Just How Smart Is Wall Street?

 Posted: August 12, 2011 1:48PM by Stephen D. Simpson, CFA

Individual investors see a steady stream of paeans to Wall Street, praising not only the substantial resources of professional investors, but also suggesting (sometimes subtly, sometimes not) that these professionals are smarter and more capable than the average investor. While there are certainly plenty of columns out there decrying the mistakes of professional investors and pointing out that disciplined individuals can do just as well, the fact remains that the financial media overwhelmingly tilts towards the idea that Wall Street is smarter than you or me.

TUTORIAL: World's Greatest Investors

But is it really? The word "smart" has plenty of definitions, but Wall Street has such a peculiar inability to learn from certain mistakes that it seems worthwhile to question just how smart the Street really is.

They Can't Stay Away From the BubblesNothing of any real size can happen in the investment world without the involvement of institutional investors. So while retail investors are often dismissed as the "dumb" money, it is the professionals who ultimately add the most air to investment bubbles.

It was professionals, not individual investors, who awarded absurd IPO valuations to stocks like TheGlobe.Com, Geocities or eToys.com. Professional investors were also apparently happy to pay upwards of 30 times sales for Cisco (Nasdaq:CSCO), Qualcomm (Nasdaq:QCOM) and JDS Uniphase (Nasdaq:JDSU) back in the bubble days.

Only a few years later, institutions happily dove into the housing bubble. Institutions apparently were not bothered by data that clearly showed affordability was declining at a precipitous rate and that lending standards were abysmally low. In fact, institutions got so casual about the bubble that they happily relied upon models that told them housing prices could never fall - even though there were plenty of examples from outside the U.S. that showed what could happen.

These are only two examples of how the institutional community is all too happy to believe "it's different this time" and "prices couldn't possibly fall from here." The fact is, that the Street is happy to play a game of musical chairs because the players almost always believe they'll find a seat before the music stops … even if years of history suggests otherwise. (Home price appreciation is not assured. For more, see Why Housing Market Bubbles Pop.)

A Few Gaps in Their Due DiligenceAlthough plenty of institutional investors now claim to have spotted the shenanigans at Enron and Worldcom and shorted the stocks, those stocks would have deflated much sooner if all of these people were telling the truth. The fact is, plenty of institutions lost huge amounts of money in names like Enron, Worldcom, CUC/Cendant, Waste Management and so on, when their accounting scandals finally became unsupportable. In fact, when Enron blew up, well-regarded names like Alliance Capital Management, Janus, Putnam, Barclays and Fidelity owned about 20% of the stock in total, and most major firms held some number of shares.

Even in the wake of scandal after scandal, institutions have apparently not filled all the gaps in their due diligence. During the housing bubble and crash, institutions were largely blind to the balance sheet time bombs of financial companies like Washington Mutual and AIG (NYSE:AIG), to say nothing of their off-balance sheet liabilities. Even in the last few months, John Paulson reportedly lost millions of dollars on his position in Sino-Forest when evidence finally arose that the company may have grossly overstated its asset base. Likewise, plenty of other smart money investors have gotten caught up in other Chinese debacles. (For more, see Hedge Fund Due Diligence.)

Overconfidence, Especially in Their Own ModelsHowever smart Wall Street professionals are, it doesn't shield them from overconfidence in their abilities and their models. Time and time again some sharp-eyed professionals will spot a profitable anomaly in the markets - junk bonds or Latin American sovereign bonds that price in too much risk of default, undervalued mortgage bonds, unexploited absolute return strategies and so on. In the early days, there are in fact plenty of great opportunities, but eventually word gets out, other investors try to replicate the strategy and investment bankers rush to fill the supply of look-alike products.

The list of well-known implosions goes on and on - from the heyday of junk bond-fueled LBOs to the numerous emerging market sovereign debt debacles to the "see no evil" models of the U.S. housing market. In almost every case, though, the fundamentals change, the experts fail to notice, more leverage gets poured into the process and it all blows up in everyone's collective face.

The case of Long Term Capital Management (LTCM), though a 13-year-old story now, is still a great example. Mixing very experienced and successful Wall Street professionals with a small army of PhDs, LTCM used very high amounts of leverage to exploit small inefficiencies in the market. Unfortunately, early success brought more capital into the firm than it could manage, more leverage was employed to squeeze bigger returns out of smaller anomalies, and then suddenly some of the key relationships underpinning its models fell apart. The end result was a spectacular failure - one so large that the federal government stepped in to help the unwinding process from destabilizing the financial markets.

TUTORIAL: Credit Crisis: Historical Crises

The Bottom LineThese are just a few brief examples of the "factory seconds" that Wall Street churns out with surprising regularity. What of the fact that Wall Street routinely puts its faith in the projections and promises of management teams with no record of competence or success? Or what of the fact that Wall Street professionals routinely trust their investors capital with people and instruments that have previously failed?

The fact is, Wall Street is made up of people and people (even well-trained and well-compensated examples) make mistakes. Whether its greed, overconfidence or a sincere belief that it is somehow different this time, Wall Street cannot resist taking a chance on money-making opportunities. The point here is not to bury Wall Street or excoriate its professionals for their mistakes. Rather, the point is that everybody makes mistakes and investors should never be intimated out of their own good judgment and common sense just because the "smart money" thinks differently. (For more on smart money, see On-Balance Volume: The Way To Smart Money.) 

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