Just how smart is Wall Street?

Individual investors see a steady stream of paeans to Wall Street, praising not only the substantial resources of professional investors but also suggesting (sometimes subtly, sometimes not that these professionals are smarter and more capable than the average investor. While there are certainly plenty of columns out there decrying the mistakes of professional investors and pointing out that disciplined individuals can do just as well, the fact remains that the financial media overwhelmingly tilt toward the idea that Wall Street is smarter than you or me.

But is it really?

The word «smart» has plenty of definitions, but Wall Street has such a peculiar inability to learn from certain mistakes that it seems worthwhile to question just how intelligent the Street really is.

The Street can’t stay away from bubbles

Nothing of any real size can happen in the investment world without the involvement of institutional investors. So while retail investors are often dismissed as «dumb» money, it is the professionals who ultimately add the most air to investment bubbles.

It was professionals, not individual investors, who awarded absurd IPO valuations to stocks like TheGlobe. Com, Geocities or eToys.com.

Professional investors were also apparently happy to pay upward of 30 times sales for , and back in the bubble days.

Only a few years later, institutions happily dove into the housing bubble. Those institutions apparently were not bothered by data clearly showing that affordability was declining at a precipitous rate and that lending standards were abysmally low. In fact, institutions got so casual about the bubble that they happily relied upon models that told them housing prices could never fall — even though there were plenty of examples from Japan and other places outside the United States showing what could happen.

These are only two examples of how the institutional community is all too happy to believe «it’s different this time» and «prices couldn’t possibly fall from here.»

The fact is, the Street is happy to play a game of musical chairs because the players almost always believe they’ll find a seat before the music stops . . . even if history suggests otherwise.

There are gaps in the Street’s due diligence

Although plenty of institutional investors now claim to have spotted the shenanigans at Enron and WorldCom and shorted the stocks, those stocks would have deflated much sooner if all of these people had been telling the truth.

The fact is, plenty of institutions lost huge amounts of money in companies whose earnings seemingly defied gravity, until accounting scandals brought them crashing back to earth.

When Enron blew up, well-regarded names like Alliance Capital Management, Janus, Putnam, Barclays and Fidelity owned about a combined 20% of the stock.

Investing in a slow-growth economy

Yet even a series of scandals has failed to fill the gaps in institutions’ due diligence. During the housing bubble and crash, institutions were largely blind to the balance-sheet time bombs of financial companies such as Washington Mutual and , to say nothing of their off-balance-sheet liabilities.

Even within the past few months, hedge fund manager John Paulson reportedly lost millions of dollars on his position in Sino-Forest when evidence emerged that the Chinese forestry company may have misrepresented some of its revenue and exaggerated some of its timber holdings.

The Street is overconfident, especially in its own models

Time and time again, some sharp-eyed professional will spot a profitable anomaly in the markets — junk bonds, undervalued mortgage securities, Latin American sovereign debt and so on. In the early days, there are plenty of great opportunities, but eventually word gets out, other investors try to replicate the strategy, and investment bankers rush out look-alike products.

The list of well-known implosions goes on and on — from the heyday of junk-bond-fueled leveraged buyouts to the «see no evil» models of the U.S. housing market. In almost every case, the fundamentals change, the experts fail to notice, more leverage gets poured into the process, and it all blows up in everyone’s collective face.

The case of Long-Term Capital Management, although a 13-year-old story, is a great example of what can go wrong. The hedge fund mixed experienced and successful Wall Street professionals with a small army of Ph.D.s to devise strategies that used very high amounts of leverage to exploit small inefficiencies in the market.

Unfortunately, early success brought more capital into the firm than it could manage, more leverage was employed to squeeze bigger returns out of smaller anomalies, and suddenly some of the key relationships underpinning its models fell apart. The result was a spectacular failure — one so large that the federal government stepped in to keep the unwinding process from destabilizing the financial markets.

The bottom line

These are just a few examples of the «factory seconds» Wall Street churns out with surprising regularity. What of the fact that the Street routinely puts its faith in the projections and promises of management teams with no record of competence or success? Or what of the fact that Wall Street professionals routinely trust their investors’ capital with people and instruments that have previously failed?

Wall Street is made up of people, and people (even when well trained and well compensated make mistakes. Whether it’s greed, overconfidence or a sincere belief that it is somehow different this time, Wall Street cannot resist taking a chance on moneymaking opportunities.

The point here is not to bury Wall Street or excoriate its professionals for their mistakes. Rather, it is that investors should never be intimidated out of their own good judgment and common sense just because the smart money thinks or acts differently.

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