Friday, January 18, 2008

Fiduciary Challenges I

In 2007 we witnessed increased market volatility, greater dispersion in returns and fallout from innovations in financial engineering and quantitative finance. These conditions intensify the challenges that face investment fiduciaries, particularly with regard to maintaining a long term investment perspective and appropriately utilizing new products that seemingly offer risk-less portfolio enhancements.

While managing a long term investing strategy is not synonymous with doing nothing, it has many advantages over a process which is predominated by a series of short term oriented decisions. As Jack Gray, a strategist from Grantham, Mayo & Otterloo put it “long-termism is not a panacea for investment decision making, nor is it a paragon of investment virtue, but it does offer some advantages over short-termism, namely better predictability, lower risk and lower cost[i]. Jack noted that barriers to long term commitment are plentiful and can be rooted in psychology and organizational behavior.

Psychologically, investors can fall into many cognitive traps. Over-reliance on data such as historical returns and believing the future will look like the past are perhaps the most common. As Ray Dalio, founder of Bridgewater Associates noted recently, with the quantum leaps in technology it is very easy to see what would have worked in the past and then lever up and over optimize those relationships. Leveraged bets on the safety and consistency of mortgage spreads over Treasuries cost billions in financial losses, jobs and organizational reputations in 2007.

Organizationally, fiduciaries should understand that while doing nothing is not responsible performance, neither is feeling compelled to adjust their portfolios to compensate for current market conditions. We have been conditioned to expect that successful meetings result in specific outcomes (usually decisions and action items). However, fiduciary committees should feel most accomplished when they think more than they act. Generally…but not always, the option to do nothing should be their favorite option. While reacting to short-term market fluctuations can often be financially destructive, fiduciaries should not feel guilty about adjusting an investment strategy based on well reasoned short term signals that may have long term relevance. Those fiduciaries who reacted quickly to the substantial realignment in the credit markets this summer seemed to have fared the best.

[i] Avoiding Short Termism in Investment Decision Making -, Jack Gray, CFA Publications December 2006 Presnetation avaiable here


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