The Wedge

Since 2003, I’ve lived my life in two worlds. Years ago, my wife and I committed with close friends to move into the inner-city of Richmond, Virginia in a faith-inspired effort to invest in our local community. During this time, we’ve spent countless hours at our local elementary school, welcomed an after-school tutoring effort into our home, and helped start an affordable housing non-profit. While it hasn’t been an easy path, I can assure you that it’s been very rewarding.

At the same time, I’ve worked in what I now look back on as an emotionally unsettled career as an investment advisor for high net worth families and institutions.

It has taken me many years to identify that my vocational angst lies not at the edges of the complex global financial system, but with its central assumptions. These central assumptions require that I ignore many of the first principles that led our family to put down roots in an economically distressed neighborhood.

I now reject the assumption that the sole purpose of a corporation is to maximize profits for the owners. In 1970, the most influential economist of his day, Milton Friedman, wrote in the New York Times Magazine that a corporation has only one purpose: to increase profits within any legal means necessary. At the time, Friedman had valid reasons to be skeptical of calls for social responsibility. He was combating many ill-conceived arguments that were contrived to pressure corporations to lower their prices to solve a monetary inflation crisis. In the process of clearing some of the dirty water, Friedman also dumped the proverbial baby. Thus, the inspirational leader and his so called Chicago School acolytes struck an academic wedge between business and personal values. The longer this wedge remains in place, the more we risk confusing future generations.

With three young boys, my challenge is to model for them the behaviors and beliefs that lead to maturity—and there’s no better place to work at this than on the soccer field. Winning is fun. I don’t need to teach them this. But if they don’t learn to carry themselves honorably on the field, they will soon find that their victories carry no enduring satisfaction.
On the “field” of finance, the desire to win never goes away, but the game gets much more complex and stretches as far as the international markets allow. Here, profit-seeking is forever running into ethical questions about ecological impact, human dignity, and property rights. Here, guiding principles become even more important. These moral and ethical principles remind us that there is more at stake in business enterprise than can be illustrated on an income statement.

In investment management, Friedman’s ideas about the purpose of a corporation directly influenced how we think about the optimal/efficient portfolio. Upon this cornerstone, all of modern portfolio theory has been built. Put simply, the optimal/efficient portfolio assumes that an investor’s only concerns are financial returns and risk of loss. In the process, morals and ethics get reduced to whatever you can legally get away with to turn a profit.

Not only does this wedge between personal and business values distort our definition of the optimal/efficient portfolio, it also perpetuates derivative concepts that have won the day in the capital markets. The most powerful child of modern portfolio theory is the now fully developed juggernaut that we know as passive (index) investing. This movement has stressed the importance of low costs and attention to broad diversification over individual stock selection. Passive investing strategies flourished by accurately noting that most highly paid active managers fail to beat an index fund that holds every stock in the target universe (e.g., S&P 500). To illustrate this, Burton Malkiel[1] preferred the punchy image of monkeys throwing darts who regularly outperformed the expensively clothed professionals.

While the movement helped investors shed unnecessary fees, it also enabled them to believe that it is possible to make money without any oversight at all. “Set it, and forget it” became standard advice. In the process, all of the responsibilities of ownership lost their meaning. If you don’t believe me, try attending a typical shareholder meeting where turnout is often just a handful of investors[2]. The very structure that was created to offer shareholders the opportunity to engage with executives is now little more than a compliance annoyance. When you consider that only 30%[3] of shares owned by retail investors get voted, you see that similar disinterest in yet another fundamental right of ownership. Concern over these trends have been noted for years but the focus on the return of an optimal portfolio leaves little energy to address issues of responsible ownership.

The emphasis on passive investing also led investors to believe there are no limits to the benefits of diversification. Most recommended investment strategies push investors to own virtually every public company in the global economy. The end result is absurd diversification and a disengaged investor.

In some cases, these companies are operating in ways that directly conflict with personal and societal values. As one personal example of the many I could cite, my own portfolio once owned an oil and gas company with a terrible track record of spills and controversial exploration practices. Without basic oversight, companies have come to believe they have our de facto blessing to maximize returns by any legal means necessary—no matter the externalities born by other parties.

At this point in my story, I think it’s worth sharing that I count Jack Bogle—the man largely considered to be the great prophet of this passive investing movement—as a personal hero. While the passive investing tsunami is fostering all kinds of irresponsible investing behavior, I believe this movement was necessary to break through to a new investor consciousness. Thomas Jefferson argued that revolutions are necessary every few decades to preserve liberty by breaking the up the establishment. Before Jack Bogle, most investors had little option other than to entrust their life savings to overconfident and overpaid money managers. The passive investing movement ushered in a creative disruption that upended the traditional investing power structures. Now it’s time to tame the dragon.

Finally, it’s time to reject the traditionally held view that a fiduciary standard is the highest form of service that the financial management industry has to offer. The fiduciary standard (which includes both a duty of loyalty and a duty of care) is a legal standard focused on financial interests. Legal standards are essential in that they ensure that our most basic rights are protected but at their best, they are also limited.

Applying fiduciary service should represent the bare minimum expectation in the financial planning profession. Fiduciary service simply ensures that a financial advisor’s recommendations are legally defensible. But I also don’t want to suggest that the step beyond fiduciary service is an easy one. Moving beyond fiduciary is a move into a universe of goals and aspirations more focused on the complexities of human and social capital than the clarity of financial capital. Moving beyond fiduciary allows investment managers to begin customizing investment advice to reflect the values of their clients. Moving beyond fiduciary recognizes that investors can get to the end of their life with only a limited balance sheet remaining and yet still have died wealthy.

Today, many have come to accept the wedge that lies between personal values and business/investment values as normative. It’s a schizophrenic mindset of honorable values on the one hand and “anything legal goes” on the other. Yet, we suffer no such confusion when we train our children. The power of living out our values never gets old—even on the soccer field.

It’s time to begin a process of aligning our principles and our business beliefs in earnest. It’s time to stop investing like passive bystanders. It’s time to figure out how to reclaim our first principles as we pursue the optimal portfolio. And it’s time to start looking for investment advisors who are willing to offer advice that moves beyond fiduciary.

1. Author of A Random Walk Down Wall Street and a leading proponent of the efficient-market hypothesis who teaches economics at Princeton University.
2. Berkshire Hathaway meeting excluded
3. SEC Proxy Voting Roundtable transcript