Wednesday, July 22, 2009

Investors Suck

My previous post, "Dispersed Costs, Concentrated Benefits", was quite a failure. But like many aspects of my life I will push on to greater failure.

I think there is a problem with corporations and the first aspect of that problem I would like to address has to do with investors in those corporations. Value investors say that you should buy a stock as if you were buying a company such as a hardware shop. That's all well and good but there is a huge difference. Let's say I buy a stock, can I walk in and talk to the managers and ask to see the books? If we go to Adam's Hardware Shop then the answer is a resounding yes. I walk in the door and everyone knows my name and I can do pretty much whatever I want. How about with the company whose stock you own? Absolutely not! Think about how backward this is. In both cases you supposedly "own" the company but in one case you have very very little say about the company. In fact you can't even get information until the managers of the company WHO WORK FOR YOU allow you to have that information. Imagine walking into your hardware store and asking the manager for the books and being told, "You'll have to wait 3 months when we come out with our quarterly report." Asides from the heart attack you would have, the manager would be out of a job that day.

The second problem with investors is that they are by their nature passive because of the most holy god of investing, diversification. What is diversification? Some say a means of spreading risk, I say it means spreading apathy. The logic of diversification is that by holding lots of stocks, one time events both good and bad can cancel each other out thereby reducing your overall risk. While mathematically this makes a ton of sense it ignores the effects on investors. First of all, a person can certainly not manage many companies as well as they could manage one. Your ability to keep track of what is going on must necessarily diminish with the more companies you own. This means that you are relying more and more on someone who has different incentives than you (the managers) and hence your monitoring costs must rise correspondingly. Second, if you are a particularly smart chap you lose your influence when you spread yourself around. When you diversify you become a smaller player and any talent you have is wasted. Finally, it provides a false sense of security to the average investor. Being scared is great motivation to make sure things go right with the company you own. Having a mindset that the good will cancel out the bad means you are not vigilant in rooting out the bad.

The last problem I will mention that contributes to the apathy of the investor, limited liability. I don't know the full history of this so I can only speculate. As an investor you can only lose what you put in. This sounds like a good idea because it facilitates the formation of capital, i.e. making it easier to raise money. There is a trade off in that once again the "owner" is not as vigilant in making sure that the managers run the company right. If the owners were on the hook for the company, this would reduce capital formation but definitely incentivize owners to be more cautious with the operation of their companies.

We have witnessed financial companies blowing up by lending money in remarkably stupid ways. The owners of these companies, the stockholders, have lost fortunes. It is easy to blame the executives but in reality the incentive structure for them is not aligned with the owners and their behavior is perfectly rational from their point of view. We need to rethink the benefits of publicly traded corporations and consider some reforms.


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