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| > Investing > Fiduciary Focus |
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| Fiduciary Focus: The Catch-22 of Investment Return |
| by
W. Scott Simon
| 08-04-04 |
|
In his war novel Catch-22, author Joseph Heller, who served as a bombardier in the U.S. Twelfth Air Force on Corsica from 1942 to 1945, explains:
"There was only one catch and that was Catch-22.… [Bomber pilot] Orr was crazy and could be grounded [and thus avoid flying bombing missions over Nazi-occupied Europe]. All he had to do was ask; and as soon as he did, he would no longer be crazy and would have to fly more missions.… If he flew them he was crazy and didn't have to; but if he didn't want to he was sane and had to. Yossarian was moved very deeply by the absolute simplicity of this clause of Catch-22 and let out a respectful whistle. 'That's some catch, that Catch-22,' he observed. 'It's the best there is,' Doc Daneeka agreed."
Many participants in the investment advisory profession today may not realize it, but they could find themselves caught in the same kind of Catch-22 circular reasoning. That behavior can, in my opinion, lead to imprudent fiduciary conduct.
Nobel Laureate Harry Markowitz, the father of Modern Portfolio Theory, identifies the fundamental problem faced by all investors: Selections of portfolio investments involve making decisions under uncertainty. This leads to the observation that risk (i.e., uncertainty) is the central factor at work in financial markets. The Prefatory Note to the Uniform Prudent Investor Act observes that the "central consideration" of a fiduciary when investing and managing assets is to determine the tradeoff between portfolio risk and return. Taken together, these mutually reinforcing notions tell us that risk is something that we should actually be serious about as investment advisors.
Yet many advisors simply ignore the existence of investment risk. The primary reason is obvious: In the sales-oriented advisory profession through which most financial products are distributed, the "good news" of an investment product's superior return sells while the "bad news" of that product's risk doesn't. High return is easy to understand; risk is much hazier. As a result, many investment advisors focus solely on investment return and ignore risk. This undue emphasis on return characterizes much of what passes for acceptable money management in America today.
There are a few problems, though, with a system that extols above all else the virtues of marketing investment return: those that obey the rules of that system risk 1) appearing foolish and 2) being imprudent. Here is what I mean by that.
Probability theory describes certain laws of nature that random variables are observed to obey. A random variable has values associated with it, which are both measurable and subject to unpredictable change. In the investment world, for example, the values of an individual stock are measurable (e.g., a $20 stock) and subject to unpredictable change (e.g., the $20 stock becomes a $12 stock, then a $34 stock, and so on). In short, then, the return generated by any given stock over any given period of time is a random variable.
A bit more expansive explanation is that the return (gain or loss) of an individual stock at the end of any period of time is a product of all the changes (positive and negative) in the values (i.e., market prices) of the stock from the beginning to the end of the period. These many changes in the prices of a stock can be depicted as the stock's "pricing path." For example, suppose that the first step taken on the pricing path of a stock begins on Jan. 1, when the stock is priced at $20, and the last step on that path is taken on Dec. 31, when the stock is priced at $34.
On Jan. 1, the content, magnitude, and sequence of information (both accurate and inaccurate) flowing through financial (and non-financial) markets that will have an impact on the pricing path of the stock (and thus determine the stock's return) over the ensuing year are unknown. From the vantage of Dec. 31 looking back in time, though, the pricing path followed by the stock appears inevitable. As a result, many investors will assign to the future the same pricing path experienced in the past.
While this is understandable, it is also wrong. In fact, at the end of Dec. 31, the pricing path actually taken by a stock for the year was merely one path--out of an infinite number of possible pricing paths--that could have been taken starting the preceding Jan. 1. In this light, the historical pricing path of an individual stock cannot be predestined; it must be random.
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| W. Scott Simon is an expert on the Uniform Prudent Investor Act and the Restatement 3rd of Trusts (Prudent Investor Rule). He is the author of two books, one of which, The Prudent Investor Act: A Guide to Understanding is the definitive work on modern prudent fiduciary investing. Simon provides services as a consultant and expert witness on fiduciary issues in litigation and arbitrations. He is a member of the State Bar of California, a Certified Financial Planner, and an Accredited Investment Fiduciary Analyst. Simon's certification as an AIFA qualifies him to conduct independent fiduciary reviews for those concerned about their responsibilities investing the assets of endowments and foundations, ERISA retirement plans, private family trusts, public employee retirement plans as well as high net worth individuals. For more information about Simon, please visitPrudent Investor Advisors, or you can e-mail him at wssimon@prudentllc.com The author is not an employee of Morningstar, Inc. The views expressed in this article are the author's. They do not necessarily reflect the views of Morningstar. |
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