Against the Gods
I read Peter Bernstein's brilliant book,"Against the Gods,"
this week. It is the historical story of risk. He takes what could
be a very boring theoretical subject and turns it into a page turner.
If you want to understand how we ended up with Enron and $100
trillion in derivatives, he takes you back to the Greeks and works
his way through the centuries, telling us how each successive
mathematical leap changed history, making modern society possible.
I highly recommend you get it and read it. At the very
least, go to Barnes and Noble, buy a latte, get the book, sit in
their comfy chairs and read chapters 16 and 17 on the psychology of
investing and risk.
Modern portfolio theory assumes we are all cold-hearted rationalists.
As it turns out, we are far from it. We are all creatures of what
burned us most recently. Bernstein tells us how Amos Tversky and
friends created"Prospect Theory" or the psychology of financial
actions.
Quotes:"The major driving force is LOSS aversion. It is not so much
that people hate uncertainty, --- but rather they hate losing."
In a later study, Tversky notes the irony:"It would follow that
cutting your losses is also a good idea, but investors hate to take
losses, because a loss taken is an acknowledgement of error. Loss-
aversion combined with ego leads investors to gamble by clinging to
their mistakes in the fond hope that some day the market will
vindicate their judgment and make them whole."
" We start out with a purely rational decision about how to manage
our risks and then extrapolate from what may be only a run of good
luck. As a result, we forget about regression to the mean, overstay
our positions, and end up in trouble."
If you have had trouble understanding why you make some of the
investment decisions you do, then read these chapters. It helps if
you read the whole book, but these are crucial. I can't recommend it
too highly.
Derivative Pleasures
Interestingly, he wrote the book prior to the 1998 Long Term Capital
Management (LTCM) crisis. It would be interesting to get his take on
that event. Today, we read there are $100 trillion in derivatives.
Derivatives are getting a bad name today, but without them, the
modern world and global trade would grind to a quick halt. Risk would
be unmanageable, and companies would not be able to function.
Enron is a example of the abuse of derivatives. These were
fraudulent from the beginning. That partners from Merrill Lynch could
participate, knowing their basis and not alert their clients borders
on lack of fiduciary responsibility.
Merill partners evidently put as little as $50,000 into a
partnership, borrowed $950,000 which Enron guaranteed, and was paid
back to Enron as"earnings". The kicker is that the partnership was
to pay the investors 15% or $150,000 per $50,000 invested.
I know that if someone were to offer me such a deal, I would get
suspicious. Why did Merrill clients not know of this conflict of
interest? At the very least, why did Merrill execs not tell their
analysts who should have looked into the situation and warned
clients? Inquiring minds want to know.
As bad as the Long Term Capital Management situation was, they only
lost about $4 billion on $1 trillion dollars worth of derivatives, or
about 4/10 of 1%. These men were not frauds and they actually thought
they were limiting risks. To the extent they only lost $4 billion,
half of which was their money, I guess they did. They simply did not
understand the nature of the risks they were taking, and they had
huge egos. This is not a good combination of traits for money
managers.
Contrary to rumor, the Fed or the government did not bail them out.
The Fed simply made sure the investment banks acted properly to clean
up a mess they created by not properly monitoring their loans to
LTCM.
What I find interesting is that at every hedge fund conference I have
attended or spoken at since LTCM and 1998 has had several sessions on
what is called"transparency". That means investors and the banks
that lend to or invest in hedge funds want to see the actual
portfolios within the hedge funds.
As you might imagine, this is quite the tug of war, as hedge funds
all think they have a new twist on the world (I get so tired of the
word"proprietary"). But hedge funds are fighting a losing battle on
that front, as investors are scared blind because of LTCM. If LTCM,
with two Nobel prize winners as winners could go bust, then everyone
is suspect.
The investment banks which lend them the capital, and who lost
billions on LTCM, are especially cautious. You should hear the hedge
fund managers gripe.
My point? These same investment banks who hold the feet of hedge
funds to a hot fire are the ones who entered into the"swaps" (or
derivative) transactions with Enron. Now, either they once again let
a huge client get away without disclosing the risks, or they knew the
risks and did not tell anyone else because they were getting huge
fees. Either way, it is bad.
If they simply were imprudent and lost money because they failed to
monitor risks, that is their own stupidity. After LTCM, anyone who
does not monitor the risk of a large client deserves to lose.
But if they knew the deals were risky and failed to disclose to their
small clients? They deserve the trial lawyers that will circle their
carcasses. As long time readers know, trial lawyers are pretty low on
my list. But they are far ahead of financial institutions who do not
disclose serious risk, when they know it, to their smaller clients.
Copyright 2002 John Mauldin. All Rights Reserved
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