One of the most frustrating things I’ve encountered as an advocate for evidence-based investing is the lack of regard that many of those involved in the investment industry appear to have for academics. Money.
There’s a vast (and growing) body of peer-reviewed academic evidence which consistently shows how most investors should simply buy and hold a diversified portfolio of index funds and occasionally rebalance it. Yet the fund houses, aided and abetted by stockbrokers, fund shops, advertisers, PR professionals and the majority of investment journalists, constantly encourage us to do the very opposite. They want to flog us expensive products; they want us to buy and sell, to speculate and chase performance.
The fact that several of the academics whose findings conflict with their business models have been awarded the Nobel Prize for Economics in recognition of their work appears to count for nothing.
There is, however, one academic whom everyone concerned with the state of the financial services industry should listen to. John Kay is one of Britain’s leading economists who understands the financial sector better than almost anyone. Neither an industry spokesman nor a consumer champion, his perspective is, plainly and simply, that of an economist.
Professor Kay’s new book, Other People’s Money, cuts to the chase. Although society needs finance, he says, we’ve created a financial system that talks to itself, that trades with itself, and which is increasingly divorced from the real economy.
He talks of the “financialisation” of the economy since the 1970s, and how it has led to more financial instability and, in the US and the UK in particular, greater inequality of wealth. Instead of servants of the people, the big financial companies have become masters of the universe.
Professor Kay likens what’s happening in financial services to what JK Galbraith referred to as “the bezzle” — the period between the commission of a crime of embezzlement and its discovery. “This is a period,” wrote Galbraith, “when the embezzler has his gain and the man who has been embezzled, oddly enough, feels no loss. There is a net increase in psychic wealth.”
No doubt many will find this unflattering assessment of the financial sector unsettling, particular in the UK, where there’s long been a political consensus that the financial sector is a force for good and crucial to the health of the economy. But, certainly in the particular part of the sector that I work in, namely wealth management, John Kay’s analysis is bang on the money.
Professor Kay is, in fact, echoing precisely what Vanguard founder Jack Bogle says in the final part of How to Win the Loser’s Game:
“The function of the securities markets,” says Bogle, “is to allow new capital to be directed to its highest and best use. But think about the maths for a minute. We probably have about $300 billion a year that goes to new and additional offerings. We trade $56 trillion, and that means something like 99.5% of what we do as investors is trade with one another. And 0.5% is directing capital to new business. There is a system that has failed society. Period.”
The fund management industry has grown exponentially; there are now, would you believe, more funds to choose from than individual stocks. Why has it grown? The answer’s simple. Because managing other people’s wealth is hugely lucrative. It also provides employment for a whole support industry — the brokers, advertisers, spin doctors and so on as I referred to earlier.
This is, in short, a self-serving system. Why else, for instance, have nearly 90% of members of the UK’s largest fund industry trade body, the Investment Association, refused to signed a Statement of Principles, which commits them to putting the interests of consumers ahead of their own? Why is the industry lobbying so hard against the introduction of MiFID II, the EU directive designed to protect investors, or against the proposed Fiduciary Rule in the United States?
Yes, it’s an industry that benefits a large number of people; it makes a positive contribution to the economy and to tax receipts. But, crucially, it doesn’t help those it’s primarily designed to help, ordinary investors.
Professor Kay doubts, as I do, that the answer lies in ever more regulation. Instead — and this is no easy task — we somehow need to change the industry’s culture and, in particular, its incentive structures. We need to look for ways of ensuring that its profitability is more closely related to its capacity to meet the needs of consumers.
In the meantime, individual investors have to be much more savvy. After all, it’s your money. You provide all the capital. You take all the risk. Why hand over a hefty chunk of your investment returns to intermediaries?
Remember the rules of the bezzle. The victim feels no loss; in fact, he thinks he’s prospering. Only afterwards, when it’s too late, does he realise that his pocket has been picked.