Financial institutions investing other people’s money often behave in a markedly different way to those investing their own. One of the possible explanations is that the actions of the agents employed to manage allocations of behalf of others is biased by self-interest in an environment lacking transparency.
Different investors have different reasons for chasing a bubble. Very simplistically, one could say that institutional investors are incentivised to herd, individuals may not understand the risks and financial intermediaries may be making too much money to stop.
A glib definition of a bank is a highly-levered financial institution with duration mismatches (short-term liabilities and long-term assets). Banks, then, are consequently always at risk of insolvency should assets be withdrawn, and almost always at the heart of any financial crisis. Banks perform the function of duration transformation – taking short-term deposits and lending to long-term projects. This is an enormously important function though in theory it need not require levered money. The solvency risk to banks makes them focus on very short-term risk, aided by a widespread interpretation of short-term volatility as risk.
Banks were not always as myopic as they are now. Merchant banks in which all major transactions were approved by partners who also owned the bank (and were often family members) had effective risk control and long-term horizons. With the invention of the computer and developments in finance theory in the 1970s, the long-term partnership model of merchant banking has given way to a market dominated by large market-capitalised investment banks. The short- term focus on profits in what is now a commoditised business (selling mass products in large de-personalised markets) combined with a (not always justified) assumption of always being able to offload liabilities in time ahead of a crisis, has destroyed the illusion that financial intermediaries are responsible actors in avoiding bubble building. Precisely the opposite is now true.
Herding & Agency Problems
The delegation of investment decisions, and particularly the growth of pension funds, has created incentive problems: its other people’s money. The incentives facing agents are typically skewed in favour of failing conventionally rather than doing something different to one’s peers and risking isolated failure. Hence herding is a major problem in global asset allocation, with institutional investors often tending to follow what others do despite their better judgement.
Saving via an institution has huge advantages. Investing in individual companies and other investment opportunities for one’s retirement requires roughly the same amount of information and analysis whether one is investing a few thousand dollars or billions, which is why pooling the savings of many individuals makes sense. It leads to informational and trading advantages (although large-scale pools of capital can also face scale disadvantages).
By having a portion of their savings in a pension fund, an individual who may previously have had a certain duration liability (weighted average time they want to spend their savings) now has two (or more) pools with different durations. The pension fund can typically invest longer term than an individual, so the institutionalisation of savings has created demand for long-term investment vehicles and strategies. These pools should care less than banks about myopic concerns, including short-term volatility, and more about longer- term large risks – especially potentially large permanent losses. They have the opportunity and responsibility to fix their sights on the best interests of savers over an extended period.
This involves thinking strategically, using scenario planning perhaps. It means being prepared for high-impact, low-probability events and sudden structural shifts, not just the continuation of past patterns. In this, institutional investors are aided, if they so choose, by types of knowledge broader than that required to manage short-term volatility and liquidity. They have time to consider big potential shifts in value over coming decades – from politics, policy-making dynamics, geopolitics and historical trends to anthropology, social changes and demographics. Most important of all perhaps are global macro-economic forces.
Yet traditional finance theory and asset allocation are silent on these sources of human knowledge and analysis. In large part this is down, not to a lack knowledge, but skewed incentives – skewed towards the short-term and the conventional, by peer-group pressure. The result is large-scale self-reinforcing herding, the adoption of short-term analytical tools and the objectives and behaviour of these long-term funds being overly-influenced by the concerns of the much more myopic banks.
Worse, the whole approach to investing has become massively distorted by the adoption of highly partial concepts of risk and of portfolio construction, the overblown importance of indices, the fetish (as Keynes called it) of liquidity, and a dangerously homogenous model of how the world’s financial markets are connected and interact. Theories and models known to be faulty are widely used for no better reason than that everyone else uses them and the absence of an obvious easy alternative.
Much more than that, though, the models have distracted us from common sense. This has even affected individual investors who lack the short-term interests of banks or the incentive problems of institutional investors.
Model assumptions are key to understanding our collective illusion. We prefer a precise error to imprecise uncertainty. Yet whilst we may have to live with this, there is no reason also to ignore the systemic bias that is inherent in doing so – and which we can have some appreciation for, if only the possible scale. Yet collectively, we do ignore this bias. The intention of regulators may be to protect individual savers, but the practice is for market practitioners to focus on not being blamed for negative outcomes affecting savers. Helping people to overcome their illusions about how financial systems work is not high on the agenda.
Extreme Bubble Risks Remain
Widespread assumptions and models from finance theory, and widespread practices of asset allocation, have failed to prevent extreme bubble formations. That we managed post-2008 to prevent a bigger financial meltdown and depression in the US and Northern Europe (though depression conditions were created in parts of Southern Europe) should not make us complacent. The basic conditions leading to extreme bubble formation are still with us. Indeed they have been exacerbated by extremely loose monetary policy over nearly a decade now …
Some things which appear very confusing at close range are obvious when you step back and look from a distance. The changed structure of banking over the last few decades, growth of pension funds and wide acceptance of common asset allocation practices have combined to make Western financial markets more vulnerable to bubble formation. From a distance, not only does this come into focus, so does the benefit of allocating assets elsewhere, off the beaten (and dangerous) track – nowhere more so than into non-listed investments in emerging markets.
Dr Jerome Booth in London.