Strategic Framing

What do you do when financial market modeling based on past performance does not work because the market is acting in a fundmentally different way?

An article in today’s Wall Street Journal explains how one Philadelphia money-management firm, Glenmede Trust, turned to scenario planning.  As someone who works with scenario planning on a daily basis, this does not surprise me.  Scenario planning is an excellent choice when facing a highly uncertain future.  When you feel past trends will not continue into the future, scenario planning offers a disciplined way to set strategy.

Using scenario planning as an investment tool is not a totally new idea.  See the 2005 article in The Journal of Wealth Management by Anne Shumadine.

At DSI, we have a team of scenario planning experts with experience in the financial services industry.  If you have more questions about how this process could work for your company, please contact me.

Ah New Years!  A time for predictions.

Predicting pop culture trends, new technologies, political changes….and of course, the economy.

Am I the only one who feels these predictions are particularly quaint this year?  I get the sense journalists and columnists are just going through the motions.  They know as well as we that 2009 is fraught with uncertainty. No one has a clue.  Once you realize that no one has a clue, the television pundits become particularly entertaining because it seems on TV you need to pretend you actually know something that other people don’t know.  Nevertheless, the ‘2009 Predictions’ stories are fun holiday reads.

In the best of times, we are notoriously bad at predicting the future.  Here at the start of 2009 we face an inflection point.  A moment when the recent past does little to help us predict the future. At such moments, rather than trying to predict the future we can focus attention on identifying the boundaries of our uncertainty.  Let’s figure out precisely what we don’t know rather than trying to look into the crystal ball and fool ourselves into believing we can see the future.  Once we identify the range of our future uncertainty, we can begin to monitor the areas of uncertainty to spot weak signals and we can design flexible strategies that enable us to thrive regardless of how the future unfolds.

This whole ‘embrace uncertainty’ thing not for you?  No worries!  I’ll be glad to refer you to an excellent pyschic who will tell you exactly what will happen next year.

One aspect of international travel that I truly enjoy is reading about the business world from a different perspective.  On my trip to Sydney, Australia earlier this month, I dug through local papers and The Australian Financial Review to get a sense of how the current economic challenges where being felt and understood in Australia.  I look forward to getting a different perspective next month when I head to South Africa.

I found in interesting article in an insert magazine in The Financial Review.  The insert magazine is rather amusingly called Boss.  In the article, Mike Hanley did a wonderful job explaining the limits of the efficient markets logic.  A key limitation is that markets consist of human beings and human perception of risk is predictably irrational.  These pervasive cognitive biases were revealed in the research of Nobel Prize winners Daniel Kahneman and Amos Tversky.  Kahneman and Tversky demonstrated how we can be easily manipulated to become risk-seeking or risk-averse, how we over value confirming data and discount disconfirming data, and how we are overconfident in our knowledge and decisions.

I find it interesting to consider the implications of Kahneman and Tversky’s work for the financial markets.  Because these biases are so ingrained and pervasive, we cannot rely on the ‘wisdom of the crowd’ to save us.  A majority of the crowd will suffer from these same biases and it is folly to simply hope these biases will counteract each other.  Rather, what is needed is a system designed to offset these human cognitive tendencies.  I certainly do not pretend to have the answer of what that system would look like.  However, it would surely include mechanisms to limit considerations of sunk costs, counteract confirmation biases and reveal limitations of investor information.

No worries eh?

The potential $50 billion loss is mindblowing.  Even if the losses from the Madoff Investment fraud comes in below this number it is still going to be a fraud of historic proportions.

To put it in perspective, the trading scandal that brought SocGen to its knees and rocked the markets in January 2008 was on the order of aproximately $7.1 billion.  If the sky was falling then, what’s falling now? (side note: If you are stressed and need to relax, close your eyes and try to answer that question.  What can be greater than the sky?  The question has a certain perverse zen like quality to it)

Now the conversation turns to the question: Why did so many people not see the warning signs?  We’ve learned that there were signs of something fishy at Madoff Investments.  The biggest one may be the low probability that any firm can continually generate such predictable returns  in variable markets.  Another warning sign was raised about the feasibility of Madoff’s reported investing strategy for a fund of such a size.

No doubt there are many answers to the question of missed warning signs.  Let me add the role of human psychology.  We depend upon social valuation to judge others in complex environments and we seek information that confirms our initial judgments.  Both these cognitive tendencies came into play in this case.

Madoff relied upon his reputation to bring in new investors.  His legitimacy as a financial professional came from his reputation.  His reputation was built up over such a long time that to spend time investigating Madoff’s expertise is easily dismissed as a waste of effort.   To use the political term in vogue these days,Madoff had been vetted and new investors could comfortably accept that.

Combine such strong reputational legitimacy with our natural bias towards confirming evidence and you have a receipe for fraud.  Our overweighting of data that supports our decisions and underweighting of data that disconfirms our decisions is well documented.  This is the same dynamic that causes politically conservative Americans to watch Fox News and politically liberal Americans to read Salon.com.  It is also the dynamic that prompts investors to discount negative analysis of companies in which they have invested.  Investors may claim the analyst is biased, missed a key point, or just doesn’t get it.  It is easy to rationalize why information is useless once you’ve decided the information is useless.  Madoff invested had $17 billion reasons to rationalize away warning signs.  They’d already made the decision to invest in Madoff.  That was the hard decision.  Seeing evidence to reinforce the correctness of that decision after the fact is easy…and natural.

For years, economists have been wringing their hands about the US consumer’s low savings rate and dependence on credit to support their lifestyle.  I recall numerous articles during the late 80’s imploring us all to be more like the Japanese consumer and save more.  Then Japanese savings rates plunged and we were urged to be more like the Germans and French.

On Thursday, The Federal Reserve reported that consumer household debt declined for the first time in 50 years of record keeping during the 3rd Quarter.

This news was met with…intense hand wringing.

Once again we can see the wonderful prisoners dillemma structure of our national economy.  What is best and rational for the individual consumer is not what is best for the economy as a whole.  For years, we’ve been told to save for our future.  Yet our economy was built to support the lifestyle of a nation of debtors.  Production capacity in the world economy is scaled to support an economy based on massive household leverage.

Now, with household investments and job prospects uncertain, the logical action for the individual is to pull back consumption and build a savings nest egg.  Of course, less credit card spending means less buying..means less sales…means less productions…means fewer jobs…means cats and dogs sleeping together.

It’s kind of disheartening to know that the health of our economic system is dependent upon the willingness of the individual household toact against their best economic interests.