Financial Driving Tests

Time to Bring Financial Numeracy to the Masses?

Take a young adult and bombard them with glitzy images of fast cars and the wonderful life they bring. Offer them easy access to as much money as they want, hand over the keys to a powerful sports car without any instruction and direct them out onto the nearest highway. Take your commission and move on without a second thought. Look surprised when the ambulance speeds by minutes later.

Welcome to the car crash that is the global economy.

Who Should We Blame?

Now we can castigate the governments, regulators and lenders who oversaw this mess. Actually we should definitely do that – partly because it’s right and proper that authority is held accountable for their actions and partly because there’s nothing quite so enjoyable as watching the rich and powerful wriggling on a petard undeniably hoist of their own efforts. However, underlying this there’s an uncomfortable truth – that the lenders were serving a demand and for every imprudent lender there was an equally imprudent borrower.

We can, perhaps, lay some of the blame at the feet of a complicit media which was all too eager to encourage a “consume all you can” culture. Sadly the media usually reflects, magnifies and distorts that which it finds in everyday life.

So, although I’d normally draw the line at engaging with a plot requiring time-travelling islands, one could see Lost as an allegory for the British Isles as it travels back economically to the seventies. Desperate Housewives is simply the natural end point of over-mortgaged middle class people with too much time on their hands descending into primeval savagery in between expensive makeovers and Ugly Betty’s what happens when you start valuing style over substance and preferring service industries to manufacturing. Yes, you get pretty girls wearing unstylish glasses and really uncool braces.

Perhaps I should get out more.

Maths Blindness in Sexed-up Apes

More critical, really, is the abysmal state of financial education across the western economies which sees people taking on debt without even being able to calculate their annual repayments. It’s the equivalent of sending a teenager out in a Porsche without the requirement to pass a driving test. Or know how to drive. Or know what a car is. And what does that “Halt” sign we just passed mean? Why are those red lights on at the back of that truck? What’s a brake?

Ouch.
 
Most people prefer to avoid maths if at all possible. There’s a reason for this – it’s difficult. Generally speaking our brains aren’t wired for it and really that’s not surprising. When we were no more than semi-erect hominids gambolling across the savannah you can understand that being good at language might have been useful – persuading other apes to do your bidding, forming alliances, persuading that sexy minx of a lemur to pop into the bushes with you, that kind of thing. On the other hand mathematical ability would have been less useful – can you remember the last time the pick-up line “Fancy coming over to my place and solving some quadratic equations?” led to a fruitful sexual encounter, let alone increased your food supply in the jungle?

The trouble is that this maths blindness leads to mass deception in the modern economy when people misunderstand the nature of risk and reward. Frankly, I don’t think we’re going to see people drawing out decision trees and calculating probabilities en masse anytime soon, but demanding a basic understanding of debt, interest rates and likely costs ought to be a fundamental requirement before permitting access to borrowing. It’s time we introduced the financial equivalent of a driving test before letting people out on the financial highway.

Politics and the Absence of Hope

There’ll be objections to this from both sides of the political spectrum. Right wingers will insist that this is an infringement of personal liberty, while feverishly sponsoring biometric identity cards, CCTV on every street corner and insurrection in unfriendly but, entirely coincidentally, oil rich, nations. Left wingers will worry about social inclusion while shutting down local self-help groups with ever-increasing checkbox health and safety legislation.

Both sides have a point but neither addresses the fundamental problem that a financially innumerate population brings – there’s no greater infringement of liberty and no greater mechanism of social exclusion than losing your home and any hope of a future. And, as we’ll shortly start to discover, there’s no greater cause of global instability and social unrest than homeless, hopeless and hungry people.

The Trap of Financial I.Q.

Of all the potential problems with a financial driving test social exclusion is both the most intangible and most dangerous. Capitalism is underpinned by the idea that the have-nots may one day be the have-alls. Without this the rich would be torn apart by the masses and we’d all live in communes and eat lentils. Partly the illusion that the lifestyle of the wealthy is achievable without needing to earn it is responsible for the mess we’re in but if you remove the possibility of a better life you’ll create social barriers that can’t be overcome – with very nasty consequences.

The danger of such an examination is that it simply becomes another sort of I.Q. test which guarantees that those from the bottom of society will fail. Many supporters of I.Q. testing have taken it for granted that the fact that society’s poorest people fare worst in these tests “proves” that they are poor because they’re stupid. Others have idly wondered if the direction of causality there might be the wrong way around – maybe people are stupid because they’re poor? See this article on New Thinking on Poverty & I.Q.

As this is psychology, hoping for a clear-cut answer is hopeless but there’s little doubt that people from poorer backgrounds have less chance of success in the casino of life. However, to deny people access to opportunities simply because fate’s dice rolled the wrong way at birth is unconscionable. People have a right to try to improve their circumstances and governments will fall – should fall – if they fail to understand and support this.

Education is better than Legislation

These problems can be overcome: basic financial numeracy can be taught and is as fundamentally important as being able to read. The internet allows a reach that was previously impossible and the development of e-learning programmes should be a priority – if governments want to stimulate the world economy through infrastructure investment they should start with the development of the soft infrastructure of their citizens rather than pumping billions into dying industries. Get kids and parents to learn together, bring communities into closer contact, build a better and more sustainable future instead of staggering from failure to fiasco like a D-rated celebrity in need of a fanbase.

This programme should be extended to other financial areas, beyond loans, The risks, rewards and costs of shares and bonds, insurance policies and saving accounts should be explained. We shouldn’t try to featherbed the population with legislation that tries to prevent miss-selling but which simply creates other problems – regulation will only ever stop the last set of issues, not the next set: we need to accept that the only real answer is education, not legislation.

There’s an opportunity here, too, for those of us willing to roll up our sleeves and get involved. It’s time we accepted that fixing this mess isn’t just a problem for governments. It starts with all of us because it’s not someone else’s problem anymore. It’s everyone’s.

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Sir Hugh Invents the Share and Gets Lost

Investing Basics (1): What’s a Share?

In 1553 Sir Hugh Willoughby set sail from England to Russia with the intention of opening the first trade route between the two countries. The idea behind his venture, the Muscovy Company or, to give it its full name (deep breath) The Mystery and Company of Merchant Adventurers for the Discovery of Regions, Dominions, Islands, and Places unknown, wasn’t unusual for the time. All across Europe explorers and merchants were sailing into the unknown in a quest for fame and, particularly, fortune.

The Muscovy Company, though, was unusual in another way. It was the first recognisably modern corporation.

Investing is a Risky Business

The problem with such ventures was risk. Sailing off into the unknown in a small wooden vessel with no maps and few navigation aids was a perilous undertaking. Voyages often came to grief when crews got eaten by unexpected cannibals, drowned on unexpected reefs, were captured by unexpected slavers or simply died through a distain for fresh vegetables and cleanliness.

So, for the investors backing these merchant adventurers, the chances of making any money whatsoever on a single voyage was relatively small with the possibility of a total loss never being very far away. On the other hand if your ship did come in you stood to make an absolute fortune: in the 1600’s a pound of nutmeg sold in England for 600 times more than it cost at source.

Would you take such odds? Most people couldn’t, because the risk and the downside was too great. Lose your money in sixteenth century England and the only bail outs you’d see would be the ones in debtor’s prison as you cleaned out the privies for the rest of your days.

This meant that were only a small number of people able and willing to invest in such opportunities because to do so meant you had to have enough cash to equip and pay for a lot of different ventures. One success could pay for many failures and still make you very rich, but you needed to be able to afford such a massive investment in the first place. So, because there were so few people able to invest that much money only a limited number of voyages could be financed.

Enter Sir Hugh.

The Origin of Shares

Sir Hugh’s Muscovy Company was the first so-called joint stock company. This meant that instead of having one single owner the company was split into equal shares (also known as “equity”) so that multiple people could buy a part of the company instead of needing to fund the whole thing. This is, minus a few bells and whistles, much the same structure as the companies we invest in today. So now investors could invest just a fraction of their savings in a single voyage, reducing the risk of a total wipeout.

The beauty of this is that people who previously couldn’t afford to invest because they didn’t have enough money to finance multiple whole voyages could now do so. They could buy small parts of many ventures and spread their risk. This is the origin of the modern portfolio of shares. Importantly it meant that there was more money – more capital – available to fund exploration and, for England, this was to become a critical factor in the race for global domination.

Trading Stocks – Where Stockmarkets Started

Fairly soon after the joint stock company became popular someone hit on the idea of trading shares, the price of which would fluctuate depending on information (“Russia’s gone to war with England, sell the Muscovy Company!”), fashion (“everyone’s wearing Russian fur this year, buy the Muscovy Company!”) or rumour (“I heard that the Muscovy Company’s ships have been eaten by a giant penguin, sell the Muscovy Company!”). Thus was born the concept of the modern stockmarket and, frankly, not much has changed in the five hundred years or so since.

All the basic concepts of stockmarket investing are present here: splitting a company into equal shares to allow investors to spread their risk by buying portfolios of shares in different companies, the trading of those shares on a stockmarket and the price of the shares varying depending on actual news, rumour or simple high spirits. People could suddenly make money by trading stocks as opposed to simply investing and waiting. Some people became very rich by dealing in stocks – usually because they had inside information – but most lost out – because they were randomly guessing at what was actually happening. Some other things don’t change much either.

Why You Should Limit Your Investments in Nutmeg

In addition foolish investors could now make the same mistakes that modern ones do. So, for instance, they might put their money in ten voyages to spread their risk but get overexcited about the current fashion for nutmeg and invest in ten nutmeg exploration companies. Unfortunately as nutmeg only came from one small group of islands this meant that their spread of investments wasn’t quite so risk free as you might think.

So the voyages might all run into the same storm, or discover that the nutmeg crop they were intending to buy had failed. Or they might find that the Dutch had annexed the nutmeg growing islands and were forcing all the natives to make clogs out of the nutmeg trees (which is approximately what actually happened, apart from the clogs).

So having investments in lots of companies doesn’t necessarily spread your risk if all of those companies have closely related businesses (technically this is known as ‘correlation’). That’s as true today for technology stocks or Chinese companies as it was for trading companies in the fourteenth century. Human nature simply doesn’t change that quickly.

So, Exactly, What is a Share?

From this example of the earliest of companies we can see many of the key points about shares:

1. Shares are initially issued to the people who put up the inital investment or capital of the company.
2. Each share constitutes an equal part of the ownership of the company (which is why it’s sometimes called equity).
3. Each share entitles its owner to an equal say in the running or control of the company.
4. Each share entitles its owner to an equal share of the profits or losses of the company for as long as the company exists.
5. Shares can be traded after they’re issued.
6. Trading is often, but not always, done on a stockmarket.
7. The price at which a share is traded is determined at the time based on the value the buyer and seller put on it.
8. If a company fails (or the ship sinks) you can lose everything but you can reduce the risk of an individual company failure by buying a portfolio of shares in different, unrelated companies; and
9. If the companies in your portfolio are closely correlated because they do similar things then your risk will be higher than if they’re in different business areas.

These points together make up most of the basic information anyone needs to understand about investing in shares. They’re also really only scratching the surface, and if you’re starting to think that this stuff is difficult and ought to be left to “experts” you might find me in agreement, as long as you’re careful about how much you pay for their “expertise”.

Sir Hugh and The Muscovy Company – The Parting of the Ways

As for Sir Hugh and the Muscovy Company, they had starkly different life experiences. One of the Company’s ships got to Russia and established a trading agreement with the Tsar, Peter the Great, that lasted until the 1917 Bolshevik Revolution. Sadly the inventor of the modern trading corporation was, like many business leaders, a whizz at finance but pretty useless at actually running a company. Captaining one of the ships, he took a wrong turning in a storm, ended up stuck in an ice-flow and died with all of his crew due to a lack of winter clothing.

R.I.P. Sir Hugh Willoughby: financial genius, bloody useless navigator.

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Darwin’s Stockmarkets

Ronnie Reagan, when asked for his beliefs about the Theory of Evolution, shrugged and replied; “Hey, it’s only a theory”. Which it is, I guess, in the same way that the Theory of Gravity is “only a theory” although somehow I doubt my pet dog will start exhibiting signs of weightlessness anytime soon. In fact Darwin’s great intellectual jump wasn’t evolution itself but an insight into what underlay the concept – an idea applicable to financial markets and sobering in what it suggests about our ability to predict anything, let alone something as complex as the screamingly mad world of finance.

Paley’s Watchmaker

Prior to Darwin evolutionists had been stymied by their inability to refute something known as “The Argument from Design”. Most famously this was expounded by the English theologian William Paley in his allegory of the watchmaker. The argument goes like this: if you were walking down a path, happened upon a watch and picked it up to examine its inner workings would you not leap to the obvious conclusion that this device must have a designer? In the same way, therefore, if you happened upon a living creature – a frog, say – and examined it in a similar manner you would, once you’d got over the nasty business of opening it up and feeling disappointed because last time you found a watch and now all you have is a dead frog oozing gunk all over your hand, also conclude that it must have a maker. Nothing that complicated could arise without the direction of a higher authority, surely?

At root this is about complexity: before Darwin scientists could see the links between animals but couldn’t figure out a method by which such complexity could arise without some control and command process. Much like the Russian state planner, who (allegedly) came to London in the wake of the fall of the Berlin Wall and wanted to know who was responsible for ordering all the bread, most nineteenth century scholars couldn’t conceive of any other way than a Creator of producing complex creatures.

Natural Selection = Natural Advantage

Darwin’s key insight was that in a world of finite resources (e.g. food, mates, million dollar bonuses, Ferraris, mortgages) any animal that had even a small advantage over another would be more successful at accessing those resources and in breeding and passing on those advantages. Even though he couldn’t figure out the mechanism behind this process of natural selection – genes and genetic mutation were unknown to him – what he’d done is identify a way in which natural complexity might arise without direction due to this underlying competition for resources.

We know that Darwin’s influences included the leading economic thinkers of his time. There’s a striking resemblance between Darwin’s natural selection and Smith’s “invisible hand” which isn’t surprising because what we see in the markets of the world everyday is natural selection in action. We also see a contingent complexity arising and it’s that combination of complexity and contingency that makes investing such a complete lottery for the unprepared.

Contingency – that the current state of the world could have been different had things happened even slightly differently – was hard for Darwin’s Victorian peers to accept because it meant that human status at the top of the pile was not pre-ordained and was down as much to luck than any God-given right. Now we know that dinosaurs ruled the planet until an asteroid strike wiped them out and allowed the rise of a new generation of animals who included our fragile ancestors. Our own genes show that the entire human population was, at various times, whittled down to a handful of survivors. So, is our presence on this planet today destiny or luck?

Are Business Leaders Skilled or Lucky?

In the same way we can consider the corporations of today. Is Bill Gates a genius or did he strike lucky? Or maybe a bit of both? The great Australian cricketer Richie Benaud states that being a successful cricket captain is 90% luck and 10% skill. It helps to be lucky, he said, but don’t try it without the skill. Sounds like many of the captains of industry to me.

One of the problems is that, with hindsight, everything looks obvious. It’s really, really difficult to see how things could have been any different than they are and that leads us to ascribe superpowers to mortal men. Think of Alan Greenspan – not so long ago he was a superhero for successfully leading the world through a series of financial crises. Now he’s a fallen figure, the man who mortgaged the future of the world economy through measures that simply delayed the onset of financial problems until they were almost too big to handle. For all the commentators that point this out now, though, how many of them were making the same statements five years ago? Hindsight makes pygmies look like giants.

To Make Money Find Your Feminine Side

Self-deceit about the past is a another common human trait. Arguably it’s central to our construction of a core identity – the belief that the person we are now is, in some fundamental way, the same person we were a day, a week, a year, a decade ago. Yet anyone who keeps a diary and goes back to it years after knows that shocks lie in store: we change, we are the flowing river not the immovable rock. So if the complexity of markets is Darwinian in nature with companies ferociously competing against each other, with some getting lucky and some unlucky and if we can’t even trust our own judgements about ourselves how can the hapless investor hope to make an honest buck?

Recognising the issues is a start, because overconfidence is a massive destroyer of value for investors. Men, it seems, are particularly prone to ascribing themselves abilities they don’t have – so successful investments are down to skill and unsuccessful ones to unpredictable bad luck or someone else’s failure – see, for example, Barber & Odean (1). Women seem more able to resist the temptation to big up their own books. Whether this is genetic or social conditioning is unclear, but the basic message to investors seems to be: be more female. Which doesn’t give all you guys carte blanche to put on high heels and lipstick. Well, unless you really want to. I’m pretty open minded about most things other than levitating dogs and randomly opening up hapless frogs in a futile quest for free timepieces.

Trade Less, Make More

What does all this mean for the investor? Less trading for a start: if markets are genuinely Darwinian then their constituents will mutate under the pressure of natural selection and today’s failure is more than likely to be tomorrow’s success (although also you need to be able to tell the difference between the temporarily fallen angel and the permanently earthbound demon – psychology can only complement stock analysis, it can’t replace it). Unlike animals a corporation doesn’t have to produce offspring to mutate, it can and often will change itself under commercial pressure. The oft-quoted and observed phenomena of mean reversion is simply the overt expression of this trend: today’s successful company is more likely to be tomorrow’s failure and vice-versa.

Unlike Darwin we have the tools and knowledge to figure out what underlies natural selection in markets. It’s not a perfect science and because people are involved we must hope it never will be – I certainly don’t want to live in a world in which my every action is predicted. As for Charles Darwin, he died not knowing how the mechanisms that underlie natural selection work even though, by the time of his death, an obscure Austrian monk called Gregor Mendel had started to unpick the nature of genes, inherited characteristics and the possibility of mutation though experiments breeding pea plants.

It’s a fact of contingent history that Mendel sent his paper to Darwin. At the time of Darwin’s death it was sitting in a bookshelf a few feet away from the desk in Down House at which he did so much of his work, its pages uncut and its contents unread. Destiny or luck?

(1) “Boys will be Boys: Gender, Overconfidence, and Common Stock Investment” Brad Barber and Terrance Odean, Quarterly Journal of Economics, February 2001, Vol. 116, No. 1, 261-292

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Don’t Give Index Trackers the Bird

You want to buy a pair of shoes but due to the Great Shoe Shop Recession of ’09 there are only two outlets left to choose from, right next to each other. To the left you have a simple, dressed down stand. To the right there’s a glitzy emporium, covered in flashy signs. The former sells cheap shoes that last for years. The latter sells expensive, fashionable footware that falls apart in months. If all that concerned you was to be well-shod for a low price for a long time, which would you choose?

In the world of investing the answer for most people is, of course, the shoddy but fashionable and expensive sneakers. Welcome to the bizarrely inverted world of fund management where the simple outperforming Index Tracker is outsold by the expensive underperforming Active Fund. It’s like watching a sprinter win the hundred metres and backing them for the marathon. Is that rational?

John Bogle invented the index tracker – a passive fund that attempts to faithfully track some chosen benchmark – in 1976 when he launched what later became the Vanguard 500 Index Fund. Amusingly, at the time, he was accused of being ‘unAmerican’ for doing so. Presumably the idea is that it’s every American’s duty, no matter how poor, to ensure fund managers are well provided for; “trickle-up” economics in action.

Since then the index tracking industry has mushroomed and the index trackers have consistently outperformed the majority of actively managed funds over every time period. According to Mr. Bogle, between 1980 and 2005 the average inflation adjusted return on a $1000 investment in an active fund would have resulted in an end fund of $3,270, a return of just 4.9% a year. In contrast the same investment in the Vanguard 500 would have yielded $7,160, a return of 8.2% (remember that these returns are adjusted for inflation: 8.2% over inflation is a damn good performance).

Most research backs this up – Kenneth French’s 2008 paper (1) on the costs of active investing supports Bogle’s contention, although it puts the cost differential at a rather lower level. No matter, the conclusion is the same: active funds reduce your returns compared to passive funds and make you take on more risk to do so. Of course, you may strike lucky and end up with an outperforming active fund, but unless you’re unusually talented that’s a gamble, not an investment. And if you’ve that much talent why are you bothering giving your money to someone else to manage?

In fact the outperformance of index trackers is even greater if you take into consideration that most of the worst performing active funds are quietly wound up or merged with other funds and promptly disappear from the comparative records. It’s magic, a perfect piece of misdirection – while you’re looking at the box waiting for the lady to reappear the magician is making off with the takings.

So what causes the difference in returns? It’s a combination of factors but primarily to do with costs – good index funds are as close to frictionless in cost terms as it’s possible to get, while active funds have to cover the expenses of managers, greater advertising costs, more dealing fees and so on. Apparently insignificant differences compound up over significant periods to destroy investor returns. For the average investor looking for a simple and safe way of investing over a lifetime the index tracker is as close to a free lunch as you’ll ever get.

The survival of the actively managed fund industry, then, ought to be a genuine source of wonder. In a perfectly capitalist world such funds should be extinct, outcompeted by their passive brethren. Yet this clearly isn’t so and that should tell us something very interesting about both human nature and the purpose of the investment fund industry. Capitalism doesn’t quite work the way the economists think it should – that’s why salesmen retire at 40 and live in shorts for the rest of their lives while economists wear suits and work till they drop.

Remember our shoe shops? The shop selling poorer quality products at higher prices makes higher margins and uses this to invest in its sales channels and advertising while staying up to date with fashion. Mining companies did well last year? OK, let’s start a mining fund. Soft commodities in fashion? Set up an agriculture vehicle. Behind this are a welter of basic psychological triggers used to persuade us to do what’s not in our interests. That’s the essence of the super-salesman and active fund managers are past masters of the use of our psychological pressure points to deprive us of our hard-earned capital.

Just as in the rest of the world fashion, advertising and smooth sales patter are potent methods of persuading people to do something that’s against their best interests. In some areas of life this doesn’t matter too much but when it comes to retirement savings going for the glitzy shoes will see you wearing rags on your feet and living in a cardboard box before you’re done. Remember – the securities industry is a machine devoted to extracting money from the public and has myriad means of doing so, tithing the unwary investor over and over.

I’m a fan of index trackers, but only in a curiously muted way. Index trackers are the least bad way of an investor avoiding the psychological traps that await the unprepared investor. Behind the index tracker is a technical issue that ensures that their design is curiously inefficient. That’s a topic that’ll have to await a future post but consider this: an index tracker needs to track its index so when people were buying dotcom stocks at stupid valuations in 1999 so were the index trackers, ditto commodity stocks in 2008.

Buying overvalued stocks at the top of the market is classic amateur investor behaviour, so having index trackers do this would seem, at least, to be non-optimal. Yet even with this inbuilt disadvantage broad based index trackers still outperform activist funds which could, if they so chose, simply sit out the more stupid phases of the market. I find that astonishing.

Of course, the clever and many tentacled securities industry won’t ever leave a good idea alone. So we’ve seen the rise of new sorts of passive funds – the sector specific and sub-sector specific index trackers, defining ever more narrowly specific industries or geographies. Closely related to these are Exchange Traded Funds (ETF’s) with even lower charges and often even more targeted remits. In fact not all index trackers actually track a market directly, they often use derivatives, increasingly more exotic ones, to simulate index tracking or rely on other indirect means to achieve equivalent exposure.

Caveat emptor – buyer beware. Specialised passive funds are for sophisticated investors not the likes of me (you, I don’t know about but definitely not me). If you don’t understand what any of the above means without resorting to a frantic search of Google and much elbow rubbing then don’t buy them. Look for a well known index tracker with no initial fee, a low total expense ratio (or TER – no more than 0.75%) and a low tracking error (which measures how closely the fund succeeds in tracking the target index – less than 0.15% over a reasonable period of years). And invest regularly to ensure you get the benefit of buying when markets are caught in one of their depressive “sell at all costs” moods. In stockmarket investment sometimes – nearly always, in fact – simple is best.

(1) French, Kenneth R.,The Cost of Active Investing(April 9, 2008). Available at SSRN: http://ssrn.com/abstract=1105775

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Perverse Incentives are Daylight Robbery

An awful lot of what goes wrong in the human world is connected to perverse incentives. These are the carrots that leaders use to encourage people to behave in particular ways only, through the law of unintended consequences, they work in more or less the opposite fashion to that intended.

We often misunderstand the nature of incentives because it’s difficult to figure out what they are or even whether they affect us – but if our business leaders get this wrong we see businesses doing extraordinarily stupid things. Worse, if our business leaders’ own incentives aren’t kept in check they themselves do extraordinarily stupid things. We’ve seen plenty of both in recent times and unwinding the mess that badly designed incentives have done to the world is going to take time, patience and thoughtful appreciation of the issues by the world’s leaders, both political and commercial.

So let’s not hold our collective breath, then.

As many incentives are obscure it’s understandable that we don’t always succeed in stopping all of the worst practices. Sometimes, though, we can detect some of the more obviously stupid ones. Like, for instance, the French authorities in Hanoi offering a bounty for every rat caught. This led to a near instantaneous growth in rat farms and no discernable reduction in the native rat population. Then there was the British tax on windows which naturally enough led to them being bricked up hence, allegedly, the coining of the phrase “Daylight Robbery”. Window tax was, at least, marginally better than what it replaced – the hearth tax which caused people to brick up their chimneys – and promptly set fire to their houses.

Trouble is, even where the effects are obvious, we don’t always do anything to stop perversely incentivised behaviour because we don’t appreciate the real damage that being done. It’s like smoking – smokers knew for years before the medical evidence was overwhelming that it wasn’t good for them. Wheezing loudly after walking upstairs to the bathroom and starting each day with a ten minute coughing fit does not constitute good health under any scenario I can think of. Trouble was we didn’t know exactly how “not good” for us it was until we’d forced a generation of puppies to cough up a lung in the name of science – thus managing to be morally ambivalent and bloody stupid at the same time, all for the perverse incentive of a nicotine fix.

Many of the worst practices in business involve share option schemes that effectively transfer equity from shareholders to company executives. Shareholders taking a long-term view of this can only really regard it as perverse – why would I want, in effect, to give some of my shares to a bunch of executives who are already being handsomely compensated for running my company? If executives aren’t being paid well enough already then give them more money, not part of your company – if they want shares then they should buy them along with the rest of us.

Incentivising managers to get their company’s share price up on a relatively short-term basis can only promote bad habits. Worse still, the hurdles set to allow executives to reward themselves at the expense of the shareholders are often absurdly low, incredibly crude and wilfully obscure. And get re-priced every so often when share prices fall. Here in the UK we’ve seen a spate of companies doing just that while simultaneously announcing rights issues that instantly guarantee the managers a juicy profit and a greater slug of equity. Nice work if you can get it, but ethical?

If these awards are so obviously perverse why do shareholders permit them? Well guess what? Many of these shareholders are themselves being perversely incentivised to do so. Larger companies have shareholder lists dominated by various pension and investment funds and the managers of these organisations are rewarded – short-term – by how well they do against various targets, most of which are directly related to the share prices of their funds’ underlying holdings.

Unsurprisingly asking these institutional shareholders to safeguard private shareholder value is like asking a kleptomaniac to look after the shop while you go on holiday and then acting all surprised at the lack of takings, stock or said kleptomaniac on your return. Most such shareholders – and there are honourable exceptions – are all in favour of management incentives that reward short-term performance of company share prices without regard to the longer-term impacts.

Being a perceptive sort I’m sure you’re thinking to yourself “what’s wrong with share prices going up in the short-term?” In and of itself the answer is “nothing” – if the performance is directly related to the success of the underlying business. The trouble is the ever present incentive to finds ways of pushing up revenues – it’s awfully tempting to managers to take on risks and debt or engage in creative accounting in order to get the share price up, particularly when the options are out of the money. Arguably the practise of not expensing options – a particular bugbear of Warren Buffett’s – led companies to over-report revenue for years:

“If stock options aren’t a form of compensation, what are they? If compensation isn’t an expense, what is it? And, if expenses shouldn’t go into the calculation of earnings, where in the world do they go?”

Even at lower levels we all too often find companies getting muddled in their incentivisation plans. Generally, you’d think, the main aim of a customer service call centre would be to provide customer service – make customers happy, ensure they remain customers, give them whatever service they’re paying for. Classic sort of customer service type stuff. Naturally companies want to cross sell down these channels which is fair enough up until they stop incentivising staff to provide customer service and start incentivising them to generate cross-selling revenue. Which results in declining customer services levels. Well, duh.

As an immediate example there’s little doubt that the pyramid of mis-selling that’s led to the astonishing bank write-offs of mortgage debt can be directly traced to the huge incentives offered to sales people to bring in business. Add to this a management that is determined to remove any checks and balances in order to ensure their own bonuses and you have a recipe for disaster. See this NYTimes article.

Conversely when companies get incentive schemes right they have powerful multiplier effects. The classic example, oft quoted by Charlie Munger, is FedEx who spent years trying to work out how to incentivise its workers to ensure they met their delivery times. Eventually someone figured out that merely paying people to be present on a shift simply guaranteed their attendance, not their performance. Paying them the same money and allowing them to go home as soon as they’d met their targets resulted in an instantaneous surge in output. Simple, yet brilliant.

There’s nothing at all wrong in executives being paid extraordinary amounts of money for extraordinary performance but rewarding them disproportionately for simply being there is nothing more than gross negligence on the part of shareholders. If shareholders accept that it’s the long-term that matters and reward managers appropriately all sides would be much better off. This is a race in which the thoughtful and consistent tortoise starts with as an inbuilt advantage over the hyperactive and inconsistent hare.

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Old? Prudent? You’ve Been Bilked!

A message from the CEO of the Bank of International Loans and Kickbacks (Bilk):

As you will probably know, we here at Bilk have been having a few problems. Now, being fair, no one – apart from a few commentators that everyone ignored – could have foreseen that buying collateralised sub-prime debt would have left us with the small matter of a ten billion dollar hole in our books. Well, aside from my risk management team, whom I replaced with an automated, state of the art computer system written by Nobel Prize winning scientists and guaranteed to never go wrong. Unfortunately it seems the concept that humans aren’t always rational is giving them some teething trouble. Something to do with “not enough atoms in the universe” or something.

Anyway, any suggestion that I replaced my risk managers because they pointed out that these loans were unsafely dependent on the ability of unemployed trailer park home owners in Tennessee to afford the interest on million dollar loans is outrageous and entirely based on hindsight. As our own, completely independent, investigation – led by the heads of our remunerations and audit committees whose appointments I personally supervised – has shown I acted with complete integrity at all times. My actions had absolutely nothing to do with the remote possibility that if we’d stopped buying this stuff our investors would have sold our stock and we wouldn’t have got those huge bonuses, which unfortunately I’m completely unable to repay at the moment because I’ve left my chequebook on my other yacht.

So in the meantime we need some taxpayers’ money to tide us over. It’s important for all of us, you see, because if we were to go under then the ramifications for the world would be severe. The contagion would probably bring down the global financial system and drag us into a decade long depression accompanied by mass unemployment, civil unrest and French politicans sneering at us. Of course that’ll probably happen anyway, but we’d still like the money, please.

Once we’ve got the money we promise we won’t waste it. No, we’ll keep it perfectly safe in our vaults where it can’t do any damage and will enable us to shift it around rapidly to cover the various huge holes in our accounts. Which is all perfectly above board, of course.

What we most certainly wouldn’t do is anything so dangerous as to actually lend it to people who need it. Absolutely not, we’ve learned our lesson – such people can’t be trusted so we don’t do that lending thing anymore. No, instead we’re foreclosing on the debt of as many businesses and homeowners as we can legally get away with every week in order to reduce the burden on you, the taxpayer. This is how trustworthy we are.

Wisely governments have responded to this unprecedented crisis by cutting interest rates towards zero and we’ve naturally had to pass this onto savers while keeping lending rates high in order to discourage people from unnecessary borrowing at lower and more affordable rates. Most savers are disproportionately older and more prudent and have saved carefully their entire working lives for a comfortable retirement, so it may seem unfair that they have to bear the brunt of a crisis that’s absolutely nothing to do with them. But as I said to my fifth under-butler’s assistant the other day when laying him off, these are difficult times and we must all make sacrifices.

In order to give us the money needed to protect the global economic system governments are printing it at record rates. So we’re expecting to see lots of inflation next year which will be good for all of us as the real value of our debt falls significantly. That is unless you’re one of those older, prudent savers who don’t earn anymore so you won’t get any pay rises and will simultaneously see the value of your savings erode still further as prices rise rapidly. Sadly I feel this shows how poorly these people have invested – personally I recommend investing in only the most expensive real-estate and post-impressionist fine art. You get what you pay for, ultimately.

Still in these difficult times we can all take comfort that our leaders are being supported by some of the brightest minds in the industry. We at Bilk have generously lent no less than half a dozen of our best people to various governments to advise them to lend us this money. As these are the same people that devised the schemes that got us into this situation I’m sure you will agree that they are obviously the best ones to get us out of it.

Hence, in reality, there are very few losers. All of you with debt, who can keep some kind of job, can rest safe in the knowledge that governments are coming to your rescue. Meanwhile we here at Bilk and other financial institutions can continue to pay ourselves the salaries and bonuses that fuel so much of our economy. In fact it’s only non-working savers who will lose out and let’s face it, they don’t have much say in the matter anyway. It’s a small price to pay that we’re taking from the prudent to bail out the profligate but frankly most of these people are quite old and would probably have died quite soon anyway.

They have, as we like to say to the happy customers who throng our branches, been well and truly Bilked.

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Reality 2.0 – Interactive Porn and Crumbling Moats

For adventure gamers like myself – that strange subset of humanity who like playing computer games involving solving fiendish puzzles with nothing more than a magnifying glass, a notebook, some chewing gum, a piece of tape and seventy-seven apparently useless and inconveniently placed household objects – the Sam & Max series by Telltale Games is the pinnacle of perfection. Now, sure, the basic concept of a pair of freelance detectives played as a six foot dog and his little buddy, a small (but extremely violent) rabbity-type creature, is conceptually a bit difficult for people whose preferred persona is Sherlock Holmes or Hercule Poirot. But the plot is funnier than a stoat in the snow.

My favourite episode so far is the fifth in which Sam and Max find themselves fighting the Internet which has created an alternative reality – Reality 2.0 – and is intent on sucking the whole human population into it for reasons that don’t become entirely apparent until episode six. For anyone versed in the history of adventure games the denouement of Reality 2.0 is quite, quite brilliant so I won’t spoil this for you if you haven’t experienced it yet.

This is art imitating life, though, and Reality 2.0 is already upon us. The rise of the internet has provided the world with a new means of interaction. History shows us that civilisations are constructed around how we communicate with each other. We may start by creating the technology but it’s not long before it’s creating us. A bit like Frankenstein’s Monster without the bolts. Or the blood. Or the monster. Actually, that’s a crap analogy. Let’s move on.

It’s obvious that without a means to communicate ideas or laws across geographies it’s impossible to hold together very large groups of people. The governments of cities, countries and civilisations rely on mechanisms to transmit information effectively. So it’s also obvious that the means of communications available will, to some extent, dictate the structure of the societies that arise. Hence yodelling explains Switzerland. Well, possibly.

One idea is that the very first form of group-speak was music – the ability of music to induce synchronised behaviour amongst its listeners suggests to some researchers that music was adaptive in getting larger groups of proto-humans to co-operate. You can see similar behaviour today amongst drunken people in night-clubs, drunken people at pop festivals and drunken people at office Christmas parties. I just can’t see how anyone could deny that music is obviously the common theme here. Although to be fair this isn’t the only theory.

Certainly we can trace the technology of mass communication back to hieroglyphs chiselled on stone and scratched on papyrus. Phonetic alphabets followed with similar underlying transmission means permitting the rise of the Roman Empire, amongst others, with their controlled but decentralised command structure. When your only means of issuing orders is by hand written decrees carried by boat and horse across the Empire there are certain limits to how you can organise yourself. Mostly these means were used to issue instructions, create accounts and produce “entertainments”. OK, mainly porn.

Mass communication only really started with Gutenberg’s moveable type printing press in the thirteenth century which initiated an explosion of easily copied books spewing out across Europe. This technological change led to, in short-order, a revival of ancient learning (the Renaissance), a challenge to the established order (the Protestant Reformation) and a huge acceleration in science and technology (the Industrial Revolution). The first mass market books were primarily religious, scientific and, err, porn.

The subsequent advent of electronic communication, particularly the undersea telegraph cables strung across the globe in the latter part of the nineteenth century, represented another step change. Globalisation was then truly underway and people everywhere could be exposed to the same information (and porn) pretty well simultaneously. However the sources of this information could be controlled, either through governments or simply due to the capital requirements to access them.

Fast forwarding to the internet age we suddenly find that mass global communication is cheap and that it’s relatively easy for anyone to publish any old rubbish (witness this blog). However, there’s a difference – this communication is not a one-way push. We are not helpless recipients. Now we can interact electronically, create new personas, control the way we appear to the world and immerse ourselves in a world outside of our physical reality. And we can push back. And there’s lots of free porn (I’m reliably informed).

Welcome to the real Reality 2.0.

The rise of social networking sites from Facebook to MySpace and from Bebo to Twitter, with their countless imitators, and the creation of massive multi-player on-line games within which people can interact (some of which are devoted to porn – please don’t ask: I don’t know, I don’t want to know) are all aspects of the human need to communicate. Yet if communication mechanisms dictate the structure of our civilisations it’s inevitable that these changes will alter our societies and the way we live.

Many traditional organisations are struggling to cope with Reality 2.0. Used to a command and control structure where they can push information without really needing to handle responses their response to the new world order has often been toe-curlingly inept. However, even people immersed in the technology are sometimes apt to forget that by publishing their thoughts they expose themselves to feedback. From Peter Shankman’s blog (http://shankman.com/be-careful-what-you-post/):

This particular Twitter posting came back to bite the agency person from Ketchum (New York office) who made some unflattering remarks about Memphis this morning before he presented on digital media to the worldwide communications group at FedEx (150+) people. Not only did an employee find it, they were totally offended by it and responded to the agency person. The kicker is that they copied the FedEx Coporate Vice President, Vice President, Directors and all management of FedEx’s communication department AND the chain of command at Ketchum. Mr. Andrews, the Ketchum presenter, did not take into account that many FedExers are native Memphians and are feircely defensive of their city and their company

Which somewhat exposes the limitations of the new media – in the end it was the command and control structure of FedEx that held the whip hand in this relationship. He who pays the piper, and all that jazz.

Even so, investors looking at their potential investments need to be carefully considering the impact of Reality 2.0, a social technology that’ll be disruptive to many old-style businesses. This doesn’t necessarily mean jumping on the bandwagon – trying to figure out who will be the ultimate winners and losers amongst the new technology companies is, at best, like playing hopscotch in a minefield. Still, deciding who will benefit and who will suffer is important if you’re interested in analysing the competitive advantages of any particular stock. Some previously impervious defensive moats based around bricks and mortar or old media are now about as useful as a chocolate fireguard.

This is not a flash in the pan. Reality 2.0 is here to stay and, unlike Sam & Max, you can’t take the Virtual Reality goggles off whenever you feel like it.

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