Fear, Greed and The Rational Investor: Lessons from the Collapse of Silicon Valley Bank
The world has been watching a train wreck unfold in the wake of the collapse of Silicon Valley Bank. This has sent shock waves through the US financial system that are far reaching, the consequences of which are not yet fully understood. A perfect storm of inflation, rising rates and poor bank governance has caused a frenzy amongst depositors who all at once decided to take their money and run. This has bolstered already heightened pessimism within financial markets with some investors questioning the resilience of the financial system. Fear it seems is contagious.
In truth, for most of us, very little emphasis needs to be placed on recent events when making money decisions. The question can legitimately be asked then, if one shouldn’t over emphasize recent market conditions then how does one judge the suitability of an investment approach? The answer lies in gaining an understanding of the dynamics of investment return and the proper application of risk in a systemic way, attribution analysis and ensuring that an investment has the ability to capture the market return in the most efficient manner. In our world of quick fixes this seems too hard when compared to the easy Sesame Street approach of simply counting stars and being able to count one, two, three, four, and five. It is much more alluring to believe someone knows something we don’t and if we can just get that information we will be on the road to riches. It has been so since the beginning of time. In no other discipline is the study of past events going to give as comprehensive an insight into the reasons people fail to achieve their objective than in finance. History serves to give perspective. Instead of panicking, an informed investor is aware of the ebb and flow of markets over time and the need for patience to stay the course when all around you are giving over to their emotions. Thinking historically allows you to invest based on long term historical evidence rather than on the way you feel. When you know what has gone before over long timeframes, you are not surprised by what lays ahead and you are able to accept the inevitable peaks and troughs as part of the investment journey.
A parallel to the recent Silicon Valley Bank debacle can be found at the genesis of paper money with a Scotsman called John Law who founded the Mississippi Company in France in 1719. He was granted a monopoly on trade with all the French North American Colonies and the right to buy French Government Annuities called ‘rentes’ in exchange for shares in his company.
Law was a convicted criminal in London who escaped to Europe and made a living from gambling at the tables of Europe’s high society. He is reported to have spent his mornings studying finance and trade and his evenings at the local gaming houses. He came to believe that paper money would facilitate trade far better than gold and silver. While in Scotland he had proposed a “land bank” that should issue paper notes backed by, and never exceeding, the total value of the state holdings of land. The land bank was meant to relieve the state of having to furnish the gold and silver to keep the economy moving and give the state the capacity to manage the amount of money in circulation at any one time. Spending, Law believed, is how a nation gets wealthy. He further developed this concept to the point where instead of backing the paper money with land the government should simply back its promise to pay the notes with the future tax revenues of the state. This is a concept that still serves as the basis for money used by modern nations today.[1]
John Law won an audience with Phillip II, Duke of Orleans who became the Regent of France. When the Duke took control of the finances of France they were a mess after years of extravagant spending. He remembered the theories of John Law and so appointed him in order to prevent France from going bankrupt. Law solved the problem by offering shares in his bank, Banque Generale, exclusively in exchange for the almost junk status, government bonds currently on issue. All taxes had to be paid with notes from Laws bank so he was assured of success. For the first time paper money was issued and officially sanctioned by a government. The paper notes soon became more valuable and accepted than gold coins that had been subject to clipping (replacing circulating coins with new coinage that had a smaller percentage of gold). The new currency boom boosted trade and commerce.
All Frances problems seemed to have been solved except that Law convinced Phillip II to back a trading company with monopoly rights over the Mississippi and Louisiana as well as China, East India and South America. The initial public offering of shares in the trading company, Compagnie des Indes, were massively oversubscribed and they skyrocketed in value as confidence boomed. The temptation for the Duke and John Law was too much. Why not print more and more notes?
The Mississippi Company would issue more and more money as the price of its shares increased. As the company’s shares rose, it issued more notes, which created more liquidity to purchase more shares not only in the Mississippi Company but also in many new ventures. This venture was the first flirtation by a modern government with paper money that had been invented by the Chinese in 910 AD. The Chinese eventually discarded paper money as it was susceptible to inflation. Like today, Central bankers could issue as much paper as they wanted.
No new capital was being injected into the economy and no trade proceeds were yet evident from the monopoly rights but the sensation was one of a massive increase in spending and prosperity. By January 8th 1720 the price of a share had risen from 100 livres to 10,100. So many commoners were becoming rich that a new word was used to describe them, millionaires! Unfortunately it was all an illusion and not sustainable. A critical lesson in the difference between investing and speculating was about to be administered.
In early 1720 an aristocrat, Prince de Conti demanded a large amount of notes be redeemed ‘on sight’ for metal coins and soon it became apparent that there really was nothing but an abstact promise backing the notes and the run was on. Investors began hording gold and the money supply and confidence dried up. The shares collapsed in value along with everything else. Turning on the printing presses could not save the situation or the country from bankruptcy. The relevancy of this and future booms has not been learnt. Ordinary people who don’t stop to think about the source of return are willing to believe anything when they become intoxicated by the lure of instant riches. They become convinced they are seeing the dawn of a new era and they want to get in on it.[2]
Irrational optimism and its devastating consequences are regularly discussed. Less considered is the arguably equally devastating psychology that emerges in the wake of a market mania. Typically, after a seemingly cataclysmic event in financial markets there are seismic shifts in investor sentiments from greed to fear. Newton’s first law rings true; things in motion remain in motion unless acted on by an unbalanced force. The inertia of declining investor sentiment compounds and self-preservation becomes the dominant going concern. Behavioral economists claim that in the normal course of events humans are wired for loss aversion. Some studies have indicated that the pain of losing is twice as pronounced than the joy of an equal gain. In the throw of financial downturn this fear of loss is magnified to such a significant degree that decisions are often made that exclude investors from positioning themselves to benefit from a subsequent recovery.
This is not only true in finance and investment but in all areas of human endeavor. In my previous role I was required to attend medical conferences throughout the year. During these conferences exhibitors would demonstrate diagnostic tools they had developed for the medical assessment of moles on the skin. They were testing for the likelihood of malignancy of the moles. Prior to using the Diagnostic tool, doctors would have a tendency to be more suspicious of a mole in the period immediately after having had several positive confirmations returned from pathology during the previous month than during other times when they weren’t preconditioned to be expecting this result. As a consequence many more expensive tests were being done than was necessary or even prudent. The tool gave the doctors a greater data set of cases to compare and so the assessment was not so subjective or reliant on the impact that the immediate past had on the psyche of the doctor making the assessment.
James O’Shaughnessy explored this phenomenon in his book, “What Works on Wall Street.” He was able to demonstrate that there are two ways that we as human beings make decisions. Normally a person runs through a variety of possible outcomes in their head relying on knowledge, experience and common sense to reach a decision. The other way is more quantitative, using no subjective judgements. Empirical relationships between the data and the desired outcome are used and it relies on proven relationships using as large a data sample as possible. O’Shaughnessy pointed out that in almost every instance where forecasting an outcome was required people preferred the intuitive, clinical approach to the more actuarial, quantitative approach and in most instances they were wrong.[3]
David Faust explored the unreliability of processing information intuitively in, ”The Limits of Scientific Reasoning” and found that “human judgement is far more limited than we think. We have a surprisingly restricted capacity to manage or interpret complex information.”[4] He studied a wide range of professionals from doctors making diagnoses to predictions of job success in military and academic training and found that simple actuarial models consistently outperformed humans. Investors that actively trade portfolios are the same, in that most of them can’t beat a passive index over the longer term. Robyn Dawes in his book, “House of Cards: Psychology and Psychotherapy Built on Myth” refers to a researcher who published a review of 45 studies comparing the two forecasting techniques. The intuitive method preferred by most people failed in every instance to beat the more actuarial method. This occurred even when the human judges had more information and they were given the results of the actuarial method before being asked to make a prediction.[5]
O’Shaughnessy found that the ‘models beat the human forecasters because they reliably and consistently apply the same criteria time after time.’ They don’t favour vivid, interesting stories over reams of statistical data. ‘People, on the other hand, are far more interesting. It’s more natural to react emotionally or personalize a problem than it is to dispassionately review broad statistical occurrences, and so much more fun! We are a bundle of inconsistencies, and while that may make us interesting, it plays havoc with our ability to invest our money successfully. In most instances, fund managers, like college administrators, doctors and accountants mentioned above, favour the intuitive method of forecasting. They all follow the same path: Analyse the company, interview the management, talk to the customers and competitors, and so on. All of them think they have superior insights, intelligence, and ability to pick winning stocks, yet 80 percent of them are routinely outperformed by the S&P 500’[6]
Seeing the demise of a financial institution like Silicon Valley Bank is certainly disconcerting. Applying a narrow lens we might think the sky is falling, taking a wider lens we see that these events are not unusual and are expected in the natural course of the capital market system. The ultimate question is whether we use our flawed heuristics to respond to these stressors or apply tried and tested investment principles to see us through the storm.
Disclosure: Please note that all information provided is of a general nature and does not take into account your current financial situation, needs or objectives. Before acting on any of the information you should consider its appropriateness, having regard to your own objectives, financial situation and needs. The Prosperity Planners Pty Ltd t/a Prosperity Planners ABN 56 679 768 897 is an Authorised Representative No. 1289369 and Credit Representative No. 532716 of FYG Planners Pty Ltd Australian Financial Services Licensee and Australian Credit Licensee No. 224543 ABN 55 094 972 540 Level 2, 39-41 Alexander Street Burnie TAS 7320.
[1] Bonner, William. 2003 Financial Reckoning Day, John Wiley and Sons p69-76
[2] Bonner, William, 2003 Financial Reckoning Day, John Wiley and Sons p 77-85
[3] O’Shaughnessy, James P. 1996 What Works on Wall Street. McGraw Hill p12
[4] Faust, David, 1984. The Limits of Scientific Reasoning, University of Minnesota Press, Minneapolis,
[5] Dawes, Robyn M.1994. House of Cards: Psychology and psychotherapy built on Myth, The Free Press, New York.
[6] O’Shaughnessy, James P. 1996. What Works on Wall Street. McGraw Hill p14