I’ve recently been reading a lot of Seth Klarman (Trades, Portfolio)’s writings, and I have found that he consistently hits the nail on the head when it comes to diagnosing some of the problems on Wall Street.
In his 1991 book, "Margin of Safety," he wrote a whole chapter that proposes the thesis that Wall Street acts in direct opposition to the interests of small (and even large) investors. As well as being a delightful read in and of itself, I think this book can provide a lot of clarity for individuals managing their own money. Today, I want to examine a specific passage in which Klarman explains why financial innovation is often not in the interests of anyone but the innovators.
Who stands to gain?
What is an innovation? Strictly speaking, an innovation is something new. But there is, I think, an additional unspoken assumption that innovation is an inherent good. After all, why design something new if it is not good or useful? This assumption has only become strengthened over the last few decades as consumers and investors have come to associate the innovative technology industry with progress, high growth and high returns.
Large banks and other financial institutions are always looking to design new financial products to sell to investors. Some examples include mortgage-backed securities pioneered by Lewie Ranieri at Salomon Brothers in the late 1970s and Michael Milken’s junk bonds from the same period. Ostensibly, these innovations are created to fill a need; in both of these cases, investors were desperate for high-yield bonds. Interest rates had just begun to come down, and U.S. Treasuries no longer provided the kind of returns that investors wanted. So, they turned to other ways to achieve high yields, and if you know anything about financial history, you’ll know that this eventually led to a series of market blowups, most recently in the 2008 financial crisis.
Of course, not all new financial products lead to spectacular blowups. Many investors use instruments like credit default swaps as sensible insurance policies to hedge themselves. Mortgage-backed securities and junk bonds have a somewhat sordid reputation, but that does not stop many investors from trading in them, and in fact many people have done very well by finding legitimate discounts among the junk.
Nevertheless, much financial innovation has clearly done more harm than good, which brings me back to Klarman. In "Margin of Safety," he writes:
“Investors must recognise that the early success of an innovation is not a reliable indicator of its ultimate merit...At the time of issuance, a new type of security will appear to add value in the same way that a new consumer product does. There is something - lower risk, higher return, greater liquidity...that makes it appear superior to anything that came before. Although the benefits are apparent from the start, it takes longer for problems to surface... What appears to be new and improved today may prove to be flawed or even fallacious tomorrow.”
The next time that you see an article touting a new financial product, investment strategy, asset class or stock, ask yourself: is this really the best thing since sliced bread? If something seems too good to be true, it usually is.
Disclosure: The author owns no stocks mentioned.
Read more here:
- Why Are Big Financial Institutions Almost Always Bullish?
- Seth Klarman: Why Institutional Investors Lose Money
- Jim Chanos Is Still Bearish on Tesla
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