Safety Dance

We can dance if we want to
We can leave your friends behind
Cause your friends don't dance
And if they don't dance
Well, they're no friends of mine
--Men Without Hats

Jeremy Grantham discusses 'career risk' for money managers. The prime objective of money managers is to keep their jobs. To achieve this, investment professionals must never be wrong on their own.

Consider a 2 by 2 decision matrix. The horizontal axis is an investment pro's portfolio positioning for clients relative to 'consensus' positioning with the choices being similar and different. The vertical axis is actual market outcomes relative to forecast outcome with alternatives being in-line and divergent.

Investment pros will prefer to position clients similar to the consensus. If markets perform in-line with the forecast, then positioning clients similar to the consensus secures money manager jobs. If market performance diverges from forecast, then positioning clients similar to the consensus, is unlikely to result in many client defections--because all investment pros were wrong.

On the other hand, positioning clients differently from consensus is a high risk proposition. If markets perform in-line with the forecast, then positioning clients differently results in underperformance versus the general industry. Clients are likely to defect. It is only when market performance diverges from forecast that positioning clients differently from consensus may provide positive payoffs.

It should be apparent that the 'dominant strategy' for investment pros is to run with the pack--to position clients similar to others. Such positioning reduces career risk.

Grantham posits that this is why market volatility is many times the volatility of underlying fundamentals that should drive stock price. He also suggests that three ways that investment pros can reduce their herding impulses are waiting for blood in streets before buying, staying reasonably diversified, and not using leverage.

These prescriptions do not seem very compelling. Waiting for blood in the streets is inconsistent with the notion of herd behavior. By definition, buying when others are selling is contrarian behavior that investment pros are unlikely to do. Diversification is in fact the de facto practice of investment pros and seems therefore destined to generate mediocre returns. Nothing new there. And, while no leverage is a good idea, many if not most money managers do not employ much leverage.

The bottom line is that money managers operate in an institutional iron cage that is hard to escape.