Another interesting consequence of that fallacy is that it applies to both bull (rising market) and bear (falling or stagnant market) conditions. When one of the worst bear markets in United States history held sway between 1964 to 1981, all sorts of professional projections were made. They truly believed that the dire situation would continue for several years into the future. The result was that the majority of retail and professional market participants missed the biggest and longest bull market America had ever seen. As of 2016, we seem to be in reverse; there seems to be a strong, powerful notion that the prevailing market conditions of the past bull market, (built on the majors stock market indices’ historical data in 1982), will endure. The market consensus is that the recent past performance averages can be easily projected into the future. That particularly applies to U.S. stock market averages that are projected to yield continuous 6 to 8% returns annually. They will very soon learn their own lessons on the rear-view fallacy.
Authority Misguidance
On of the most powerful and dangerous biases of all—and with serious personal consequences—is the bias related to false and misled authority. Blind obedience is sometimes a way to rationalize foolish actions. Based on Charlie Munger’s observations, “We tend to obey an authority, especially when we are uncertain, supervised or when people around us are doing the same. We are most easily influenced by credible authorities, those we see as both knowledgeable and trustworthy. Names and reputation influences us. And symbols of power or status like titles, possessions, rank uniforms, or a nice suit and tie.”21 This goes as far as associating complexity and incomprehension with authority and sophistication. Sometimes, we are overly impressed by something that simply sounds clever, even though we don’t understand them. Another example is when famous people endorse products, even though they do not use the products or services that they endorse. Even worse is that today anyone can call themselves an expert by simply rigging the system. Tim Ferriss, in his iconic book The 4-Hour Workweek, gave a blueprint on how anyone can become a respectable authority with a few simple steps in a matter of days. Voilà, people listen and follow.
Lollapalooza Tendency
The term “Lollapalooza Tendency” was coined by Munger in a famous speech at Harvard University.22 He defines it as “the tendency to get extreme consequences from confluences of psychological tendencies acting in favor of a particular outcome.” What that means is that cognitive biases seldom operate in a vacuum independently from each other. Instead, for any decision, we might have several biases working congruently in one direction causing a snapping effect in our brains.
What does this mean for individual investors? In their decision-making process, whether buying or selling, it is never only our logical brain that is responsible for each decision. Social proof and loss aversion have as much importance in one decision as “authority-misinfluences” and over-optimism.
Women and Investing
According to a research report by Fidelity Investments, women seem to be better savers than men. Their study showed that while men save 7.9% of their salaries, women save 8.3%. Over time, this small difference has a big impact on potential wealth accumulation.
The report also suggests that women are better investors as well. Terrance Odean and Brad Barber, who conducted the research, found "that women outperform men annually by about one percentage point." According to them, one possible reason for this is that “women are less inclined to check their portfolios... and they change their asset allocation less frequently than male investors.” “When women do invest, they do better,” says Kathleen Murphy of President of Fidelity Personal Investing. “But too many women don’t.”23
From my experience observing female investors, I always had the impression they are less emotionally invested in the investment decision process than men. For male investors, investing seems to be a matter of pride and personal self-esteem. They see it as a competitive game where making prudent investment decisions is secondary, but beating their peers is a priority. Their over-competitiveness leads them to take higher risks and lower their guard for smooth talking advisors that usually ends in purely speculative bets.
However, women are not free of cognitive biases. Again, Japan offers an interesting case study. In Japan, where homemakers traditionally manage the family’s budget, Japanese have, on average, done very well for themselves financially. In their culture, many husbands are known for spending their money on drinks with their colleagues, trips to the race tracks, and Pachinko parlors. Under the careful but rigid leadership of the dominant homemaker, most Japanese families still consider themselves middle class with a conservative attitude and emphasis on traditional education and classic cultural development. This attitude has always been reflected in their private investment operations symbolized by the stereotypical homemaker.
Even financially savvy Japanese homemakers have not been free of psychological misguidance in the form of herd mentality or authority-misinfluences. When opinionated leaders touted stocks and real estate until the bitter end of the Japanese Bubble economy, many households contributed to the bubble madness. In the dreadful post-bubble era, nearly everyone became ultra-conservative, preferring cash to any other investment opportunity.
Then, when families felt pressured by a new world of ultra-low interest rates on their savings, many female investors engaged in “yen carry trade.” According to Investopedia, “The carry trade is a form of speculation in which investors borrow a low-cost currency like the yen and buy high-growth currency, netting a profit. In recent years, for example, Japanese housewifes began accumulating Australian dollar deposits, which yielded a significantly higher rate than they could get at home.”
The investment rationale was to buy higher interest yielding currency (for example, Australian dollars that yielded 5%), by exchanging Japanese Yen that yielded almost nothing. Most of Japan was not concerned with currency rate fluctuations, as long as they could cash in the dividends from their international investments. Besides, during this period, the Japanese yen was consistently weakening, giving them capital gains when they exchanged their foreign currencies back into yen. (They received more yen than they had initially invested). Convinced by the logic and reaffirmed by female opinion leaders, hordes of Japanese homemakers joined the trend and became a force to be reckoned with in currency markets. According to the Bank of Japan in 2007, Japanese homemakers’ trading activity helped stabilize the currency markets because of their tendency to buy on dips and sell into rallies.
What began as a conservative money making opportunity quickly turned into an orgy of currency speculation that ended in 2008 with horrendous losses. A significant amount of this trading was carried out through online margin accounts, which offered leverage of 20 to 100 times. Because it was so easy to do and highly encouraged by Japan's opinion leaders, Japanese investment banks and brokers hired more female role models to encourage their clients to trade and to make use of easy financial leverage.
When the Japanese yen suddenly strengthened, in the wake of the subprime crisis, their yen trade collapsed. With their over-leveraged positions, many families lost the household savings that they had been amassing for many years in savings and trades. To make matters worse, their delicate stock market portfolios collapsed at the same time.
According to Noriko Hama, an economist at Kyoto’s Doshisha University Business School, in a Financial Times interview in 2009, “I tend to think the Mrs. Watanabes [i.e., ‘Mrs. Joneses’] have been silly. They got carried away by this wind of savings to investment, this idea that financial wizardry is the thing of the 21st century. IT banking and FX trading; all of these things came at them and they were swept off their feet.”24
Nevertheless, female investors seem to have a failsafe system embedded in their decision-making when it comes to managing their household money. They tend to follow their risk-averse instincts much more often than their male counterparts. Combined with the previously mentioned factors, women, on average, make bette
r investors.
Every aspiring and seasoned investor needs to understand that when it comes to making decisions concerning money, every decision is as much determined by rational parameters as it is by non-rational factors: our lizard brain and cognitive biases, as well as theories, models, and mathematical formulas. We can see the link and transformation about why investing can quickly become speculation. If all three forms are in some way betting money on the future and dealing with uncertainty, human inclination tends to lean towards the easiest form of action, even if we don't understand the deeper ramifications of each small bet we make. Wall Street has long recognized the inner conflicts of each player and has found ways to exploit those conflicts. In the next chapter, we will take a closer look at Wall Street’s financial incentives and why we are encouraged to be speculators and gamblers.
CHAPTER 6
WALL STREET AND CASINOS
“The most dangerous untruths are truths slightly distorted.”
—George C. Lichtenberg
Ever wondered what Wall Street folks do in their free time?
They gamble!
Gambling culture is rampant on and off Wall Street. Financial workers love going on the occasional weekend tour to Atlantic City or Las Vegas. If they don’t gamble in casinos, they speculate and trade for their own accounts in currencies, stocks and derivatives. Wall Street has been trying to shut down this practice, due to an obvious conflict of interest. It seems there hasn’t been much success thus far.
These are the people who control the money game and who want us to play it. We need to look at their financial incentives, and how they profit from and take advantage of an imperfect system with imperfect players. They are a hybrid group that is part game facilitator/part proxy/part player made up of investment banks, brokers, money managers, and henchmen. Wall Street institutions are terrible money managers for their clients and terrible investments for their shareholders but have managed to create a system that keeps generating enormous sums of money for themselves, provided they can keep cash moving through it.
Fee Incomes and Attracting Customers
In a recent interview at Berkshire Hathaway's annual shareholders meeting, Warren Buffett said this about Wall Street’s money-making capability:
“There’s been far, far, far more money made by people in Wall Street through salesmanship abilities than through investment abilities...”
This observation is certainly true. The majority of Wall Street works in back offices, IT departments, and sales and marketing divisions. They range from the foot soldiers at rural sales offices to professional account managers in M&A (Mergers & Acquisitions) departments in Manhattan. Only a few people make their living through investment decisions, and the majority do an unsatisfactory job for their clients. They regularly fail to beat their benchmarks or add value for the fees they charge. According to the Financial Times, “86% of active equity funds underperform.”25 Investing directly in banks and investment banks is not a walk in the park either. As a matter of fact, they are usually appalling investments for their shareholders. In an almost predictable fashion, they disappoint and demand new capital, diluting existing shareholders interest.
To give a short, illustrative example of a Wall Street firm’s failure and its appalling investment track record, consider the case of Deutsche Bank, a global commercial and investment bank with asset and wealth management departments. When announcing a €6.2 billion ($7 billion)26 write off for the quarter ending October 2015, they revealed some staggering losses from proprietary trading (trading for themselves) and write-offs from past strategic investments, such as acquiring Banker’s Trust (purchased for $10.1 billion way back in 1998). They might all be accounting gimmicks, but since 2008, they have made three capital increases of about €17 billion ($17 billion) in total. Since 2012, they have also periodically declared giant losses of over €10 billion ($11.3 billion) with some meager earnings in between. Since 2015, their stock price has lost more than 50% of their value. Even worse, Deutsche Bank’s constant battle with the law became a permanent financial burden. The bank has had to make several provisions for ongoing legal skirmishes with financial regulators, which amounted to $1.4 billion in 2016.
Deutsche Bank is not alone in this situation; a string of investment and management failures have rippled through the industry. Leading banks like Royal Bank of Scotland, UBS, and Citigroup come to mind. For their shareholders, that means having to be on standby to provide fresh capital when management messes up. If that isn’t sufficient or shareholders resist, there are still central banks and governments that are prepared to bail them out. Their largest shareholders are usually pension funds, endowment funds, insurances companies, and asset management companies, which I am sure you already have a financial interest in.
Still, Wall Street has created the most wondrous money-making machine the world has ever seen. No other industry pays higher average salaries and grants, as well as huge bonus payments. The pay ratio of compensation and benefits to net revenues of an investment bank like Goldman Sachs is around 40%. In 2015, Goldman Sachs’s compensation amount was about $13 billion, with 37,000 employees on the payroll.27 No other industry has become as important to our economic system while contributing so little to the economic prosperity of society. It’s a cash cow that keeps on giving for those participants who understand how to milk the cow.
So, how did the big players acquire their colossal riches? And how do they continue to stay on top?
To begin with, there is one thing you need to remember: there is almost no way to play the money game without going through Wall Street. The gatekeepers of the financial market are brokers, commercial banks, and giant investment banks. Together, they control armies of salespeople, entire product categories and markets. They collect fees and huge amounts of data from their clients and other financial institutions. They deal at the highest level with the largest money managers and even governments. They control and partly own exchanges and electronic settlement systems. They own shares in the Federal Reserve and are members of its money-clearing system. They influence financial regulations through massive lobbying activities and, therefore, the rules of the financial games we play today. A testimony of their power and influence can even be seen in the architecture they sponsor. More than 2000 years ago, we saw monuments built for gods that could be seen from the far reaches of any city. Today, when we enter the most dominant cities in the world, the first thing we recognize are the banking towers in the distance. That says something about the gods we worship today.
With power over the system, the biggest financial institutions in the world and their often brilliant employees, have set about to create an elaborate network of products and mechanisms that provide two key incentives: 1) people playing the system need to make more money 2) people outside the system must start playing.
A lucrative business model
If we look closely, we can identify the two main revenue sources on Wall Street.
Fee income: the most vital, stable and recurrent source of income.
House bets: the secondary revenue model is based on lucrative house bets
Fee income has very low risk and is relatively easy to manage.
It might require an elaborate sales distribution network and marketing staff to coordinate themselves. But once this dream factory starts running smoothly, financial institutions can move up a gear or two, and money will flow in. Whenever money flows from A to B, there is a possibility to take a cut. Their primary goal is to convince clients to play and stay in the money game at all costs, which encourages their business traffic and increases trading volume. Then, they move on to collect their fee income, which represents the building block of all those famous bonus pools.
This system is not very different from a casino business model. In casinos, it's not a secret that they operate on simple principles. It’s a big numbers game, and the house always wins. The more people that enter a casino, the more money can flow. The more games they play,
the higher the chance that the casino takes all of their money. As Nicky Santoro explained in the movie Casino (1995), “...in casinos, the cardinal rule is to keep them playing and keep them coming back—the longer they play, the more they lose, in the end, we get it all.”
There are some eye-opening parallels between legalized gambling and playing the financial markets:
Casinos lure you in with either free or relatively low-investment games. Slot machines or simple card games draw in millions of new players. Wall Street’s financial institutions see to it that even their youngest clients get a taste of the stock markets. Today, many banks invite their young and potential future clients to take part in “harmless” stock market games with fictitious money.
At casinos, many players don't know the details of the games—the exact rules, tricks and probabilities involved in every single bet they place. Even fewer know the games well enough to play them successfully. Likewise, potential new investors read everything that is promoted by the financial media and Wall Street but don't really understand the core principles of chance and prudent money management. They get lost in investing strategies, trading screens, rumors, and financial jargon. They miss the most what’s important—not to lose money.
Have you ever seen a trading desk at an online broker or trading floor? They’re big, blinking screens with red and green flashes and banners scrolling with screens changing every second. Add to these intra-day and long-term charts and you feel like you’re at the racetrack or in front of Pachinko slot machines.
Casinos tend to celebrate their few winners with loud sirens and music. They provide the instant feedback and the encouragement that other players need. Financial markets don't have to do this. The financial media and winners do it for them. It’s just like when your neighbor brags about his latest stock market gains or when celebrity money managers talk about making another $1 billion in winnings for their clients. It all seems so simple and easy.
Modern Investing Page 6