A Random Walk
There is a concept in investment management called random walk. It’s exactly what it sounds like, one movement is not connected to another and is therefore random in nature. It is the Shit Happens of finance, and it is used to describe the stock market and its gyrations.
As a guy who managed very large money management businesses for many years, I spent some time thinking about random walk theory and whether there was a way to consistently beat the system. People would regularly ask me for investment advice and I would regularly tell them to put their money in a Vanguard Index Fund. If they needed to feel proactive, I would tell them to pick their Index with some flair. Go for the Russell 2,000 rather than the S&P 500. The point is that I simply don’t think anyone can beat the market. There are many reasons for this view and it is certainly a hotly debated issue in investment circles. The entire hedge fund space is dominated by people who have gotten very rich proving me wrong. Actually, what I believe they have proven is that people think they can beat the market by picking a hot hedge fund, and hedge fund managers can and do certainly get rich off this thought, but it is unclear that the investors themselves outperform the market over time.
Does this really matter? I think it does in one way. If you accept that markets are zero sum games, which is to say that for every winner there is a loser, the only value being added by trying to beat the market is to make you richer than the other guy. The pie does not get bigger by this process. In fact, if you define the pie as investor money, I would suggest that the pie gets gradually smaller from this pattern since managers take out a bigger share than returns provide investors. That cannot be good except for managers. I would rather these smart guys spent their time on making the pie bigger, wouldn’t you?
For ten years, I taught at Cornell’s Business School and focused on topics in investment management. A very enlightened Dean (he was actually my first professor at Cornell thirty years before) told me that I should find topics that inspired me and that students wanted to learn about. I spent a semester thinking and decided that there were several such topics, one of which was hedge funds. This was in 2007 and no one would say that hedge funds were new instruments by then, but there were still few courses taught on the subject and the demand was brisk for the topic.
Over the ten years, no matter what other courses I thought up and taught, my Search for Alpha course on hedge funds was always the sell-out. In my last few years of teaching I maxed out at 110 students with 20-30 on the waiting list. 110 was the largest lecture room size we had without going to one of the big lecture theaters. I was particularly struck by how many engineers registered for the course. Someone in the Engineering School told me that incoming freshman were asked what field of engineering most interested them. Over 40% listed “Financial Engineering”, which is basically the trading game underlying hedge funds. I’m not sure who will be left to build our cars or get us to Mars.
Despite everyone searching for alpha (alpha is outperformance in hedge fund land), I increasingly lost faith that alpha can be found on a consistent and verifiable basis. This is certainly a harsh view that not all would share, but it so affected me that I didn’t want to teach people about searching for alpha anymore. That is what caused me to stop teaching more than anything else.
The whole episode made me stop and think about my chosen field. The truth was that I didn’t choose it. It was a random walk thing. I was a senior manager at the bank in 1994 and I had chosen to run a large nasty operating area called the Retirement Services Department. This was the area that did all the recordkeeping for pensions and particularly 401-k plans. It was a complex and difficult area that no one was being paid well enough to do. Strangely enough, one of our employees (No, I did not know him nor do I remember him) was Jeff Bezos. Stop and think about that. The richest man in the world, who has made his name and fortune by efficient processing and cost-cutting was working in a business that we found difficult to do properly because it was so unprofitable. Bezos random walked himself over to a hedge fund from our shop and random drove himself cross-country writing his Amazon business plan as he drove to Seattle.
Anyway, in 1994 the bank suddenly had the head of its Private Bank leave. He was a guy who had been President of Fidelity and had thought he was coming over to be the next CEO. When that became less likely he chose to leave right after getting the board to agree to a $60MM investment program into the Private Bank. The bank to its loyal soldier (that would be me) to shift and take over the business. It was a business, it was not my passion. It was a job, a task, not my passion. I got random walked into random walk land. If you assessed my entire career I suspect I could make a case that every assignment was a random walk in one way or another.
The Private Banking business had been one of the backwaters of banking for years, but demographic trends were suddenly favoring it. With the aging of the population and the wealth concentration trends of the world, more an more people wanted their wealth managed and Private Banks were suddenly moving from the backwater to the mainstream. We used to say that it was a “walk the dog” service business, but that was also changing. We had a hot ticket unit (run by my pal Marcus) that constructed new and leading edge interesting investment products to satisfy the naturally asymmetrical desires of high net worth individuals. Let me explain that in simple language. People want the upside without the downside. That means that they want investment products that use options to create asymmetrical outcomes where they can win or break even without losing. It sounds like alchemy, but it’s really not that hard if you understand options modeling and our team did.
After six years of running and building the Private Bank, we sold our bank to a big foreign bank for a bunch of money. I had been the victor and so I knew how the vanquished were required to act. I bowed my head and handed over my sword to the conquering horde. Strangely enough, Marcus, the head of my hot ticket unit went on to fame and fortune building out the hedge fund business for that foreign bank and got bought out for a boatload of money. And the guy who took my sword from me? The guy with the regal “Von” in the middle of his name? He still runs the consolidated Private Bank globally and he has some serious heat with which to contend. It turns out he lends to Donald J. Trump and his unit is accused of extensive Russian money laundering involvement. Hmm.
Sounds like the good guys (Bezos, Marcus and me) all random walked our way to a better place.