From Synthetic to Simple – The Nature of Investing: Resilient Investment Strategies through Biomimicry

Transformation 2

From Synthetic to Simple

“We have a great new product,” my friend, a financial advisor, announced. “It’s a synthetic market-hedging security, constructed so that if the market goes down, your losses are limited, but if the market goes up, you capture all of the gains.”

Chatting at a coffee break, this conversation seemed innocent enough, but it came on the heels of the gigantic derivatives losses of 2008 and 2009, so everyone’s risk antennae were up. My advisor friend (I’ll call him Joe) fielded every question with grace and confidence and highly technical language. Still, this security clearly sounded too good to be true, so I asked the question I always ask when someone proposes seemingly magical models to me: “When will this not work?”

To his credit, Joe was well informed, and highlighted two important caveats: first, these mechanics only worked within certain bands of market performance, so if things were extremely bad or extremely good, the construction of the securities’ performance did not hold. Second, these securities could not easily be sold, because once set up for a specific time period, they had to run their course, and could not be undone. The idea behind this offering was not a bad one, but it was very specific, managing a particular range of risk for a particular market for a particular time period.

Somehow as we talked, the image of processed cheese popped into my head. I grew up near Philadelphia, so trust me, I understand the value of Cheez Whiz, especially when properly applied to a steak sandwich or perhaps a soft pretzel. But everyone knows Cheez Whiz is not exactly the centerpiece of a healthy nutritional plan. In fact, one thing I admire about Cheez Whiz is the “z”—there is truth in that letter. This product doesn’t even pretend to be actual cheese. We could use a labeling equivalent like this in the investment world—fundz of fundz, maybe, or derivativz—some signal that the product in question is not quite natural.

In the absence of such a label, we can employ the principles of nontoxic production.

Nature’s Principle: Nontoxic Production

By now, we’ve all heard about “toxic securities,” the ones that are unsellable, and seem to be worth less than zero. But what is the source of this toxicity? We don’t often think of investing as a manufacturing business, but in fact all investments involve some sort of creation. Therefore, the means of creation are a vital component of a healthy financial system. If you are manufacturing auto parts and your goal is to have no toxic waste, you need to design that into the process from the very beginning. The same is true for finance.

To address these questions of healthy creation, we have nature’s principles of life-friendly chemistry, which emphasize nontoxic production. The subprinciples in this category are:

  • Do chemistry in water.
  • Build selectively with a small subset of elements.
  • Break down into benign constituents.

At first glance, this principle is a tough one to apply to social systems like investing: after all, in nature, chemistry is a literal, tangible thing. But even when studying natural systems, the word “chemistry” tends to throw some people off: we are talking about biology, right? So why all of this focus on chemistry and toxicity?

Well, at the molecular level, all that happens in the world is chemistry—whether it’s in the forest or in the test tube. Assembling and combining elements produces a huge range of functions that are important in nature as well as in manufactured products—characteristics like color, structure, and strength. So when we think about the concept of nontoxic production, we mean that products in nature are assembled in a way that does not harm life.

Comparing the production processes in nature with the ones in human factories turns up some startling differences. There are no solvents in nature, no highly synthesized reagents, no dyes made of rare elements. Just as importantly, when natural organisms break down, we are left with benign, simple elements like carbon and nitrogen. There are no toxic dumps in nature.

For example, those amazing colors in peacock feathers? They are not colors at all, at least not the way we commonly think of color. The pigment in those feathers is actually brown. It’s the structure of the feathers that reflects light to display all of those brilliant blues and greens. Small crystal-like structures are arranged to reflect and filter different wavelengths of light. There are no synthetic chemical compositions or artificial dyes required.1

Some might argue that humans have more complicated needs than natural systems (never mind that we are part of nature ourselves). We need to build tall buildings, for example, and how could you do that without steel? Well, spider webs are stronger than steel, with the proteins made completely “in house”—inside the spider. There is no need for two-thousand-degree furnaces. This isn’t to deny steel’s value to the world, but rather to illustrate that nature produces equally amazing products using a very simple subset of elements in elegant ways.

The subprinciples of healthy production add more nuance to this core concept: first, do chemistry in water. This is the “how” of nontoxic production, and reflects the fact that nature does not have the luxury of dumping synthetic reagents into the middle of its processes, nor does it have a warehouse full of synthesized, complex materials at its disposal. For example, tiny diatoms are among the most abundant organisms on earth, found almost anywhere that there is light and water. By some estimations, the photosynthesis of these simple creatures accounts for over 20 percent of the planet’s oxygen production. One unique feature of diatoms is that their cell walls contain a large proportion of silica, which keeps their shapes remarkably consistent. When these walls are assembled, it’s through the employment of specific proteins; essentially the diatom creates glass walls internally, with proteins—no need for a huge, energy-intensive furnace.2

If the first subprinciple relates to “how,” the second one answers “what”: build selectively with a small subset of elements. When we look at the periodic table, it gives each element equal space, equal weight on the chart. But in the reality of the natural world, the elements are anything but evenly distributed. Almost every beginning chemistry student has memorized the acronym CHON, because the vast bulk of natural organisms’ mass is made up of just four elements: carbon, hydrogen, oxygen, and nitrogen. The next bundle of common elements includes calcium, chlorine, magnesium, potassium, phosphorous, sodium, and sulfur. And after that, the whole alphabet soup of the rest of the periodic table—well, those elements are really pretty rare. In the human body, for instance, 96 percent of our mass is made up of oxygen, carbon, hydrogen, and nitrogen.3

Once any product has been assembled, the next logical question is, “what then?” The answer is the subprinciple, break down into benign constituents. This concept is quite specific, demanding that decomposition results in no harmful by-products. However, it does not say that there are no toxic elements along the way. Take cobra venom, for example, an obviously toxic substance that still manages to be in alignment with life’s principles. The venom is assembled without synthetic reagents, from simple elements, and then it breaks down into benign constituents. In between those stages, it performs its intended purpose—a highly toxic purpose (at least for the prey). The venom ensures protection and function for the snake in a spectacularly effective way, but with no toxic elements leftover at the end of the process.4

When we consider the application of these specific scientific ideas to human social settings, two important themes emerge. First, this kind of production is not just simple—it is elegant. When I look out the window and see the woods in the distance, dozens of types of trees and shrubs and living organisms, it seems miraculous that the ingredient list for that huge variety of life is so short. This is a key subtlety within the second subprinciple: not only is there a small subset of elements, but they are assembled in elegant, even exquisite, ways. It’s like a master pastry chef who can fill a whole bakery with different arrangements of flour, butter, eggs, sugar, and yeast. A little salt here, a little vanilla there, maybe an occasional dash of cardamom or cinnamon, and voilà! Immense variety, produced with a tiny subset of ingredients plus elegant assembly techniques. Compare this vision of a gorgeous organic bakery with a stroll down the shelf-stable bakery aisle at the grocery store, where each label is less pronounceable than the last, and this abstract life’s principle is suddenly crystal clear.

One misperception we often hold is that something simple, elegant, and benign is also somehow limited. This is the second vital concept that relates to nontoxic chemistry: life-friendly processes are not limiting, or lesser. To be fair, many of us have worn scratchy natural-fiber shirts or eaten leaden whole-grain muffins. But these shortcomings are problems of design and assembly, not shortcomings of natural components. As we can see from the toxicity of cobra’s venom, the strength of spider’s silk, the variety of the forest, and the elegance of the diatom, life-friendly chemistry does not mean “weak.” It does not mean “plain.” It does mean that we can create variety and function and splendor in a way that is conducive to life, instead of harmful.

We’ve been conditioned to think that limits are inherently bad, that they are something to be transcended, that every barrier should be broken. Janine Benyus notes, “We humans regard limits as a universal dare.”5 But limits at the start of a process—to the number or type of inputs, or to the conditions surrounding a problem and its solutions—do not necessarily limit the creativity of outputs. In fact, limits are often a spur to innovation. Instead of focusing energy on creating new components, all of that attention can be focused on creating different, better outcomes. This concept was highlighted in recent years at the LEGO company, where one element of the organization’s comeback was shrinking the menu of components that new product designers could work with. The smaller, more limited menu turned out to be the inspiration for much better products.6 Sometimes the best way to get a terrific out-of-the-box answer is to start with a lot of inside-the-box constraints.

Figure 2–1 Life-Friendly Chemistry: The Honey

Bees process pollen and nectar into an amazing array of products, like honey, wax, and royal jelly—a perfect illustration of building elegant products with a small subset of elements.

Translation to Investing

Even if you like spiders and French bakeries, this particular principle might seem irrelevant to the investment realm. What constitutes “chemistry” for finance? More importantly, what would “water-based chemistry” or nontoxic assembly and disassembly look like?

I found my way through these challenging questions by starting with the second subprinciple, the “what.” This is the principle that talks about using simple components in elegant ways. When I think back to the story that begins this chapter, the magical market-hedging security, I see a product that is clearly a bit misaligned. This security is really a bundle of other securities, all of them market options that link to various performance scenarios. None of the elements in this security is a primary investment transaction or relationship. It’s like a financial Twinkie, one synthetic ingredient layered on top of another to form what appears to be a coherent whole.

Now, I have been known to enjoy the occasional Twinkie, but the central question behind life’s principles is always “for what purpose?” A Twinkie might provide enjoyment, it might provide caloric intake, but it does not provide true nourishment. So I asked a similar question about the market-hedging security: toward what end? What is the purpose of this creation? What is its function?

This proved to be a helpful starting point. The hedging security was designed to provide a sense of comfort, because it would cushion some potential downside in market performance. And it also provided a sense of control, because the purchaser could feel agency, having taken action to protect her capital and perhaps even to grow it. But the key word in those sentences is “sense”: a Twinkie provides a sense of indulgence, but it does not provide true nourishment. Likewise, this security provided a sense of comfort and control, but it did not do much to address real underlying risk and uncertainty for the investor.

Thinking through that particular subprinciple of “what” led me back to the other principles of nontoxic production. I was especially struggling with the idea of water-based chemistry: What is the equivalent of water in finance? When we think through the benefits of water as a chemical base, we see that it offers several characteristics: first, it is flexible. Sometimes water is a key catalyst in a chemical reaction, but other times it is a neutral carrier for other elements. And second, water itself is bountiful and nontoxic. In most environments, it is present before any chemistry takes place and it is there long after, too.

Considering these characteristics, I believe that the “water” in finance is community, connection to the world. When we start and end our investing with community, there is a continuity of chemistry throughout the process, a link that binds investing to activity in society. Sometimes people serve as a vital catalyst in our investing process, and sometimes people are more neutral actors, but they are always present.

In contrast, when we start an investment process with synthetic securities as our ingredients, the only possible output is one that is more and more synthesized, farther and farther from the primary investments that fuel the real economy, that nourish our real communities. People are far away from every stage of this process, and far from its outputs. The problem is that though people are removed from these synthetic creations, we are still impacted by the outcomes, the results that echo back in a powerful way onto the real world and the people in it.

When we want to refocus on “water-based chemistry,” then, we need to refocus on the nonsynthetic pieces of finance, the direct transactions and primary relationships that form the authentic core of investing. And what provides the supportive, nontoxic environment in which those primary connections occur? Community of people, links between individuals and all of their various needs, contributions, and endeavors. This is our water.

Those synthetic creations, the Cheez Whiz and Twinkies of finance, are not inherently useless instruments, but we have mistaken them for the real thing, for true nourishment, for solutions to our deepest needs. What’s essential are the direct connections, the primary transactions that form the core of investing: the “whole foods of finance.” The financial Twinkies need to be around the edges, more rare—not at the center of our investment plates. Moving closer to the primary, unsynthesized forms of investing automatically brings us into closer alignment with life’s principles.

Natural Scorecard: Mortgage-Backed Securities

By now, thanks to the financial crisis of 2008, terms like CMO, CDO, and CDO-squared have entered into common use, and everyone seems to understand that many of these creations were ultimately “toxic.” The trouble with this line of thinking is that it is just as simplistic as the one that led us into danger in the first place: financial creations are generally not bad or good, but they all have specific characteristics that may solve a certain problem, or may cause a different one. Examining mortgage securities through the lens of nature’s nontoxic principles brings a deeper understanding of this nuance.

When I was first assigned to be a housing analyst in the early 1990s, my knowledge of mortgages was mainly drawn from George Bailey’s description in It’s a Wonderful Life. When there’s a run on the Bailey Building and Loan, George explains that he doesn’t have all of the townspeople’s money back in a safe; it’s been loaned out to their friends and neighbors, as mortgages on their homes.7 Turns out, this is not such a bad model to have in mind: in its most essential form, a mortgage is a simple, direct transaction, connected to specific people and specific communities.

Before leaping ahead to the current century’s mortgage woes, think of a plain old mortgage on a single-family house. In this transaction, you have a house, a buyer, and a lender. Simple elements, connected directly to one another, with a straightforward mechanism that is easy to unwind. This kind of transaction can bring great benefit: before the mortgage market was developed, you’d have to save up for years and years, or be born into some serious financial luck, to be able to afford a home purchase.

When it comes to disassembly of a conventional mortgage, it’s pretty simple. Take apart a traditional mortgage and you are left with those same essential components—a house, a buyer, and a lender—and they can all separate and go on to be reconfigured in different combinations. Importantly, it doesn’t matter if these elements separate for happy reasons, like the loan being paid off, or unhappy reasons, like the borrower being unable to repay. Regardless of circumstance, the components are benign.

Compare this sort of simple mortgage against the “life-friendly chemistry” principles:

  • Is there “chemistry in water”? Are the components all connected in community? A direct transaction, by definition, is tied to specific people and places, so yes.
  • Is the product built selectively, with a small subset of elements? Yes, a straightforward, old-school loan only needs a lender, borrower, and asset.
  • Does the product break down into benign constituents? At the end of its life, the loan components can easily separate and go on to other uses, so yes, the breakdown process is benign.

Single, simple mortgages, then, are pretty well aligned with principles of life-friendly creation: they’d earn a grade of A-minus, or perhaps B-plus.

Now, let’s look at a more modern version of mortgage finance, the collateralized mortgage obligation (CMO), or its broader financial category, the collateralized debt obligation (CDO). There is a lot of complexity in some of these instruments, but at its heart, all that a CDO does is bundle together loans in order to rearrange the pieces and resell them. In certain circumstances, this kind of arrangement could be very useful: say you are worried about the economy in one geographic area, but you know that a big employer is thriving the next county over. Or say that you’ve already made a lot of high-risk loans and you want to balance that out with some lower-risk lending. A CMO allows you to mix geographies, borrowers, and loan types in ways that should enable an investor to pick and choose their exposures. This kind of arrangement could also benefit borrowers, since it allows their risk to be mixed together with others, which should generally make their cost to borrow lower.

Though a CMO is more complicated than a simple mortgage, it can certainly serve some useful purpose. So how is it that this whole category came to be associated with toxicity? Here is a condensed history of what happened to this market in the years heading up to the 2008 financial crisis:

We saw a rapid increase in the volume of primary activity—the aggregate value of those plain old home mortgages in the United States grew from $1.5 trillion in the beginning of 1986 to $11.1 trillion at the end of 2007, an increase of over sevenfold.8

The nature of primary activity, those underlying loans, was changing at the same time: in 2006, over 23 percent of all mortgages originated were subprime, compared with levels of under 10 percent before the mid-00s bubble.9

During that same period, the aggregate level of securitizations was increased. Mortgage securitizations increased even more than underlying mortgage activity, from $410 billion to $6.4 trillion, an increase of over fifteen-fold (roughly twice as fast as the underlying mortgage activity). Note that this is the total, cumulative level of securitizations, not new issues, and not notional value.

Mortgage securitizations took on new and bigger forms during this period too: at the peak, issuance of new ABS, MBS, and CDO instruments was almost $600 billion in just one quarter (2Q2007).10

Synthetic CDOs provided yet another extension and abstraction of activity. These securities are essentially a bet on the performance of other mortgage securities—their value is determined by payment streams on credit default swaps, not from payment streams on loans related to tangible assets. They are an abstraction of a derivative, related to (but far removed from) actual houses, people, or primary mortgages.11

During a short period of time, then, several layers of changes were piled on top of one another: first, primary mortgage activity increased in volume and decreased in quality; second, processing of that primary activity into securitizations increased in both volume and complexity; and third, new synthetic products were created on top of those processed securities. All three layers present problems, and each layer shows less and less alignment with the principles of nontoxic production.

A plain old mortgage was pretty well aligned with the concept of nontoxicity, but now compare the final layer of financial creation, a synthetic CDO, against principles of life-friendly production:

• Is there “chemistry in water”? Are the components all connected in community? The whole point of a CDO is to disconnect the components of specific borrowers, assets, and places from one another, in the hopes of reducing risk—and for synthetics this is all the more true. So, the answer is no.

• Is the product built selectively, with a small subset of elements? The CDO takes all of the basic elements of individual loans, adds them together, and rearranges them in a purely manufactured way. The synthetic takes this one step further, creating artificial ways to bet on already packaged bundles of securities. No again.

Does the product break down into benign constituents? Because the CDO has rearranged all of the pieces, and then the synthetic has abstracted them even further, these securities are hard to deconstruct. The owner of a CDO effectively owns a little piece of lots and lots of loans, and the owner of a synthetic only owns pieces of credit protection payments, so the breakdown process for any one of these securities is inherently difficult and incomplete.

Synthetic securities began as specialized complements to our basic investing diet, used for unusual circumstances and for particular purposes. In this very specific context, their form might have fit function, even if the composition process was not exactly life-friendly. But we moved these sorts of securities to the center of our investing plates, which pulled a large portion of our financial activity out of alignment with life’s principles. By doing so, we needlessly made mortgage financing toxic, no longer conducive to life.

This analysis does not mean there is no role for CDOs or other securitized products in the world, but it does show that there are limits for such products. Once those limits are surpassed, risks are magnified instead of diminished. A rare Twinkie within a mainly kale-and-quinoa diet might be great, but an all-Twinkie approach to nutrition is perilous. The existence of processed securities is not a problem, but their rampant and unnecessary growth facilitated much more investment trauma than could have ever been delivered by organizations like the Bailey Savings and Loan, no matter how many defaults there were in Bedford Falls.

Evolution

Contrary to the mortgage finance example, there is plenty of evidence that less synthesized forms of investing and creation are thriving. For example, there is active discussion in angel investing communities about how to fund “normal growth” companies, those whose business prospects are solid, but where the needs for funding are modest and the complications of selling (and buying) equity are unnecessary. Equity investing in a small start-up company is often a painful process for all concerned, with lots of legal paperwork, expense, and sometimes contentious negotiations between investor and investee. This is a tough way to start a constructive business relationship! For companies where plain vanilla loans are appropriate instead of equity, the basic agreements can often fit on one sheet of paper, and the main terms to negotiate are just time and price—a simple set of parameters.

Simpler forms of consumer banking also seem to be seeing a revival. One of the most popular programs of Green America in recent years is their “Break Up with Your Mega-Bank” guide, which helps individuals seek out local banks and credit unions that might serve their needs better than a large financial institution.12 In the United States, credit union assets crossed the $1 trillion mark in 2012, and the industry reported record earnings.13 After several waves of bank consolidation throughout the 1990s and 2000s, I found that my account had migrated from a small local bank to a big national one, without my ever deciding to make that switch. Ultimately, I wanted and needed the service of a smaller institution, and so I switched back to a group with more direct and personal customer connections—more aligned with life-friendly principles.

Similarly, platforms like Kickstarter and Kiva allow for direct links between investors, supporters, inventors, and small business owners. Different forms of crowd funding, like Mosaic Energy, offer similar potential, though there are still lots of regulatory complexities to be sorted out. In these cases, the platforms also put the decision of how to invest back in the hands of the actual investor: some enable support in the form of gifts, some in the form of loans, some in the form of product purchase. The forms of support are simpler, which means you don’t need lots of layers of processing between you and your investment.

Pathway to Practice

How can we avoid the “Twinkie portfolio”? As with our other life’s principles, this one offers some clear pathways to progress: instead of just asking about mechanics of an investment or its clever design, begin by asking “to what end?” If the proposition is merely clever, but not serving a vital need, move on. If it is serving that vital need, then ask how. Can you trace its connection to real products, real people, real communities? Can you identify the simple elements that are elegantly assembled to make it? Can you look ahead and envision a benign, straightforward disassembly process or sale?

Once this set of principles becomes engrained in our thinking, we can extend our incorporation of them to other layers of investing. If you are comfortable that a fund’s construction aligns with life-friendly chemistry, what about all of its subcomponents? What about its managers? What about their sales processes or the infrastructure of their supporting operations?

I don’t mean to keep harping on Cheez Whiz, but the analogy is a great one. Once we realize we might want more cheese than cheez in our diet (or better yet, less cheez and more carrots), we naturally start asking, what about the bread? What about the person making the sandwich? What about the city that surrounds the sandwich stand?

As we examine each layer, we get closer and closer to deeper, more complete alignment.

We live in a society that values technology, innovation, and creativity. Importantly, this “life-friendly chemistry” concept does not need to be at odds with those values. Instead, it reorients them, demanding even more elegant, effective solutions.

In an investment context, this means that if we’ve been solving a problem with a synthetic solution, we demand an organic one, one that is simpler and yet just as effective. Or better yet, we reexamine the problem to see if it can be solved another way—perhaps in a way that requires an elegant, personal, artisanal approach rather than a product that was designed for ease of manufacture and infinite scalability. This might seem harder and less efficient than an “off the shelf” solution, of course—but were you here in 2008 and 2009? Is it really harder than that? What was the price of that efficiency?

If we need yield, we might find a few simple stocks or bonds that serve that purpose, rather than a complicated CDO-type product. Or we may find a local business that needs a loan, where we understand the risks and want to support their mission. Or we may ultimately question, why do I need that yield in the first place? Is it enabling something in my life that I truly value, or have I just been told I need it so often that I’ve forgotten to ask why?

Rather than asking, “Can you make me a purple Twinkie?” we are asking, “Can you make me a cream-filled, curiously shaped cake without all of these chemicals?” Or maybe even, “Can you make me a salad that is so good I forget I about the cake?” Now that is a worthy challenge!

Sowing Seeds of Nontoxic Investing

Here are some simple ideas that help to start us along the “life-friendly” path:

• Consider the core purpose of any synthetic investment: Is it performing a function that you really need? Is it performing that function well?

• Simplify. If you are tempted to buy a security that claims to manage S&P risk, perhaps that means you really just want less exposure to stocks in the first place. There are usually simpler ways to achieve any given purpose than buying a highly processed investment product.

• Invest with the goal of elegant simplicity, not needless complication. Aim for a few investments that are simple, suitable, and easily disassembled, rather than a Twinkie portfolio.

By aiming for simple, “organic” forms of investing, we can avoid some of the risks of toxicity that are inherent in overly processed products. We can eliminate needless synthetic creations and come closer to investing in a connected, integrated way.

We can move from processed complexity to elegant simplicity.

We can shift from synthetic to organic.