11 May 2012 I’m Not Speeding – I’m Qualifying
A bumper sticker caught my eye this morning, and quite nearly my front bumper, as the car’s driver inserted himself ahead of me. The sticker read “I’m Not Speeding – I’m Qualifying,” an obvious reference to NASCAR, which was born in these parts. It occurred to me what a fitting description of market traders at today’s large banks, if not the banks themselves.
If you’ve seen or heard the news in the last 24 hours you’ve certainly heard of JP Morgan’s $2 billion trading blunder, and it’s stock’s 8% decline as a result. Jamie Dimon, Morgan’s CEO, and until now, Wall Street’s risk management king, said “There were many errors, sloppiness and bad judgment.” Might a better explanation be hubris?
Ironically, Morgan’s trades were not intended as proprietary risk trades, the target of government regulators through the so-called ‘Volker Rule.” Rather they were meant to be a hedge for the bank’s loan portfolio against what it called ‘structural risks’ (increasing interest rates and a slowing economy to name a couple). The bank’s trading department amassed huge positions in credit derivatives, which are synthetic (derived) assets created to behave or respond in a prescribed manner, given a certain set of circumstances.
Dimon said yesterday their derivative strategy was “flawed, complex, poorly reviewed, poorly executed and poorly monitored.” He admitted that he should have paid more attention to the newspapers, as the Wall Street Journal printed a warning on April 5th of a trader at Morgan, known in the market as the ‘London Whale,’ made large bets on credit derivatives. Morgan’s response then was that his unit was meant to “hedge structural risks.”
So here we are four years after a banking crisis that almost destroyed the global economy and it seems we have learned or done little to mitigate the risks that huge banks subject themselves and us to, whether through hedging or speculation. Either way, they continue to make out-sized bets on their ability to read the future better than the market and their competitors.
So very smart people like Jamie Dimon of Morgan and Lloyd Blankfein of Goldman, to name but two, cannot continually beat future uncertainty, no matter how good they think their models are. Even, the Federal Reserve gave JP Morgan a clean bill of health based on stress tests just a few months ago.
MODELS CANNOT PREDICT HUMAN MISTAKES
The problems at Morgan shine a bright light on what we see as an inherent flaw in how financial services are delivered to individual investors who are saving for important long-term purposes. The vast majority of financial advisers fund their clients’ portfolios with actively managed mutual funds, separately managed accounts, and hedge funds which are intended to better capital market returns.
In order to rise above the crowd and attract the attention of advisers and investors, managed accounts must have great track records of stellar market-beating results. Problem is, they are run by human beings, and human beings make mistakes, not the least of which is ‘speeding to qualify.’ And at high speeds, we in NASCAR country know very well what happens when mistakes are made. If they survive the crash, drivers are given a new car for the next race and they start again.
But lifetime investors don’t have the luxury of getting a new start. They are forced to make sacrifices instead; such as increasing their savings, moving goals further out or compromising on them, or worse, taking even more risk to make up for their losses. We are continually amazed at the propensity of people to continue to chase what they cannot control at the expense of controlling what they can.
They can indeed control expenses, taxes and under-performing the market and by so doing, ensure that they will keep substantial amounts of their wealth. The returns of the capital markets are sufficient to meet lifetime savings goals, without enhancement, so by harnessing these markets with efficient indexes, investors can save expenses, taxes and ensure that they will not under-perform.
Some of you may chafe at the mention of indexes, as they eliminate the possibility of out-performing. But consider your purpose for investing. Is it to outperform some benchmark or is it to adequately fund every goal you value? You can dramatically improve your chances by efficiently harnessing the capital markets, rather than trying to beat them. The reason quite simply is that odds are hugely against anyone beating the markets over long periods of time. Worse, when your managers make mistakes, you make sacrifices that could have been avoided.
As my friend Dave Loeper of Wealthcare Capital pointed out earlier this week, even Warren Buffett, the legendary long-term market-beater, encourages investors to use index funds for their long term saving purposes. He is able to make investments in sizes, at discounts, and at times individual investors cannot even remotely emulate. Even with all these advantages though, an investment in Berkshire Hathaway over the past decade has underperformed our Vanguard Total Market index (VTI) by 0.21%, and by nearly 8% over the last 3 years.
By controlling what is controllable and measuring the uncertainty of what is not, we can help you confidently meet and exceed your important goals and aspirations.
Have a great weekend.