Investors, Know When To Say No To Innovation

20 February, 2018 / Articles
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Innovation is routinely hailed as the foundation of America’s economic success. From the internal combustion engine to the assembly line to the semiconductor and beyond, new tools and techniques have historically propelled productivity gains and boosted GDP growth. When it comes to the financial markets, though, the record is spottier.

Paul Volcker went so far as to say, “I wish someone would give me one shred of neutral evidence that financial innovation has led to economic growth — one shred of evidence.” Surveying the dizzying array of new financial products introduced in the years leading up to the Global Financial Crisis, the former Federal Chairman stated that the ATM was the only useful one.

In every market cycle, investment banks and asset managers, along with stock and commodity exchanges, launch novel financial instruments and investment strategies. Noteworthy examples of decades past include portfolio insurance, credit default swaps and no-documentation mortgages.

The common thread in these innovations is that they represent lucrative new lines of business for the purveyors. Much like their counterparts in industries such as consumer electronics, toys and beverages, financial services companies see new, high-growth products as the key to elevating their stock prices. Whether the innovations genuinely improve the financial health of their clients is at best a secondary consideration.

Far be it from me to criticize financial companies’ executives for seeking to maximize their shareholders’ wealth. It is certainly preferable to maximizing their own wealth at the expense of shareholders, which has been known to happen. In a free market that fosters innovation, however, investors have to be judicious in taking advantage of financial innovations. When the inevitable market downturn occurs, it frequently turns out that it is the financial innovations that have taken advantage of the investors.

The Current Crop “Comes a Cropper”

The present market cycle has been one more chapter in the history of dubious financial innovations.Cryptocurrencies are merely the most ballyhooed. The proliferation of ETFs that facilitate speculation on every conceivable “factor” likewise echoes past excesses. Wall Street excels in latching onto a valid idea and carrying it too far.

As the stock market’s uninterrupted march to new highs came to an abrupt halt in the last few days, the innovative products reacted in familiar fashion. Bitcoin, already down by 51% from its peak, suffered a 22% decline on Friday, February 2 and Monday, February 5. Even more spectacularly, the short-volatility trade, embodied in the VelocityShares Daily Inverse VIX Short Term ETN, went into freefall with a one-day 93% plunge on February 6.

Don’t Hesitate to Seek Advice

A final financial innovation characteristic worth noting is complexity. This quality actually appeals to hardcore traders, who prefer greater challenges over time, much as young game buffs progress from tic-tac-toe to chess. Complexity also makes it hard, even for investment professionals, to detect hidden risks. Promoters of the products are not eager to point out those snares, preferring to leave potential customers in the erroneous belief that the cord connecting high returns and high risk has finally been severed.

The bottom line is that no one should feel ashamed to say, “This looks too good to be true, but I cannot figure out what the catch is.” A trustworthy financial advisor may recognize the flaw, based on experience in past cycles, or as a result of having researched the innovation. In fact, considering the relentless onslaught of new financial products, steering clients away from ticking time bombs can be a significant component of the value added by a knowledgeable advisor.

Who knows? Careful scrutiny might even lead to the ATM in the haystack—the one truly useful financial innovation out of the thousands that will be launched in years to come.

The science man and innovator, Fernando Fischmann, founder of Crystal Lagoons, recommends this article.

 

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