Financial Gaslighting

Note: This is my 1,000^th post at Above the Market, which began publication nearly five years ago, in August of 2011.  I remain as astonished as ever at the attention it has received. I am grateful to each and every reader. Thank you.

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In 1821, a man named William Hart dug the first natural gas well in the United States on the banks of Canadaway Creek in my home town of Fredonia, New York. The well was 27 feet deep, was excavated by hand using shovels, and its gas pipeline consisted of hollowed out logs sealed with tar and rags. Natural gas was soon transported to businesses and street lights in town. These lights frequently attracted travelers, often causing them to make a significant detour to see this new “wonder.” Expanding on Hart’s work, the Fredonia Gas Light Company was formed in 1858, becoming the first American natural gas company.

Gas lighting is thus an inexorable part of my personal history. But I’m even more interested in gaslighting.

In the 1938 play Gaslight, a murderous husband is intent on inducing instability in his wife in order to accommodate his venality. When she notices that he has dimmed the gaslights in their house, he tells her she is imagining things—that they are as bright as ever – as a way to get her to question her senses and her sanity. The British play became a classic 1944 American film from George Cukor, starring Ingrid Bergman as the heroine and Charles Boyer as her abusive spouse, out to convince her that reality is not what she perceives. In this sort of story, our most dangerous enemies are always those closest to us, masquerading as lovers and friends. Gaslight reminds us how uniquely terrifying it can be to mistrust the evidence of our senses and of what we know to be true.

Taking off from the film, “gaslighting“ in contemporary usage means a form of intimidation or psychological abuse whereby false information is systematically presented to the victim, causing him to doubt his own memory, perception or even his sanity. As in the movie, gaslighting is a hallmark of domestic abuse, but one can see its use and impact almost everywhere. I wrote much of this while in Washington, D.C., perhaps the world’s gaslighting capital.

In the investment management world, the overarching priority for the vast majority of money managers is to gather assets and revenues and only peripherally to provide quality performance for investors. Gaslighting is routinely used to try to obscure those priorities and to convince investors that, despite the reality of what they see, investing in product X or with firm y is a smashing good idea. 

Alternatives to Being an Evidence-Based Financial Advisor

There is a new and growing movement in our industry toward so-called evidence-based investing (which has much in common with evidence-based medicine). As Robin Powell puts the problem, “[a]ll too often we base our investment decisions on industry marketing and advertising or on what we read and hear in the media.” Evidence-based investing is the idea that no investment advice should be given unless and until it is adequately supported by good evidence. Thus evidence-based financial advice involves life-long, self-directed learning and faithfully caring for client needs. It requires good information and solutions that are well supported by good research as well as the demonstrated ability of the proffered solutions actually to work in the real world over the long haul (which is why I would prefer to describe this approach as science-based investing, but I digress).

The obvious response to the question about whether one’s financial advice ought to be evidence-based is, “Duh!” But since all too few in the financial world practice evidence-based investing, we ought carefully to look at the possible alternatives to being an evidence-based advisor. Here is a baker’s dozen of them for your thoughtful consideration. If I’ve missed any I’d appreciate your letting me know.

Chris Rock Explains Bias Blindness

When the nominations for the 88^th annual Academy Awards were announced this past January and for the second year in a row included no minority nominees for any of the major performance categories, my first thought was here we go again. But my second thought was that Chris Rock would be hosting the Oscars’ award ceremony and that there might be fireworks.

I was not disappointed. Rock quickly let it be known that he would not be boycotting the ceremony (as he quipped during his Oscar monologue, “How come there’s only unemployed people that tell you to quit something?”) but also that his opening monologue would be addressing the #OscarsSoWhite controversy in a big way.

He sure did.

The Jewelry Effect

I’m not a fisherman, but I was fascinated recently to come across an article about the science behind the creation and use of fishing lures. Size, shape, color and even taste all matter. Interestingly, however, there is a surprising degree to which the effectiveness of the lure doesn’t matter commercially. For example, there is a dizzying array of bass lures in variations of blues and purples (see at left, for example) even though bass cannot see those colors as anything other than gray. But people buying lures seem to like those colors. Those involved in the research and sale of fishing lures refer to this phenomenon as the “jewelry effect.”

“We design lures for the fish, but fish don’t buy lures,” says Keith A. Jones, a director of research for an Iowa lure-maker. “It’s hard to convince anglers that a lure’s color doesn’t make much difference.” Scientific reality doesn’t even get much respect in the fishing world.

Jones recognizes that, to be commercially successful, lures need to be aesthetically pleasing to the people who buy them. Accordingly, some lures that work well need a design change to sell. Ted Dzialo, executive director of the National Fresh Water Fishing Hall of Fame and Museum in Hayward, Wisconsin, simply captures the essence of the issue. “I think most lures are designed to catch more fishermen than fish.”

If this sounds remarkably similar to the money management business to you, you’re not alone. So-called “smart beta” is really good marketing because it takes advantage of demand for beta-driven solutions but it is no panacea. Moreover, “factor investing” can trace its origins back to at least Benjamin Graham and is hardly new to smart investors. After the financial crisis, consumers rushed to money managers offering tactical management in order to try to avoid the next big downturn even though there is precious little evidence that it works. And hedge funds continue to lure major assets and major investors – perhaps because those investors want to prove to themselves and others that they’re rich – even though hedge fund performance has been, in two words, truly dreadful.

There are plenty of other examples, of course, but you get the idea. Good investing is necessarily a long-term enterprise and we humans struggle badly with the long-term. The short-term is too alluring. Our efforts at hyperbolic discounting generally suck. Thus we are always prone to eat the cake and skip our work-outs.

Those who market money management are well aware of these tendencies. And, to be fair, there isn’t much that’s sexy about good money management. We want the next Apple rather than diversification. We want to avoid the next big crash but every last drop of upside. We want to get rich quick and think we’re smart enough to find that next big thing. But we are routinely disappointed and, when we think we’ve (finally!) found the Holy Grail, it turns out that Holy Grail Investment Management is run by Bernie Madoff.

Most money management firms set out first and foremost to lure and catch investment dollars and only secondarily to manage the assets won effectively. The jewelry effect is at least as prevalent in money management as in fishing. But pretty it’s not.

A Hierarchy of Advisor Value

I talk often with lots of advisors of all sorts and from a wide variety of firms. They are profoundly disillusioned an astonishingly high amount of the time. When the markets are strong, they are disappointed that they didn’t capture enough of the upside. When the markets are weak, they are apoplectic that they didn’t avoid the downturn. When markets are sideways, they’re just plain frustrated. When they try to anticipate these movements they usually fail and when they don’t – a very rare event indeed – their next moves inevitably don’t keep up the good work. They hate seeming to start from scratch every day and living from transaction to transaction, dependent upon the machinations of markets for survival.

This profound disillusionment is well-earned, of course, and is predicated upon three primary problem areas: execution; expectation; and erroneous priorities. The basis for each of these problems can be established in surprisingly short order.

In terms of execution, the trade ideas they offer rarely turn out well and the performance provided by money managers, when they go that route, almost never meet expectations such that it’s not unfair to say that much of the money management business has been an abject failure pretty much across-the-board, even for the mega-rich. Poor investor behavior makes that dreadful performance even worse — we trade too often, at the wrong times and into the wrong instruments. We chase returns via managers, sectors and trades that have been hot only to be disappointed when mean reversion inevitably sets in. Our inflated expectations make matters worse still because investors expect outperformance as a matter of course and investment managers tell them to expect it, implicitly and explicitly. That’s what makes the sale after all.

Erroneous priorities include a failure to manage to personal needs, goals and risk tolerances as well as “plans” that change with every market movement. It shouldn’t surprise anyone that clients with huge appetites and tolerance for risk when markets are rallying frequently want to go to cash at the first sign of trouble. At the advisor level, the priority problem is even more fundamental and encompasses each of these problem areas. Much of what tries to pass as “financial advice” is actually glorified (or even not-so-glorified) stock-picking. In my experience, most advisors and their clients wrongly think that the advisor’s primary function is to pick good investment vehicles.

Advisors are well aware of the failures of the money management business, of course, as well as the limitations of a transactional business model. That’s a big reason why their disillusionment is so existential. They have been let down again and again by the idea that they have (finally!) come up with a formula for success only for reality to crush those promises. Even worse, and consistent with that conundrum, a 2012 study from the National Bureau of Economic Research concluded that financial advisors reinforce behavioral biases and misconceptions – the problems outlined above – in ways that serve the advisors’ interests rather than those of their clients.

Still, many of these advisors keep hoping against hope. They routinely tell me that if they proposed a data-driven, evidence-based approach with their clients that actually had a reasonable chance for success, their clients wouldn’t perceive a need their services. Not so coincidentally, that’s a big reason why so many advisors are terrified by the proposed Department of Labor fiduciary rule with respect to retirement accounts. And that’s why the Dilbert cartoon reproduced below about index funds (one possible data-driven approach but hardly the only one) is so wickedly funny.

Proper advisor priorities begin with a recognition of what is important and what is achievable. That’s why I have created this hierarchy of advisor value, which was developed for a presentation I have been giving to groups of advisors. 

Managing to this hierarchy won’t make the markets any less infuriating, but doing so will make the financial advice business much more fulfilling and gratifying. It can even make that business more lucrative, at least over the longer-term. Simply put, it will require carefully and truly putting the client’s interests first, even when the client doesn’t see it that way. 

The Great Myths of Investing

As the great Mark Twain (may have) said, “It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so.” That’s particularly true in the investment world because we know, to a mathematical certainty, that avoiding errors provides more bang for the buck than making correct calls and generating outperformance. Fixing what we “know for sure that just ain’t so” provides a remarkable opportunity for investment success.

On the other hand, it simply doesn’t make a lot of sense to spend enormous amounts of time and energy looking for a strategy or a manager that might (but probably won’t) outperform by just a little bit. As the great Spanish artist Pablo Picasso put it, “Every act of creation is first of all an act of destruction.” What we want to do is to find the next great investor, the terrific new strategy, the market sectors that are about to heat up or the next Apple. But what we should do is eliminate the things that make it so hard for us to get ahead. Accordingly, I will highlight some of the great myths of investing — ideas that lots of people, alleged experts even, claim to be true and act as as though are true “that just ain’t so.”

There are lots of myths at work in our lives, of course, falsehoods that are often believed and which are used to further a favored narrative. But George Washington didn’t really cut down a cherry tree and wax eloquent about not telling a lie as a consequence. Isaac Newton didn’t come up with his theory of gravity because an apple fell on his head. Columbus didn’t discover that the earth was round (that had been established centuries before). Ben Franklin didn’t fly a kite in a storm and discover electricity. And Einstein never flunked math. If any of these are news to you, I’m sorry to have had to break it to you.

Such myths persist because they “work” in some way. Their story elements — ease of recall, readily adaptability, explanatory power — make them useful and even important.  But utility and truth are hardly the same things and neither are utility and helpfulness.

So here is my list of the top ten great myths of investing. Since they aren’t true and are indeed damaging, if you can eliminate them from your mind and your investment process, your results will necessarily improve.

Here We Go Again: Forecasting Follies 2016

Image from xkcd

In a great scene from the classic film, The Wizard of Oz, Dorothy and her friends have — after some difficulty and fanfare — obtained an audience with “the great and powerful Oz.” When, during that audience, Dorothy’s dog Toto pulls back a curtain to reveal that Oz is nothing like what he purports to be, Oz bellows, “Pay no attention to that man behind the curtain,” in an unsuccessful effort to get his guests to focus their attention elsewhere.

Like the Wizard, the great and powerful on Wall Street would have us pay no attention what is really there — “behind the curtain.”  Yet once in a great while the Street rats itself out so that we get to find out, beyond a shadow of doubt (if you still had any), what the big investment houses really think about what they do and who they do it to.

The now-defunct Bear Stearns won a noteworthy 2002 legal decision involving former Fed Governor and then-Bear Chief Economist Wayne Angell over advice he and the firm gave to a Bear Stearns client named Count Henryk de Kwiatkowski (really) after the Count lost hundreds of millions of dollars in a just a few weeks (really) following that advice by trading currency futures on margin (really). The Count had been born in Poland, escaped invading Nazis, been banished to Siberia by the Soviets, escaped and travelled across Asia on foot to Tehran, talked his way into the British Embassy, became a renowned RAF pilot, moved to Canada, became an engineer, and made a fortune trading used airliners, most famously selling nine 747s to the Shah of Iran over a game of backgammon in the royal palace (really). He also became the owner of the famous thoroughbred racing institution, Calumet Farm (really).

Bear offered the Count “a level of service and investment timing comparable to that which [Bear] offer[ed its] largest institutional clients” (which is not to say that they were any good at it). The key trade was a huge and ultimately disastrous bet that the U.S. dollar would rise in late 1994 and early 1995. At one point, the Count’s positions totaled $6.5 billion nominally and accounted for 30 percent of the total open interest in certain currencies on the Chicago Mercantile Exchange. The jury awarded a huge verdict to the Count but the appellate court reversed. The appellate judges determined, quite conventionally, that brokers may not be held liable for honest opinions that turn out to be wrong when providing advice on non-discretionary accounts.

But I’m not primarily interested in the main story. Instead, I’m struck by a line of testimony offered at trial by then-Bear CEO Jimmy Cayne that does not even show up in subsequent court opinions, despite extensive recitals of the facts of the case. The generally “cocksure” Cayne apparently thought that his firm could be in trouble so he took a creative and disarmingly honest position given how aggressive Bear was in promoting Angell’s alleged expertise to its customers. Cayne brazenly asserted that Angell was merely an “entertainer” whose advice should never give rise to liability.

In Times Like These

“My Mama told me there’d be days like this.” – Van Morrison

Stock markets are in turmoil all over the globe. Monday was especially violent and what passes for financial television was awash in bluster, doom and gloom. Markets were gapping down in China, in London, in Japan and elsewhere. Emerging markets were getting crushed. Here in the States, the S&P 500 dropped about 4 percent, with the other major benchmarks performing similarly. The next day, on what appeared to be “Turnaround Tuesday,” a day-long rally was overcome by a major sell-off just before the close, pushing all the major indexes underwater for yet another day. Today has opened well, but (obviously) we don’t know what’s coming.

Over the previous six trading days, the benchmark S&P index has lost well over 200 points, or roughly 11 percent, putting it on track for its worst August in 17 years. But since the markets haven’t seen a significant correction (a loss of at least 10 percent) since 2011, we have been due for one. When financial markets are free-falling, and all correlations seem to converge on 1.0, analytically we move into the realm of the physics of landslides, where things are inherently complicated and unpredictable (which is not to say that more “normal” times are somehow simple and predictable).

Hot Pants Investing

I watched Mike Krzyzewski’s first Duke win from the stands in Cameron Indoor Stadium as a student in 1980 and his fifth national championship victory earlier this month at home, on television, with my grandchildren. I’ve probably seen a majority of the games in-between one way or another. Coach K is an icon, and widely regarded as perhaps the best college basketball coach of all-time. He is the winningest college basketball coach of all-time. But when has hired 35 years ago, he wasn’t even generally considered to be in the running for the job. During the entire month-long coaching search, Krzyzewski’s name never appeared in any North Carolina newspaper as even a long-shot candidate for the job. No radio station nor any television station suggested him as a possibility.

Then Duke Athletic Director Tom Butters insisted that he was getting the “brightest young coaching talent in America” to lead his basketball program (video from the hiring news conference here – notice how “Krzyzewski” is repeatedly mispronounced in the report) when he hired Coach K. There was no live coverage of any kind. The local morning paper had reported that one of “three Ws” – Bob Weltlich of Ole Miss, Old Dominion’s Paul Webb or then top Duke assistant Bob Wenzel – was going to get the job. But Butters hired the West Point graduate, then just 33 years old and coming off a losing season at his alma mater. Butters had ultimately listened to Bob Knight, who told him that Krzyzewski had his own good attributes without the bad.  The headline in The Chronicle (Duke’s student newspaper) was “Krzyzewski: This is Not a Typo.” Ironically, the local afternoon newspaper got the scoop several hours before the press conference, but it was after deadline and there was nowhere to report it.

This story seems quaint today, with the idea that a major college basketball hiring could remain unreported and largely secret until the press conference and that the coach hired had not even been considered a candidate is appropriately presumed to be impossible in this digital age. Obviously, times have changed. To get at what that sort of change means to our culture and to the financial services business, we have to go back into ancient history, even before 1980.

Follow the Money

Hal Holbrook had a wonderful supporting role in the Watergate saga All the President’s Men, a 1976 Alan J. Pakula film based upon the book of that name by Pulitzer Prize winning reporters Bob Woodward and Carl Bernstein of The Washington Post. Holbrook played the conflicted, chain-smoking, trench-coated, shadowy source known only as “Deep Throat” (over 30 years later revealed to have been senior FBI-man Mark Felt). Woodward’s meeting with his source when the investigation had bogged down is a terrific scene.

Sadly, Holbrook’s iconic line – “Follow the money” – was never spoken in real life and doesn’t appear in the book or in any Watergate reporting. Still, Woodward insists that the quote captures the essence of what Felt was telling him. “It all condensed down to that,” Woodward says. More importantly, it provides a profound truth. Indeed, when asked 25 years later on ”Meet the Press” what the lasting legacy of Watergate was, legendary Post editor Ben Bradlee replied with the words of screenwriter William Goldman, if not Mark Felt: ”Follow the money.” It provides good guidance for reporters generally and really good guidance when one is looking at the financial advice business.

With this important touchstone at the forefront, it’s crucial to recall that the financial advice business generally builds products and portfolios for marketing purposes rather than investment purposes. For the industry as a whole, “results” relate to sales far more than to what investor-clients end up getting. Accordingly, the idea is to play to people’s hopes, fears and prejudices rather than speak the (less marketable) truth. Moreover, if something can be positioned as new, novel or complex — and thus offering a plausible justification for a high fee — so much the better.