Robust to Bureaucracy

Because not everyone has the ability, the interest or the time to devote to managing their own investment portfolio, there is a real place for outsourced investment management.. One solution is to buy index funds, which have a low cost, and either piggyback on the work of professional investors or follow the natural evolution of the market, depending on your perspective. I prefer having people use their judgment in making investment decisions on my behalf. However, when choosing a person or organisation to manage money, bureaucracy is a threat to success. Having a small group of people in close communication renders decisions more robust.

A family member invested his money with a national organisation. They have 85 PhDs on staff and have relationship managers to communicate with investors. The problems that occurred illustrate the problems inherent in a bureaucracy.

First, there is little direct responsibility. When a poor decision is made, who does the investor turn to? In this case, the US investment group moved back into US financials too early in late 2008. But that group doesn’t answer directly to investors, and it’s a story that the investor hears third hand, from the relationship manager. The relationship manager can’t specifically take responsibility for investment decisions or outcomes, only for asset allocation. In a small group, it is easier to define ownership of a task or an outcome.

And a bureaucracy is definitely not efficient. Transactions took a week or more to complete. There is also a greater chance for miscommunication. A hypothetical example may be an investor who wants to increase their Canadian exposure. They explain that to their advisor, who buys a Canadian mutual fund. The fund, however, may be allowed up to 49% foreign exposure. The manager may see great opportunities in the US and be increasing the American exposure. The investor’s choice was not communicated to the manager, and the outcome wasn’t as expected.

In the example above, the manager was possibly taking a contrarian position. Many investment funds are managed in competition with other funds. For that reason, very few managers want to stand apart from the crowd, for fear of falling behind in performance. This leads to groupthink, where prevailing ideas are repeated, not due to their merit, but due to their popularity. People tend to “herd” around a similar position, with the consolation that, if the position turns out to be wrong, they won’t be blamed, since “no one saw it coming”.

Decisions by committee aren’t only apt to herding, they also take a long time and tend to avoid extremes. I have witnessed this in my work with our community association. The board never addressed the investibility of the significant cash reserves we held. There were two directors who had had bad experiences with investments, three who were inexperienced at investing and two others who hesitated to push their opinion onto others. For this reason, the reserves remained in open GICs, earning a relatively low rate of return. Committees tend to avoid risk and stick with the tried-and-true. But when investing, standing apart from the crowd is often the best way to profit.

When choosing an organisation to manage your investments, choose a small group that is in close communication. This helps to maintain the speed and efficiency of operations and the clarity of repsonsibility and decision-making. It may also help to contain costs. This should keep your portfolio from being unnecessarily at peril in the event of a negative circumstance.