Friday, July 10, 2009

Smart Money?

Is it reasonable to assume that, by and large, those who manage large sums of money (bank execs, fund managers etc.) possess above average judgment in financial matters?

Generally speaking, according to John Kenneth Galbraith the answer is no.

In his book, A Short History of Financial Euphoria, Galbraith says, in fact, no such dependable relationship exists. 

" a world where for many the acquisition of money is difficult and the resulting sums palpably insufficient, the possession of it in large amount seems a miracle. Accordingly, possession must be associated with some special genius." - John Kenneth Galbraith in A Short History of Financial Euphoria (Page 14)

Galbraith later adds:

"In fact, such reverence for the possession of money again indicates the shortness of memory, the ignorance of history, and the consequent capacity for self- and popular delusion..." - John Kenneth Galbraith in A Short History of Financial Euphoria (Page 14)

Financial memory, according to Galbraith, turns out to be rather short as he explains later in the book.* 

During periods of speculative excess poor judgment by what are supposed to be the best financial minds is the norm...not the exception. The financial heroes or geniuses before a bubble bursts become (often most deservedly) the villains after the crash. So the so-called "smart money" during speculative episodes proves to be rather not so smart:

"...we compulsively associate unusual intelligence with the leadership of the great financial institutions-- the large banking, investment-banking, insurance, and brokerage houses." - John Kenneth Galbraith in A Short History of Financial Euphoria (Page 15)

Galbraith explains this tendency as follows:

"...the investing public is fascinated and captured by the great financial mind. That fascination derives, in turn, from the scale of the financial operations and the feeling that, with so much money involved, the mental resources behind them cannot be less.

Only after the speculative collapse does the truth emerge. What was thought to be unusual acuity turns out to be only a fortuitous and unfortunate association with the assets. Over the long years of history, the result for those who have been thus misjudged (including, invariably, by themselves) has been opprobrium followed by personal disgrace or a retreat into the deeper folds of obscurity. Or it has been exile, suicide, or, in modern times, at least moderately uncomfortable confinement. The rule will often be here reiterated: financial genius is before the fall."
- John Kenneth Galbraith in A Short History of Financial Euphoria (Page 17)

Note: What the great investors with long track records of success seem to have in common is that they do not rely on so-called financial genius. For most, it was working and thinking hard to gain insights on a quality business, buying it at a fair price, then allowing the superior economics of the business itself to compound over time. It was about making smart long-term investments while employing only modest amounts of debt.

From my viewpoint, the term financial genius is too often just code for someone taking excess risk with other peoples money under the guise of some supposedly new innovation.

That innovation is almost always just some new form of leverage.

" operations do not lend themselves to innovation. What is recurrently so described and celebrated is, without exception, a small variation on an established design, one that owes its distinctive character to the aforementioned brevity of financial memory. The world of finance hails the invention of the wheel over and over again, often in a slightly more unstable version. All financial innovation involves, in one form or another, the creation of debt secured in greater or lesser adequacy by real assets." - John Kenneth Galbraith in A Short History of Financial Euphoria (Page 19)

Leverage that works great until it doesn't.


Related post: 
The Madness of Crowds

"...for practical purposes, the financial memory should be assumed to last, at a maximum, no more than 20 years. This is normally the time it takes for the recollection of one disaster to be erased and for some variant on previous dementia to come forward to capture the financial mind. It is also the time generally required for a new generation to enter the scene, impressed, as had been its predecessors, with its own innovative genius." - John Kenneth Galbraith in A Short History of Financial Euphoria (Page 87)
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