May

5

This web site's contributors and readership consists of astute individuals looking to make informed investment decisions (or perhaps, more appropriately, trading decisions). However, it's worth remembering that many participants in the market maintain positions based on less objective criteria.

While taking a break outside today, I encountered an older gentleman returning to his workplace (a large diagnostic laboratory where he delivers lab samples to and from doctor's offices). He asked me what I did, and I replied "Investing", without going into great detail. He then asked me jokingly if I could get his investments back out of Enron. He then proceeded to explain that he had lost the majority of his 401K as an employee of Enron (he had been a petroleum engineer at a company acquired by Enron for over 20 years, then spent several stints with Enron in Houston). He reminisced that many times he had ridden on the same elevator with Ken Lay and Jeff Skilling, and had been told repeatedly, "Make sure you're buying that stock, T*****!" Now, at 76, he's a delivery driver, happy that his diabetic wife gets free lab work, but unlikely to retire any time soon. One can only hope that his eyesight and reflexes enable him to retain his current position for the foreseeable future.

After he walked away, I thought about my own fortunes. My first job in finance was with a firm that will soon cease to exist, and my immediately previous position was with a firm that recently announced substantial job cuts worldwide. Both firms pushed their risk boundaries past what might be considered reasonable bounds. Neither appears to have engaged in the fraudulent activity associated with Enron (as far as we know), but they may have arguably breached their "duties" to their stockholders in their pursuit of profits with insufficient regard for downside risk. I'm fortunate to work for a small firm that engages in high risk investment (seed and early-stage venture capital). The risk is high, but transparent and straight-forward to those who participate.

How often do we as investors/speculators encourage risk-taking behavior that bundles up participants who are unaware or uninformed about the risks involved? We can argue that anyone who takes an equity stake in any enterprise has the duty to inform themselves about the nature of their investment. If that is really the case, though, does some type of duty exist within the corporation to insulate and diversify their rank and file employees who serve in functional positions with little strategic input? Would doing so cool the market for high growth stocks, and would that chilling effect ultimately prove less expensive that the potential social burden that results from the destruction of shareholder value if and when things blow up?

Many people here have made and lost fortunes (some more than once). The difference would seem to be that the DailySpec readers were probably easily classified as willing participants. Does a duty exist to make a firm's members aware of the risks of stock concentration at least, and risk-taking strategy implications at most? I think many will state that we are all willing participants. However, we should remember that when things go the wrong way, collateral damage occurs. The question I suppose that I'm posing would be how much of that damage is needless. I can only thank reason and fortune that I'm in a good position now, and hope my new friend finds a way to enjoy some part of his golden years, even if they're not turning out as he planned.

Stefan Jovanovich adds:

"Everybody cheats" (See Breaking Away). Allowing companies to adjust the forecast rates of return on their defined benefit plans' portfolios was the way everybody in management cheated under the "old" pension plans. Allowing companies to contribute their own paper to 401(k) plans instead of cash has been the way everybody in management has cheated under the new pension plans. But it would be disingenuous to claim that the knavery is only in the board rooms. The poor, lowly employees in Enron had their own part in their financial ruin. The cheating in Enron was not just done by the senior managers of the company; it was endemic throughout the company. So was the boosterism for the stock and its price. The peer pressure to "buy the stock" came as much from lower and mid-level employees as from Lay and Skilling. Once "ordinary" (sic) employees come to "believe" in their company's stock, they become the most emphatic preachers of the new financial faith. People know when they are being greedy or lying to themselves; the question is what they do about it. Some or none or all of this may apply to the poor soul Jim Rogers met. 

Russ Humbert expands the scope of the analysis:

Why risk management is taken for granted or ignored:

1. Everybody is a genius when things are going great… It couldn't be that you got lucky. A good risk manager reminds everybody they are not as smart as they think they are. A good risk manager tells them to walk away from the table, or at least take some chips off of it. Which is always interpreted as "you are preventing us from making money". It is very hard to argue with success, if it's the gambler that just threw 4 straight 7s to Buffet at his annual meeting.

2. When everything has gone to Hades a good risk manger can't win. First he has to convince them that there are no excuses, take your losses like a man. Certainly there will be someone to blame, from the con-man to the incompetent fool; the loss could have been avoided. Learn from it. In investing, everyone has a choice. In 401k a good variety of choices with proper accounting for $ should be the only obligation from the business. Second, he has to direct them to the opportunity in the panic, rather than look for the scapegoat. When things are bad, risk is always overestimated by someone needing an excuse to cope out of making scary calls and implying nobody is to be trusted. Hurricane and earthquake insurance premiums increase after the fact. Try convincing managment now is the time to be in earthquake business when everybody is wanting to buy it.

3. Many believe risk management should be free. (For an example, look no further than nationalized health care). Nobody wants to pay for the research and personalized understanding that takes time and money. Ask your superiors for resources, on something they consider a sunk cost that constrains them, and they are not interested.

4. Many believe investment risk management is simple common sense, which can easily be regulated. Working for an insurance company, and seeing the high regulations imposed on insurance companies investments, it's clear regulations and common sense don't mix.

5. Many believe risk is not a personal choice and a cookie cutter approach for everyone works fine. Think of the millions that have suffered and died due to FDA's approach. But with personal choice comes personal responsibility. Tell this to the risk addict. Or tell this to the insanely paranoid.

6. The Lake Wobegon effect where every child is above average, clearly applies to investing. In a investing/business you can always find a area where your business does a better job of managing risk than the rest of the industry. Or if not the industry average, you can find someone that does a more shoddy job than you. Hence, you are above average in every aspect. Further it never occurs to you that everybody may be lemurs headed for the cliff. Try being the risk manager to a disfunctional buisness, I think I would rather tell a Mom her son can't move on to the next grade.

7. A close kin to Lake Wobegon is many believe they are "blessed" and therefore can ignore purdence. While risk management applies to the masses, they got G*d on their side. If its simply because they were born to the right parents that their luck can't run out. Or it could be the opposite, they have had such a string of bad luck that the Big Guy owes them. Pity the poor risk manager arguing with this.

8. The Rating Agencies are thought to be better than internal controls. Nobody considers that the ratings are a game and are often exploited. This has many parts:

a. As I wrote in an earlier post, the subprime mess is largely due to socialist industry averaging of risk management.

b. When the game is to get the rating, not to manage the risk, there are a million loopholes. Simply learn what they review, and take your risk elsewhere (hopefully this increases your returns). Hedge funds/Sharpe ratio, go with liquidity. Investment banks balance sheet, move them off balance sheet with SIV's. P&C companies, do reinsurance with side contracts like AIG and GenRe. Life and Annuities insurance companies, use variable annuity guarantees and interest rate guarantees (which are now being monitored after large loses)

c. It seems Enron bought their rating. From the magazine ad claiming "Car of the Year" to Nobel Prize. You should assume raters have some price: dollars, political, or connections and you should not consider them totally objective.
 


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