Page 3 of 3 No such thing as a Sure
Thing By Julian Delasantellis
goes down the drain because the
trader let his ego get in the way of selling out
of the position. That does not come to be seen as
a learning experience; it's more like an
insolvency experience, a bankruptcy experience,
and a threat to integrity of the financial system
as a whole experience.
Over at the hunt
club, and in between canapes and Pouilly
fuisse with the rich and famous, the Great
Trader who runs the hedge fund gets a daily marked
to market profit/loss report on the firm's
trading position, and it is
then, when seeing what trouble the firm actually
is in, he lets out a string of colorful invectives
certainly not customarily heard at these fine
locales.
Great Trader doesn't give a damm
about the little trader's ego; all he's interested
in is keeping the firm solvent before he's
summoned to the offices of the president of the
New York Federal Reserve Bank like an errant
schoolboy sent up to the principal's office. He
finds a guy, gives him a fancy title such Audit
Control Officer (ACO) or Compliance Affairs
Manager (CAM); what mission this fellow is really
being given is the same task given to Pontius
Pilate by Tiberias - go and restore order in my
provinces. In Pilate's case it was Judea, in this
guy's case it's down at the trading desks.
What this ACO or CAM does is go down to
the trading floor with his mighty gladius sword
and just lays the place to waste. He tells the
traders to sell everything, take the losses, just
raise capital in order to keep the fund solvent,
and "don't give me any of your sob stories".
Everything gets sold, no matter what the
price. Thus, the heavy mid-August selling.
Lo and Khandani stress that it was not
long/short equity-market neutral, a strategy that
falls under a new class of mathematically
back-tested stock investing strategies called
"quantitative", or "quant", that failed, it was
just that the existent market structure was
insufficiently broad and deep to allow everybody
that wanted to sell out of the strategy to do so
simultaneously in an orderly fashion. On paper,
the strategy could have worked well.
"The
losses were more likely the result of a resale
liquidation of quantitatively constructed
portfolios rather than the specific shortcomings
of quantitative methods."
This observation
is true, but misleading. Investing is not a game
like fantasy baseball, it is not meant to be done
on paper, but with real money being invested by
real, emotional human beings. Paper gains are just
that, paper, and worth just about as much. You, or
more likely your data-mining software, may think
up a great investing strategy; maybe, if you load
your program with enough data fields, you'll find
that in the past it was a good idea to buy stocks
whose CEOs put beer on their corn flakes, and sell
stocks whose CEOs talk in a pirate brogue and walk
around with parrots on their shoulders. That may
work for a while, but if you can't sell out of it
when you need to your paper gains are just that -
paper. In the final analysis, at least in this
life, it's not the paper that counts, it's what's
in your wallet, what's in your bank account,
what's in your house or garage, what's in your
toybox.
If Lo and Khandani's analysis is
right about this being the cause of August's
market turmoil, to me, it just once again proves
the point that greedy people are too busy and
preoccupied to study history. Twenty years ago, as
what would become the Crash of 1987 drew ever
closer, canny investors thought that they had
discovered their Sure Thing too. Back then it was
hedging their individual stock positions with the
then newly created stock index futures; this was
called "program trading". Much like this August,
this strategy collapsed when everybody tried to
sell out of it at the same time; the worldwide
stock market holocaust of October 19 of that year,
was the result.
Former CNBC anchor Ron
Insana identifies the most dangerous phrase in
stock investing by the initials TTID - "This time
it's different." Long/short equity market neutral
is not that much different from program trading,
which was not that much different from the bucket
shop trading that precipitated the 1929 crash,
which was not that different from the South Seas
bubble of the early 18th century, which was not
that different from Tulipmania in 1637 Holland,
all the way back to the beginning of human
history. The players and techniques do change, but
mindless greed trumping reason and good judgment
is always the same.
Once again, it is
Charles Mackay's astounding 1841 book, Memoirs
of Extraordinary Popular Delusions and the Madness
of Crowds, that said it first, and still best.
"Money, again, has often been a cause of
the delusion of multitudes. Sober nations have all
at once become desperate gamblers, and risked
almost their existence upon the turn of a piece of
paper."
We're over a month past the
gymnastics of August, and some semblance of order
has returned to many of the markets. The Shanghai
and Hong Kong stock exchanges, which weren't hurt
all that much in August, are once again moving
higher; US stock exchanges are back near their
highs, even with the actual precipitant cause of
the selloff, the subprime mortgage crisis, looking
as bleak as ever. The US Fed has aggressively cut
interest rates to support equities, and will
probably cut again. Perhaps more importantly, a
whole lot of people who had huge positions in
quant strategies such as long/short equity market
neutral have been blown right out of this market.
Maybe we're safe for a while - until the next
numskull comes up with an investing sure thing
that subsequently blows up in everybody's face.
In the meantime, perhaps it's time for
Lo's class to take a field trip. A couple of miles
from his sparkling classrooms in Cambridge lies
the local thoroughbred racing track, a tired,
wheezing old place called Suffolk Downs.
I
once visited this locale to do some investing, and
was stunned to see what a depressed place it was.
The smell of stale beer greatly overpowered that
of fresh horse droppings, and the walls looked
like the last paint applied to them came from
World War II US Army surplus. The fixtures were
rusted and dirty, as, of course, were the
offerings at the snack bar.
My fellow
investing clientele looked no better. They, much
like the horses they were wagering on, appeared
tired, wizened and wheezing - a few actually had
taken their oxygen tanks with them. (The bettors,
not the horses.) Their faded, torn working-class
painters' or carpenters' attire was all they had
to protect them from the New England cold in the
unheated grandstand, and if it was near the end of
the month they had to limit their betting until
their next Social Security pensions check arrived.
Thirty or 40 years previously, when they
first arrived at the track, they probably thought
they had a Sure Thing as well.
Julian Delasantellis is a
management consultant, private investor and
educator in international business in the US state
of Washington. He can be reached at
juliandelasantellis@yahoo.com.
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