A devastating chapter in ‘The Investor’s Manifesto’ by William J. Bernstein (www.wiley.com) is the one titled ‘Muggers and worse.’ In every town and city, people generally avoid certain areas after dark, and it is the same in the investment metropolis, he writes in a section named ‘The world’s largest bad neighbourhood.’
Cautioning not to venture ‘more than 10 yards form the front door,’ the author observes that the prudent investor treats almost the entirety of the financial industrial landscape as an urban combat zone. “This means any stock broker or full-service brokerage firm, any newsletter, any advisor who purchases individual securities, any hedge fund. Most mutual fund companies spew more toxic waste into the investment environment than a third-world refinery… Who can you trust? Almost no one.”
The first and foremost reason for this awful state of affairs in the industry, according to Bernstein, is the absence of any educational requirements on brokers and financial advisors, let alone the managers of hedge, pension, or mutual funds. While doctors, lawyers and accountants are required to study for years to pass gruelling exams that are the equivalent of post-graduate degrees, the brokers are not required to graduate high school, he rues. “Worse, an incompetent or mendacious broker can devastate your net wealth much faster than even the least capable accountant. As frosting on the cake, he will get rich in the process.”
Limited world vision
The second reason, the author notes, is that people do not go into the financial services industry for the same reasons that attract individuals to social work, government service, or elementary education. “It is rare to meet a hedge fund manager or mutual fund executive who has a vision of the world that extends very far beyond his or her own self-interest… Consequently, you should extend an extra degree of caution to anyone who wants to manage your finances.”
Adding to your woes is the art of soft sell that brokers can be good at. The book cites an undercover journalist’s finding at two leading financial companies – that most trainees had no financial background at all. “As one of them, a used car salesman, wryly put it, ‘Investments were just another vehicle.’”
One learns that both financial companies, in this case, did school their charges in the basics of stocks and bonds, but only enough to give clients the impression that they knew what they were selling. “The bulk of the training observed by the reporter centred in language-lab-type facilities, where the neophytes endlessly rehearsed and discussed sophisticated sales scripts. The brokerage firms specifically designed these well-oiled spiels to draw from clients their needs and fears.”
Greed and fear
Unusually for a book about investment, an illustration of the human brain finds place in a chapter titled ‘The enemy in the mirror.’ For, the muggers are not just out there in the alleys, but up here in the head, too! And to know them, a brief course in anatomy is required.
Were you to divide your skull exactly into symmetric right and left halves along a vertical plane, most of the limbic system would lie on or near it on either side, the author describes. In front of the brain – just behind each eye – sit a pair of neuron groups called the ‘nuclei accumbens,’ the brain’s ‘anticipation centre,’ he adds
“They are most electrically and metabolically active during the anticipation of eating, sex, agreeable social activity, and most importantly for our purposes, financial reward. If greed resides any single place in the brain… it is here.” And proving that anticipation is better than pleasure, these neurons have been found to ‘respond much more to the prospect of reward than to the reward itself.’
The illustration also shows ‘amygdalae,’ the ‘fear centres’ closer to our temples, mediating ‘some of our deepest negative emotions: revulsion, fear, and loathing.’ Our limbic system, which pretty much resembles that of most vertebrate species, serves the function of rapid interpretation of and reaction to environmental stimuli without necessitating any conscious thought, writes Bernstein.
“Nearly every time we invest, our cortex, where we consciously calculate and reflect, battles with our limbic system, the repository of our instincts and emotions. The extent to which we succeed depends in no small part on how well the cortex keeps the limbic system in check.”
Reflection vs reflexion
Reflection takes time and effort, whereas ‘reflexion’ happens automatically and nearly instantaneously, the product of millions of years of evolution, he explains. “In every field of human endeavour, whether it is flying, medicine, or armed combat, this reflexive/ reflective split cleaves the world into amateurs and professionals, the former driven by their emotions, the latter by calculation and logic.”
The author warns investors of some of the reflexive behaviours that can be maladaptive to financial decision making. First in the list is our craving for easy-to-understand narratives. Is that not how we understand the world around us, you may wonder? Yes, but in the world of finance, things can get complex in a hurry, the author instructs. The narrative in today’s investing climate speaks of world economy imploding and corporate profits collapsing, and about a decade ago, the prevalent narrative was about how the Internet was to change everything.
Alerting investors that popular finance books can provide an excellent barometer of uninformed narrative-borne public sentiment – since ambitious financial authors tend to pander to it – Bernstein recommends that one has to learn to automatically mistrust simple narrative explanations of complex economic or financial events.
Entertaining and investing
The second reflexive behaviour is that we want to be entertained, so much so our purchases of both consumer goods and investment vehicles can be broken into two parts, viz. entertaining and investing, the author finds. For example, a lottery ticket which is ‘a miserable asset class if ever there was one,’ has the ‘greed’ centre headily ‘dreaming about spending the rest of your life in Maui’ as a happy diversion supplementing the low return.
In the entertaining class, the author puts also the initial public offerings (IPOs) of the stock of exciting new companies. “A wealth of research demonstrates that IPOs have, in general, lousy returns with very high risk. This is not a new observation; three-quarters of a century ago, investment legend Ben Graham, in his seminal ‘Security Analysis,’ wondered why folks bought IPOs.”
The answer to ‘why’ is that it is so much more fun taking a chance on finding the next Amazon.com or Microsoft than owning a doggy industrial company, says Bernstein. “In short, IPOs are the investment equivalent of a lottery ticket, with high entertainment value and low investment returns… If you want excitement in your life, it is far safer and cheaper to take up skydiving than to seek it in your investment portfolio.”
Recommended addition to the reading list of those looking for light in the investment labyrinth.
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