Taking a Ferrari into the Back Country

Posted by Brad McMillan, CFA, CAIA, MAI

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This entry was posted on Jul 9, 2012 10:13:43 AM

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A couple of days ago, I wrote about how financial factors and decision models are receding in importance compared with other, noneconomic factors. While there are examples around the world that illustrate the process, it still is not necessarily apparent, given the constant financial headlines, whether and why this should be the case. I think it is helpful to take a look at the same phenomenon from another angle to show why this change has to happen and why, in the end, it will be a good thing.

Decision models are like cars. They are designed to get you where you want to go in as pleasing a way as possible. Pleasing, of course, depends on who you are and what you are trying to do. Large SUVs, for example, are optimized for size and carrying capacity, with a helping of off-road capability as well. But they are not optimized for either speed or fuel economy.

On the other end of the spectrum are the new Smart cars. I haven’t seen many in the wild yet, but the fact that they are optimized for fuel efficiency must offset the fact that they appear to be deathtraps in the event of a collision. The buyers know this—I saw one with a license plate that actually said “DETHTRP.”

On the other other end of the spectrum, you have the sports cars. They are optimized for speed, and on an open highway are the best at what they do, but off-road or at $4 a gallon, they do have drawbacks.

Over the past 20 years or so, our decision processes have been optimized for speed in the form of growth. Deregulation, growth of financial institutions and assets, and a focus on the service sector of the economy allowed growth to go at a higher speed. When the road is smooth and in good repair, and gas is affordable, that makes a lot of sense. With a smooth economic environment over that time period, the chance of an accident was low, and our Ferrari went pretty well.

Until the crash. We found out in 2008 that the road was less smooth and, therefore, the natural speed limit was perhaps lower than we had thought. As the road has turned rockier, our Ferrari has been less fun to drive, with its finely tuned suspension bouncing around and occasionally bottoming out. On these roads, maybe a Jeep makes more sense after all.

The road does not look to be getting smoother any time soon, and adapting to the rockier roads ahead essentially means trading some of the optimizations that gave us speed—less regulation, lower capital levels, less transparency—for optimizations that encourage robustness. Yes, we will go slower, and the journey will still be bumpy. But, as we continue to change our decision processes to emphasize nonfinancial factors more, hopefully, we will actually complete our journey in the Jeep and not break down by the side of a dirt road in a Ferrari.

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