Although the purpose of our journal is to focus on issues related to integrated wealth management, not to toy with philosophy, the current environment offers an unusual opportunity to remind ourselves of the need for intellectual honesty and rigor. It is but a trite truism that the last 50 years have seen both an unprecedented explosion of knowledge and a trend toward increased superficiality. Whether one looks at the use of increasingly short—and thus decreasingly meaningful—sound bites, at the frequent confusion between analysis and entertainment, or even at the proliferation of various instant messages that shine by their lack of depth, the careful observer is left with the notion that it is getting more, rather than less, difficult to make sense of many events or developments. And this, despite more access to more data and more analytical tools to study and assess those data! That this trend can affect politics and their efficiency is hard to ignore. Yet, more to our point, it makes it immeasurably harder for investors to maintain the proper balance between science and art, between fact and fiction, and thus between serious analysis and mindless blabber.
This quandary was recently brought to the fore for me in a conversation with one of the families we are honored to serve. It had started with a debate where we quickly noticed that we may have been confusing principles and ideology; it concluded with an agreement that it is crucial to have a clear notion of the fundamental distinctions that exist between them. Principles can be viewed as some form of “truth” that has been both theoretically elaborated and empirically tested. Ideology— which in this context is not characterized as good or bad—can be defined as a light that one chooses to shine on a particular outcome. Thus, and applied to the economic sphere, one must distinguish between elementary principles or relationships that have stood the test of time and geographical diversity and ideology that postulates that certain outcomes are or are not acceptable and may thus require policy actions that do not seem to aim to achieve economic optimality. For instance, it is a well-established economic principle that raising unemployment benefits, or minimum wages, will ceteris paribus tend to contribute to higher unemployment. It follows a perfectly understandable debate. One end of the ideological spectrum will predictably argue that unemployment, though deplorable, is a necessary economic “cleansing rite”and that private philanthropy can mitigate its most adverse implications. The other end of the ideological spectrum will equally predictably argue that a strong safety net is indispensible, as the human hardships associated with unemployment or “under-compensation” are simply not socially acceptable.
The point in the foregoing example is that intellectual honesty and rigor require us to understand the differences between a macro-economic principle and ideologically driven preferences. There is no value judgment associated with the recognition that such a difference exists. The point of any argument, in this framework, is to evaluate the tradeoffs associated with an ideologically driven preference versus the theoretical solution that may only be optimal in one context and can be viewed as substantially suboptimal in another. One is having a serious policy discussion; one is not muddying the waters by pretending that the principle does not exist or apply. Fundamentally, intellectual honesty is about being prepared to look at any and every situation with a completely neutral mindset. In fact, it is even more than that; it involves refusing to look at anything without shedding all biases that could cloud one’s judgment. Intellectual rigor involves forcing our intellectual processes to follow the appropriate steps to get to the correct conclusion. It eschews any shortcut that might make life simpler but that might also lead to the wrong conclusion. The combination of the two, intellectual honesty and intellectual rigor, is the functional equivalent of the proverbial “steel trap mind,”which has no preconceived notion and is totally open to whatever conclusion may arise. It might not like what it finds and thus eventually seek change, but it has no doubt as to what a fact is. A contrary example helps complete the description: One of the most classical sources of error is either to ignore certain facts that might contradict one’s view or to confuse facts and opinions.
An interesting twist on this dichotomy is to observe the need for some allowance for cultural issues. Although culture and cultural background can be defined as just another form of bias, they arguably may be most difficult to shed. They belong to our subconscious and their influence is thus potentially much more diffuse. Thus, although a superhuman may be able to take a totally dispassionate view, a more realistic outcome is that culture may inject various forms of a priori that we only discover when confronted with different cultures. There may be a case that cultural bias can only be shed through discussions across cultures, failing which, any bias will likely go unnoticed. While it may be generally true that cultural biases can be relatively innocuous in “normal”circumstances, it is equally true that they may become an overwhelming force at precisely the worst possible times.
The current economic environment provides a useful Petri dish to observe the phenomenon and its potential impact. Last summer, two headlines appearing on virtually the same day and covering the same topic offered a useful starting point. One talked of “equity markets being rattled by the global credit crisis.” The other pointed to “equity markets being rattled by the U.S. credit crisis!” One was published in the U.S. while the other originated in the U.K. At some initial logical level, the distinction is almost trivial: what difference does it make? At another, it can become crucial: What if we were at a major global turning point, with the U.S. leadership about to be transferred to some other nation? How can one deal with a turning point if one is not even aware of its existence? To what extent can a cultural bias prevent someone from recognizing the end of the leadership of his or her own culture? One can view the current economic downturn as the unfortunate consequence of a global credit crisis brought about by an excessive use of leverage and imprudent bank lending; one can also view it, paraphrasing the words of Wen Jiabao, China’s premier, when describing the U.S. economic model in Davos, as “an unsustainable model of development, characterized by prolonged low savings and high consumption.” The former can be expected to be self-correcting. The latter may require some structural change.
An investment policy implication of this observation may be the need to start focusing on two new axes of portfolio diversification. Cultural diversification, which we briefly discussed here in our last issue, would be the first. It would involve making a determined effort to diversify the points of view likely to be espoused by the managers in each family’s stable. Ensuring that they will likely look at the world from distinct and different cultural perspectives would help families protect themselves against a form of group-think that would predictably follow if all managers share a common educational and cultural background. Government risk diversification would be the second and is based on the premise that confiscation is one of the biggest risks incurred by families. This can take many forms, from the outright “nationalization” of their assets with or without compensation, to the more innocuous but no less lethal erosion of purchasing power brought about by rampant inflation. Consciously taking steps to protect one’s wealth against government exactions is a potentially crucial new dimension of the policy process for wealthy families, particularly as they become more global.
In a changing environment, it is crucial to think differently. Recently, as I was working on a question raised by one of the families we serve, it appeared that flexibility is one of the elements that explain why certain people survive catastrophic situations while others do not. History indeed suggests that overseas Chinese and Jews seem to have been uniquely able to survive and prosper, despite having had to stay on the move. The common thread is that the successful ones were always ready to leave, engaged in businesses that did not tie them to a single location, and focused on education in skills and trades as a commodity that would be valuable anywhere. They worked to maximize their flexibility to pick up and leave if there was a problem. Second, and by contrast, consider landed aristocracy, for instance, in France or in England. The bulk of the family’s wealth and status was local and tied up in land and buildings. Their income was linked to local factors. Their trades were primarily agriculturally based and could thus not easily be relocated, unless they had spare financial resources—which they rarely did—to purchase land in a new location. Their educational focus was not on skills and trades, but on liberal arts. When a revolution came—be it political, industrial, or just cultural—they were sitting ducks: They were unable to leave because they had too much invested in where they were and no means to transplant themselves with comparable status in a different environment.
In short, if it is true that the current environment marks the start of an important global structural change— and is not just a more severe variant of a simple economic cycle—it will be necessary for wealthy individuals and families to adopt a different approach. The past is no longer necessarily prologue! This has three important dimensions. The first is the need to ensure that one is dedicated to intellectual honesty and rigor: One may not like what one sees, but one should deal with the world the way it is and not the way we would like it to be. The second is the need to look at different diversification axes to ensure that one has brought the broadest perspective to analyze and evaluate both the situation and any opportunity it contains. The third is the need to maintain a high degree of flexibility. Although this might seem inconsistent with the notion of intellectual honesty and rigor, the reconciliation of the two comes in the recognition that principles are hardly ever allowed to operate in a “pure” form. There is an almost never-ending interaction between principles and multiple forms of ideology, and this is where flexibility is required in order to recognize what trade-off is being made, what its likely implications are, and then to determine how best to react.
Our Fall 2009 issue of the Journal of Wealth Management keeps up with the recently observed trend: Our authors have become considerably more diverse in terms of their geographical origin, and we are deeply grateful for it. How better to illustrate the value of our suggestion that cultural diversification is an important source of insight?
As usual, our first four articles relate to broad issues of investment policy, in the most inclusive sense of the phrase. Catherine Boulatoff and Carol Marie Boyer start us off with a focus on a form of socially responsible investing, “green investing,” concluding that though not necessarily outperforming the Nasdaq average, green firms have greater insider ownership, larger investments in research and development and better corporate governance. Then, Willi Semmler, Lars Grüne, and Caroline Öhrlein discuss dynamic consumption and portfolio decisions by using dynamic programming, which allows the computation, with sufficient accuracy, of the decision variables and the consumption– wealth ratio at any point of the state space. The third article is by Jeff Grover and Angeline Lavin, who look at the issue of passive versus optimized asset allocation; although done in the context of investing for retirement, their analysis lends itself to private wealth management as well. The final article in this group is by Lujer Santacruz and Peter Phillips and considers the optimality of portfolios recommended by Australian financial advisors to the private investors in that country.
The next article, by Stephen Horan and David Adler, constitutes a section on its own as it presents the conclusions of a review of the tax-aware investment practices of investment managers focused on taxable accounts. It serves as a useful reminder that massive progress has been made over the last 10 years or so; it also suggests that more needs to be done.
The next four articles are connected to the world of alternative investments, as broadly defined. The first, by Thomas Heidorn, Dieter Kaiser and Christoph Roder, investigates the risk of hedge funds of funds, analyzing their maximum drawdown. An article by Chokri Mamoghli and Sami Daboussi takes this analysis further, looking at the performance of hedge fund portfolios in a downside risk framework. And K.B. Subhash considers the role of entrepreneurs in minimizing information/incentive asymmetry and maximizing wealth by focusing on the venture capital industry. Our final article in this section is by Nigel Lewis and asks whether there is a role for commodities in lifestyle funds.
We conclude this issue with a book review by Greg Gregoriou, who reports on The Econometric Analysis of Hedge Fund Returns: An Errors-in-Variables Perspective by FrançoisÉric Racicot and Raymond Théoret.
TOPICS: Wealth management, in wealth management
Jean L.P. Brunel
Editor
- © 2009 Pageant Media Ltd