The Principle of Institutional Stupidity



Around the turn of this century, I used to be a trader. At the same time, the world was given to a singular bout of extreme stupidity, the after-effects of which have still to wear off. This was a very bad time to be a trader, but I survived, mainly thanks to my incorrigibly contrarian outlook on the markets (ie, I was short on IT, at a time when everybody thought it, or rather, IT was rendering the Business Cycle extinct).

The Realization

Around this time, I went to a (foreign) bank, and wanted a loan against my shares, to meet my margin requirements. Now, my portfolio was entirely “old economy” (a funny word, much in use in the last century). Since 95% of trading volume was in IT stocks, liquidity on my portfolio was poor. And the bank told me that it was not going to finance “illiquid” stocks.

The stocks were Balrampur Chini (since then, up 600% from Rs.75), Paper Products (up 240% from levels of Rs.75), Bata and SRF (which are hovering around the same levels after a few spikes up and down). With the exception of Bata, the Bank turned away ALL the scrips.

The bank was happily financing the scrips I wanted to short (DSQ mainly, now down >95%), because of its huge “liquidity”. The only scrip from my portfolio, which the Bank was willing to finance (Bata) has been the biggest under-performer in my portfolio. 

The Understanding

With the benefit of hindsight, we can say very clearly that there is almost a one-to-one relationship between the Bank’s willingness to fund a share then, and the scrip’s subsequent under- performance. One would think that this is a statistical coincidence, but think about it some more……!

The Bank’s search for “liquidity” during bullish times, coincides with my search for “foolishness” during the same bullish times. The same fools who dominate trading during bullish times, are the ones thronging the corridors of the Bank, looking to increase leverage, so that they can all go bust at the end of the bull market.

So there is a near certainty that most the bank’s “customers” are going belly-up, precisely because they are the bank’s customers. The bank lives off their dead bodies, calling in the loans at the end of the bull market and selling their stock at the bottom……….in fact, Bank selling creates the bottom of the market (as we saw in 2001 after the Ketan Parekh scam).

The Bank turns away long- term survivors of the market (like me!), and picks up (nay, it creates) the future dead ducks. It relies on its ability to sell stock at the bottom, and this is called a “business”………..!!! You would think that all those fancy foreign-trained MBAs in those hallowed granite corridors would have better sense about how to build a business………..but no, you would be wrong.

Sometimes, a stock has low liquidity because it is under-valued, and in “strong hands”, who are not selling till the stock is a multi-bagger. A good securities analyst would be able to figure out “the strength of the consensus” and see absence of liquidity as a positive bullish sign…………….but such a securities analyst cannot find a job in a foreign bank.

The Principle of Institutional Stupidity

You’d think a Bank would understand that the liquidity it supplies to the stock, promotes “foolishness”. And therefore, if it has enough of a lending portfolio, it is the de facto supplier of foolishness to the market. What it is seeking to track (ie, downside risk) is actually impacted mostly by its own lending actions.

If it is so obvious to an individual, why does a big Bank not “get it”?

Because of the “Principle of Institutional Stupidity”.

The term was first used by Peter Lynch, who pointed out that structural flaws in the way organizations are built, ensure that they do not operate at a high level of intelligence, even the basic level of intelligence that we use as individuals. You will see this same principle in operation every time you have to interact with a big co.

Between 75- 85% of Mutual Funds do not beat the market in any given year. Their long-term track records are even worse, if you factor in “survivorship bias” (the fact that we evaluate only the surviving Mutual Funds in any comparative study, not including the schemes that are closed down).

Take Away

The level of foolishness is directly proportional to the number of people who have to evolve a “consensus”. An individual (at least, an intelligent one) is able to make complex trade-offs, which 2 individuals will never be able to agree on. And if you have a Committee, your chances of understanding anything fall further…….if you are a co, especially a big, arrogant, and successful co, you don’t have a chance. And God forbid, if you are the whole market………..even HE cannot help you! Thank God I am an individual……….!!!

If you like this article, please feel free to check out my article on fighting inflation. And please do comment and discuss your point of view in comment section below.



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