Casualties of Complexity

At the risk of sounding naïve, I believe that many of the problems we experience as investors and the institutions that regulate us are brought on by complexity.

The book, A Demon of our Own Design, got me started thinking this way. Written by Richard Bookstaber in 2007, it gives an insider’s view of the 1987 Crash and the collapse of Long-Term Capital Management, the hedge fund that took down UBS when it collapsed in 1998. Each disaster, and several others described in the book, was caused by an attempt to use complex financial strategies to circumvent the normal movement of financial markets – and each failed miserably.

None of the designers behind these strategies were intellectual light-weights. The author himself received his PhD from MIT in economics; but in all cases the complexity of the product design (portfolio insurance, currency options, etc.) failed to take into consideration some factor that only seemed obvious in hindsight. There was too much complexity in the plan to take all possibilities into consideration in advance.

Ironically, the last chapter of the book recommended that “rather than adding complexity and then trying to manage its consequences with regulation, we should rein in the sources of complexity at the outset.” This was written before collateralized debt obligations and other complex financial instruments created what some are now calling the Great Recession of 2008.

Not only did we experience a global drop in the equity markets in 2008, but to add insult to injury people had their money stolen from them by people like Bernie Madoff. Now the Obama administration is proposing regulation to prevent what we’ve been through from happening again. While I believe that regulation usually does more harm than good, I understand that something needs to be done.

If complex regulations are proposed to control investment companies then more inventive ways to circumvent the regulations will result. I propose simplicity instead. Make all brokers, financial planners, financial consultants, investment advisors, money managers, etc. follow the same 3 rules:

1. Use an INDEPENDENT company to hold your client’s assets.
2. Hold yourself to a fiduciary standard when you work with your client.
3. No matter what you are doing, or who you work for, follow rules 1 and 2.

There is hope, since the Obama proposal mentions establishing a fiduciary duty requirement for all advisors, but we’ll see if it makes it through a Congress that is heavily lobbied by groups that don’t want to be held to the standard.

People who lost money before these rules were in place might have been saved by them, but they could have saved themselves as well. All of the Bernie Madoff victims interviewed said they did not know how he was investing their money and could not explain how he could give them a steady 10% per month return when markets were falling. Complexity can be very seductive to investors because it appeals to the belief that really, really smart people have secret ways of outperforming the market.

If we don’t understand something because it is too complex, then we risk becoming a casualty of the complexity. My rule – keep it simple enough to know what you have and what you are doing. It works in life as well as investing, but that’s for another day and another blog…

By Jeannette Jones, CFP®