Financial History 25th Anniversary Special Edition (104, Fall 2012) - Page 20

“The Future of Finance” By John C. Bogle, Founder, The Vanguard Group The future of finance will be different than its recent past. The traditional and principal role of finance in our economic system and our society has been to allocate investment to its highest and most profitable uses — the most promising existing businesses and new businesses created by entrepreneurs. In the recent era, however, the principal role has become to facilitate speculation in the financial markets. For example, in recent years, finance has raised some $250 billion annually in equity capital for business, while the volume of stock trading averaged $33 trillion — 0.8% for investment and 99.2% for speculation. The task is to bring these two models into a sounder balance in the years ahead. The major lesson of the past 25 years is that the financial markets imprudently magnify changes in the intrinsic values of stocks as stock prices lose touch with economic reality. Moment-by-moment volatility engenders excessive trading, enriching financial firms even as it (relatively) impoverishes investors. We need investors to understand Benjamin Graham’s time honored maxim: In the short-run the stock market is a voting machine; in the long-run it is a weighing machine. The role of leadership in finance is to restore prudent investing to its traditional dominant role in our society. This view is almost universally shared by the “wise men” of our era — the Volckers, the Buffetts, the Donaldsons, the Whiteheads — of which there are all too few. We must develop a new generation of leaders imbued with the idea of patient long-term investing, with strong ethical values and with a clear understanding that the role of finance is to serve not Wall Street, but Main Street — those human beings out there who are trusting us to invest soundly for their future well-being and their financial independence. “Have We Learned Our Lessons?” By Henry Kaufman, President, Henry Kaufman & Company, Inc. While we have experienced substantial turmoil in the financial markets in recent decades, it is nevertheless unclear whether or not we have learned our lessons. One of those important lessons is that financial institutions have an important dual responsibility. On the one hand, they serve as fiduciary for the savings and investment process. On the other hand, as private institutions, they need to achieve a reasonable rate of return on their capital. Unfortunately, balancing these two responsibilities has not worked well in recent decades. Entrepreneurship has overcome the responsibility of financial trusteeship. It is far from clear whether the Dodd-Frank legislation will allow financial institutions to move ahead effectively and efficiently. In the euphoria leading up to the recent financial debacle, it was also forgotten that good times breed the illusion of boundless liquidity. Indeed, liquidity seemed to be interpreted by many as the smooth and quick access to borrowing rather than the liquidity displayed on the asset side of the balance sheet. Another related lesson that should have been learned is that marketability is not the same as liquidity. Liquidity is a characteristic of the markets where marketability has to do with how easy it is to trade in a particular security or class of securities. Adding to this perception of liquidity has been securitization, but this can give a false impression of seamless marketability. The fact still is that marketability varies considerably over a financial cycle. In these last few decades we also should have learned that marking financial assets 18    FINANCIAL HISTORY  |  Fall 2012  | www.MoAF.org to market is an imperfect process. The fact is that the capacity to effectively mark to market varies with market conditions. When market conditions deteriorate and liquidity seizes up, no one can readily claim that the last quoted price in organized markets or quoted by dealers in the over-the-counter market is the real market value. Finally, we should have learned that modeling risk has great limitations. This practice has become increasingly popular with the improvement in computer technology. Unfortunately, many of these models have relied importantly on historical statistical overlays. As Mark Train once noted, history rhymes but does not necessarily repeat itself.