Tracking your investments

The world is slowly recovering from a major financial meltdown.  People blame the collapse on a number of different things: a bubble of inflated housing prices, relaxed requirements for qualifying for a mortgage, predatory lending practices, greed on the part of mortgage companies and investment banks….  There are certainly many places to point fingers.  Each of these places, however, was doing what seemed logical when looking at a small piece of the puzzle.

As is often the case, we must back up and take a larger systemic view to see further.  Once upon a time, people borrowed money to buy a house, paid it back over time, and ultimately the bank was able to lend that money to someone else.  With the creation of the FNMA (Fannie Mae) in 1938, the income streams of those mortgages being repaid were converted to bonds, so that they could be sold to other investors and the banks to re-lend their money more frequently.  This allowed many more people to afford houses.  In the 1970s, private banks got into the business of creating their own bonds based on debt repayment streams.

Nothing ever stands still, of course.  People continued to look for new wrinkles on these themes to allow them to expand the business, or to increase the profit on the business they had.  Some of these investment vehicles got very complicated, intended only for professional bankers who could understand and evaluate them where the mass public could not.  Or, so went the pitch at the time.

As it turns out, many of those professional bankers couldn’t fully understand and evaluate these instruments, either.  And this is in spite of reams of financial reporting about the quality of the underlying mortgages, the default rates, and other things that might affect the debt repayment streams.  No one has time to read the reams of financial reporting.  Instead, they simplify it, and boil it down to a relatively few values and ratios that they do read.  These derivative indicators became proxies for a real understanding of the risks and rewards of bonds based on mortgages.  And then there were derivative financial instruments based on the bonds based on the mortgages, and they had their own proxies for the risks and rewards.  I don’t know how many layers there are to this particular onion, but I do know that, at some point, the proxy measurements diverged from the real understanding of the risks and rewards.

Where have I seen this phenomena before?

I’ve seen it in businesses that couldn’t quantify the actual value of the software systems they were building, so they substituted the cost of building them as that value.  I’ve seen it in project managers who couldn’t quantify the actual productivity of their developers, so they substituted proxy measures such as “hours worked” and “lines of code” as an indication of productivity.  I’ve seen it in project managers who couldn’t quantify the actual progress of a project, so they substituted conformance to their original plan as a proxy.  And for individual items on that plan, when they couldn’t discern the actual progress on an item, they substituted reports of “percent completion” as a proxy.

All of this makes perfect sense at the time.  There is some correlation between lines of code and productivity.  And by using proxies that are quantifiable, we can crunch the numbers and come up with a few key indicators to let us know how we’re doing on productivity, progress, and value.  And we can calculate the amount of risk we have, at least, the amount that we’ve anticipated.  We end up with a handful of indicators that make us feel on top of things and in control.

And, like in the financial industry, as long as things keep going well, these numbers seem to work for us.  But we have no way of knowing how much and in what ways our proxy measurements vary from the things that really concern us.  And we have no way of knowing what risks are not included in our numbers.  And we have no way of knowing in what ways the future might differ from our increasingly successful past.

There were those who took a systemic look at the financial industry and predicted that trouble was coming.  As the system mutates over time, it rewards behavior that varies from what we really want.  The increase in that behavior then drives further changes in the system.  It’s a lead-pipe cinch that the future will differ from the past.  But looking at proxy measures won’t tell us that.

“The prudent mariner will not rely solely on any single aid to navigation, particularly on floating aids.”  This advice used to be printed on all US nautical charts.  It’s good advice for the prudent manager, also.  Proxy measures are like floating aids to navigation.  They only give an approximate position, as they drift around their anchor point.  And sometimes, unseen by us, the anchors themselves drift from the known location where we set them.  As we reward lines of code or hours worked, these measures drift further and further from a representation of productivity.  As we measure conformance to plan, then that conformance becomes more important and accomplishing the goals that the plan was created to accomplish becomes less immediate.  That conformance then becomes a poor proxy for accomplishing our goals.

So, look around.  Find some other aids to know where you are, and where you’re heading.  Don’t wait until it’s too late to prevent disaster.

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