Wednesday, December 31, 2008
Friday, December 26, 2008
For a Darwinian, life is about two things: survival and reproduction. Of the two, the second is the more significant. To put it crudely, the only Darwinian point of survival is reproduction. As a consequence, much of daily existence is about showing off, subtly or starkly, in ways that attract members of the opposite sex and intimidate those of the same sex. In humans—unlike, say, peafowl, where only the cocks have the flashy tails, or deer, where only the stags have the chunky antlers—both sexes engage in this. Men do it more than women, but you need look no further than Ascot race course on Gold Cup day to see that women do it too. Status and hierarchy matter. And in modern society, status is mediated by money.
Status, though, is always relative: it is linked to money because it drives the desire to make more of the stuff in order to outdo the competition. This is the ultimate engine of economic growth. Since status is a moving target, there is no such thing as enough money.
The relative nature of status explains the paradox observed in 1974 by an economist called Richard Easterlin that, while rich people are happier than poor people within a country, average happiness does not increase as that country gets richer. This has been disputed recently. But if it withstands scrutiny it means the free-market argument—that because economic growth makes everybody better off, it does not matter that some are more better off than others—does not stand up, at least if “better off” is measured in terms of happiness. What actually matters, Darwinism suggests, is that a free society allows people to rise through the hierarchy by their own efforts: the American dream, if you like.
The hope this analysis brings, though, is that there is nothing particularly special about biologically based brands such as skin colour. If other brands of group membership can be strengthened, the traditional ones may diminish, even if they do not disappear completely. If this theory of race is correct (and more research is certainly needed), it indicates a strong prescription: policies that encourage groups to retain their identity within a society will cause trouble, but those that encourage cultural integration will smooth things over.
A Darwinian analysis thus sheds light on a number of pressing questions. There are others. The rise of metabolic syndrome (obesity plus high blood-pressure equals diabetes plus heart disease) seems to Darwinists the consequence of people trying to sate appetites for sugar and fat that evolution put no brakes on because they were so rare in the natural world.
Pretending young adults are children so that they can be educated en masse in schools is another area ripe for investigation. And the refusal of people to adhere to the patterns of behaviour prescribed for them by classical economics has already spun off a field called behavioural economics that often has Darwinian thinking at its roots.
No one is suggesting Darwinism has all the answers to social questions. Indeed, with some, such as the role of hierarchies, it suggests there is no definitive answer at all—itself an important conclusion. What is extraordinary, though, is how rarely an evolutionary analysis is part of the process of policymaking. To draw an analogy, it is like trying to fix a car without properly understanding how it works: not impossible, but as likely as not to result in a breakdown or a crash. Perhaps, after a century and a half, it is time not just to recognise but also to understand that human beings are evolved creatures. To know thyself is, after all, the beginning of wisdom.
The Origin of Species
Tuesday, December 23, 2008
Barely nudging Mr. Madoff out of the top of the news was the Federal Reserve's announcement last Tuesday that it intends to debase its own paper money. The year just ending has been a time of confusion as much as it has been of loss. But here, at least, was the bright beam of clarity. Specifically, the Fed pledged to print dollars in unlimited volume and to trim its funds rate, if necessary, all the way to zero. Nor would it rest on its laurels even at an interest rate low enough to drive the creditor class back to work. It would, on the contrary, "continue to consider ways of using its balance sheet to further support credit markets and economic activity."
Wall Street that day did handsprings. Even government securities prices raced higher, as if, somehow, Treasury bonds were not denominated in the currency with which the Fed had announced its intention to paper the face of the earth. Economic commentators praised the central bank's determination to fight deflation -- that is, to reinstate inflation. All hands, including President-elect Obama, seemed to agree that wholesale money-printing was the answer to the nation's prayers.
One market, only, registered a protest. The Fed's declaration of inflationary intent knocked the dollar for a loop against gold and foreign currencies. In many different languages and from many time zones came the question, "Tell me, again, now that the dollar yields so little, why do we own it?"
It was on Oct. 6, 1979, that then-Fed Chairman Paul A. Volcker vowed to print less money to bring down inflation. So doing, he closed one monetary era and opened another. With Tuesday's promise to print much more money, the Federal Reserve of Ben S. Bernanke has opened its own new era. Whether Mr. Bernanke's policy of debasement will lead to as happy an outcome as that which crowned the Volcker anti-inflation initiative is, however, doubtful. Whatever the road to riches might be paved with, it isn't little green pieces of paper stamped "legal tender."
Yes, today's policy makers allow, there are risks to "creating" a trillion or so of new currency every few months, but that is tomorrow's worry. On today's agenda is a deflationary abyss. Frostbite victims tend not to dwell on the summertime perils of heatstroke.
But the seasons of finance are unpredictable. Prescience is rare enough in the private sector. It is almost unheard of in Washington. The credit troubles took the Fed unawares. So, likely, will the outbreak of the next inflation. Already the stars are aligned for a doozy. Not only the Fed, but also the other leading central banks are frantically ramping up money production. Simultaneously, miners and oil producers are ramping down commodity production -- as is, for instance, is Rio Tinto, the heavily encumbered mining giant, which the other day disclosed 14,000 layoffs and a $5 billion cutback in capital expenditure. Come the economic recovery, resource producers will certainly increase output. But it is far less certain that, once the cycle turns, the central banks will punctually tighten.
The public has been slow to anger in this costliest and scariest of post World War II financial crises. Wall Street and the debt ratings agencies have come in for well-deserved castigation. But pointing fingers rarely find the Federal Reserve, whose low, low interest rates helped to set house prices levitating in the first place.
After Mr. Bernanke gets a good night's sleep, he should be called to account for once again cutting interest rates at the expense of the long-suffering (and possibly hungry) savers. He should be asked to explain how the central-banking methods of the paper-dollar era represent any improvement, either in practice or theory, over the rigor, elegance, simplicity and predictability of the gold standard. He should be directed to read aloud the text of critique by Elihu Root and explain where, if at all, the old gentleman went wrong. Finally, he should be directed to put himself into the shoes of a foreign holder of U.S. dollars. "Tell us, Mr. Bernanke," a congressman might consider asking him, "if you had the choice, would you hold dollars? And may I remind you, Mr. Chairman, that you are under oath?"
Mr. Market Miscalculates: The Bubble Years and Beyond
The Mystery of Banking
And for those worried about inflation, you may want to consider TIPS.
Thursday, December 18, 2008
Consider these tales from the front lines:
* There had never been a national decline in home prices, but now the Case-Shiller index is down 26% from its peak in July 2006, according to the Financial Times of November 29.
* In my twenty-nine previous years with high yield bonds, including four when more than 10% of all outstanding bonds defaulted, the index’s worst yearly decline was 7%. But in 2008, it’s down 30% (even though the last-twelve-months’ default rate is only about 3%).
* Performing bank loans never traded much below par in the past, and holders received very substantial recoveries on any that defaulted. Now, even though there have been few defaults, the price of the average loan is in the 60s.
The headlines are full of entities that have seen massive losses, and perhaps meltdowns, because they bought assets using leverage. Going back to the diagrams on pages 4-5, these investors put on leverage that might have been appropriate with moderate-volatility assets and ran into the greatest volatility ever seen. It’s easy to say they made a mistake. But is it reasonable to expect them to have girded for unique events?
If every portfolio was required to be able to withstand declines on the scale we’ve witnessed this year, it’s possible no leverage would ever be used. Is that a reasonable reaction? (In fact, it’s possible that no one would ever invest in these asset classes, even on an unlevered basis.)
In all aspects of our lives, we base our decisions on what we think probably will happen. And, in turn, we base that to a great extent on what usually happened in the past. We expect results to be close to the norm (A) most of the time, but we know it’s not unusual to see outcomes that are better or worse (B). Although we should bear in mind that, once in a while, a result will be outside the usual range (C), we tend to forget about the potential for outliers. And importantly, as illustrated by recent events, we rarely consider outcomes that have happened only once a century . . . or never (D).
So in most things, you can’t prepare for the worst case. It should suffice to be prepared for once-in-a-generation events. But a generation isn’t forever, and there will be times when that standard is exceeded. What do you do about that? I’ve mused in the past about how much one should devote to preparing for the unlikely disaster. Among other things, the events of 2007-08 prove there’s no easy answer.
The global “thought leaders” in the audience at Zeitgeist had just spent two days talking about solving the world’s biggest problems by applying the Enlightenment values of reason and science that Google espouses. But Mr Brin, usually a very private man, opened with an uncharacteristically personal story. He talked about his mother, Eugenia, a Jewish-Russian immigrant and a former computer engineer at NASA, and her suffering from Parkinson’s disease.
The reason was that Mr Brin had recently discovered that he has inherited from his mother a mutation of a gene called LRRK2 that appears to predispose carriers to familial Parkinson’s. Thus Mr Brin, at the age of 35, had found out that he had a high statistical chance—between 20% and 80%, depending on the study—of developing Parkinson’s himself. To the surprise of many in the audience, this did not seem to bother him.
One member of the audience asked whether ignorance was not bliss in such matters, since knowledge would only lead to a life spent worrying. Mr Brin looked genuinely puzzled. First of all, he began, who’s talking about worrying? His discovery was merely a statistical insight, and Mr Brin, a wizard at mathematics, uses statistics without fretting about them. More importantly, he went on, his knowledge means that he can now take measures to ward off the disease. Exercise helps, as does smoking, apparently—although Mr Brin, to laughter, denied taking up cigarettes (a vice of his father’s).
But Mr Brin was making a much bigger point. Isn’t knowledge always good, and certainly always better than ignorance? Armed with it, Mr Brin is now in a position to fund and encourage research into this gene in particular, and Parkinson’s in general. He is likely to contact other bearers of the gene. In effect, Mr Brin regards his mutation of LRRK2 as a bug in his personal code, and thus as no different from the bugs in computer code that Google’s engineers fix every day. By helping himself, he can therefore help others as well. He considers himself lucky.
The moment in some ways sums up Mr Brin’s approach to life. Like Mr Page, he has a vision, as Google’s motto puts it, of making all the world’s information “universally accessible and useful”. Very soon after the two cooked up their new engine for web searches, in the late 1990s at Stanford University, they began thinking about information that is today beyond the web. Their vast project to digitise books has been the most controversial so far, prompting a lawsuit from a group of publishers in 2005 that was resolved in October. But Messrs Brin and Page have always taken a special interest in the sort of information that most people hold dearest: that about their health.
Wednesday, December 17, 2008
Yes. After my junior year in college and right after graduating, I worked for Mutual Shares Corporation, which was run by a wonderful gentleman named Max Heine. I learned a huge amount about value investing. It turns out that value investing is something that is in your blood. There are people who just don’t have the patience and discipline to do it, and there are people who do. So it leads me to think it’s genetic.
What gave you the resolve to say no to all the other investment approaches?
There are several answers. First, value investing is intellectually elegant. You’re basically buying bargains. It also appeals because all the studies demonstrate that it works. People who chase growth, who chase highfliers, inevitably lose because they paid a premium price. They lose to the people who have more patience and more discipline. Third, it’s easy to talk in the abstract, but in real life you see situations that are just plain mispriced, where an ignored, neglected, or abhorred company may be just as attractive as others in the same industry. In time, the discount will be corrected, and you will have the wind at your back as a holder of the stock.
We think it’s madness to target a return. Return lies in some relationship to risk, albeit there are moments when it’s out of whack, when you can make a high return with very limited risk. My view is that you can target risk versus return. So you can say, I’ll take the very safe 6 percent, I’ll take the somewhat risky 12, or I’ll take the enormously risky 20, knowing that 20 might actually be minus 20 by the time the actual results are known. We just don’t think targeting a return is smart.
Tuesday, December 16, 2008
JEREMY GRANTHAM: If you look back at 1982 and 1974, the market was much cheaper than it is today. In '74 it was about 40% cheaper, and in '82 it was about 60% cheaper. Look at the bad times we had in '74 and '82, and I think several of us would conclude that this time is likely to be as bad - possibly worse. Bubbles like this always overcorrect.
How bad will you feel if you put in your cash reserves and the market continues to go down? You're going to feel awful. And how will you feel if you don't buy in the cheapest market for 20 years and it runs away and leaves you? Horrible. You have to step your way through so that the regret, which is going to be huge anyway, is about neutral.
RODRIGUEZ: This recent collapse is very temporary. We've been waiting for prices to come down, and we finally started buying Oct. 8. We put in approximately 25% of our cash between Oct. 8 and Oct. 23, and of that, about 70% has been into energy.
GRANTHAM: Absolutely. They're still the cheapest part of the market. And I don't do individual companies, but the five classic positions - and the biggest in the fund - are Coca-Cola (KO, $44), Procter & Gamble (PG, $60), Microsoft (MSFT, $19), Wal-Mart (WMT, $53), and Johnson & Johnson (JNJ, $55). These guys' profit margins did not inflate materially.
The rest of the market, particularly the junk, went to legendary highs. These guys barely moved in comparison. Consequently their earnings didn't go up as much: People thought they were has-beens, and their stocks languished in the great rally. As a result, they came into this time period, when you really need them, the cheapest they've ever been on a relative basis. Now they're extremely cheap on an absolute basis as well.
But all the historians were saying, "Yeah, but every 15 or 20 years, the market takes half of them out and shoots them. That doesn't happen to the Coca-Colas." So in the end we decided that no banks could ever be high quality.
Wednesday, December 10, 2008
The truth is that no investment asset is inherently safe. Risk or safety is an attribute of price. At the right price, a lowly convertible bond is a safer proposition than an exalted Treasury. Watching the government securities market zoom, many mistake price action for price.
In their magnum opus, Security Analysis, Benjamin Graham and David L. Dodd advise that "bonds should be bought on their ability to withstand depression". They wrote that in 1934. So far is that rule from being honoured by today's financiers that not a few bonds - and boxcars full of mortgages - could hardly withstand prosperity. Two urgent questions present themselves. One: does something far worse than recession loom? Two: does that certain something definitely spell much lower interest rates?
In corporate debt and mortgages, anomalies and non sequiturs abound. They are especially prevalent in convertible bonds. More so than even the average stressed-out fund manager, convertible arbitrageurs have been through the mill. It was they - and almost they alone - who owned convertibles. Now many of these folk must sell them.
Few buyers are presenting themselves, however, though extraordinary bargains keep popping up. Thus, at the end of October, a Medtronic convertible bond with a 1.5 per cent coupon with the debt maturing in April 2011 briefly traded at 80.75. This was a price to yield 10.6 per cent, an adjusted spread of 1,600 basis points over the Treasury curve (adjusted, that is, for the value of the options embedded in the convert, notably the option to exchange it for common stock at the stipulated rate). Contrary to what such a yield might imply, A1/AA minus rated Medtronic, the world's top manufacturer of medical devices for the treatment of heart disease, spinal injuries and diabetes, is no early candidate for insolvency. Almost every day brings comparable examples of risks not borne by people who, in this time of crisis, have come to define risk as "anything not guaranteed by Uncle Sam".
"Risk-free return" is the standard tag attached to the government's solemn obligations. An investor I know, repulsed by prevailing government yields, has a timelier description - "return-free risk".
Security Analysis: Sixth Edition
Mr. Market Miscalculates: The Bubble Years and Beyond
Tuesday, December 9, 2008
BERKOWITZ: Although the fall in stock prices hurt our performance, it has been a blessing. We've been buying companies at prices that even when I was in my most pessimistic mood, I didn't think we would see so quickly. These are 1974-type valuations, and what's fascinating is that stocks fell to these levels not because of earnings issues but because of the sheer magnitude of the forced liquidations. So this is still a bargain hunter's dream.
We are selling that which is cheap to buy that which is cheaper, in order to make more money in the future and to help manage taxes for our shareholders. And we're pairing our stock positions with senior subordinated debt.
Yes. Some of the stocks we hold are so cheap that we fear the companies will be taken over at too cheap a price. So we're buying discounted bonds that have anti-takeover triggers, meaning the price of the bonds will immediately rise to 100 cents on the dollar on a change of control. And if we like the stock, we don't mind owning bonds that are yielding 15%, 16%, 17%.
It gets slowly liquidated, or Eddie Lampert, its chairman, takes the company private. But I don't think he'd do that to shareholders.
We didn't buy Sears based on the business. There's too much retail in the U.S. If the retail works, then it's a grand slam home run. We invested because of the company's real estate holdings. It has some fabulous locations -- a Kmart in Bridgehampton, N.Y., and a Sears on PGA Boulevard in West Palm Beach, Fla., for instance. The real estate alone is conservatively -- and I mean conservatively -- worth $90 per share [the stock traded at $53 in mid November].
We bought Wellcare Health Plans after the FBI raided the company in October 2007 in an investigation of overbilling practices. The stock quickly went from $120 to the $20s. We took a couple of months to study it and started buying in the $30s. We saw that the company had a good reputation, its customer service was great, insurance brokers were still sending business to the company, and it was still growing.
Wellcare shares tanked November 13 after the company said it was being hurt by higher medical costs and was in default on some debt covenants. WellCare is fine. Nothing has changed. If we are wrong on the company, we do not deserve to be in business. What an opportunity!
UnitedHealth and WellPoint serve one out of every five insured. They are the insurance system of the United States, and they'll continue to be the insurance system. These companies were the darlings of the investment world not long ago. Whether their stocks are down because of forced liquidations or because of fear that the government is going to put caps on what they can charge, I don't understand the rationale for why these stocks are trading where they are. UnitedHealth will earn between $3 and $3.50 per share of free cash in 2008. That's a significant amount.
The free cash a company generates divided by its market capitalization. If we can get a double-digit free-cash-flow yield, I'm interested, especially if we can't kill the company and especially in a world of 3% or 4% risk-free yields.
Let us start with the bystander. Almost everyone in risk management knew that quantitative methods – like those used to measure and forecast exposures, value complex derivatives and assign credit ratings – did not work and could provide undue comfort by hiding risks. Few people would agree that the illusion of knowledge is a good thing. Almost everyone would accept that the failure in 1998 of Long Term Capital Management discredited the quantitative methods of the Nobel economists involved with it (Robert Merton and Myron Scholes) and their school of thought called “modern finance”. LTCM was just one in hundreds of such episodes.
Yet a method heavily grounded on those same quantitative and theoretical principles, called Value at Risk, continued to be widely used. It was this that was to blame for the crisis. Listening to us, risk management practitioners would often agree on every point. But they elected to take part in the system and to play bystanders. They tried to explain away their decision to partake in the vast diffusion of responsibility: “Lehman Brothers and Morgan Stanley use the model” or “it is on the CFA exam” or, the most potent argument, “modern finance and portfolio theory got Nobels”. Indeed, the same Nobel economists who helped blow up the system at least once, Professors Scholes and Merton, could be seen lecturing us on risk management, to the ire of one of the authors of this article. Most poignantly, the police itself may have participated in the murder. The regulators were using the same arguments. They, too, were responsible.
Bystanders are not harmless. They cause others to be bystanders. So when you see a quantitative “expert”, shout for help, call for his disgrace, make him accountable. Do not let him hide behind the diffusion of responsibility. Ask for the drastic overhaul of business schools (and stop giving funding). Ask for the Nobel prize in economics to be withdrawn from the authors of these theories, as the Nobel’s credibility can be extremely harmful. Boycott professional associations that give certificates in financial analysis that promoted these methods. Remove Value-at-Risk books from the shelves – quickly. Do not be afraid for your reputation. Please act now. Do not just walk by. Remember the scriptures: “Thou shalt not follow a multitude to do evil.”
Fooled by Randomness: The Hidden Role of Chance in Life and in the Markets
Sunday, December 7, 2008
Friday, December 5, 2008
Wednesday, December 3, 2008
Tuesday, December 2, 2008
Sunday, November 30, 2008
Wednesday, November 26, 2008
Corporate bonds are pricing in the highest default rate since the Great Depression and some senior secured debt is trading for as little as 50 percent what investors would recover in a bankruptcy, Montier wrote. The drop in bonds may amount to “the investment opportunity of a lifetime,” he said.
Sunday, November 23, 2008
The complete interview is available HERE.
Related previous posts:
GMO: Quarterly Letter – Jeremy Grantham
GMO - Jeremy Grantham: Q2 Letter
Thursday, November 20, 2008
In this environment, it’s not surprising to us that the stocks of companies with shaky balance sheets, poor business models and/or weak competitive positions are getting clobbered, but Berkshire’s freefall in the past few weeks is certifiably crazy – and a buying opportunity that will long be remembered.
"During our third quarter conference call on October 31, 2008, I disclosed that we had reduced our equity portfolio hedging from 100% to 65% of our equity investment portfolio and of course that at some point we may remove the hedge on our equity portfolio. That day has come," said Prem Watsa, Chairman and Chief Executive Officer. "Given the unprecedented decline of the equity markets during the past several months, we felt it was prudent to promptly inform our shareholders that we closed out our equity index total return swaps this week and effectively eliminated our equity portfolio hedge. While we believe the recession may be long and deep, we also believe that stock prices may have already discounted the worst of the economic decline. As value investors, we are finding an incredible number of investment opportunities across the world. That said, in the short term we recognize that stock markets can continue to fall significantly."
Wednesday, November 19, 2008
"We do try to buy our businesses like we buy our stocks," Mr. Buffett told me, "and buy our stocks like we buy our businesses." By that he means, among other things, that he wants to understand how the enterprise generates cash, how well-managed it is and whether its customers would stay loyal even if it raised the prices of its goods or services. Note carefully: None of these factors are contingent on the current price of the stock.
"Being a businessman makes me a better investor and being an investor makes me a better businessman," Mr. Buffett explained. "Most businessmen limit themselves to their own field, and most investors don't really think about businesses. And many businessmen are semi-oblivious to the yardsticks other people use outside that field. I'm always comparing everything to everything else. The question I want to answer is. 'Where do we get the most for our money in something we can understand?'"
"I prefer, and [Berkshire Vice Chairman] Charlie [Munger] prefers, the permanent ownership of [private] businesses," Mr. Buffett added. "That's been my focus for well over 20 years. But it's just that sometimes, marketable securities are so much more compelling." Mr. Buffett didn't say whether he thinks now is one of those times, but he did state publicly earlier this month that "I've been buying American stocks."
Tuesday, November 18, 2008
Monday, November 17, 2008
Thursday, November 13, 2008
Monday, November 10, 2008
I'll tell you the one really nice reason to be a value investor: When things like this happen, you cannot help but go nuts at the opportunity. What this looks like is the end of 1974, where good stocks are selling at three times sustainable earnings and stocks that normally wouldn't have sold at less than 20 times earnings are selling at 10 times earnings. These are exciting times. The short-term issue is that in the near term there will be a painful macroeconomic environment and we don't know how long it will last.
The craziest thing to do is take recent earnings and add a multiple to it. There are a lot of stocks, like steel companies, that have very high recent earnings and trade at only four to five times earnings. They look like a 20 percent return stock, but those earnings won't be sustainable. If you look at steel companies five years ago before this huge capacity run-up, their earnings were about a third to a quarter of what they are now. You have to stay away from those kinds of enthusiasms--things that look cheap on the basis of peak earnings. You're looking for [stocks] that are protected by assets.
What you don't want to do is use unmoderated price-to-earnings. Never look at current or even recent earning, especially in areas like oil companies where we know they are inflated and coming down. Typically, what a value investor will do first is get a sustainable earnings number, an average PE over a business cycle. You really have to go back 10-12 years to get a feel for what average margins typically look like in these businesses. That's what you use for earnings. The second thing, when you look at a PE, you're always assuming it's sustainable. You always want to make sure it's protected either by assets or the kind of moat that Buffet talks about. Otherwise, even if it's been making lots of money, it's a business that will be competitively vulnerable.
The first thing is that for value investors, you are not going to try to forecast the future. Most value investors would say if it's anything like credit crunches we've seen in the past, it will be gone in a year. That's what the betting has to be. It's a short-term problem and not something you focus on. It has, however created opportunities in debt markets. Banks are dumping senior secured debt, selling it on the market for 50-60-70 cents on the dollar. The implied returns are north of 15 percent, and because you're senior to everybody else in the event of bankruptcy, you're likely to get paid. That's where opportunities have been created by the credit crunch. If you listen to Buffet, it's where he's been investing up until now. Those opportunities are still there, but my guess is they're going to go a way.
Thursday, November 6, 2008
Wednesday, November 5, 2008
Market Value of Enterprise/Debt
better index of the fair going concern value of a
The Graham Standard:
Monday, November 3, 2008
It’s important to open with a disclaimer that you should be circumspect about what we, or anyone else, have to say about the past, present or future. We humans tend to suffer from hindsight bias—we think we had more foresight than we did—and our predictions are frequently off the mark. So the goal here is not to make any predictions, but rather to point out salient features of what is going on and what those features might mean for the market.
To summarize, we believe this will prove to be a good time—and maybe even a great time—to invest for people with time horizons beyond a year or two. While there’s no way to know where the market will be in the short term, many conditions are in place for better performance. More directly, we believe the market at these levels represents substantial value for long-term investors.
Thursday, October 30, 2008
Wednesday, October 29, 2008
Over the past few centuries, public policy analysts have assumed that step three is the most important. Economic models and entire social science disciplines are premised on the assumption that people are mostly engaged in rationally calculating and maximizing their self-interest.
So perhaps this will be the moment when we alter our view of decision-making. Perhaps this will be the moment when we shift our focus from step three, rational calculation, to step one, perception.
Perceiving a situation seems, at first glimpse, like a remarkably simple operation. You just look and see what’s around. But the operation that seems most simple is actually the most complex, it’s just that most of the action takes place below the level of awareness. Looking at and perceiving the world is an active process of meaning-making that shapes and biases the rest of the decision-making chain.
Economists and psychologists have been exploring our perceptual biases for four decades now, with the work of Amos Tversky and Daniel Kahneman, and also with work by people like Richard Thaler, Robert Shiller, John Bargh and Dan Ariely.
My sense is that this financial crisis is going to amount to a coming-out party for behavioral economists and others who are bringing sophisticated psychology to the realm of public policy. At least these folks have plausible explanations for why so many people could have been so gigantically wrong about the risks they were taking.
Nassim Nicholas Taleb has been deeply influenced by this stream of research. Taleb not only has an explanation for what’s happening, he saw it coming. His popular books “Fooled by Randomness” and “The Back Swan” were broadsides at the risk-management models used in the financial world and beyond.
In “The Black Swan,” Taleb wrote, “The government-sponsored institution Fannie Mae, when I look at its risks, seems to be sitting on a barrel of dynamite, vulnerable to the slightest hiccup.” Globalization, he noted, “creates interlocking fragility.” He warned that while the growth of giant banks gives the appearance of stability, in reality, it raises the risk of a systemic collapse — “when one fails, they all fail.”
Taleb believes that our brains evolved to suit a world much simpler than the one we now face. His writing is idiosyncratic, but he does touch on many of the perceptual biases that distort our thinking: our tendency to see data that confirm our prejudices more vividly than data that contradict them; our tendency to overvalue recent events when anticipating future possibilities; our tendency to spin concurring facts into a single causal narrative; our tendency to applaud our own supposed skill in circumstances when we’ve actually benefited from dumb luck.
Taleb is characteristically vituperative about the quantitative risk models, which try to model something that defies modelization. He subscribes to what he calls the tragic vision of humankind, which “believes in the existence of inherent limitations and flaws in the way we think and act and requires an acknowledgement of this fact as a basis for any individual and collective action.” If recent events don’t underline this worldview, nothing will.
If you start thinking about our faulty perceptions, the first thing you realize is that markets are not perfectly efficient, people are not always good guardians of their own self-interest and there might be limited circumstances when government could usefully slant the decision-making architecture (see “Nudge” by Thaler and Cass Sunstein for proposals). But the second thing you realize is that government officials are probably going to be even worse perceivers of reality than private business types. Their information feedback mechanism is more limited, and, being deeply politicized, they’re even more likely to filter inconvenient facts.
This meltdown is not just a financial event, but also a cultural one. It’s a big, whopping reminder that the human mind is continually trying to perceive things that aren’t true, and not perceiving them takes enormous effort.
Fooled by Randomness: The Hidden Role of Chance in Life and in the Markets
Tuesday, October 28, 2008
Monday, October 27, 2008
Tuesday, October 21, 2008
The type of people who saw these problems unfolding, on the other hand, had much less career risk or none at all. We know literally dozens of these people. In fact, almost all the people who have good historical data and are thoughtful were giving us good advice, often for years before the troubles arrived. They all have the patience of Job. They are also all right-brained: more intuitive, more given to developing odd theories, wallowing in historical data, and taking their time. They are almost universally interested – even obsessed – with outlier events, and unique, new, and different combinations of factors. These ruminations take up a good chunk of their time. Do such thoughts take more than a few seconds of time for the great CEOs who, to the man, missed everything that was new and different? Unfortunately for all of us, it was the new and different this time that just happened to be vital.
What Mr. Paulson did not get around to mentioning was the excess of confidence that preceded the shortfall. Under the spell of soaring house prices (and before that, of stock prices), Americans trusted the things they ought to have doubted. But markets are cyclical, and there is always a new day. In compensating fashion, people will eventually doubt the things they ought to have trusted. Investment opportunity follows disillusionment. It's complacency that precedes bear markets.