When I was training to be a doctor, the advent of evidence-based medicine (EBM) was a major step forward.
Doctors were losing the confidence of their patients, and EBM – “the conscientious, explicit and judicious use of current best evidence in making decisions about the care of individual patients” – became a major factor in reversing this loss of trust.
Could evidence-based investing be the medicine the financial system needs now?
Even the sector’s most bullish advocates would acknowledge a near-catastrophic loss of trust. And when trust goes, the political support the market depends on can also disappear in appar- ently unpredictable ways – annuities and the UK insurance industry being the latest example.
Yet, for some, the treatment I am proposing would seem bizarre. Doesn’t finance contain some of the most sceptical and best-trained minds? With its status in society and the salaries on offer, hasn’t the sector attracted the best-qualified college graduates? Don’t indi- vidual firms have huge research budgets and don’t they also collaborate to sponsor some of the best-financed research groups? Aren’t many of the Nobel prize economists from finance?
A big part of the challenge is that the well- known scepticism of the sector goes hand in hand with major ‘groupthink’ weaknesses – or herding. These behavioural biases help explain why the sector has such difficulty in acknowl- edging and managing its irrational behaviour.
I was reminded of this recently at the launch of First State Investments’ Responsible Investment & Stewardship Report. The keynote speaker, Dominic Barton, head of McKinsey
& Co, had just gone through the evidence that corporate short-termism is economically and socially damaging, and that investor short- termism is probably the most important driver of this.
But when exploring what asset owners and investment managers could do to be a bigger part of the solution, the easy answer – once again – became the dominant one: “We don’t have the evidence to warrant a major change.” To be fair, the audience wasn’t saying it thought the evidence wasn’t there, just that it thought investment decision-makers held this view. But one can assume this audience – people who were interested enough to spend a whole morn- ing out of the office – have good insight into the sector’s immunity to change on sustainability and long-term investing.
The double standards for evaluating evidence became clearer later that same day when I attended another conference on long-termism, sponsored by Long Finance. Paul Woolley, formerly of GMO Woolley, reminded us that
on some really big assumptions – such as the validity of capital asset pricing models and the efficient markets hypothesis – all the data suggests the theories are valid only in specific and highly artificial situations. That is, these theories are widely overstated and form a weak theoretical foundation for the whole sector.
Take also the work of Jack Bogle and other academics and consultants who, over many decades, have shown asset owners are unable to pick the few active fund managers who might deliver real value when all fees are taken into account.
More recent work reveals that pension funds in general are being taken for a ride when they allocate assets to hedge fund and private equity managers.
This refusal to act on hard empirical data that challenges industry norms is not simply a question of behavioural bias – rather, it is one of the well-known ‘dirty secrets’ of this sector. The public may not know exactly how this intel- lectual capture happens but they can certainly smell the outcome.
What is the prescription? Use more common sense, read Tim Harford’s excellent piece in the FT on the risks of ‘big data’, and better manage the huge conflicts of interests in the research supply chain. Trust me, I’m a doctor!