get those businesses more efficient so they can stem those losses and perhaps return to profitability. So intuitively it does sound like the right thing to do. Free market capitalism at work. Sever the employee, pay the severance, account for it, show that as a loss right now but thereafter show an improvement in your costs and thereby your profit.  You bet.  But show an improvement in your top line (revenues).  Absolutely not. Short sighted and stupid.

Let me suggest that contrary to intuition this is exactly what we should not be doing now.  Drill down a little bit and I believe that you will see that every action in that direction reduces aggregate demand including the demand for the goods and or services of the very business that engages in the action. Several hundred years ago, John Donne in his Mediation XVII* very articulately described the human predicament in this regard.

If it were just one concern that engaged in RIFs and other draconian expense cuts such actions would not materially effect aggregate demand and hence our economy (or that firm itself). That is simply not the case in a recession. It is on this basis that I propose that business efficiency efforts should be accomplished under normal market conditions and by firms that under such normal conditions need to do so**-not in an economic downturn.  You see you simply cannot act as if you are in a vacuum – you’re not.  Permit a simple example.  Suppose you have a Citi employee who has a Citi mortgage. Then suppose you RIF that employee. Does it matter if you alternatively change employers and lenders?  It does not.

We should advocate that during a recession, policy makers (both in the private and public sectors) engage in actions which are designed to prevent the deterioration of demand for the goods and services we produce – not encourage it. By way of example, making someone unemployed,  and by doing so making others afraid of the same consequence,  during a recession (and therefore likely unable to become reemployed) causes them to cease to be active participates in our economy as consumers – for all practical purposes they stop spending.  Such cost efficiency during a recession isn’t efficiency; it’s more akin to the purge cycle of Bulimia Nervosa. Just like the disease, the RIF (Purge) is not a cure for the condition; it’s an integral part of the condition.

The simple way to prevent this self fulfilling phenomenon is to engage in activity  during an economic downturn that reassures people that they will remain employed (perhaps at a diminished level of income).  We have not done that.  Instead what we have done is to adopt an all or none approach, RIF people during an economic downturn from businesses that in large part were efficiently employing people (both in number and activity) during a normal business environment. We then react by enacting policy to reemploy people in different jobs in different industries (thereby creating, among other problems, a massive need for retraining people for jobs that will not be permanently needed when the business environment returns to normal).

Once employees are RIF’d from a business that business may become efficient for the level of demand for its goods and services which existed at the time the RIF’s were planned.  It will not remain efficient if the level of demand changes and that most assuredly is what will happen.  More RIFs create more unemployed people and intensifies the fear in those remaining employed thereby further reducing demand.  Even after the economy hits its lowest point and although it may stay there for a period of time it will eventually improve and then those same businesses will become inefficient again, this time in the opposite direction.  Binge and Purge, Purge and Binge.

Indeed recently business commentators have been in essence echoing this sentiment. Many of them have cautioned that although we have seen improvement in corporate earnings that improvement has been only comparative (from disastrous to lousy) and not favorable in "real" terms.  They go on to say that cost cutting can only go so far in terms of reversing the economic outlook and that until there is real "topline" growth no real recovery will occur.  I agree. What I disagree with is that it was necessary to cut those costs in the manner and to the extent we did and were encouraged to do so. I might add that in terms of cutting costs in the near term by  RIFs is not in a real time cost savings.  Accounting rules which govern how we treat expenditures for severage packages exacerbate this unfourtunate tendancy.

We can enact policy initiatives which are no more expensive (and probably less) than the policy initiatives we currently have in place. The ones in place do not specifically target or encourage employee retention. Our policy initiatives can and should encourage businesses to retain employees which would be retained but for the recession.  If we do not change then we will continue the binge and purge cycles in our economy that so closely resemble the eating disorder I mentioned above.

In summary, making RIFs and taking draconian cost reductions during an economic downturn is worse that just being a day late and a dollar short.  It is a self fulfilling and self destructive phenomenon. Policy, both public and private should be to avoid this at all, excuse the pun, costs.

*In part here is Mediation XVII: “No man is an island entire of itself; every man is a piece of the continent, a part of the main; if a clod be washed away by the sea, Europe is the less, as well as if a promontory were, as well as any manner of thy friends or of thine own were; any man’s death diminishes me, because I am involved in mankind.  And therefore never send to know for whom the bell tolls; it tolls for thee.” 

Nunc Lento Sonitu Dicunt, Morieris

Yes I am aware that it's text is euro centric and sexist, however, the text was written for a contemporary audience n 1623.

**The domestic automotive industry is an example of an industry that was not efficient under normal market conditions.