Fundholders, Salespeople and Timeframe of Judgement

“Don’t worry Mr Berry, I can assure you that these fund managers are put through their paces rigorously. Not only do we meet them and psychologically profile them every 3 months or so but we are inspecting their results practically every day.” It was with these words that my investment advisor for a well known financial services company lost my custom in his attempt to sell me the virtues of their “fund of funds” investment practice.

I know from my work with investors in other similar well-known organizations that there are several fundamental problems with entrusting your money to people who work for institutions. Some people will tell you that the problem is that the money isn’t theirs and therefore they don’t care enough about it. This is not the problem. Or certainly not the only problem. Just as problematic is the fact that because they are accountable to others they care too much! About the Short Term, at least!

This isn’t entirely fair. There are some great companies out there with whom to entrust your savings and obviously there are equally big problems with investing it yourself such as plain old ignorance and your own personal fear of failure.

But ask any analyst what are the essential problems with his traders decisions and he will tell you: despite a billion dollars of IT telling them exactly what to do, professional investors still go and make emotional decisions. Most notably, they sell appreciating stocks too soon and depreciating ones too late. Why?

Because anyone who buys or acquires an asset (like a stock or share but hopefully the regular reader of this blog will think more broadly than this) that goes up in price will experience a pretty small increase in their overall utility or happiness as the price of that asset increases.

Let’s imagine for a moment that you are operating in an environment where your short term results are scrutinized. Lets imagine that someone (could be your manager, could be your fund-of-funds manager, could be your shareholders, it doesn’t really matter) sees the increase that you have just enjoyed as a green number on your screen or balance sheet. Looks good. Everyone’s happy. The problem is that you know that all the information you have is telling you to hold on to that asset because it’s Long Term value of Expectation is good and positive. It could go down – possibly even to below the buy price. But it could go up. Perhaps significantly so…. But it could go down.

And then that green number is would turn red. And all your congratulations would be rescinded. And the good first impression which you initially created would be called into question. So, despite the fact that everything is telling you to hold onto that asset the law of diminishing marginal utility means that as it does so you have more and more to lose and proportionately much much less emotionally to gain. So what would you do in a rational-emotional sense while it’s still green?

Conversely, let’s imagine for a moment that the price of the asset falls soon after you purchase it. You experience an initially quite severe loss of utility as you now have an ugly red number on your screen or in the wrong column on your balance sheet. What do you want to do deep down right now? Get rid of it sure. But that’s just going to bank the loss and preserve it for posterity and everyone to see. What do you really want to do in this situation? That’s right. Exactly what Nick Leeson wanted to do. You want to get even on the deal. You want hold on to it. Because even though all the information is telling you that this thing has a negative future Expectation… it could… it could go up. Maybe even back above the buy price. It could become a green number!

If it goes down it will just become a bigger red number, “well” you think, “you’ll deal with that when the time comes”. Your results for the day/week/month are going to be reviewed this afternoon, you decide to hold onto it just in case it goes up before then and turns green. Although it doesn’t.

What was the problem here? You work for an investment bank. And yet you’re making the emotional decisions which are not profit maximizing and therefore not serving your clients effectively. Why is that?

The problem is one of outlook, corporate culture or individual mentality. In the example cited, I am stressing the essentially Short Term nature of your assessment in a world where it is Long Term results that ultimately matter. Again, the Long Term is no particular time frame but just whatever your overall goal is. If someone could guarantee you that you’d make a 23% return this year you wouldn’t care what the results were in week two! By evaluating you on irrelevant results, the culture is forcing you to make rational-emotional decisions, of the kind that brought down Barings Bank.

These are the same rational-emotional decisions which persuade a poker player to quit for the evening because he’s made a sum of money with which he’s happy even though his opponents are drunk and effectively giving it to him in the Long Term. Of course, there is nothing to say that the next hand won’t give those same drunkards a four of a kind against your aces full, but that doesn’t matter. Your Long Term Expectation is positive. Quitting is effectively losing you money even though it may look like you’re saving it. And I’ll say it again, this isn’t just happening at the poker tables of Las Vegas, it’s happening every day with billions of dollars at stake. Short term accountability is costing you and me money! Oh the irony!

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