Of Bad Businesses, Unethical Managers, and Stock Market Volatility

“I’m fast losing hope in this world!” my friend Ravi exclaimed as we started talking over desserts after our last weekend lunch.

“So soon?” I asked him. “What happened?”

“Are you reading newspapers these days Vishal? Or are you still abstaining from them?”

“I still don’t read newspapers, Ravi. But tell me what’s the news that has gotten you worried?”

“You read the news about ICICI Bank’s alleged sanctioning of a huge loan to Videocon because its chairman supposedly had dealings with the bank’s CEO’s husband? There are no honest people left in the corporate world it seems!”

“Yeah Ravi, I came across this news on Twitter recently. It’s bad if it’s true.”

“As if the continued volatility in the stock market wasn’t bad that we have some or the other news of companies and management involved in scams that shake the markets further.”

“As far as I know Ravi, this fraud hasn’t been proven as of now. But given the way banks have been managed across the world and in India over the years, I have no doubt that these allegations may have some merit.”

“Yeah, I know you hate banks and bankers…”

“No Ravi, I don’t hate banks and bankers. I just hate their unfair and often unethical practices, which they indulge in time and again, thanks to the bad incentives under which they operate.

“Yes Vishal, the incentives are really bad at banks. I was recently talking with a mid-level credit manager appraising lending at a bank, and he told me how lending at his bank is often done at the whims and fancies of the bank bosses (and big industrialists, customers etc.) than the creditworthiness of the borrowers. And he also revealed that the bigger the lending amount, the bigger is the potential for corruption. This is because senior bankers receive bigger incentives – direct and ‘indirect’ – the bigger the amount of money they lend. Damn the return of the money thus lent.”

“Well Ravi, after hearing you, I can imagine what may have happened within ICICI Bank, and PNB some time back, which has caused them a bad name. Big lending, bad incentives, unethical practices…these are like steroids that create big frauds and hurt most stakeholders except the ones who perpetrate such scams.”

“So how does one safeguard one’s investments from such frauds which may not be big enough to wipe out the portfolio, but leave a bad taste for investors in such businesses?”

“For me, the rule is simple Ravi. I avoid banking and finance businesses and those that borrow a lot of money. My reason is that incentives and intentions get maligned when managers have power and lot of money.”

“You are right Vishal. This goes contrary to what Spiderman said that with great power comes great responsibility.”

“How I wish that were the case, Ravi. Sadly, in the corporate world, you must be very careful when you see people in power dealing with a lot of money.”

“Like senior bankers?”

“Yes, also CEOs who manage businesses that require a lot of debt because they ultimately end up managing balance sheets. In such cases, the fiduciary responsibility that they have towards other stakeholders often gets diluted. Not always, but often.”

“In short, money and power make you mean.”

“No Ravi. We all are mean in our own worlds and magnitudes. Just that excessive money and power magnifies our meanness. Power and money corrupt most of us, and thus we must watch out for our behaviour when we are getting into such a situation ourselves.”

“But there are rich people who are also honest, right?”

“Of course, there are. Just like Warren Buffett often says, money just brings out the basic traits in us. If we are jerks before we have money, we will simply be jerks with a billion dollars. This also holds true for nice people before and after they get rich.”

“So, money and power are just enablers of corruption and not always the cause.”

“That’s exactly what I meant to say, Ravi.”

“Well, let’s leave that topic now and move on to another one that is concerning me as of now…”

“You want to talk about the stock market?”

“How did you know that, Vishal?”

“Because nothing concerns you more than what your stocks are doing, Ravi!”

“You are being sarcastic, Vishal. Of course, I am concerned about a lot of things outside stocks!”

“Oh, I was just pulling your leg. Shoot what’s worrying you!”

“Just this continued uncertainty and volatility surrounding stock prices. The Indian market has crashed almost 10% over the past two months and a few of my stocks have crashed around 20-25%. What do you make out of it? What can fix this uncertainty and volatility?”

“Ravi, first things first. Don’t use the word crash. A 10% decline in the market or a 20% decline in stock prices isn’t a crash. It’s a minor correction. Two, if you study Nassim Taleb, markets are organic and complex systems, not machines to be fixed. And by nature, organic systems are antifragile, that is, they are self-healing and gain from disorder. So, if someone were to remove all volatility from the stock market through mechanical fixes, such as government interventions or quantitative easing by central banks, then you remove all the healthy stressors that allow the market to learn from its mistakes organically and heal itself.”

“Explain in simple words please!”

“In simple words, some volatility is good for your portfolio. It keeps you alert so that you choose only those stocks or businesses that can stand the test of time and are not troubled much by such volatility.”

“Hmmm…”

“Consider forest fires, Ravi. These clear the forest of highly flammable material and weed out weak and vulnerable growth. But when you suppress these fires artificially, like when you want someone to fix short-term volatility in stock prices or you trade out of stocks just because they are facing volatility, you impose a false short-term stability while increasing long-term risk. Then you get fewer fires but more devastating ones.”

“So, you are saying that there is no long-term stability without short-term volatility?”

“That’s paradoxical, but that’s true. Error and failure, Taleb insists, are essential sources of information if they are limited and localized. Attempts to eliminate these – error and volatility – will backfire in the long run.”

“So you advise that I just let the volatility be?”

“Yes, Ravi. The best way to deal with volatility is to avoid it. And you can do that by not getting stressed about it, and by using it to your advantage by finding stocks you were eyeing that have fallen in prices.”

“And what if I don’t find new, good stocks that have fallen enough for me to buy them?”

“Look within, my dear friend, and see if any of your existing stocks provide such value. A lot of our problems in life are solved when we look within.”

“I’ll do that, Vishal. Thanks for your advice.”

“My pleasure, Ravi. Now stop eating that dessert. The liver within you must be crying from a sugar overdose!”