Tempting fate

Falsehoods and myths tempt investors to make decisions that fail to fulfil the promise they offer - and in some cases precipitate disastrous results. Vanessa Drucker in New York summarises the most common investment fallacies.

Investing is a dangerous activity, characterised by myths, fallacies and even lies. All of these traps are variants of falsehoods, poised to lead investors astray. Like urban legends, some distortions gain force through dint of repletion. Some arise through fuzzy logic. Others consist of misrepresentations, derived from efforts to simplify complex mathematics or financial theory. Sometimes governments create “spin”, for policy purposes that may be misguided.

Here is a short collection of untruths. The list is not exhaustive, but touches on some egregious common fallacies that are relevant in today’s investing climate.

Diversification protects against risk

When Harry Markowitz published his theory of portfolio allocation in 1952, investors rejoiced at what appeared to be a free banquet. According to portfolio theory, asset diversification could lower risk and volatility, since different correlations govern relationships among securities.

Sadly, over the past few years, diversification has ceased to deliver on its promise. Almost all markets have been moving in tandem, with asset classes rising as a bloc, and offering no shelter on the way down. As policymakers aim for growth at almost any cost, investors no longer make selections according to company fundamentals but rather on the perceived direction of macro policy. Correlations, which merged to one during the extreme period of the credit crisis, remain closely integrated. Some investors have taken refuge in international equity funds as a play on diversification across the world at large. “Even that does not work,” says Axel Merk, president and chief investment officer of Merk Mutual Funds in Palo Alto, California. “All the large caps want to do the same, that is, to export to the US consumer.”

Where can investors put their eggs, if multiple baskets no longer add protection? Merk suggests playing macro themes through currencies, as a pure play on government intervention, noting that, “At least policymakers are predictable.” One can also zoom in on 10 or so significant currencies, versus thousands of stocks. Even in these days of common trajectories, currencies have shown a low correlation to equities.

As another myth of currency behaviour, it is often held that currencies move with breathtaking volatility, capable of rapidly wiping out positions. Although it is true that many traders use leverage to amplify their bets in this asset class, they need not do so. If the euro moves from, say, $1.32 to $1.35, it makes headlines, because it moves economies; if stocks moved by the same degree, no one would blink. (article continues below)

Inflation is dormant

Do you eat, drive or heat your home? Food, energy, copper and other commodity prices are rising (see graph), while anything that cannot be imported from Asia is soaring in price. In America, that would include education and healthcare as key components of the service sector.

Investors and central bankers should not merely be looking at this month’s inflation numbers, but rather at expectations. Inflation is foremost a function of expectations, which in turn hang on the credibility of the central bank. When Ben Bernanke, the chairman of the Federal Reserve, announced on December 5, 2010 that he was “100% confident” that the central bank would be able to ward off inflation by raising interest rates and unwinding stimulative programmes, listeners were sceptical. “Bernanke says he is not printing money, but no one believes it. It’s always dangerous when people don’t trust their government,” says Lynn Turner, who was formerly chief accountant at the Securities and Exchange Commission (SEC).

An arguable theory holds that inflation depends on an output gap in the economy, which is the difference between an economy’s actual and potential real GDP. While the arguments for and against the concept are complex, note that since the 1970s the gap has often failed as a predictor.

“Bernanke has stated that he wants to see inflation higher, although many markets don’t believe him,” says Merk. Likewise, many did not take Paul Volcker seriously in the 1980s in his quest to bring it down. Merk says, “Bernanke is determined to create inflation and he will not stop until he does so.”

Emerging markets are better than developed ones

There is a mistaken belief that developing nations no longer nationalise foreign investments. One does not need to look far back to see that inward investment declines create pressures that may lead governments to flout established contract law. “People wrongly assume that the only countries that fail to respect property rights and laws are those run by populist dictators, like Venezuela and Zambia,” says Peter Hagan, a managing director of LECG and former chairman and chief executive of Merrill Lynch’s American banks.

Recall how the Russian Ministry of Natural Resources suddenly revoked Shell’s oil drilling permit in 2007, threatening a $50 billion lawsuit on the grounds of environmental damage. Shell was essentially bullied into shedding half its position in a $22 billion project, leaving room for Russia’s Gazprom to step in.

Historically, emerging market companies have yielded more and sold at lower price to earnings ratios, primarily because investors have recognised the sovereign risk attached. Lately, developing countries have recognised the benefits of maintaining a positive climate for Western investors. “At some point, that will change, and we can expect to see increased taxes and national takeovers of assets,” Hagan warns.

For example, Ghana, with a fairly supportive government, has become the latest investment darling. That region of Africa, however, has experienced a series of coups and government overthrows. Where is the guarantee that in 10 years’ time it will support capital investment? In Cameroon, another recent investment hotspot, democracy and the rule of law have not yet been fully established.

Trust precision and analysis

Since the early 1990s, financial quants have been ready to analyse any data to death. An entire generation of analysts flourished who had little experience in industry on the ground.

“Garbage in, garbage out,” Hagan reminds. “When the foundation is fundamentally wrong, the first lie is set in place…if the underlying data and assumptions are wrong, statistical analysis will not only produce results that are equally wrong but will also create an articulate constituency ready to defend the results.” In other words, financial professionals have an obligation to start by challenging those underlying assumptions. They must not be blinded by impeccable precision and exactitude.

”Banks do not need to recognise losses until they sell their bad assets. That creates an incentive not to sell, but sit on those assets”

As a historical illustration, the real estate debacle provides 20/20 hindsight. Before the collapse of the subprime market, it was almost an article of faith that the American real estate market, being regional in nature, would never decline everywhere simultaneously. “We’ve never had a decline in house prices on a nationwide basis,” announced Ben Bernanke on July 1, 2005. The fallacy derived from observations of a different market in an earlier time. Fifteen years before, mortgages were a local business run by local banks and driven by local issues. Securitisation, however, consolidated the industry into a single market with a common driver. Investors mistakenly assumed that the earlier dynamics of the industry structure still applied. “One false piece of information becomes legitimised by repetition,” Hagan notes. “While it may not be a lie, the data is inappropriate.”

American banks have cleaned up their balance sheets

In February 2010, the Congressional Oversight Panel (COP) announced that, among about $1.4 trillion commercial real estate loans, over half, due to mature between now and 2014, were under water. The panel, which oversees the $700 billion bank bail-out program (Tarp), predicted that losses on those loans could range from $200 billion to $300 billion. The five-member panel’s report read, “The Congressional Oversight Panel is deeply concerned that commercial loan losses could jeopardise the stability of many banks, particularly the nation’s midsize and smaller banks.”

The COP group recommended that weak banks should be compelled to face deteriorating portfolios, but was more willing to cut some slack for those whose loans were still performing. Their rationale was that unloading commercial real estate too soon could depress values into a downward spiral.

“It has been deliberate official policy not to look too hard at losses,” says William Black, a professor of economics and law at the University of Missouri-Kansas City School of Law. “Accounting rules have been gimmicked, so that banks do not need to recognise losses until they sell their bad assets. That creates an incentive not to sell, but sit on those assets.”

Dodd Frank law has made banking system more robust

Last year’s financial legislative reform is an excuse for an agenda. Many items included in the 2,700 pages of statutes had nothing to do with banking, and diluted the law’s focus. In the sense that the objective of the legislation was to head off the next problem or accelerate its resolution, the bill has failed.

“It does nothing to make big banks smaller, or to make them break off propriety trading,” says Patrick Daugherty, a partner at Foley & Lardner, who is expert on banking law. He explains, “Proprietary trading has been reconfigured as customer oriented businesses, which will continue to transact as before, under different names.”

With so much material to analyse, and who knows how many thousands of regulations yet to be enacted, it is unlikely that another behemoth like JPMorgan or Citigroup could evolve. Today’s banking business requires more regulatory staff than bankers, and in smaller institutions, back office staff will outnumber those in the front office. Thus, Dodd Frank has cemented the oligopoly in place. “Community banking is drying up because the cost of organising and maintaining community banks has become too high,” says Daugherty.

While the mantra of “too big to fail” has been widely acknowledged, nothing has been done to remedy the dilemma. The big six – JP Morgan Chase, Bank of America, Citigroup, Wells Fargo, Goldman Sachs and Morgan Stanley – enjoy implicit government guarantees, whereby their bondholders can count on being protected, with no haircuts to fear. In consequence, the giants can borrow more cheaply than smaller institutions.

From 1980-2005, about 440 American bank mergers a year condensed the industry from about 11,400 to 7,500 institutions. Twenty years ago, 10 American banks represented a quarter of all banking assets. Jane D’Arista from the Political Economy Research Institute at the University of Massachusetts says: “By the end of 2008, five dominant banks controlled 97% of all derivative action.” The banking sector itself has swelled, compounding the problem. According to Simon Johnson, co-author of 13 Bankers, by late 2010 the big six commanded assets worth 64% of GDP, versus in 2006 when they represented 55% of GDP, or 1995, when the same entities’ holdings accounted for 17% of GDP.

Newly created agencies will fortify bank oversight

The Dodd Frank legislation has created new agencies, as well as bestowing additional oversight authority on the Federal Reserve. At least the latter allows the central bank to ratchet down permissible leverage and to require additional capital for larger banks, which is a net positive. As for the newly minted agencies, they may muddy the supervisory process.

The Financial Stability Oversight Council will be composed of a group drawn from the heads of every major financial regulatory agency and the White House. Authority has therefore been spread and watered down over a wider base. More communication and focus were needed, rather than a cumbersome, deliberative system for administering financial emergency powers.

“We won’t have speedier decision making. In fact, it will be slower, because more people are involved, with diffuse accountability, and nothing whatever has been done about foreign holding companies,” says Daugherty.

At the SEC, Dodd Frank places additional burdens on a staff-constrained body. On October 20, 2010, the agency’s chairman, Mary Shapiro, explained that the new legislation would compel the SEC to shift resources from one area to another. The commission’s $1.5 billion budget is hard pressed to issue 105 rules, conduct over 20 studies, and create five new offices.

Recent events at the SEC should have demonstrated the folly of allowing the agency to become overstretched. Only two days before Bear Stearns imploded, a former SEC chairman, Christopher Cox, was asked whether he was concerned about the investment bank’s financial condition. He told reporters, “We have a good deal of comfort about the capital cushions at these firms at the moment.” That sorry quote carries two critical implications. First, it reveals how out of touch the top echelon at the agency was. Second, it indicates that the SEC was ill-equipped to regulate broker dealers as they grew in scale. The agency has grown by a factor of four over 50 years, while investment banks are 100 times as large.

Rebalancing portfolios is a proven tool

“There’s no clear mathematical justification for rebalancing, although people believe there is,” says Michael Edesess of the Hong Kong Advanced Institute for Cross-Disciplinary Studies and a principal of Denver-based Fair Advisors. Contrary to the popular received wisdom, the Markowitz model for modern portfolio theory (MPT), should not be applied to rebalancing.

Almost all mathematical assumptions about securities’ movements derive from a so-called “weak random walk”, which states that prices move independently of one another in non-overlapping time periods. Nonetheless, MPT applies only to short time periods, such as a year – and there will be many such intervals in a typical investor’s lifetime. “The model is so sensitive to inputs that they have to be jerry-rigged to produce reasonable outputs,” Edesess explains, and even then they do not function well in practice. Managers using MPT generally reapply the optimisation model over and over to subsequent periods.

A reliance on rebalancing can damage a portfolio’s performance in the long term because it is short-sighted and focuses on the wrong risk measure. Edesess takes the example of holding 30-year Treasuries. Suppose a portfolio begins with stocks and Treasuries, evenly split. One would have to sell some of the bond component (which provides the long-term safety-net) if the equity market dropped substantially. In other words, an over-emphasis on rebalancing may “divert attention from a true long-term risk control strategy”.

Note, however, that empirical examples frequently suggest that rebalancing has worked better than a buy-and-hold strategy over certain time periods. The likely explanation rests on mean reversion, the principle that prices return to an average value over time, despite fluctuations. Edesess concludes, “There does seem to be some empirical justification for rebalancing, but it’s still only anecdotal.”

Alternative assets provide alpha (and justify expenses)

A high alpha value indicates that a security has outperformed the broader market, taking into account its particular volatility. In their quest for alpha, “Institutions have wanted to run portfolios like the university endowments of Yale and Harvard. That led some to invest up to 70% in alternatives,” says Cliff Draughn, president and chief investment officer of Excelsia ­Advisors in Savannah, Georgia. David Swensen, a Yale endowment manager, helped popularise alternative investing with his two books, Pioneering Portfolio Management and Unconventional Success. One pitfall, which even thwarted the university endowments, was that managers ignored funding requirements. “By neglecting to match liabilities, they created their own credit crunch. When they needed to withdraw money they had to sell assets from their more liquid classes,” Draughn comments.

”It makes as much sense as trying to invest the way he does by hiring an investment manager who is about his height and weight!”

Edesess further dismisses the validity of the practice for individual investors and other funds. He quips, “Investing the way you think David Swensen invests, by allocating the same percentage he does to ’alternative assets’, makes as much sense as trying to invest the way he does by hiring an investment manager who is about his height and weight.”

One fallacy that underlies the entire approach is the notion that alternatives constitute a legitimate asset class in their own right. Yet the term covers a broad waterfront. The subset of hedge funds, for example, which are often deemed alternatives, includes some funds that resemble mutual funds alongside others that constitute a very different species. You might as well just define the entire class as certain investments that charge more than others.

One might expect the alternative asset class allocation strategy to have been discredited, particularly in the light of the poor performance exhibited by the top university funds themselves. Alas, human vanities still triumph over common sense. Edesess observes that, “wealthy investors, or those who aspire to be viewed as experts, choose their investments not to get the best return, but to be thought of as part of some elite group.”

Escape velocity will rescue the economy

America has suspended fiscal and monetary austerity. (The European Central Bank, by contrast, has taken a more rigorous stance on monetary policy). On the fiscal front, a prevalent thesis holds that tax rises must be postponed until the economy achieves a firmer footing, according to the rationale that additional funds sloshing in the system may help kick-start activity. In December, such arguments bludgeoned the White House into a compromise, engineered to achieve the equivalent of fresh fiscal stimulus: it agreed to retain Bush era tax cuts for the wealthy, while extending tax cuts for the middle class.

Despite handwringing over the public deficit, and the election victories of allegedly fiscal conservatives under the tea party umbrella, no serious action has been taken to balance the budget. Whatever the new ranks of elected officials vote, “they do it like any other pig at the trough,” Turner observes.

Congress has garnished its tax extensions with a vague hint that it will address the problem anew when the economy is healthier. But if lawmakers will not bite the bullet now, when will they? Surely they will be hesitant in 2012, when the next round of presidential and congressional elections looms. Politicians will be doubly constrained, having promised in their recent election campaigns not to impose new taxes. “Nobody in Washington DC or the White House wants to lose their jobs,” Turner says. He warns: “You can’t spend yourself to greatness. There is no alternative to fiscal responsibility.”