Sound Portfolio Advisors

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We have reached the point in the credit crisis where the post-mortem

has begun of trying to determine what happened, why it happened

and perhaps most importantly, what we can learn from it. Of these

questions, the easiest to answer, at least on the surface, may be what

happened.

As has been pointed out here before, what happened was a classic

panic similar to many other financial crises going back (at least)

hundreds of years in history. In most ways it is very much the same

old story, but much worse than we have seen in modern times and

much more unexpected because the widely held assumption was that

we were now simply too sophisticated to have a recurrence of a good

old-fashioned panic. The severity was greatly exacerbated due to the

enormous amount of debt involved across economic sectors as well as

the tight integration of the modern global economy.

It didn’t just seem severe at the time, it actually was. As more and

more of the details become available, the picture of just how severe

the depth of the crisis was has begun to emerge. It isn’t an overstate-

ment to say that we came within days, and perhaps hours, of the

failure of the global financial system. As much as that statement may

sound like hyperbole, Andrew Ross Sorkin’s book, Too Big to Fail

(which will likely prove to be the most complete record of the actual

events of the credit crisis) claims that AIG came within 15 minutes

of running out of cash and beginning to default on trades. Current

efforts to engage in revisionist history of events aside, it’s difficult to

make a plausible case that AIG’s collapse would not have resulted in

the collapse of counterparties around the world. These were not just

large institutions, but included individual life, auto and property

insurance policies. Virtually all payment systems would have frozen,

resulting in massive runs on financial institutions.

COMMENTARY

Problems cannot be

solved by the same

level of thinking

that created them

- Albert Einstein

APRIL 2010

© Sound Portfolio Advisors 2010

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PRIME AND PROXIMATE

The next and much more difficult question is why didit happen? Before getting too deeply into this question,we should build a framework of causes to work within.In both philosophy and risk management, causes aredivided into proximate cause and prime cause.Insurance companies, perhaps ironically, deal with thisissue all of the time. For example, let’s say a treebranch falls on your car and destroys it, which youthink should be covered by your insurance. So you callthe nice folks at the insurance company and they say“Yes, the branch falling was the cause of damage toyour car. However, it was the category 5 hurricane thatcaused the branch to fall and you don’t have hurricanecoverage. Sorry you get nothing.” The branch falling isthe proximate cause, but the hurricane is the primecause. This is really the point of the old joke “it wasn’tthe fall (prime cause) that hurt him, it was the suddenstop (proximate cause).”

This is an important distinction because

coverage of the credit crisis has cited a broadrange of causes including excessive amounts ofleverage and risk taking, a diminished regulatorystructure, lax oversight, excessive greed, loosemonetary policy, increasingly rapid speed withwhich information and panic can spread, thefailure of corporate governance, the separationof the negative outcomes of risk taking from therisk taker and allowing financial institutions tobecome too big to fail.

We’ll look at many of these causes in more detail later,where it will become apparent that most of these causes are proximate rather than prime.

ANATOMY OF A PANIC

As mentioned above, the basic mechanics of this crisiswere similar to panics throughout history which meansthat a review of the dynamics of these panics is proba-bly in order. The fuel of panic fires is leverage (oftenknown as debt) and lots of it, but saying a bubble iscaused by too much leverage is an oversimplificationthat ignores how the leverage develops. So let’s explorehow excessive leverage comes about.

All debt is preceded by someone extending credit tosomeone else (as the old saying goes “100% of alldefaulted loans were approved by a banker”). Credit isbased on faith. This faith is based on an idea that supports the belief that the debt will get repaid andthat the collateral is worth at least as much as the loan and will retain its value. The stronger the belief in the idea is, the more credit is available. The morecredit that is outstanding based upon a particular idea, the greater the motivation to foster this ideadespite mounting evidence against the actual validityof the idea.

It is worth stopping here to point out that these

ideas on which leverage is based, and fromwhich bubble ultimately develop, don’t necessarily start out to be flawed or even incorrect. In fact in many cases they have been

historically correct, or at least quite plausible, up until

that point. However, just because something hasalways been the case does not mean that it willalways be the case. Stating that you have never

been in a car accident is very different from stating

that you will never be in a car accident. In other words,

past isn’t necessarily prologue.

To illustrate this point further let’s take the example of a person who turns 100 years old. We could say thatbased on past evidence, we have 36,500 instances (thenumber of days you have to live to be 100) of that per-son waking up every day, which leads us to the conclu-sion that the 100-year old will never die. This nowstarts to look pretty absurd and you’re probably sayingto yourself, “just because they haven’t died doesn’tmean they won’t die.” You would say this becauseyou’ve known and heard of lots of people dying andbecause by this point we are aware of the collectiveexperience of several billion people having lived on theplanet and as far as anyone can document (religiousbeliefs aside), no one has gotten out alive.

Imagine for a moment though, that we have just beenbeamed down from another planet and our 100-yearold was the only person we had ever encountered andwe were unaware of the billions of people who hadlived and died before. Given the evidence of the thousands of prior days, we might well conclude thatwith a 100 year track record of successful living, thisperson will continue on indefinitely.

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While this is perhaps an extreme example, it does illustrate how erroneous ideas develop from plausible facts. We’ve seen that these ideas don’t necessarily start out as untrue, but rather over timethey are stretched to achieve unsupportable conclusions. In markets this is often done by latecomers to the game in an effort to justify evergreater amounts of leverage. Warren Buffett refers tothis as the cycle of “innovators, imitators and idiots.”Innovators discover or create the idea, imitators copyand take advantage of it and the idiots don’t under-stand it, but try to copy it and make money like theother two, but end up holding the bag.

For an idea to support a bubble it has to be incrediblystrong and widely held. Usually they are so strong andwidely held that those souls brave enough to questionthem when the bubble is forming are labeled asheretics, idiots or worse for not buying into the “new paradigm.”

Eventually the evidence of the fallibility of the idea can no longer be ignored and finally overwhelms thefirm grip with which it is held. The idea and all of theleverage piled on top of it comes crashing down. Inother words, reality turns out be substantially different from what was very firmly believed or“known” to be the case.

Clinically this process of reality being different fromexpectation is referred to as disconfirmed expectancyand leads to the psychological process of cognitive dissonance. Speaking non-technically this is the mind’s version of short circuiting while trying to reconcile two clearly conflicting ideas. In other words, what happened was profoundly different from what you thought would happen. This is what a friend once referred to as an “aw-shucks”moment (or words similar to that).

The aftermath of this process leads to a widerange of emotions including confusion, fear,anger and most importantly in this context,panic. This should sound pretty similar to theexperience most investors had in the fall of 2008and into the spring of 2009.

This process is certainly not limited to market participants and is essentially the same as themoments following an accident or unexpected death.For a useful, if not extreme, example of how we

respond to a situation that differs significantly fromexpectation, we can go the Montana/Wyoming border in the summer of 1876. This was the scene of theBattle of Little Bighorn in which General Custer andhis troops were completely wiped out by the opposingLakota and Northern Cheyenne warriors. In the daysfollowing the battle, other Calvary troops, upon makingdistant sighting of warriors wearing parts of the uniforms of Custer’s troops, were unable to accept theobvious explanation and spent days conjuring oftenfantastical theories that would explain what they hadseen in a way that did not involve the complete deci-mation of their comrades.

Fast forward more than 125 years from the plains toWall Street and the modern financial system and youmight recognize the same dynamic which took place.

Time and technology have changed, but humannature remains constant.

Ultimately the panic subsides, and time fades thememory of the panic. Inevitably a next great ideabegins to emerge and the cycle begins anew.

If you found the above description of the dynamics ofbubble formation to be too esoteric, or just boring,below is a much more succinct summary.

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reasonable bounds by coming up with every conceivable type of derivative instrument imaginable,setting themselves up to be the last in the chain ofBuffett’s innovators, imitators and idiots progression.

As these derivatives became more complex, they beganto abandon the principles that made the simpler derivatives such as futures work so well. As notedabove, these include having a direct interest in theunderlying asset on which the derivative is based andunderstanding and acknowledging counterparty risk.

By the time we got to the peak of the credit bubble in 2007, derivatives were literally beingwritten on other derivatives that had an underlying asset of yet more derivatives thatwere ultimately backed by a pool of very low quality subprime mortgages.

In this case not only did the end derivative buyer nothave an interest in the underlying asset, almost no one knew what the underlying asset was or who thecounterparties were. Even worse, it was widelybelieved that somehow these structures made all of the risk disappear.

But wait, it gets better. Not only did the risk not disappear (instead it just got shifted to another party),but no one could figure out where the risk was orwhere it could turn up next. It was this piece of cognitive dissonance and the fear of the unknown thatit spawned, which took us to the brink of a completeseizure of the global financial system back inSeptember and October of 2008.

An incredible aspect of the derivatives issue is how many times over the last 25 years theyhave created enormous problems and that we have failed to learn the appropriate lessonsand take the necessary safeguards to prevent these blow ups.

Take for example the following description of a congressional hearing on derivatives:“…then chairman of the House Committee on Banking,Finance and Urban Affairs released derivatives legislation he had been preparing. His bill included aproposal to study whether Congress could tax deriva-tives speculation and a law making “improper

management” of derivatives illegal. DemocraticRepresentative Edward Markey and others joined thefray. Markey’s office announced that he “has been con-cerned about how the market has expanded fromsophisticated financial intermediaries and Fortune 100companies toward smaller and less sophisticated end-users, either corporations or municipal governments.”….Markey had asked the SEC to study derivatives morecarefully and recent swings in the stock and bond markets…..“Instead of waiting for catastrophe to strike,we should show American financial leadership andtake a proactive stance.”

The next day George Soros had the following testimony:“There are so many of them (derivatives), and some ofthem are so esoteric, that the risks involved may not beproperly understood even by the most sophisticatedinvestors….some other instruments offer exceptionalreturns because they carry the seeds of a total wipeout.”He also warned of a meltdown, in which regulatoryauthorities would have to intervene to protect theintegrity of the financial system.

These hearings weren’t held in the last fewweeks or even last few years as you might havethought. No, they were held 16 years ago inApril, 1994.

They were in reaction to the derivatives crisis at thetime which involved the bankruptcy of Orange County,California, and significant losses at a number of com-panies including Gibson Greeting ($20 million) andProctor & Gamble ($100 million), among a host of others. Ironically, at almost exactly the time of this testimony the venerable, 130-year old firm of KidderPeabody was discovering that one of its traders hadengaged in hundreds of millions of dollars worth ofderivatives trades which had gone bad, effectively sinking the firm.

At the end of 1994 the Mexican Peso crashed,significantly aided by the Mexican banks’ use of derivatives, and resulted in the US and various international monetary authorities having to provide$50 billion in aid to the country to try to prop up its currency.

These derivatives blow-ups were followed the next year by a rogue trader named Nick Leeson using derivatives to make various bets on the Japanese stockmarket which resulted in the loss of $1.4 billion and


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in bringing down his employer, Barings, then the oldestbank in England. But, there was plenty more derivatives carnage to come.

In 1997, Victor Niederhoffer lost all of a $100 millionhedge fund in a matter of a few days due to bad derivatives bets. Prior to that unfortunate turn ofevents, he was a widely accomplished and respectedacademic and hedge fund manager who had managedthe top hedge fund in 1996 and was so well regardedthat George Soros sent his own son to work for him.

The next year in 1998 the most spectacular derivativesdisaster up until that time took place when the hedgefund Long Term Capital Management crashed. Thefirm’s highly leveraged derivatives bets resulted inlosses of $4.6 billion and resulted in the intervention ofregulatory officials to save the integrity of the financialsystem that Soros had predicted in his congressionaltestimony nearly five years earlier.

Derivatives can create such damage because, unlikestocks and bonds, the losses that many derivatives cangenerate go far beyond the amount invested and can bealmost limitless. If you buy $10,000 of a stock and thecompany goes out of business you’ve lost $10,000. Buy$10,000 worth of a derivative that goes bad and youcould lose millions. Now you can begin to understandwhy Warren Buffet referred to derivatives as “financialweapons of mass destruction.”

In the end many derivatives were, and continueto be, written not because they serve any social or economic purpose but because they generate enormous fees.

This was possible because these derivatives were completely unregulated. How is it that a market of tens of trillions of dollars in size, that has destroyednumerous institutions and repeatedly put the entirefinancial world at risk, could be unregulated? It’s agood question with a lengthy answer, which just happens to be supplied below.

MARKETS AND INVESTORS ARE RATIONALOf all of the ideas that led to the credit crisis the development of the beliefs that markets and investorsare rational was clearly the most important primecause. This belief and those associated with it, hadbeen building for over 100 years before the credit crisis

and ultimately grew to become the bedrock of economicand financial theory and regulation.

Before we start discussing whether markets andinvestors are rational, a few disclaimers are necessary.First, given that this paper is for general consumptionand not a strict academic treatise, I’m going to make anumber of simplifications with terminology. I will usethe phrases efficient prices, rational investors and efficient markets to encompass the Efficient MarketHypothesis, the Rational Agent and Modern PortfolioTheory generally. It is important to understand theseconcepts because they have come to be the frameworkfor all of modern finance and how the tens of trillionsof dollars of the world’s assets are allocated and managed.

RATIONAL PRICES

One of the central assumptions of these models is thatthe price of any security at any given time reflects allknown information about that security. This is basedon the theory that while each market participant mayonly have a little bit of information regarding a securi-ty, collectively they possess all known informationabout a security. Because of this, all known informationabout a security is baked into the price meaning thatthe price must be correct. The logical extension of thisis that trying to pick securities is futile because as amarket participant you can’t know as much as themarket collectively. There is an old economics joke(that’s not a typo) that goes something like this:

Q: Why did the economist walk past the $100bill on the sidewalk?

A: Because theoretically someone else alreadypicked it up.

RATIONAL PEOPLE

Another assumption underlying modern academic andeconomic theory is that of the rational agent. In otherwords, individuals act rationally when making economic and financial decisions and emotions don’tenter into the process. This actually started out not somuch as a theory, but as a simplifying assumption thatallowed academics to focus more on market dynamics


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and get past the details concerning individual agents.The problem that developed over the years is that subsequent academics and practitioners forgot thatthis was a mere simplifying assumption made for thesake of expediency and came to regard it as an inarguable truth.

EFFICIENT MARKETS

These efficient securities prices and rational investorsthen comprise efficient markets. Efficient markets, itfollows, provide the best allocation of capital for societyand are self-correcting. Those who allocate capital wellare richly rewarded and those who allocate capitalpoorly are brutally punished. The rewards and punish-ments are meted out by the market through redistribu-tion of capital from those who acted badly with it tothose who treated it well. It has been said that marketcrashes are a mechanism for returning capital to itsrightful owner. To summarize, the theories lead to theconclusion that rational investors and perfectly effi-cient securities prices create markets which themselvescreate the optimal allocation of capital for society.

Just as derivatives started out to be a very goodand useful idea, but eventually became overrun,distorted and overwrought, so too did the concepts of efficient prices and markets andrational investors. We eventually came to believethat markets and prices weren’t just rationaland efficient, but that they were perfect.

This was academic gospel, handed down from genuineNobel-prize winners high atop the ivory tower of theUniversity of Chicago. To argue with the establishedparadigm was academic career suicide.

This belief in the perfection of markets carried over tothe regulation (or lack thereof) of those markets. Thisstarted in earnest in the 1980s as a reaction to whathad been a period of intense regulation and had beenbuilding since the aftermath of the Great Depression.The idea culminated in the belief that, since marketswere perfect, regulation of them was not only unnecessary, but served to hinder and distort the perfection of the markets.

Eventually a great deal of the regulations put in placefollowing the 1929 crash were dismantled. Probably

the culmination of this regulatory dismantling was the repeal of the Glass-Steagall Act in 1999 which separated commercial banks from investment bankingand insurance. In addition to the repeal of regulation,enforcement was often politically neutralized as wasthe case of the Securities and Exchange Commission.

As the regulatory mantle was shrugged off, institutionsbegan to merge and grow larger. This larger size andthe accompanying expanded resources resulted ingreater influence over the regulatory structure whichoversaw them.

This led to institutions growing even larger and garnering greater influence over their ownoversight and so on, in a self-reinforcing cyclethat resulted in institutions that were so massively overleveraged and so systemicallyimportant that their failure would be sociallycatastrophic. Thus the multi-trillion dollar derivatives market went unregulated and the era of Too Big To Fail was upon us.

There was no better poster child for this movementthan Alan Greenspan. In his view, the ever-largerfinancial institutions that came about from a ]diminished regulatory environment were quite useful because they could underwrite products thatreassigned risks that simply couldn’t be done by smaller banks. Furthermore, these financial institutions would be essentially self-regulatingbecause competitors would keep each other in check.It was these philosophical underpinnings that ledGreenspan to thwart any attempts to regulate thederivatives markets.

As an aside, it is important to point out that theseswings between the Ayn Rand-style, Laissez-Faireapproach of virtually no regulation of markets on one end and the populist approach of put the bankers-in-straightjackets and eat-the-rich overregulation on the other is as old as financial bubbles are. In their extreme, neither approach is particularly beneficial to society.

A complete lack of regulatory oversight resultsiin dislocations that are too severe for the bodypolitic to endure and can result in social instability. Excess regulation on the other


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hand, severely limits growth. Historically weswing through just the right mix as we’re busy rushing from one extreme to the other.

A BRIEF HISTORY OF EFFICIENCY

To understand why the efficient market theory became so dominant, we have to go all the way back to the late 1800’s when economics and finance firstbegan to show up on the radar screen of mathematicsand science. It was then that mathematicians began tolook at markets as testing grounds for then-emergingtheories and approaches, specifically in the fields ofprobabilities and statistics. Economists have longaspired to be taken seriously as a “hard” science ratherthan a social science and this provided just the openingthey were looking for. By the mid-twentieth century afull scale move to more mathematical-based models,greatly aided by the advent of the electronic computer,was in full swing and was a great boon to this aspira-tion. This movement to more scientific (appearing atleast), quantitative models resulted in a Nobel awardfor economics being created in 1968. It is worth notingthat economics is the only prize that is associated withNobel that wasn’t specified in Alfred Nobel’s will.

The problem with economics being categorized along with the natural sciences is that there is anexpectation of discovery of objective, immutable,unchanging laws. The discovery of these laws has, infact, been the primary focus of research in finance andrelated economics. The underlying assumption wasthat there was an objective, immutable model and setof laws to be discovered that govern how markets work.Like the laws of nature or laws of science, it wasassumed that these laws of economics and finance,once discovered, would be timeless. The laws of gravityhaven’t changed much since Newton’s time and so itwas believed that the economic and financial laws andmodels being put forth were equally immutable.

THE PRICE ISN’T NECESSARILY RIGHT

We can see how theories of markets, prices andinvestors provided the philosophical cover to create anenvironment for systemic failure. Were or are thesetheories fundamentally flawed?

Let’s look first at the rational agent. As mentioned

earlier this was actually more of a simplifying assumption to be able to focus on the dynamics of securities pricing and markets than a stand alone theory. The problem that developed over the years isthat subsequent academics and practitioners forgotthat this was a mere simplifying assumption made forthe sake of expediency and came to regard it as aninarguable truth.

The rational agent began to come unraveled as early as the 1970’s with the work of psychologists IvanTversky and Dan Kahnemann, whose work shows thatmarket participants really aren’t always rational. Thegood news, however, was that people did tend to showconsistent irrationality. In fact an entire series of identifiable, consistent irrationalities have been shownto exist through a number of very simply replicatedexperiments. In summary, they show that we are unduly influenced by our environment and recentevents. We also tend to be too overconfident in our abilities, much more sensitive to loss than gain and arevery influenced by being in a group. In other words,

we’re not the cool, objective and rationalthinkers we believe we are.

Given the widely erratic price swings andinvestor behavior of the last 18 months, itwould seem all but impossible to defend therational agent, efficient prices or efficient markets in their strongest forms.

Even those who held most vehemently to these principles, many of whom were personally involved in the dismantling of the regulatory structure andbuilding the edifice of the perfect market doctrine,crumbled and recanted in the depths of the crisis.As Ben Bernanke said to Henry Paulson at the heightof the crisis, “There are no atheists in foxholes and noideologues in financial crises.”

What these three failed beliefs have in common is theywere used as justification for leverage and involvedleaps of faith across chasms that were ultimately toowide. The fact that there had never been a nationwidehousing price decline does not logically lead to the conclusion that there can never be a nationwide housing price decline. Derivatives in and of themselvesare a very useful concept. Derivatives that contort andhide risk and exist for no economic reason other thanfee generation are a very bad idea. A theoretical


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framework for the making of economic decisions andcapital allocation is a very useful concept. A theory thatforgets that simplifying assumptions were made in its’construction and denies regularly occurring real worldevents might be worse than no theory at all. All areplausible theories and useful facts on the surface, butthe overwhelming majority of believers failed to realizewhen the train went off the track.

The invalidation of the idea of the impossibility of anational housing decline and derivatives’ ability toeliminate risk are more product-oriented, historicallystandard bubble justifiers. The failure of the edifice oftheoretical economics and finance is clearly the mostsignificant and problematic in that it represents thedeath of a central and very dominant paradigm.

REAL RATIONAL INVESTORS

Despite the iron clad grip of the rational market theories and the resulting “why bother” indexingapproach by the academic community, a few practitioners had long-rejected the theories.Interestingly, these practitioners include the first and second most successful investors of our (and perhaps all) time, namely Warren Buffett and George Soros. Buffett has made $50 billion from investing while Soros has $13 billion (but he’s givenaway $7 billion). While united by their rejection of the dominant academic theories of the era, their investment styles, philosophies and even personalitiescouldn’t be more different.

Soros is a super-sophisticated philosopher/investor that specializes in global macroeconomic trends attheir broadest. In the parlance of the industry he is topdown and cares very little about specific companies orstocks except as they may relate to an overall thesis.

Soros essentially says that of course marketsaren’t rational because bubbles form and burst,they always have and they always will as longas people are involved.

He further aims to not only identify a bubble, but participate in its expansion, correctly decide where thetop of the bubble is and then short the bubble as itdeflates. An approach probably best described as simple, but not easy.

In pursuing his approach Soros has formed his own,and by many accounts, arcane philosophy on marketscentered on his concept of “reflexivity.” It is based onthe idea that systems (like markets) that involve people are not static, but dynamic, that is to say subject to change. In the case of markets, as participants react to market events, it induces changes in the markets, which causes further reaction from market participants, inducing more market changes, and so on such that the outcome islargely unpredictable.

His thesis is somewhat analogous to the idea from thefield of quantum physics which says that the observereffect inherently affects the observed. The mere act ofobserving something changes it. If this is the case, as

Soros believes it is with markets, then true objectivity is impossible. He further argues thatthe mere realization of the imperfection of ourinformation makes our information much moreuseful (or more perfect to get completely ridiculous).

This imperfect understanding would mean that we cannever accurately predict outcomes because we can’thope to perfectly understand the situation, thereforewe must expect the unexpected. This could easily leadone to the question if we expect the unexpected, doesthe unexpected then become the expected? Soros mightsay “exactly what I’ve been trying to say for years!”He might also add the caveat that our mere expectingit reduces its likelihood.

Contrast the somewhat complex and arcane philosophy of Soros with the plain, home-spun and usually obvious-sounding approach of Warren Buffet.Buffett lives in Omaha, Nebraska, in the same househe bought in 1957 and drives himself around in a latemodel Cadillac. In contrast to Soros’ global macro view, Buffett made his fortune focusing on individualstocks. His approach also involves the core thesis that the markets and their participants aren’t alwaysrational or efficient. Buffett’s (and any value investor’s)true skill is in identifying intrinsic value or what theprice of a stock should be as distinct from what themarkets says it is and exploiting that gap. Again,simple, but not easy. After purchasing a stock that hebelieves is undervalued by the market, Buffett’s preferred holding period is “forever.”


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In short, Buffett has shown that it is possible to value securities more accurately than the market does. This has proven so difficult for therational market and indexing adherents to believe, thatthey simply choose not to.

The academics discount using either Buffett or Sorosas evidence against rational market doctrine by arguing that their results are random, unique eventsfrom which we aren’t entitled to more general conclusions. In other words, both practitioners are such rare, unique cases that they just don’t count. Thewheels come off of this argumentative wagon with theevidence that their results are neither rare nor unique.Soros has plenty of company among fellow managersfollowing a similar approach, not the least of whom ishis ex-partner Jim Rodgers.

Buffett, in typical fashion, addressed the issue quiteclearly and well before others in a speech he gave at his alma mater, Columbia Business School,commemorating the 50th anniversary of the publica-tion of Securities Analysis, the bible of value investing,written by his mentors Ben Graham and David Dodd.Perhaps most interestingly this was in 1984, so Buffethas been facing this criticism for over 25 years.

In short, Buffett lays out why he isn’t a freak productof the Gaussian bell curve that we all understand asrandom chance. If he were, in fact, a freak product ofrandom chance, he shouldn’t personally know any (or at least very, very few) of the other managers (out of a pool of tens of thousands) who significantlyoutperformed the markets up until the period when hegave that speech in 1984. According to the academicsthe number that would have outperformed the marketconsistently over any given time period would havebeen so small as to be statistically insignificant,essentially random freaks of nature with nothing incommon other than their own lucky outperformance.

Buffet goes on to talk about nine managers that he has known, who had until that point significantly outperformed the market on a consistent basis over different time periods. They didn’t all hold the samesecurities or necessarily even use the same approach.The only things they had in common were their adherence to the principles laid out by Graham andDodd and their outperformance of the market.

It’s worth noting that Buffett’s performance wasn’tmuch inhibited by his speech as he went on to producea return of 8,420% from the date of the speech,May 17, 1984, through January 30, 2010, versus areturn of 586% for the S&P 500 over the same period.That means that $10,000 invested with Buffett wouldhave become $842,000 versus $58,600 in the S&P 500,an outperformance of better than 15 times. This sort ofconsistent outperformance across multiple, non-randommanagers should certainly have caught the attention ofthe academics strongly advocating efficient market the-ories. Assuming, of course, that they were interested inthe pursuit of objective reality above the furthering oftheir own careers. Apparently it isn’t just Wall Streetinvestment bankers are consumed by self-interest.

So what was the response by the academic communityto this evidence? Largely deafening silence punctuatedwith periodic condescension. According to a paper pre-sented at a conference in Australia in 2004:

Despite this exceptional record, as far as references toeither the man or his methods in standard finance oreconomic texts, Buffett is virtually invisible…..in asearch of 23,000 pages of finance only 20 pages referredto Buffett. Similarly, a search of the leading academicjournals for references to Buffett and BerkshireHathaway located only a handful of articles.

Even more, many of the references to Buffett are simplythere to dismiss his results as a statistical anom-aly…..Nobel Laureate, Merton Miller explains “if thereare 10,000 people looking at the stocks and trying topick winners, well 1 in 10,000 is going to score, bychance alone, a great coup, and that’s all that’s goingon.” Burton Malkiel says “In any activity in which largenumbers of people are engaged, although the average islikely to predominate, the unexpected is bound to hap-pen. The very small number of really good performerswe find in the investment management business actual-ly is not at all inconsistent with the laws of chance.”

Why let the evidence get in the way of a goodacademic theory? As a practical matter, no onewho has had a successful academic career, letalone won a Nobel Prize, based on advancing atheory is suddenly going to say, “Wow, nevermind, I guess I kind of really blew that call.Sorry.” No, you’re going to stick with your storyat all possible costs.


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In the words of Seth Klarman, quite possibly the bestvalue investor of our time after Buffett (and my bet tosucceed him at Berkshire Hathaway), “Fifty billion dollars are a lot of aberrations! Rather than abandontheir theorizing to study Buffett exhaustively to seewhat lessons could be learned, too many people cannotbear to re-examine their faulty theories.”

It has been said that science advances in the grave-yard. It is an attempt to say that the dominant paradigms of the day are vigorously defended by theirinventor/discoverers in spite of the potential validity ofother views. It is only when this literal old guard isgone that the field is opened up to other, potentiallymore accurate views.

In the case of economics and finance it isn’t so muchthe literal graveyard that sees old theories die, but thegraveyards of crashing asset prices and markets.

The last 18 months would seem to have provided the silver bullet that finally killed the efficient market vampire that had survivedprevious attempts on its life in the dot-com bust of 2000, the Long Term Capital Crisisof 1997 and the 1987 crash.

Soros, and his fellow successful macro approachpractitioners, have shown that markets aren’t alwaysrational. Buffett and his contemporaries have shownthat securities prices aren’t always perfect. Both haveshown, as has the field of behavioral finance, that theindividuals who comprise markets and set securitiesprices aren’t always rational. In other words,

Kahneman and Taversky killed the rationalinvestor, Buffett killed the efficient securityprice and Soros killed the efficient market.Academia seems to be in no hurry toschedule the funerals.

Before exploring what all of this means on a practicalbasis and what the implications are for the day-to-daymanagement of your portfolio, it is worth taking amoment to explore what is perhaps the most criticalunderlying dynamics that allowed these theories todevelop. One of the critical features of developing theories in general and economics in particular is thenecessity of making simplifying assumptions. Peoplewrite papers based on other people’s papers which arein turn based on previous papers. This dynamic

continues much like the children’s game of telephoneuntil we no longer know what the original theory was.As part of this, what were originally simplifyingassumptions morphed into gospel truth.

I am consistently amazed when I speak with my colleagues at how few of them have ever read the original seminal papers or books in the field.They basically look at other people’s synopsis of themand carry on without ever questioning their validity.This is the dynamic that led us to ultimately go from“markets are mostly efficient” to “markets are perfect.”

Perhaps by necessity, if everyone holds the same market belief, it is surely doomed to failure. Even what had become the most knowable and quotable of all investing truths in recent years, thatindexing beats active management is ultimately headed for the graveyard.

THE DEATH OF INDEXING

Where the rubber of the efficient market theories hitthe investing road for the average person was the concept of indexing, also known as passive investing.This was really the distillation of rational market theories which said “the market is so rational and perfect that you can’t beat it, and trying to do so isfutile, so just buy all of the stocks that comprise theindex and go with the flow instead.” To support this,study after study purported to show that most activelymanaged funds didn’t consistently beat the index. Likeany dominant paradigm that ultimately fails, this onewas mostly true but certainly had its short-comings,which were largely ignored.

The concept of indexing eventually came to mean buying the S&P 500 index. The popularity of thisapproach peaked around 2000 just in time for adherents of the theory to get hit by what was by somemeasures the worst decade ever for large cap US stocks(those that comprise the S&P 500). Those who boughtinto the theory wholeheartedly were hit with a doublewhammy. They avoided all other asset classes, such assmall cap, international and emerging market stocksas well as bonds and commodities all of which did considerably better than the S&P 500. In fact, of justabout all of the things the average person was likely toinvest in starting in 2000, buying the S&P 500 indexwas just about the worst thing one could have done.


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Perhaps more importantly, the average actively managed large cap mutual fund beat the S&P 500 in the decade ending December 31, 2009. Having been there I can tell you with great certainty that

if on December 31, 1999, you would havedeclared that for the next ten years most active managers would beat the index and thatthe highest returning asset classes would be gold, emerging markets, and real estate youwould surely have been carted off in a suit thatdidn’t allow much mobility. The thundering herd achieves its greatest speed just before going over the cliff.

There were and remain two primary flaws with theindexing argument. The first is, which index should weuse? The S&P 500? The Russell 2000? The MS Europe,Australasia, Far East (EAFE)? In short, while the aca-demics claim that it isn’t possible to consistently beat“the market,” they often fail to define exactly whichmarket they’re talking about.

What is also missing in this debate about active versuspassive management is the concept of quality. Thesestudies are all quantitative. It is economics and financeafter all, and numbers, we’re told, don’t lie. The numbers may not lie, but perhaps they’re just lookingat some of the wrong ones. A portfolio assembled byWarren Buffett, Seth Klarman, Julian Robertson or ahost of other experienced, successful investors is hardlycomparable to the portfolio assembled by the newlyminted MBA running a portfolio for a third rate investment shop. Yet these studies don’t reflect anything of the sort. A portfolio is a portfolio is a portfolio.

As with every paradigm that goes through the

innovators, imitators and idiots cycle, the idea of

indexing went too far. Somewhere along the line the leap was made from “investors are uunnlliikkeellyyto beat the market” to “investors ccaannnnoott beat the market.

SO WHAT LESSONS CAN WE LEARN?

The Dominant Market-Related EconomicParadigms Are Ineffective Markets and securities

are not always efficient and investors are not alwaysrational, and we have to stop pretending they are.The search for an all-encompassing theory of markets is the domain of the academics.

As a practitioner it isn’t my job to solve theworld’s problems, but rather to realize that inefficiencies exist and to identify and take advantage of those on your behalf.

Too Big To Fail Is Too Big The well documentedproblem with Too Big To Fail is the implicit guaranteethat goes along with that statement. In other words,it’s functional socio-economic blackmail. If the largefinancial firms don’t get bailed out when they’re introuble, they’ll bring down the whole system. It’s notjust about being too big, it’s about the risks that thosethat are too big take because they are effectively largely unregulated and have an implied safety net.Academics might call it asymmetrical risk-taking,but the rest of us would better understand it as theequivalent of walking into the casino, having someonehand us a pile of money and saying “you keep the winnings, I’ll take the losses.” Nice work if you can get it.

Since the credit crisis, not only have we failed toaddress the Too Big To Fail problem, but the Too Bighave gotten bigger. Four U.S. institutions -- Bank ofAmerica Corp., Wells Fargo & Co., JPMorgan Chase &Co. and Citigroup -- held 35 percent of the country’sdeposits on June 30, 2009, compared with 28 percentby the four biggest two years before, according to theFDIC and the Fed. The world’s 10 largest banks at theend of 2008 had 26 percent of the assets out of the top1,500 banks, up from 18 percent in 1999.

I had a hedge fund manager (yes, I know, my motherwould be very disappointed to learn that I talk to thosesorts of people) make the argument to me recently that while these institutions might be larger by somemeasures, they are significantly less leveraged thanthey were going into the crisis. I would counter argue,that it won’t be long before they start to resume leveraging and they will once again hide it until it’s too late. The point is that there remains much moresystemic risk than most people want to admit. In thewords of Hank Paulson, “The largest financial institutions are so big and so complex that they posea dangerously large risk.” This comes from a guy whoused to run Goldman Sachs and the US Treasury.


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Bubbles Are a Real and Inevitable Part ofMarkets. As long as there has been money there havebeen bubbles. While we will hopefully rework andenforce our regulatory structure and reduce systemicrisk, we should be under no illusion this will eliminatebubbles. In fact we can be all but certain that even now new bubbles are forming. Just as the low rates following the bursting of the dot-com bubble and 9/11led to the housing bubble, so current low rates will lead to a future bubble.

Traditional Methods of Diversification Need tobe Reconsidered. Despite Andrew Carnegie’s adviceto “put all of your eggs in one basket and then watchthat basket” most investors agree diversification is agood idea. Unfortunately in bubbles, diversificationtakes it on the chin in one form or another. For example, in the dot-com bubble people came to believethey were diversified because they owned 10 differentinternet stocks. They failed to understand that all ofthese stocks would move up and down together whichmade them highly correlated mathematically speaking.

Over the course of the last bubble, diversification hadbeen implemented by diversifying across equity assetclasses that were believed to have low correlation. Saidanother way you could put together a portfolio of largecap stocks, small cap stocks and say, emerging marketsstocks and the risk to their overall portfolio would bemuch lower than if you owned just one of the assetclasses and overall return would be higher due to moreconsistency of returns. The elusive free lunch seemed tobe in hand.

The problem, as Soros’ theory of reflexivity would predict, is that once everyone started doing it, thegame changed. Correlations between equity asset classes rose dramatically over the years taking awaymost of the free lunch provided by diversification.This didn’t become readily apparent until a broad market meltdown when prices of all equities collapsed,independent of what particular asset class theybelonged to.

This approach to diversification worked pretty welluntil it was needed the most. Sort of like one of thosehorror movies where the monster chases its victim who jumps into a car that previously had been working just fine but suddenly won’t start. A method of managing risk that works except when there’s a lot of risk probably isn’t a particularly good method.

It has become clear through this episode that diversification among asset classes as they have been traditionally defined is ineffective during periodsof intense market dislocation (which seem to be happening with greater frequency and severity).While it can be argued that this approach to diversifi-cation is still effective over the long run, such as thedramatic underperformance of gold relative to equitiesin the 1990s and vice versa in the 2000s, it leaves avery high likelihood of concentrated short-term lossesthat are unacceptable to the average investor.

In short, an approach that works pretty well,most of the time, doesn’t really work at all.

The lesson from the meltdown is that you can’tincrease an overall allocation to risk assets justbecause of diversification among risk assets.

What is needed is a return to the distinction ofrisk assets and risk-free assets and an acknowledgement that risk-free assets have a rightful place in a portfolio. The risk-free allocation serves as a type of insurance that keeps performance in line with investor expectations duringtimes of severe market dislocation.

The great conundrum of investing is over the long runwe’re concerned about the return on our capital, but inthe short run we’re worried about the return of ourcapital. Investors have a unique mix of priorities onthese two competing ends and the effective combination of risk and risk-free assets allows thecoexistence of the long and short-term objectives to the extent possible.

With the risk-free portion of the portfolio allocated,attention can be turned to the management of the riskasset portion. The increase in correlations of risk assetswill likely demand that we redefine how these assetsare categorized, perhaps along the lines of style orapproach rather than simply geography or market capitalization. The allocation to risk assets should thenbe actively allocated among those with the most attractive valuations. This active allocation within riskassets allows for a Soros-like recognition and exploitation of the inevitable bubbles and their crashes.A subset of the risk assets could also be managedthrough the selection of individual securities based on a Buffett-like recognition of the inefficiencies ofsecurities prices.


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CURRENT MARKETS

While the credit crisis is usually referred to in the pasttense, the reality is that we have yet to fully emergefrom it, and the world economy is still very much onlife support. Despite the massive rally from the lows oflast March, a number of challenges remain.

Unwinding the stimulus and the law of unintended consequences. Adding the massiveamounts of stimulus and liquidity was perhaps theeasy part and the successful removal of it may presenteven greater challenges. While massive inflow of liquidity and stimulus appears to have been successfulin avoiding what could have been the worst case scenarios with the economy and markets, the successful removal of these “training wheels” remainsto be seen. Perhaps a good analogy of the situation isthe theft of a priceless work of art from a museum.To pull off the caper it is necessary to both get in andout of the museum without being detected. We seem tohave gotten in and gotten the goods, but getting outand away might prove to be a lot trickier. Unfetteredbelief that this will happen successfully, which themarkets seem to have priced in, may represent a triumph of hope over experience. Historically governments haven’t been particularly good at determining the timing of removing liquidity, and thelaw of unintended consequences tends to rule.

Too Big To Fail remains too big. As noted earlier,the big banks are now even more concentrated and for-mer investment banks now have new access to the fedwindow for very low cost financing. These banks now ahave a lower cost of capital and a demonstrated gov-ernment backstop. The motivation to pursue impru-dent risks is greater than ever.

Housing will also continue to present a challenge. Beyond the subprime issue we are startingto see rapidly mounting defaults on prime mortgagesespecially the larger jumbo mortgages. This is especially troubling because, consistent with thedynamics outlined above, it was believed that, based on models developed over decades for mortgage holderbehavior, these loans would perform as predicted.What the models failed to detect was mortgages goinginto default not because borrowers are unable to pay,but because they are choosing to not pay. Again, just as Soros’ reflexivity would predict, consumers adaptedto the mortgage market and have begun to decide it’s

simply not worth it continuing to pay the mortgage ona house they paid $1 million for that is now worth$500,000. The default rate on jumbo mortgages nearlytripled from 3.2% in December 2008 to 9.2% inDecember 2009. This trend may accelerate as more and more people do it and the moral stigma of defaulting on a mortgage fades.

Commercial mortgages and smaller banks. Whilethe overleverage in housing ended up largely on thebalance sheet of larger banks, the overleveraging ofcommercial real estate has remained with the smallerand mid-sized banks. The effects of these defaults haveyet to be fully felt at these institutions, but when it is,the impact will be dramatic.

Weaker sovereign, state and municipal debt.As recent events in Greece and Dubai have shown,national governments around the world have been anything but immune to the effects of overleverage and derivatives exposure. As many states, most notablyCalifornia, and a growing number of municipalitieshave shown, the bill from the piper is just now beingpresented and payment may be a long painful process.

A BETTER OUTCOME AHEAD

Despite these challenges there is much to be encouraged about over the long run. The economy and sentiment have improved remarkably over thepast year. Assuming even a modest continuation ofthis, stocks are reasonably priced.

Ultimately the good news is that the structural issuesand misconceptions that have been building, in somecases for decades, are finally front and center. Aftersweeping things under the rug for a long time, it’s notnecessarily pretty when you ultimately pick the rug up,but it’s the first step in getting things really cleanedup. With this acknowledgement and understanding ofthese issues, and providing we are able to muster thepolitical will, we should ultimately come through thisprocess with a system that is structured to handlemarket and economic realities for decades to come.

Perhaps the most encouraging is the general pessimism and lowered expectations. This is encouraging because mass expectations tend to be dead wrong and an excellent contra-indicator.


Niall Ferguson, Penguin Books, 2009

Charles R. Morris, Public Affairs Press, 2009Frank Partnoy, W.W. Norton & Co., 1997, 2009Henry M. Paulson Jr, Business Plus, 2010

James Sterngold, Bloomberg.com, March 8, 2009

George Soros, Public Affairs, 2008

Justin Fox, Harper Business, 2009The Death of Rational Man, David Ignatius, February 8, 2009

Andrew Ross Sorkin, Viking Penguin, 2009

Eric Martin and Michael Tsang, Bloomberg.com, June 29, 2009

Alice Schroeder, Bantam Books, 2009

Nicholas Larkin and Millie Munshie, Bloomberg.com, December 7, 2009

Christopher Condon and Jody Shenn, Bloomberg.com, January 5, 2010

Mark Deen and David Tweed, Bloomberg.com, September 14, 2009

John Price and Edward Kelly, Keynote paper presented to the First International Workshop on Intelligent Finance: A Convergence of Mathematical Finance with Technicaland Fundamental Analysis, December 13-14, 2004

Royce & Associates, October 2009Tom Lauricella, The Wall Street Journal, December 20, 2009

Andrew Lo, The New York Times, January 9, 2009.

Gadi Decher and Alan Katz, Bloomberg.com, December 15, 2009

Warren E. Buffett, from a May 17, 1984, speech at Columbia Business School

Harry Markowitz, Financial Analysts Journal, 2005

Robert M. Persig, William Morrow & Company, 1974

Henry M. Paulson Jr, moderated by Jeffrey Immelt, Chairman of the Board and CEO of GE at the 92 Street Y, February 18, 2010Seth Klarman from an October 20, 2007, speech at Massachusetts Institute of Technology

Charley Ellis, McGraw Hill, 2010Seth Klarman, Beard Books, 2000, (authenticity questioned),originally published by Harper Business, 1991

Mutual Fund Scorecard, Fund averages cited are the respective Lipper Mutual FundIndiciesMutual Fund Scorecard, January 5, 2010

The Ascent of MoneyThe Sages, Warren Buffett,

George Soros, Paul Volcker and the Maelstrom of Markets

F.I.A.S.C.O.On the Brink

‘On the Edge’ Banks Facing Writedowns After FDIC Loan Auctions

The New Paradign for Financial Markets. The Credit Crisis

of 2008 and What it MeansThe Death of the Rational Market:

A History of Risk Reward and Delusionof Wall Street

The Washington PostToo Big to Fail: The Inside Story of Wall

Street and Washington Fought to Savethe Financial System – and Themselves

Cash Best as Record CorrelationHints Herd Collapse

The Snowball: Warren Buffett andthe Business of Life

Gold Can’t Beat Checking Accounts30 Years After Peak

No Good Deed Goes Unpunished asBanks Seek Profits from Bailout

Stiglitz Says Banking Problems Are Now Bigger Than Pre-Lehman

Warren Buffet: Investment Genius or Statistical Anomaly?

The Case for Active Management:How Have the Royce Funds Fared?

Investors Hope the ‘10s Beat the 00sFear, Greed and Crisis Management,

A Neuroscientific PerspectiveRegulators Resist Volker Wandering

Warning of Too Big to FailThe Superinvestors of Graham

and DoddsvilleMarket Efficiency: A Theoretical

Distinction and So What?Zen and the Art of Motorcycle

Maintenance: An Enquiry into ValuesOn the Brink: Inside the Race to

Stop the Collapse of the GlobalFinancial System

MIT RemarksWinning The Loser’s Game: Timeless

Strategies for Successful InvestingMargin of Safety

Wall St. Journal

Wall St. Journal

SOURCES

Documents

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