Comey’s “Higher Loyalty” And Its Message For Wall StreetAdvisor Perspectives
In his controversial book, A Higher Loyalty: Truth, Lies, and Leadership, the former FBI director James Comey – in a much-quoted opening “Author’s Note” – says, “We are experiencing a dangerous time…” a time in which “basic facts are disputed, fundamental truth is questioned, lying is normalized, and unethical behaviour is ignored, excused, or rewarded… It is a troubling trend that has touched institutions across America and around the world – boardrooms of major companies, newsrooms, university campuses, the entertainment industry, and professional and Olympic sports.” This diagnosis would elicit broad agreement across the political spectrum. What has precipitated this disastrous ethical decline?
Wall Street (by that term, meaning the financial industry not only in Wall Street but in the City of London and other financial centers) routinely lives numerous lies. Increasingly over recent decades, it has become well known in the finance field that the search for verifiably effective investment management in pursuit of the goal of outperforming the market average is highly likely to be futile. Nevertheless, pension and endowment fund consultants and money managers cynically pretend that it is a very important pursuit requiring expensive expert services, such as their own. Accordingly, they construct arbitrary and ineffectual but technical-sounding methods for doing it, without fully informing their clients, the public, or investors who are in their care of the likely futility and expense of the whole exercise.
Before lying became normalized in politics, it became normalized in finance. It is well known that in an infamous transaction known as the ABACUS deal, Goldman Sachs contrived to sell a collateralized debt obligation (CDO) to one set of clients in order to enable another major client, John Paulson, to select securities to include in the CDO, the better to short it. This most surely required that Goldman salespeople, representing the CDO to the buyers, not tell them the truth. When questioned in 2010 by Senate subcommittee chairman Carl Levin whether this was unethical and a conflict of interest, Goldman CEO Lloyd Blankfein said, “In the context of market making that is not a conflict.”
Can such a response be justified? Up to a point it can. The economic philosopher Israel Kirzner wrote several books arguing cogently that entrepreneurs need to keep certain information away from their clients, in order to be able to reap a profit from their entrepreneurship. Is there a point at which keeping information away from clients crosses the border into lying? There surely is. And there is another reason why Kirzner’s argument does not apply well to the financial industry, which I will take up later.
This lying is winked at, and even admired by the finance profession. In an article covering a talk by Seth Klarman, founder of the Boston-based Baupost Group, at a CFA Institute annual conference shortly after the Goldman revelations, Advisor Perspectives CEO Robert Huebscher wrote that “Klarman was more forgiving than most of Goldman Sachs.” As justification for that forgiveness, Klarman said, “I know Wall Street will always try to rip our eyeballs out.” This is representative of the normalization of – and even begrudging admiration of – Wall Street’s lying.
Motivated misunderstanding and misinterpretation of mathematics
Much of the mathematics used in finance is a lie. It is used for sales or marketing purposes, not to actually obtain results or even to be correct.
Of course, very few people who use a marketing pitch perceive themselves as lying. If the marketing pitch employs or is based on mathematics that they don’t fully understand – even if they have written it themselves – then they will still not perceive themselves as lying. They will convince themselves that it is the absolute truth. Let us instead call it motivated misunderstanding and misinterpretation of mathematics.
This motivated misunderstanding and misinterpretation of mathematics is not only endemic in Wall Street, especially in the investment advice and management field, it is its stock in trade. For example, the mean-variance optimization model is heavily used in marketing of investment advice, even though it is widely acknowledged that it does not work at all for practical purposes.
Too much motivated misunderstanding of mathematics – sometimes going to absurd extremes – is vetted by academia. Two articles were written using mathematics to “prove” that any non-cap-weighted portfolio has a higher expected return than the cap-weighted market. This is a logically impossible result. A total stock market cap-weighted portfolio can be decomposed arbitrarily into two non-cap-weighted portfolios, only one of which can beat the market portfolio.
In any other field, the authors would notice that they had proved a logical impossibility. They would go back to figure out where their math went wrong. But instead of doing that, they submitted their articles to a finance journal and incredibly, the peer-reviewed journal published them. In the finance field, the level of motivated credulousness is so high that the authors had a good chance of acceptance by the fraternal community of motivated misunderstanders and misinterpreters, including academia. This is what Comey calls “the silent circle of assent” – invoking his prior experience in the United States Attorney’s office in Manhattan prosecuting the tightly-linked and internally loyal Cosa Nostra families.
Read the full article here by Michael Edesess, Advisor Perspectives