“Financial memory should be assumed to last, at a maximum, no more than 20 years. This is normally the time it takes for the recollection of one disaster to be erased.”
These words of Galbraith are quoted at the conclusion of an interesting new working paper by Robin Greenwood and Stefan Nagel. The authors explore the idea that “inexperienced investors, who have not yet directly experienced the consequences of a stock market downturn, are more prone to the optimism that fuels the bubble…younger managers appear to be trend-chasers….the trend chasing behavior of young managers reflects their attempts to learn and extrapolate from the little data they have experienced in their careers. Such extrapolation may be excessive if young managers don’t properly adjust for the small sample of data at hand or use simple models to forecast returns….Taken together, the facts are consistent with the popular view that inexperienced investors are susceptible to buy assets with inflated prices during bubble periods.” It is not surprising to learn that inexperience can be costly. But the interesting aspect of this is the conjecture at the end of the paper that, “a bubble can only arise following the arrival of a new generation of investors who are willing to commit their capital to buy overpriced stocks.” This is a provocative point, though its specifics and implications will fuel some interesting debates.
How long does it take to forget the lessons of a crisis? In investment management, is the tradition of educating the young professionals so bad that they are virtually ignorant of the past? Do crises occur on about the same frequency as generational turnover among investment professionals? Is the problem that “recollection…[is] erased,” or instead, is the recollection just willfully ignored? As an educator, Dean, and financial historian, answers to questions such as these are very important, not least for their implications about how B-schools should prepare the rising generation of managers.
As any teacher knows, rote learning is easily gained and then easily forgotten. But the learnings from a financial crisis are anything but rote. They are traumatically-etched into memory. The employees of Bear Stearns will not likely forget the painful lessons about risk management, liquidity, and capital adequacy. Psychiatrists tell us that the symptoms of post-traumatic stress disorder can persist for decades. The outlook of my parents and the millions of other Americans who lived through the Crash of 1929 and the Great Depression was marked indelibly by the experience. It seems unlikely that the problem is that the “recollection” is erased, but rather, that it isn’t conveyed very well to the rising generation of investors. Some of the histories of previous booms and busts lend credence to this possibility. ((See John Brooks, The Go-Go Years, and Adam Smith, The Money Game,–both describe the investment boom of the 1960s and the rise of a new generation of investment managers and practices.)) Yet, I find it hard to believe that the profession of investment managers, drawing heavily on graduates from MBA programs, imposing a gateway training experience (the CFA Charter exams), and requiring ongoing professional education should dodge so badly the lessons of financial history. MBA and CFA training give relatively little emphasis to business and financial history. Perhaps we need to resume a kind of Homeric tradition where the elders teach the young the sagas of past virtues and villainies.
But how many sagas would it take to do the trick? The reality is that financial crises occur with great frequency and that they differ through time. There were 13 financial panics in the U.S. in the 19th Century (about one every eight years). After the founding of the U.S. Federal Reserve System and despite the intervention of the Bretton Woods system and various multilateral institutions, the 20th Century saw a material number of crises as well. Just in the last 25 years, we have had crises associated with sharp changes in the price of oil and other commodities (1984-1988 and 2006 to present), sharp cross-border movements of “hot money” (1994 (Tequila Crisis), 1997 (Asian Flu), 1998 (Russian Bond Default and collapse of Long Term Capital Management), collapsed expectations about new technology (2000-2002), and real estate (2007 to the present). When you add it all up, periods of instability (the busts and the booms that precede them) seem to overshadow the moments of calm. Economists and financial historians see a number of elements common to all financial crises, but they are not summarized easily in a sound bite. To the extent that each crisis is different, an instructor could fill the better part of a semester with cautionary case studies. No one said that restoring recollection would be easy.
Then too, there is the possibility that whatever one might teach, the lessons will be willfully ignored. For the rank-and-file investors this seems hard to believe—the zeal for protecting one’s capital and making a buck should be sufficient to recall previous disasters. Yet, as behavioral economists reveal, factors such as fatigue, emotion, and cognitive limits can override rational decision-making. And in the case of large institutional investors, problems of information, governance, and managerial oversight can give risk-seeking managers more rein than might be warranted. It seems likely that the lawsuits cropping up from the current financial crisis will test the theory of willful neglect of the past.
John Kenneth Galbraith was not especially sympathetic to finance or business professionals. His solution for the problems of the economy was to insert government into the works. Libertarians would assert that Galbraith’s solution is part of the problem: various safety nets mean that investors do not have to live with the consequences of their decisions. Regulations and the institutions governing financial markets may make it easy for people to forget the past.
Recalling the past is one of the foundations of wise decision-making. Walter Wriston, the former CEO of Citibank, said, “Good judgment comes from experience. And experience comes from bad judgment.” In other words, we grow in wisdom in proportion to our life experiences—the most meaningful experiences arise from mistakes. This has a number of important implications for how firms and B-schools might anticipate the next financial crisis:
- Wisdom management. Among human resources professionals today, the concept du jour is “talent management”—this richly deserves the attention it is getting. But at its core, it is (or should be) all about the recruitment, development, and retention of wisdom among leaders and managers. Retention should be of particular concern to CEOs: the baby-boom generation is approaching retirement. A mass exodus from corporate ranks can erase a great deal of corporate memory.
- The quality of experience is what matters. Seasoning (or experience, to use Walter Wriston’s term) is a proxy for wisdom. In turn, age is a proxy for seasoning. Greenwood and Nagel use the phrases, “young manager” and “inexperienced investor” almost interchangeably. In fairness to them, age is perhaps the only quantifiable proxy for seasoning. Yet I know some people in their late ‘50’s whose hopes about the world continue to triumph over their tough experiences. And I know some twenty-somethings whose wisdom overshadows some fifty-somethings. The issue isn’t the age or seasoning of an individual, but rather, the kind of experiences he or she has had. The story goes that Thomas Watson (the founder of IBM) called into his office a young manager of a project that failed and had to be written off. The young manager thought he was to be fired. Instead, Watson informed him that he was being reassigned to another high-priority job. Watson explained that he had just spent $10 million educating the young manager and wasn’t about to lose its benefits by letting him go.
- Get wisdom fast. “Fast wisdom” may be an oxymoron in capital market terms, much like “jumbo shrimp.” I have argued that churning rapidly through different jobs and employers is probably a mistake (see my earlier blog posting, “the Five-Year Hitch”). You can gain some wisdom by working alongside a master in the field. And I think you can gain some wisdom by studying the past successes and failures of others. An executive claimed that a rigorous case-method MBA program could deliver the equivalent of 10 years of work experience.
The late Sir John Templeton (an iconic professional investor) asserted that the phrase, ‘this time it is different,’ is one of the most dangerous statements in investment management. Lessons from the past are highly relevant to current practice. Firms and schools need to promote the retention of collective memory about past crises as prologue to future challenges.