When Comfort Blankets Go Bad: Risk, Perception and Investing Theater

Investing as Performance Art

The security analyst Bruce Schneier describes many of the security measures on public display as  “security theater”: a meaningless set of rituals designed to provide a comfort blanket. He argues that these measures provide no useful protection and mainly serve to make our lives more difficult, increasing the risks we have to take while simultaneously restricting our freedoms.

I’d argue that much of the performance art we see around investing serves much the same purpose – and with much the same outcome. Box ticking regulations don't actually do much for investors other than make their lives more confusing and difficult; but with a lot of thought, and a bit of investing theater, we might be able to better align real risk and perception to everyone's benefit.

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Bitcoin Bugs’ Belief

Bitcoin Bugs

From time to time something odd happens to the gold price – it goes down. This is usually a shock to the advocates of anti-fiat money who’ve been squirreling away the shiny stuff against the inevitable day when nation states collapse. They get quite cross when they discover that the said nation states may in fact be flogging their gold at historically high prices and driving the price down. Apparently the thought that countries might resist collapsing hadn’t occurred to the gold bugs.

In the meantime we’re seen the rise of Bitcoin, one of a number of cryptocurrencies that offer freedom from central regulation. Bitcoin and its ilk isn’t backed by anything, which makes it more than ordinarily a punt on the perverse willingness of people to believe in ephemera. And that, of course, is simply another case of history repeating itself. Have we learned the lesson?

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Five Commandments for Investors (Or Why Dogs Can’t Catch Frisbees)

Dogs and Complexity 

One of the more thoughtful regulators around is Andrew Haldane of the Bank of England whose speech “The Dog and the Frisbee” from 2012 remains the touchstone for anyone wanting to appreciate the reasons that modern economics has made a mess out of understanding the real world.  To boil the whole thing down to a single statement: you can’t control a complex system with complex rules, complex systems require simple rules.

Applied to regulation this is revolutionary, applied to investing it adds to reams of evidence suggesting that most investors need to avoid overcomplicating their analyses, that simple rules of thumb outperform detailed analysis and that mostly we’d be better off going off to the beach with a Frisbee rather than pouring over the latest numbers. It’s all guesswork anyway, best take the easy option.

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Regulatory Omniscience is A Fictional Conceit

Who Guards The Guards?

If you’re a regulator you’re likely to be conditioned by motivated reasoning: you should want more stringent regulation because, after all, that’s what you get paid to do.  You’ll base the need for more rules on reasoned analysis, but your analysis will be directed by your incentives.

Regulators are human; ergo, they’re subject to behavioural bias. Quis custodiet ipsos custodes?

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Totally Addicted To Debt

Squeezed Addicts

Predictably the recent set of rating agency downgrades caused squeals of anguish from top tier banks, expressing outrage that their efforts to make themselves less risky aren’t being treated with the respect they think they deserve.  Or perhaps their executives are simply angry that their bonus-justifying profits are being squeezed?

Their real problem, though, is that the world has changed.  Their debt fuelled addiction to old-style business models is under threat of extinction.  Those last century profit margins are gone for a generation or more: it’s time to go cold turkey, whether they want to or not.

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What’s YOUR Competitive Advantage?

The Zanzibar Effect

Everywhere you look in the investment industry it appears that the odds are stacked against the smaller investor. In every trade we make there’s a counterparty against whom we’re taking a bet and all too often they’re better informed and equipped than we are. For the most part trading is simply a way of enhancing the profits of the securities industry.

As any investor knows, the key to a successful business is establishing a competitive advantage, so it makes it all the odder that most traders seem determined to compete head on with institutions in exactly the areas they want us to. There’s no rational explanation for this other than people are blind to the ways in which they’re being exploited. In terms of competitive advantage private investors engaging in short-term trading against financial institutions is the greatest mismatch since the Anglo-Zanzibar War of 1896 which lasted only 45 minutes - and which ended with the British being paid for the shells they’d fired into their opponent’s country.

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Europe, Taxed by Tobin

1808 and All That

The soap opera that is the Eurozone continues unabated, as the intransigence of the UK has caused a split that seems likely to cleave the European Union in two. Regardless of the rights or wrongs of the situation the British appear to have approached the negotiations over Europe’s finances with the finesse of a bulldozer and the subtlety of a sledgehammer.

The UK has calculated that agreeing to the latest half-baked plan to save the Euro, which they’re not part of, is not in their national interest. As this “national interest” appears to be that of the UK’s financial sector, which helped caused most of the problems in the first place, this looks a bit strange. What’s even more strange is the main issue is the imposition of a so-called Tobin tax on financial transactions: which is peculiar mainly because the British already have such a thing and have had it since 1808.

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Ideology, Paving the Road to Financial Ruin

"A fool and his money are soon elected" – Will Rogers

An Emergent Crisis

In Ending the Divine Right of Bankers we looked at the way in which democratic governments have become subject to the whims of markets: and how markets may soon find themselves bowing to the dictats of voters. However, this is only half the story because it would be a mistake to see this as an orchestrated outcome by a cabal of shadowy figures. Instead it’s just happened, an emergent property of the interaction of democracy and capitalism.

Of course the road to ruin is littered with good intentions and what we’re now seeing is the natural tendency of trends to overshoot. It’s the result of a nasty combination of free market ideology taken to extremes and the self-interest of corporations, exploiting any opportunity to enhance profitability and bonuses. It is, as ever, an outcome of combinatorial human behavioral errors rather than a set of deliberate policies.

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Game On: Basel III

Bonfire of the Principles

The next set of banking regulations, aka Basel III, has arrived, albeit it'll be implemented one micro-step at a time. It has, of course, been accompanied by horse-trading of the kind that can only be done behind closed doors by an unelected and unaccountable body. After all, it’s not as though their actions will ever affect the rest of us, is it?

Regardless of what this shadowy group has decided the actual behaviour of the world’s financial community will continue to be cautious while the pain engendered by its latest fiasco remains large in the minds of its officers. Yet these memories will fade and animal spirits will once again take over, when Basel III will become, like its predecessors, an opportunity to be gamed, not a constraint on unethical behaviour. In the end we need less rules, more principles and better regulators.

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The Small Cap Trap

Rampaging Elephants

The theory is that small capitalization stocks offer great rewards. After all, as Jim Slater pointed out in The Zulu Principle: “elephants don’t gallop”. Well, apart from when they’re being chased by a psychopath, armed with an elephant gun, in a bulldozer. As the last few years have shown, even behemoth sized corporations can grow startlingly quickly if they’re priced to go bust and then get bailed out by obliging governments.

Still, the idea that smaller cap companies offer outsized rewards is hard to shake. To the extent that share price grows with earnings then it ought to be easier to double the price of a small company than a large one. Which is, more or less, true. The only trouble is that it’s probably more likely you’ll see it sink to zero.

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Basel, Faulty?

Containment, Not Cure

The international banking regulations known as the Basel II Accord have come in for some stick, given the fallout from the banking crisis of 2008. This is, on the face of it, a bit unfair given that Basel II hasn’t yet been fully implemented in most countries and anyway was designed to try to head off some of the problems that have occurred.

Still, most observers reckon that Basel II wouldn’t have prevented the crisis and the tendency of regulators, like generals, to fight the last war means that proposed changes won’t help. Whatever causes the next crisis it won’t be the same as the last one and while regulators are busily building a Maginot Line to stop one kind of problem they’re unlikely to notice that they’re also incentivising banks to invade Belgium, or at least find a way to go around the new regulations. We need a new kind of regulation, one that recognises we can’t stop the disease, but that it can be contained if we act quickly enough.

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