Curious and thoughtful investors can be forgiven for wondering how so many silly things can be going on. Why is there so much interest in stocks when valuations are so high? Why were central banks so aggressive in easing monetary conditions and are so slow in returning to normal? Why have cryptocurrencies exploded in popularity? What can or should investors do about it?
In the effort to explore answers to these questions, it makes sense to consider a realm that persistently engenders similar types of silliness, that of corporate culture. Indeed, one of the influential business books that has withstood the test of time well, the Fifth Discipline by Peter Senge, provides a framework for diagnosing how dumb things can happen as well as a prescription for how to correct them. Such insights can also be effectively applied by investors to understand much of the silliness occurring in today's markets.
It's easy to pick on corporate culture and office behavior partly because there is so much good material, i.e., lots of stupid things happen. Indeed, Senge points out that "Organizational politics is such a perversion of truth and honesty that most organizations reek with its odor." In addition, many of us have experienced this firsthand. Constantly dealing with such gaffes could be deeply frustrating if not for important outlets of comic relief such as the Dilbert cartoon and The Office sitcom and the empathy of our colleagues.
Senge describes that silly things happen because most organizations have a multitude of "learning disabilities" that cause them to fall well short of their full potential. He goes on to explain that these disabilities impair organizational performance despite "the best efforts of bright, committed people".
One of the disabilities Senge highlights is "the fixation on events". As he describes, conversations in organizations are often dominated by "events" such as "last month's sales, the new budget cuts, last quarter's earnings, who just got promoted or fired ..." But such disproportionate focus on short term happenings, which is strongly reinforced by the media, ultimately "distract us from seeing the longer-term patterns of change that lie behind the events and from understanding the causes of those patterns."
In the investment world, the explosion of volatility in the first couple of weeks of February sparked all kinds of headlines as to what happened and why. But the bigger story was the "longer-term patterns of change" that lie behind that event which we documented in blog posts [here] and [here].
Another disability is "The myth of the management team". This refers primarily to the notion of "skilled incompetence" (articulated by Chris Argyris [here]) by which people become "incredibly proficient at keeping themselves from learning". In order to maintain "the appearance of a cohesive team", participants often "seek to squelch disagreement" and avoid voicing serious reservations publicly". These behaviors are exacerbated by tendencies to reward "people who excel in advocating their views, not inquiring into complex issues."
Of course these things happen all the time on both sides of the investment table. Financial commentators bloviate about what is happening in the market, investment committees get dominated by strong personalities and individuals often fail to get clarification when they don't understand certain terminology or explanations. As Senge notes, when "we feel uncertain or ignorant, we learn to protect ourselves from the pain of appearing uncertain or ignorant."
Since learning disabilities feature so prominently as causes of bad investment decisions, identifying and eliminating them is an excellent place to start. Some good, general practices are to focus less on specific results and more on processes and trends that produce them, to resist urges for aggressive action in the absence of substantial justification, and to maintain a sense of curiosity to figure out what is really going on.
One of the modern heroes of this rational approach is Steven Pinker whom David Brooks discussed [here]. As a "scientific rationalist" (as Brooks calls him) Pinker puts "tremendous emphasis on the value of individual reason." According to this worldview, "The key to progress is information — making ourselves better informed." Indeed, Pinker used the "better informed" approach to make a fresh and extremely compelling argument in his book, Better Angels of our Nature.
Investors can take the same approach with investment information. Senge describes people who pursue "personal mastery" as those who "have a special sense of purpose that lies behind their visions and goals" and who "are deeply inquisitive". Rather than simply accepting headlines and popular narratives, they can dig in to the numbers and figure things out for themselves, or find someone who can. They don't accept popular wisdom as sacrosanct.
As useful as such a course of action is, however, by itself it is insufficient to disentangle a complex landscape. As Brooks also notes, "Pinker’s philosophical lens prevents him from seeing where the real problems lie."
In order to capture a deeper, more holistic understanding, Senge recommends a concept he calls "systems thinking". He describes that systems thinking revolves around the concept of "feedback" that "shows how actions can reinforce or counteract (balance) each other." As such, systems thinking involves "seeing interrelationships rather than linear cause-effect chains." In essence, it is a matter of seeing the forest for the trees.
This is actually a fairly powerful insight for investors. One key to investment success for long term investors is to get the big things right and not fret too much about the little things. Systems thinking accomplishes this by "seeing through complexity to the underlying structures generating change. Systems thinking does not mean ignoring complexity. Rather, it means organizing complexity into a coherent story that illuminates the causes of problems and how they can be remedied in enduring ways."
In putting Senge's theories to work, we can see that the most relevant "underlying structures" of today's investment landscape include high levels of debt, high levels of spending, high levels of financialization, and significant demographic headwinds. Together, these factors represent a system that generates change by way of posing a massive threat to economies and incumbent governments.
Such threats significantly limit the universe of viable public policy responses. As burdens become progressively harder to bear, longer term "fix the system" options become nearly impossible to implement. Policies that are more palatable in the short term, such pursuing ultra-loose monetary policy, emerge in their stead. This has paved the way for a lot of dumb things to happen.
One of the dumb things is that valuations have been extremely high for years now but have stubbornly refused to recede. Is this phenomenon more indicative of improving growth prospects or of an accident waiting to happen?
Interestingly, fund managers, who ostensibly bring expertise to bear on the issue, provide less than enthusiastic endorsement for stocks. As the Financial Times reports [here], the evidence from a Bank of America Merrill Lynch survey of fund managers indicates that "many are invested in equities even though they think they [equities] are overvalued". This goes some way in explaining why valuations have remained high, but why have managers become so relaxed on valuation?
Systems thinking helps explain the paradox. Robert Buckland portrayed in the FT [here] exactly where the rubber hits the road for managers. Although Buckland notes of value investors that "Their time will come", he qualifies the assessment with, "But it could be a long, career-threatening, wait before that occurs." In other words, the persistent intervention of central banks severely undermines the role of fund managers by forcing them to either forgo fiduciary duties to mitigate risk by eschewing overvalued securities or to forgo business opportunity by missing out on rising markets. As a result, most remain invested in equities.
Perhaps nowhere is such a temptation to chase returns more pronounced than in the realm of cryptocurrencies such as bitcoin. While many of these currencies do entail some interesting technology (such as blockchain), their current incarnations are far removed from anything resembling stable currencies.
Successful hedge fund investor Paul Singer [here] pulled no punches in his assessment: "This [cryptocurrency trend] is not just a bubble. It is not just a fraud. It is perhaps the outer limit, the ultimate expression, of the ability of humans to seize upon ether and hope to ride it to the stars ..." He goes on to describe the fever to buy cryptocurrencies at progressively higher prices not as "the validation of the thing", but rather as "an indication of the limitless ignorance of swaths of the human race.”
Much of that "ignorance" is not so much dearth of intellectual capacity as "missing the forest for the trees". Indeed, systems thinking allows long term investors to see through the day-to-day details of statistics and events to capture the bigger picture. In doing so, systems thinking also helps reveal many of the fault lines of conventional thinking.
Many of those fault lines emerge from oversimplification. Explanations such as "day traders caused the tech bust in 2000" or "real estate speculators caused the financial crisis in 2000" contain some element of truth, but fall far short of describing the many interrelationships and processes behind those events.
A more accurate depiction is that "systems create their own crises". This dynamic is captured by descriptors such as "systemic risk" or "fragile" environments. As Senge notes, "In complex human systems there are always many ways to make things look better in the short run. Only eventually does the compensating feedback come to haunt you." As a result, as Senge notes, "more often than we realize, systems cause their own crises."
An overly financialized, highly leveraged system creates incentives for central banks to take the easy way out by creating loose monetary conditions which in turn creates (for a time anyway) incentives for speculation on tech stocks, real estate, or cryptocurrencies. It's all part of the system. Failure is not a function of some bad actors but rather an inherent characteristic of a system that fosters an environment conducive to unsustainable behavior.
As Senge also notes, "The reason that structural explanations are so important is that only they address the underlying causes of behavior at a level that patterns of behavior can be changed." This is where things start to come home for investors. The highly leveraged and financialized system in which our financial assets reside can only be changed from outside of that system.
In other words, it's going to take comprehensive public policy that succeeds in resolving the problems that the Dodd-Frank did not in order to effect lasting change. While increasing bank capital has represented progress, it is but one patch in a very leaky bucket.
Until such fundamental change occurs, investors will be well served to appreciate that their financial assets reside in an inherently risky and unstable financial system, much more so than twenty or thirty years ago. One consequence of there are more and more "investments" that can blow up. Another consequence is that high valuations create lots of downside risk. They are not, as Singer scolds, "the validation of the thing". This is especially relevant given that financial assets comprise the vast majority of most retirement plans.
At a more granular level, the application of systems thinking and the awareness of various learning disabilities provide powerful tools by which investors can filter market information. Simple cause and effect explanations in regards to complex mechanisms like the economy or markets should be treated with a great deal of skepticism.
Finally, for long term investors who are trying to plot a course for retirement, it is more important to get the general direction right than all of the little zigs and zags during the interim. This means staying focused on the things that matter most. One way to do that is to avoid getting caught up in the types of "learning disabilities" that can distort accurate readings of the landscape. Another is to step back and view complex mechanisms (such as markets) rife with complicated and indirect relationships. Both rely on having the courage to call out things that seem wrong and having the fortitude to address the consequences. The reward, however, will come in the form of seeing through many of the dumb things that happen in markets and ultimately in the form of protecting your assets.