fundamental laws and fundamental flaws of finance
We should stop being so surprised. They have already revealed themselves to be monumentally stupid, but the weekend’s announcements from many major banks that they are heavily exposed to the Madoff investment fund still leaves me open-jawed with astonishment.
How much money were these guys paid? To invest their clients’ money? In something which was so obviously a fraud? What value exactly have they been adding all these years?
In physics, there are many different fundamental laws. If an experiment, or a theory, appears to break any of these laws, it is subjected to intense scrutiny, and so far all such cases have been shown to be wrong. Two of those fundamental laws are the first and second laws of thermodynamics, often expressed respectively as “you can’t get something for nothing”, and “you get damn all for sixpence”. Now these laws also apply in finance. I believe, though I do not think I have the maths to prove, that the same laws apply identically in finance. But never mind the maths: there is another well-known financial law, which is probably another expression of the second law of thermodynamics, and it goes like this –
“If it looks too good to be true, it probably is”.
Guess what. The Madoff fund looked too good to be true, and lots of people for many years have been saying so. Quite a lot of smart people steered clear of it, and told others to steer clear of it, for almost exactly that reason. (The other reason given was that it was conspicuously lacking in transparency. If it had been transparent, its fraudulent nature would have been revealed much earlier).
What Madoff did, cleverly, was to produce returns which were on the almost-believable side of unbelievable. He didn’t promise his clients 50 or 100% returns on Treasury Bills, just 10-12%. On a lucky day, an average trader might make those returns for real – but no real traders get lucky and stay lucky that long. The financial sector likes to believe that there’s less luck and more skill in investment, because if it’s skill, and not luck, it justifies how much they all get paid. They wanted to believe that Madoff really was that smart, because they wanted to believe that they were all smart.
We’ve come to see over the last few weeks and months that mostly, they weren’t that smart, and the Madoff fund just shows how dumb many of them can have been. Britain’s got a pin-up poster girl of finance, a lovely-sounding lady called Nicola Horlick, aka “superwoman” because she has brought up five children while earning millions as a fund manager. She was on the radio yesterday morning confessing that she’d put some of her clients’ money into the Madoff fund and was exposed to the tune of a few million here or there, and – get this – because she thought the returns were believable.
What’s that quote from Lincoln again? About fooling people? He said it in relation to democracy, but it’s just as applicable to finance.