In hedge funds, the most common example is a culture where (usually recently high-performing) portfolio managers appeal to their chief risk officers for exceptions to risk rules – usually around position sizing or stop losses – and are granted them more often than not. It becomes a habit, a comfortable routine. I’ve seen billions lost overnight to that sort of behavior.
Normalized deviance often extends well beyond obscure, behind-the-scenes rule bending. Mismarking positions to smooth PNL, bid rigging, manipulating the end of day price on mutual funds, are all legal violations that can — and have — become systematic in investment organizations. Many — if not most — of the high-profile scandals that have been uncovered in recent years involve some degree of normalized deviant behavior.
If you’re a professional investor, I’m guessing you have seen some form of normalized deviance as well — and you have probably witnessed its consequences.
At Essentia, we are periodically asked about how to overcome normalized deviance that has taken hold within a given investment team. Step one, before grabbing the compliance whip, is to understand why deviance has taken hold, and address those issues — they are often too fundamental to correct with stricter compliance policies.
If you’re the leader of an investment team, it’s worth seriously considering: What rules and processes do we have that we truthfully do not follow more than 50% of the time? I suggest asking this with genuine curiosity, rather than with an eye toward enforcement at this point. This will lead you to the why — which is what you’re really after.
Once you have identified these unfollowed rules and processes, consider the following as you plan your next steps:
- Maybe you haven’t made the rules — or the consequences of breaking them — clear enough. If a process or rule is presented as yet another tedious regulatory or security item that’s going to make individual team members’ jobs more burdensome, without a good explanation of why it matters to them, you can expect it to ultimately be ignored. If you have an internal communications or marketing department, use it to make your head of risk, compliance, information security, research, or whomever is putting the rule or process in place (and, more importantly, their key messages) compelling and high-profile.
- Maybe the rules are misaligned to the functions they’re governing. If you’re asking a trader to own compliance on something that should really be owned by a supervising principal, it may not be effectively observed, simply because the trader isn’t the right person to be observing it.
- Maybe the user experience of following the rule or process contains too much friction. An individual who is bought into the “why” will do extra work, but only up to a point. Is there a more efficient or more user-friendly way this unfollowed rule could be implemented? We have found this to be a particularly acute issue among our clients; so much so that we have designed our automated Nudges to make it easy for them to follow their own investment process, with as few clicks as possible.
- Or is the rule itself too rigid to be followed in the noisy, complex world of investment decision-making, where every position and context is different? This is another scenario that comes up a lot with our clients. It’s why when Essentia sends a Nudge, it’s a “call to process,” not a reminder to follow a hard rule.
- Maybe, in fact, the rule that’s being broken or the process that’s being ignored is just no good. It could be obsolete, or maybe it was misguided all along. Perhaps the deviance should become the new normal. A simple example of this is the weekly meeting that shows up in calendars but isn’t reliably attended or is regularly rescheduled. Does it simply need to be moved to a more mutually convenient slot, or does the meeting need redefining altogether, so its attendees feel it’s worth prioritizing?
- Sometimes the rule or process is important, relevant, and appropriate … and you just have to crack the compliance whip. A critical compliance rule that is even occasionally ignored is an existential threat to an investment organization in this day and age, so the whip is the popular choice in those situations. But when the behavior you’re looking for is not a legal requirement, connecting it to compensation can be a very powerful motivator, too.
Legal and performance consequences aside, normalization of deviance is a waste of energy, pure and simple: even ignored rules consume precious compliance and reporting cycles. Maintaining such a rule is untenable and unacceptable, but it’s also more common that most organizations will admit.
Successful investment leaders will not lose sight of the fact that normalized deviance is wasteful, self-defeating, demoralizing, and — as pilots or surgeons can attest — a disaster waiting to happen.