Less Algebra More Fudge Brownie - What Will Managed Investing 2.0 Look Like?

Did you see the article in the Wall Street Journal lately about how investors are pulling cash from hedge funds?  Seems like their returns are lagging the stock market. Of course that’s hardly new. The era of managed investing seems to be coming to a close as index funds take over. Far better to do as badly as everyone else than to once in a while beat everyone.

So managed investing is starting to look like a dying breed. But I have no doubt that in due course, it will come back into favor again. But next time it’s gonna have to look very different and perform much, much better. What will managed investing 2.0 look like?

It’s clear that in order to predict the market better you are going to have to have your programs think more like humans, not machines. That’s a problem right now. Economics and decision sciences are still focused primarily on becoming more logical, not less. And the universities by and large are still not teaching behavioral economics and finance. We’ll have to wait for a new generation pf professors to get that move under way, so that probably means at least one more generation teaching economics and finance that generally doesn’t work, at least not where it’s most needed.

Clearly MI 2.0 is going to have to start cracking some of the codes that underlie human mixed rationality. Inter alia that implies some or most of the following:

• Simulation of irrational decisions and decision-making; as we all know, smart people can make dumb decisions. We’ve got to build that into investment programs.
• Simulation of herd decision-making – that’s another that needs to be built in to economics and financial programs.
• Simulation of powerful but unreasonable people – there are many powerful market players who are unreasonable and don’t act like they should. That’s another factor to be included.
• Corruption and criminal activities – the Panama Papers remind us that some of the largest money flows are illicit. The Hong Kong office on Mossack Fonseca handled one third of all the firms business. Somehow you’ve got to include those factors too.
• Narcissism – many decisions get taken out of narcissism and image – if you don’t include that you’re losing a lot of the action.
• Actors with too much information – there’s increasing evidence that the more information you have, often the poorer the decision. Part of the reason has to do with unconscious filtering of data you don’t like or disagree with but there are other factors too. Today’s investors and analysts have so much information that it may well have led to massive dysfunction. We should also be learning how to deal with lean and more human datasets – ones we can actually understand without having to have it interpreted for us by computers and software that act as pure black boxes that are impenetrable to everyone.
• There are a lot of recent reports in the scientific press about how most research results can’t be replicated. There are many reasons for that. But it leads to the question of how much we are all relying on results we all believe in but that really can’t be replicated, or at least, never have been.

The implication is that actively managing investments requires more human insight and less math. Have you caught up with the controversy about teaching algebra at school? Theres a powerful current of opinion emerging that algebra is increasingly unrelated to the real world, at least for most high school students. Is that something sophisticated investors also need to include in their thinking?

Much about managed investing has focused on numbers, math, rational decisions, getting tons of data. Most analysts are long on finance, short on human insight. That’s the fudge brownie part.

Fudge brownie is the opposite of algebra. Fuzzy, inexact, not good for your health, tempting, irresistible. Exactly what we humans always fall for.

You know the old saw, “No one ever went broke underestimating the intelligence of the American public?” We could paraphrase to say that no analyst would ever go broke by underestimating the good judgment of CEOs and management teams. Of course that’s not to say that many don’t have good judgment. It’s just to state that analysts need to inject a healthy amount of cynicism about human motives and judgment into their calculations. Less algebra in other words, more fudge brownie.

As the Bard put it so exquisitely “Alas, our frailty be the cause, not we, for such as we be made of, such we be”.

By “frailty” I have it on excellent literary authority that Shakespeare was referring to fudge brownie.