Financial markets keep getting complex with every passing day and as they do, they make lesser and lesser sense. Seemingly unrelated events, in hindsight, turn out to be highly correlated in the unlikeliest ways. One is left scratching one’s head, wondering what possibly could have given a clue to the relationship before-the-fact. Experts come up with all kinds of sophisticated after-the-fact analyses and theories, often involving mathematical rigor. Amidst the chaos, the human element is completely ignored and disregarded. Human behavior and psychology is assumed to be homogeneous across nations and borders for it seems inconceivable to imagine that which defies conventional logic and belief.
Every finance textbook starts with an assumption that the investor is rational and always makes predictable rational choices. In a basic course on portfolio management, the first thing taught is the Capital Asset Pricing Model (CAPM) which completely hinges on the belief that all investors have homogeneous expectations and will always choose one particular portfolio over all others. This chosen portfolio becomes the market portfolio which is then used to derive equations and perform the remaining mathematical calculations of parameters that further feed as inputs into still more equations. Yet, what if the most fundamental assumption weren’t true? The whole model would crumble and the results become meaningless. It turns out that hardly anybody in the industry uses this model in a professional setting, instead relying on much more nuanced and complicated ones-none of which can be claimed as infalliable. These are mostly proprietary in nature owing to the sheer effort involved in guessing and quantifying investor and market psychology before a winning one can be constructed even if for a short term- for the notoriously fickle investor mindset influenced by events can never be relied upon. The point here being that guessing the investor mindset is the basic ingredient of the recipe and that requires a sound understanding of cultural context.
Residents of some countries are more conservative with regards to their investment philosophy than others. For some people, religious beliefs and strictures prevent investment in companies belonging to certain sectors so for this group of investors, these companies are as good as non-existent from a market portfolio perspective. Cultural taboos such as gambling cause aversion to use of derivatives with the result that markets for these instruments are not well-developed in such countries, India included. In India, even many High-Net Worth (HNI) individuals prefer to park their money in more traditional forms of investment such as real estate than succumb to the temptation of exotic but incomprehensible products peddled to them by suave bankers. Hedge funds in Asia have had a hard time getting business even in places like Hong-Kong and are essentially non-starters. None exist in India.
Indians have had a strong cultural affinity for gold for centuries. Gold resonates strongly with our cultural ethos and forms an integral part of our ceremonies. Along with real estate, it is one of the most commonly exercised investment options. Periodic bouts of high inflation since independence and absence of banking facilities in rural areas have only served to enhance its perception as a safe investment option. Yet, until recently, there was a strong stigma attached to pawning gold jewellery to meet immediate liquidity requirement owing to the strong emotional connect with family jewellery. The perception that pawnbrokers seek to profit from the distress of their customers didn’t help matters. Yet, in the last few years companies like Muthoot Finance and Manappuram Gold have built big businesses out of nothing but loans against gold. These companies made a thorough study of cultural mindsets and prejudices and sought to remove the stigma by advertising aggressively and bringing in ethics and professionalism to an unorganized sector. As a result, mindsets are undergoing a shift and traders are increasingly seeking to use gold to meet working capital requirements due to the flexibility and hassle-free experience these companies offer. Manappuram has sought to persuade customers through the argument that gold kept idle in safes and vaults is dead investment and a drag on the economy whereas if used to issue loans it generates economic activity and contributes to economic growth. This is an example of how a sound understanding of culture allowed entrepreneurs to build multimillion dollar businesses out of nothing.
Reams and reams of pages have thus far been filled over the financial crisis raging in Europe. Mainstream newspapers and magazines have been competing to offer analyses and forecasts by various pundits in the field. Theories and arguments continue to be proffered for causes, effects and solutions. Despite having kept a close eye on a number of mainstream publications, I have been hard put to come across pieces focusing on cultural traits as a cause of the whole affair. Conceded, oblique references continue to be made to the profligate tendencies of the Greeks and their bloated public sector but that’s about it. There has been no effort to delve deep and connect the dots across countries under siege. It was left to the story-telling acumen of financial journalist Michael Lewis to point out the real culprit in cultural factors of every country that finds itself in trouble today. All of his knowledge comes from first-hand experience gained through his journey to these places and interaction with politicians, financiers, tax officials and the common men and women. In his recently released book “Boomerang” he describes his journey in detail with trademark wit and humour. This book takes us to five countries- Iceland, Greece, Ireland, Germany and the State of California in the US. The one sentence of his that succinctly sums up the book is “All these different societies were touched by the same event but each responded to it in its own peculiar way.”
Lewis begins by describing how Icelanders wanted to give up their traditional craft and profession of fishing and become investment bankers overnight. Highly educated young men who had studied in elite American universities, found it beneath them to engage in fishing. In keeping with their aspirations they introduced their fellow-countrymen to the world of high-finance. Enticed by the possibility of mind-boggling returns though currency trading, all fishermen sought to become traders. The typical Icelandic male suffers from an alpha-male tendency, owing to the tales of heroism and conflict he has been brought up on. This attitude was reflected in the behavior of its banks which spent huge sums on buying up assets abroad, without an iota of due diligence or research. Needless to say, it was only a matter of time before the banks would collapse, taking the economy down in their wake.
Lewis’ next destination is Greece. He talks about an institutionalized culture of fiscal recklessness and a system that facilitated tax evasion and irresponsibility. He describes how the Greek government understated its fiscal deficit figures by a factor of five to be in compliance with EU norms simply by cooking up whatever numbers it found convenient to report. He tells us that an independent statistical service or an equivalent of the US Congressional Budget Office simply doesn’t exist. The party in power simply reports whatever numbers it wants to. Non-payment of taxes has become a cultural trait, with the only people paying taxes being those who can’t get out of it i.e. salaried employees of corporations whose wages are paid net of tax. Nobody is ever punished for tax evasion which is seen as just another cavalier offence, akin to a gentleman not opening the door for a lady. The “don’t-give-a-damn” attitude of the Greeks and the cause of their woes are wonderfully summarized in this quote from the ancient orator Isocrates: “Democracy destroys itself because it abuses its right to freedom and inequality. Because it teaches its citizens to consider audacity as a right, lawlessness as a freedom, abrasive speech as equality, and anarchy as progress.” The lenders to this country seem to have been totally unaware of the Greek mindset while generously doling out funds year after year. Puzzlingly, nothing seems to have changed even now, with a multi-billion dollar bailout on the cards. It would simply be a case of throwing good money after bad and won’t do anything to resolve the fundamental issue- the Greek mindset.
Lewis then goes on to describe the plight of Ireland where the real estate frenzy did it in. Flush with money due to factors not yet fully understood, Irish banks embarked on a lending spree especially to the real estate sector. So much so, that real estate loans formed 28% of all credit on banks’ books. It was madness all around with almost a fifth of the population employed in the construction business and scores of houses being constructed all around despite lack of evidence of demand. Everybody Lewis asked gave vague answers, not being sure himself or herself. But why did this real estate boom come about all of a sudden? Lewis says that Irish people told him that because of their sad history of dispossession, owning a home is not just a way to avoid paying rent but a mark of freedom. What is also surprising is that when the banks finally went down, there was no uproar on the part of the populace, only the merest of whimpers. In any other country, citizens would have flayed their politicians alive, given half a chance. Here, not only the people didn’t protest, they agreed with their politicians whole-heartedly when told that they couldn’t afford to not pay back their creditors anything less than hundred cents on the dollar (the creditors themselves had already braced themselves for a loss and written down their investment).
In the eurozone, Germany has been the one country that remains fiscally strong. Yet, it is staring at massive losses if their borrowers default. Banking in this country has largely been a boring affair, just like the old days when banks the world over were all the same. Owing to the German culture of taking at face value everything on paper that has supposedly been verified, its banks have gotten themselves into a mess. They didn’t have the required sophistication to gauge the quality of instruments they were investing in and lending against and were used by financial institutions around the world to dump their trash. Germans took rules at face value and were blind to the possibility that the Americans were playing the game by something other than the official rules. The only reason they agreed to the Maastricht treaty that created the euro was the fact that it had “rules”. The same instincts allowed them to trust American bond salesmen, the promises of the French regarding a “no-bailouts for sick member countries in EU” and the sworn statements of Greeks that their budget was balanced.
Despite such overwhelming evidence for a case against bringing together nations so culturally diverse, talk has been going around of a more tightly “fiscally-integrated” Europe, as a last-ditch measure to save the Euro. That’s a euphemism for sanctioning profligate practices of the irresponsible countries, subsidizing them, giving free lunches and leaving the responsible ones to pick the tab.
These instances make one wonder whether it’s time to write the epitaph of financial theory as we know it. Clearly, a one size fits all kind of a thing doesn’t work and only ends up causing needless agony and pain. Perhaps it’s time that we started factoring in culture as one of the myriad variables when coming up with sophisticated models and business strategies and estimating risk and return relationships. A simple theory grounded in basics would do much more good than one using meaningless stochastic calculus.
