My high school English teacher used to have a saying he’d repeat to students when one of us managed to ask a good question: “The more you know, the more you know you don’t know... ya know?” I still use that line with my own students. The rather simple idea here is that the more you know about a subject, the more you know where the gaps in your knowledge remain; the more you try to understand nuances; the less hubris you display; and so on. Put crudely, dumb people don’t know they’re dumb because the ‘known knowns’ and ‘unknown unknowns’ far outweigh the ‘known unknowns’. This leaves these individuals with the false impression that they are smart... when, in fact, they are not.
Anyway, all this discussion about high school English is an attempt to explain why I found this new State Street Report interesting and worrying. After interviewing over 3000 people in financial services, it was found that the community of institutional investors (i.e., public pension funds, sovereign wealth funds, etc.) overwhelmingly think that their own level of financial sophistication is “very advanced” and, in fact, that it is more advanced than all of the other groups canvassed.
Is that your impression of pension Board members? I’m not so sure. I think there may be a few “unknown unknowns” for this bunch.
I’m not suggesting these people are dumb; I just think a bit more humility is warranted. I say this because the same report that shows the institutional investors identifying themselves as having “very advanced” skills in finance... also demonstrates that these same investors are not acting in their own best interest. In fact, they often do things that run counter to their interests. In addition, the report shows that most institutional investors don’t have the sophistication to manage alternative investments or identify the risks associated with these strategies (despite the fact that they are all pouring into these assets right now).
Does that seem like a ‘very advanced’ thing to do? No. No it doesn’t.
As an example of doing things not in their own interest, the report cites the over-reliance among institutional investors on benchmarking managers:
“The current benchmark model does not speak to the needs of the investor. Relative performance based on peer groups or indices may serve the provider, but the investor’s view of value is more complex and reflects their own personal blend of alpha seeking, beta generation, downside protection, liability management, and income management.”
I wholeheartedly agree with the perspective that benchmarks often do more harm than good for long-term investors. There is great comfort in being out in front of your peers at an intermediate checkpoint, but this does NOT necessarily mean you’ll still be winning the race when you cross the finish line (see John Paulson).
Anyway, back to my English teacher. The same guy who offered so much wisdom about knowledge was also known for... throwing teenagers out the window of his (ground floor) classroom. (It was another era.)
The more I learn about the business of institutional investing and finance, the more willing I am to throw certain aspects out the window and start fresh. And benchmarks would likely be one of the first to be defenestrated. The State Street report sure makes a strong case for such an approach...
