What's Wrong With Finance

Finance is so strange.

On one side are American households, with $83 trillion of net worth. On the other is massive complexity and widespread ignorance. Combine the two, and you get some sad truths.

Half of Americans can't come up with $2,000 in 30 days for an emergency. Two-thirds of mutual fund managers lag their benchmark. Two guys who won the Nobel Prize for designing a sophisticated finance formula went bankrupt using their formula. According to economist Glen Weyl, the average salary of a top-25 hedge fund manager is more than that of all teachers in the Chicago school district combined.

It's just strange.

There are all kinds of things wrong with the financial industry. But as I see it, four problems in particular are responsible for most of the folly.

Problem No. 1: Extreme bias toward action, mostly due toexploitativefeearrangements.

Investing should mostly be a hands-off endeavor. You pick a selection of stocks, bonds, cash, and real estate that fits your goals, and then you let it work.

The evidenceis overwhelmingthat the more you fiddle with the knobs -- trading in and out, selling this, buying that, flipping this, being concerned about that -- the worse you'll do over time.

The problem is that, as a business, you can't charge high fees for doing nothing. While finance should be a simple, hands-off industry, the easiest way to make the most money off clients is to provide complicated, hands-on service.The more complicated it looks, the higher the fee you can charge.

The days of commissioned stockbrokers whose only incentive is to sell you the biggest rip-off mutual fund are coming to an end. That's great news. But every financial advisor, money manager, and investing company still must answer their clients when those clients ask,"What have you done for me today?"Few financial professionals who want to stay in business can say, "I didn't do anything for you today. I actually haven't looked at your portfolio in months, and I don't plan on it, either." Clients won't pay for a money manager who does nothing, even if doing nothing is the appropriate thing to do.

So financial professionals come up with new strategies. New investment outlooks. New trades, economic analyses, formulas, and theories. They have to look busy.The bias is overwhelming to do something rather than nothing -- that's how you make a living in this business. But action often benefits the advisor more than it does the customer.

This isn't a jab at all advisors and money managers. I think most are good, honest people who want to do the right thing. But they also have bills to pay. And they work in an industry that has set a high bar of expectations for what constitutes "fair" compensation.

An ironic truth is that every financial advisor and money manager I've ever spoken with says the industry is full of greedy, high-fee professionals who are doing clients a disservice, butthey themselvesare never the problem. Everyone thinks they're doing it the right way, and everyone else is the problem. As an investor, realizing how powerful self-interest can be is paramount to understanding how the industry works.

Problem No. 2: An overuse of numbers and formulas and an underuse of psychology and sentiments.

I have one finance textbook. There's a chapter titled, "Assessment of Confidence Limits of Selected Values of Complex-Valued Models," and another called "Conformal Mappings of Functions of a Complex Variable." Finish those and you can enjoy "Least-Squares Method from the Point of View of the New Axiomatic Theory."

I have no idea what any of that means. And I promise you that few people who have mastered finance in a practical way do, either.

Einstein said "Not everything that can be counted counts, and noteverything that countscan becounted." This is so true in finance. A lot of math is useful to understanding investing. But the most important parts of investing are soft behavioral traits such as patience and an even temper.

The problem is that it's hard to measure temperament with math and formulas. And you can't measure the irrational psychology of bear markets. Or the anguish of a losing streak, marketing bias, herd thinking, or spousal disagreements. So these factors are largely absent from how finance is traditionally taught, even though they're massively important.

In 2007, every Wall Street bank had a precise forecast of what the economy would do in 2008. They used math models constructed by the smartest Ph.Ds. studying the correlations of a century's worth of economic data. But none of them could have known that investors would simultaneously lose trust in the global banking system in mid-September. You can't measure trust. But nothing mattered more in 2008.

Here's how Charlie Munger put it:

Thinking of investing as a math-based subject makes you fall into all kinds of traps. You might know how to calculate valuation out to the fifth decimal place, but if you have a short temper and panic when stocks fall, none of it matters. And if you lack the humility to realize the market probably doesn't give a damn about your fancy valuation model, you're in trouble.

It's actually worse than that, because calculating valuation with precision likely gave you the confidence to take on lots of risk. That raises the odds that you will actually panic when stocks fall. Loyola Law School professor Lauren Willis summed this up when describing why some financial education programs backfire. As it's taught, financial education "appears to increase confidence without improving ability, leading to worse decisions," she wrote.

A paradox in finance is that many failures are caused by using theories exactly as they were taught in school, while many successes are due to people doing things that were natural extensions of their personality. A calm novice will almost always beat a short-tempered genius.

A few years ago I asked Mohnish Pabrai, a wildly successful hedge fund manager, what his secret was. I asked because his office looks nothing like a normal hedge fund. It's just him, some books, and a nap room. "Control over my emotions," he said. "That's it?" I asked "It's huge. You'd be surprised," he said. Finance needs more of this thinking.

Problem No. 3: No consistent measures of performance.

Someone on TV says, "Stocks are going to fall next week. I recommend investors sell." The next week, stocks fall.

Was he right?

Some would say yes.But we have no idea. We can't say if he made a good call because the investment industry has no consistent measures of performance.

For one, this is only a week's performance. What happened the following week? Or the week, month, year, and decade after that? How did he perform last year, and over the last 10 years? To gauge an investment manager's effectiveness, his entire track record, warts and all, has to be considered.

But here's what's really tricky.

Even if we have a long track record -- say, 20 years -- we still can't say whether an investment manager has been a success for his investors. That's because all investors have different time frames. If you're in your 20s and saving for retirement, you have all the time in the world to ride out bear markets, endure a bad year, and patiently wait for long-term returns. If you're a 90-year old widow trying to survive off of $100,000, you most certainly do not. A bad year could affect your ability to survive. The same money manager can be extremely beneficial, or devastatingly harmful, depending on your own personal time frame.

Take legendary investor Bill Miller, who beat the market for 15 years straight. That's quite a winning streak. But as Miller himself put it: "As for the so-called streak, that's an accident of the calendar. If the year ended on different months it wouldn't be there and at some point the mathematics will hit us."

Miller's legendary reputation caused investors to pile into his fund after years of beating the market. Then the streak ended, and Miller had a few rough years. No big deal -- it happens to everyone. But, disheartened by the broken streak, his investors fled, withdrawing billions of dollars just as the fund was suffering losses.

In the end, Miller's fund still beat the S&P 500. But the average Bill Miller investor did not. They underperformed what they could have gotten in a passive index fund.

How then do we judge Bill Miller? There's no consistent way. He had periods of outstanding performance, periods of poor performance, a career of decent performance, and his average client who suffered poor performance. You can make an argument that Miller was either a huge success or a dismal failure, and everything in between.

When there's no consistent way to measure performance, it's difficult for investors, advisors, and the media to make good judgments. We end up lauding managers who have actually done net harm to their average client, and criticizing managers who might be in an inevitable down streak amid a career of great performance.

Since it's so hard to make a good judgement about skill, money ends up blindly sloshing around the investment world, chasing past performance, fleeing every possible downturn and, in hindsight, often being somewhere it shouldn't.

Problem No. 4: People have no money when compound interest is in their favor, and lots when it's not in their favor.

I've given several presentations outlining the long-term history of the stock market. It's simple: The market has offered fantastic long-term returns, but at the cost of frequent volatility. Since there's no way to forecast when volatility might come, it's imperative that investors have a sufficiently long time horizon to endure it. You should be willing to hold stocks for at least five years, ideally much longer.

Every time I've said this, someone raises their hand and says, "Well that's great. But I don't have five or 10 years. I need my money now, today, to live off of. But I also need to earn a high return to fund my retirement."

And several times I've given the same talk, a young person emails me and says, "Well that's great. Time's on my side. But I don't have any money to invest right now." Of course you don't. At this stage of your financial life all you care about is how to manage your student loans, which is literally the opposite of compound interest.

A painful irony in investing is that the stock market works best for people who have decades to invest. But those people tend to have little money. By the time investors have a high income and can save a lot of money, they're near retirement and don't have time on their side.

This turns into a double-whammy. People end up without enough to retire on, and then take too much risk while they're in retirement in a desperate attempt to make up for it. When people need stock returns but can't afford short-term volatility, they are bound to be disappointed. Alas, I think this is exactly what many investors not only expect, but need.

This leads to frustration, and gives investors a feeling that the stock market is a casino that cheated them out of their hard-earned retirement money. In reality, it didn't. It's just not meant for people who don't have years in front of them.

Stocks just hit an all-time high. Nobody -- not a single person -- who has stuck it out in a diversified portfolio of U.S. stocks has ever lost money. But millions of investors have indeed lost money in stocks, because they don't have the patience to stick it out. More often than not, the reason they don't have the patience is because they literally don't have the time. They need their money to live off of now, today.

I don't know the answer to these problems. I do think the financial industry is moving in the right direction. Fees are coming down, transparency is going up, behavioral finance is popular, and millennials understand that they need to save for themselves. But problems are still rife. As an investor, recognizing and understanding those problems is the first step to trying to avoid them.

For more:

The article What's Wrong With Finance originally appeared on Fool.com.

Contact Morgan Housel at mhousel@fool.com. The Motley Fool has a disclosure policy.