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Deception through complexity

April 27, 2012

(Be prepared to skim the Black-Scholes definition and formula)

If there is one thing I hate it is how complex our investment system has become. I have to question if we have not gotten too smart for our own good. The investment industry has been taken over by PhDs with math and engineering degrees who believe you can predict certain investment performances by plugging it into a formula.

The Black-Scholes Model is probably one of the most famous formulas and is defined in Wikipedia as:

a mathematical model of a financial market containing certain derivative investment instruments. From the model, one can deduce the Black–Scholes formula, which gives the price of European-style options. The formula led to a boom in options trading and the creation of the Chicago Board Options Exchange. lt is widely used by options market participants. Many empirical tests have shown the Black–Scholes price is “fairly close” to the observed prices, although there are well-known discrepancies such as the “option smile”.[2]:770-771

The model was first articulated by Fischer Black and Myron Scholes in their 1973 paper, “The Pricing of Options and Corporate Liabilities”, published in the Journal of Political Economy. They derived a partial differential equation, now called the Black–Scholes equation, which governs the price of the option over time. The key idea behind the derivation was to hedge perfectly the option by buying and selling the underlying asset in just the right way and consequently “eliminate risk”. This hedge is called delta hedging and is the basis of more complicated hedging strategies such as those engaged in by Wall Streetinvestment banks. The hedge implies there is only one right price for the option and it is given by the Black–Scholes formula.

It seems to me that anytime you have to have over a dozen different links to help define your definition, you might be in something just a little too complicated.

I don’t really expect you to read this next part, but you can take a look at just this one small aspect of how the S-B equation works and get a glimpse of how complexity has wormed its way into our financial markets. When the mortgage market collapsed in all its glory, many a PhD was left standing with their mathematical formula stating, “That’s not how the formula said it would work.”

 

(Again, notice all the links to words and concepts that help us understand what we are reading. Also this is not the end of the formula; I just stopped at this point because I knew most of you have probably clicked off this blog by now.)

I like to understand what I am investing in, and if I am investing in derivatives that are exchanged based on a formula, such as the above formula, I can assure you I would not understand how the investment works. So what is my option? My option is to trust someone else to explain the complex investment I’m putting money into. Investors, particularly institutional investors and pension trust fund investors need to demand transparency, simplicity and clarity from the creators of investment instruments. We should not accept the excuse from criminals who want to claim that hundreds of billions of dollars suddenly came up missing and they are not sure why because the ‘accounting was too complex’.

If the firm selling the investment cannot clearly explain what it is proposing to have you put your money into, the complete mechanisms on how the investment will work and how his fees will be paid, DO NOT INVEST IN IT.

You have heard me say many times that the entire derivative market is a ticking time bomb. It is because the entire market is way too big and way too complex. The average investor has been herded like sheep into overly risky, leveraged and complex investments. And regulators whose job it is to protect investors from ill-fated schemes claim that there was no way they could have known that the whole thing would blow up. It seems to me that there has been a complete lack of prosecution for the fraud that has been orchestrated against average investors and it is all based on the defense that these are very complex instruments. If the originators of these investments can use the excuse that they couldn’t understand their own accounting, then they should be locked up for incompetence.

It is my theory that these complex investments are no accident; instead, they were created by the financial industry to cheat investors who trusted their financial advisors. Do most financial advisors believe they are cheating their clients? I think for the most part no. However, they should not sell something they marginally understand or don’t understand at all. And they should not push an investment product based on it being one that  will pay them the highest fees. “Fees” will be the subject of a future blog.

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