Biases and Lessons

Today's financial community is suffering from a failure to learn the lessons of the past and from biases that cannot be overcome by all our quantitative techniques. Primary lessons involve the limitations in our modeling and forecasting, the occasional irrationality of the market, and the need to focus on our fiduciary responsibilities. Biases can blind us to the remembrance that the future does not repeat the past and to the inevitability of hard times. During the 60 years of the Financial Analysts Journal's existence, the financial markets have grown in size much more than the economy itself, new credit instruments have come to play important roles in portfolio management and trading, and the volume of new issues and secondary-market trading has grown tremendously. Together with the unprecedented growth and innovations, however, have come financial mishaps, scandals, and credit market upheavals. Investors, institutions, and official authorities should have learned important lessons from this history, but I suspect we have not learned the necessary lessons. We are plagued by financial misconceptions and biases.Many market participants still lose sight of the distinction between the marketability and the liquidity of an obligation. The narrow credit spreads that seem to give emerging market debt and corporate junk bonds such allure when the financial system is awash with credit are only temporary symptoms of marketability, not true liquidity.With the rapid growth of securitization has come the imperfect practice of marking to market. Investors need to realize that when market conditions deteriorate and liquidity declines, one cannot really claim that the last quoted price (even in organized markets or quoted by dealers in the OTC market) is the real market price.The modeling of risks has great limitations. The increasing reliance on quantitative models is understandable; models are comforting, and the quantitative and econometric techniques developed in the last generation have given investors and portfolio managers a sense of confidence in their ability to forecast financial trends and behavior. But models are basically backward looking. They are essentially useless when an underlying structure, such as liquidity, changes. Moreover, models are built on assumptions of rationality, and rational analytical techniques cannot predict extremes in financial behavior.Related to these underlying biases are the rise and prominence of “the consensus forecast.” The concept is understandable. Being with the consensus minimizes risk and avoids isolation; running with the crowd is comfortable; one cannot be singled out for blame or targeted because of success. As a practical matter, however, the consensus forecast cannot be accurate. If a large number of market participants could anticipate big shifts in economic and financial behavior, they would act accordingly, heading off the dramatic changes in the first place.Our forecasting is biased by the weight of history, reinforced by statistical averaging. The widespread impulse to believe that the future is grounded in the past is, again, understandable, but it should be viewed with great caution and skepticism. The critical ingredient in making good projections is often a matter of identifying what differs from the past.We suffer from a clear and chronic bias against negative predictions. People are inclined to optimism, and negative forecasts make for bad politics. Negative forecasts, however, are often the accurate forecasts.Even if one could deliver an absolutely correct forecast of impending crisis, our large business organizations and financial institutions do not have the will (or perhaps the capacity) to take advantage of it. Their people, their machinery, their procedures—all are geared to build market share and to expand. When contraction or crisis forces corporate restructuring, seldom is the process managed with vision. Moreover, when downsizing comes, the resulting write-offs—certainly a reflection of earlier management errors—are heralded by the market. This lack of intellectual honesty extends to the accounting treatment of the losses as one-time write-offs.The most important lesson that we have not yet learned well is that people in finance are entrusted with an extraordinary responsibility—namely, other people's money. This basic fiduciary duty is too often forgotten in our high-voltage, high-velocity financial environment. Our job, however, is to make critical judgments about how to channel money and credit into a broad range of economic activities. To carry out this singular and crucial task properly requires objectivity and a strong appreciation of the public trust in our hands.When this responsibility is not carried out, when financial institutions are not reined in, the causes are laxity on the part of the senior managers of financial institutions; the failure of our professional schools to emphasize economic and financial history, ethics, and the values and responsibility inherent in prudent financial behavior; and the asymmetrical actions of the Board of Governors of the Federal Reserve System. When asset values fall suddenly, the Fed usually eases monetary policy to provide greater liquidity and to counteract any decline in domestic spending. When asset prices advance strongly, however, the Fed usually does not respond by tightening monetary policy in a timely fashion. This asymmetry has given rise to an expectation in the market that faulty investments will be bailed out by the central bank.Eventually, many of these neglected lessons and biases will be learned and overcome. If history is any guide, however, the learning may well not occur until after another round of financial adversity.