By Mark Harrison, CFA
Opening the CFA Institute 65th Annual Conference in Chicago, behavioral investor James Montier condemned theorists, policymakers, and practitioners for creating the financial crisis with "bad models, bad policies, bad incentives, and bad behavior." Worse still, Montier contended, nothing much has been learned from the disaster - setting us up for yet another calamity.
Montier began his talk by attacking key financial models. "In finance, we forget we have made abstractions and take the models as if they were reality," he said. Value at Risk (VaR), a popular measure of downside risk and potential loss, "cuts off the very part of the probability distribution (the extremes) which you most need to worry about." VaR - combined with leverage and naïve calculations about volatility based on overly recent data - has escalated institutional risk to the point that it has become systematic risk. "You are introducing an enormous amplifying device into global markets," he added.
Also on Montier's list of bad models with bad assumptions is the Capital Asset Pricing Model (CAPM), the bedrock of fundamental and quantitative investing. "Effectively they say that the only form of risk you need to worry about is volatility, that you can ignore illiquidity and leverage," said Montier. But the collapse of LTCM in 1998 showed the damage that illiquid assets can cause. In the wake of the 2008 financial crisis, it's a lesson that nobody seems to have learned, he added.
Behavioral biases and neuroscience can help investors understand such a failure of collective common sense. According to Montier, studies show that when experts are advising people they switch off the area of the brain associated with common sense. "Automation bias" makes people defer to and trust technology even if evidence suggests otherwise. Narrow framing explains why UBS's market risk committee relied on VaR without questioning the evidence. Professional fund managers anchor onto irrelevant data just as much as everyone else, he argued.
Montier reserved particular venom for professionals trying to "impress with complexity" by substituting theory for experience, because complexity impresses clients and justifies high fees. For Montier, if you don't understand something, then you just shouldn't invest in it. Investment advisers should take a form of the Hippocratic Oath, making explicit to clients any deficiencies and limitations in their models to discourage the temptation to test models that could prove destructive at the client's expense.
Regulators share a large part of the blame for promoting bad behavior. "Regulators adopting value-at-risk is a little bit like asking children to mark their own homework," Montier said. "Bad policy sets up bad incentives." He believes regulators are hostage to the industry over which they are meant to show oversight. This is a form of regulatory capture, and the impact can be seen in the banking industry's steadily increasing leverage, which grew from not much more than 1x assets in the 1850s to 35x or more in recent times, when regulators started using VaR - a model that leaves no margin for error. More recently, Montier said, the Federal Reserve fostered bad behavior among investors by cutting interest rates too far, promoting a chase for bond yields in an environment where bond issuers paid for their own ratings.
Investors have their own, numerous behavioral flaws to blame, according to Montier. For instance, they have failed to look out for the unexpected, or black swans, just around the corner. They are overly optimistic due to evolutionary development. They have an illusion of control, such as relying on VaR to capture the nature of risk. They are guilty of self-serving bias, for example, by getting rid of risk officers who ask too many probing questions about collateralized debt obligations (CDOs). In addition, investors suffer from inattentional blindness, or not anticipating surprises, the subject of a famous experiment by Simons and Chabris, and their own myopia leads to an overt focus on the short term, another evolutionary flaw.
So what solutions does Montier offer to a world in which, in his words, "everyone should accept that the model is over?"
His manifesto for change is that we should continue to develop more realistic models incorporating illiquidity and leverage, bad behavior, bad incentives, and delegation. Investment mandates should not be dictated by benchmarks but by breadth and skill. "Finance theorists should be banned from being finance theorists unless they have been practitioners," he contended. Use of classic Markowitz mean-variance optimization techniques should be abandoned in his view because, "instead of obsessing about optimality, we need to consider robustness and build portfolios designed to survive multiple different environments."
For Montier, risk/variance itself needs to be totally redefined. "Risk is not volatility," he told conference delegates," risk properly defined is the permanent impairment of capital."
The answer, Montier contended, is that leverage and financial innovation must be reined in and financial history must be studied more deeply. As John Kenneth Galbraith said, "The world of finance hails the invention of the wheel over and over again, often in a slightly more unstable version." Investors should be especially on their guard for financial innovation which disguises higher leverage.
Summing up, Montier said: "Central banks have to learn not to be asymmetrical, they must learn to lean against the wind." Markets do not always do the right thing and are, at least for Montier, highly inefficient. One solution is that capital adequacy should be contracyclical, encouraging bankers to up reserves in good times, rather than procyclical. Most importantly, regulators need to learn the right lesson from the crisis: It wasn't the result of investors taking on too much equity-like risk. It was rather due to overpricing of equity-like risk. Telling everyone to buy expensive bonds is not the solution: Central bankers "are sowing the seeds of the next recession by telling everyone to go out and buy expensive assets all over again."