fooled by randomness

Why Going For That Big Short May Not Be So Smart

Posted on August 10, 2021 by Nicholas Peart

The economist John Maynard Keynes said it best with his immortal words about financial markets being able to stay irrational longer than one can stay solvent. I think it was Keynes who said those words yet it doesn’t matter. What matters is how important and powerful those words are. I personally think these are some of the most important words of advice for any investor whether they are a novice or seasoned. One may have complete confidence and conviction in a security they are investing in yet there is always the chance that things don’t go according to plan regardless of how much due diligence they may have done on it.

The Big Short is a well known book by Michael Lewis, which was later made into a successful film. The book is about an investor and fund manager named Michael Burry who places an enormous bet against subprime mortgage bonds. He was one of a small handful of investors who at the time discovered how rotten those bonds were and how they had the power to create an enormous financial crisis, which they eventually did in 2007-8. He placed his bet relatively early in around 2005. At the time, it was seen as a rather contrarian thing to do as the majority of people in the financial world were amazingly unaware of how toxic those bonds were.

Although Burry would eventually be vindicated and handsomely rewarded for his bet, I personally think that the way he went about it wasn’t so smart. To be clear, I am not for one moment knocking his deep research and analysis. In fact, I applaud his diligence and ability to discover serious flaws in that corner of the market whilst everyone else it seemed was asleep at the wheel. Yet I don’t think it was a smart move for the following reasons. Firstly, his move to short those bonds represented a very high percentage of his total fund, which made a lot of investors very nervous. If you are a fund manager or work for a fund, it is quite common for an individual security to not represent more than 10% of the total fund. Anything higher than that percentage has the potential to create a lot more risk and volatility to the fund. What’s more, it was expensive to hold such a large short position as large payments to service it were due every month. It was understandable why those investors and others at his fund were nervous and had very little patience. Secondly, and more importantly, I don’t think Burry ever familiarised himself with Keynes’ quote. Although it took about two years for his bet to come good it could have taken much much longer. It is entirely plausible that had his fund had to wait even longer for his bet to come good there would have been so much pressure on Burry to finally close his short and thus cut the loses the fund was making by holding it.

You see it doesn’t matter whether Burry was fundamentally right in his analysis. He was completely correct. These bonds were a train wreck waiting to happen. But that’s not the point. The point is that timing the markets is very very difficult. Alternatively, Burry could have done the following. He could have still made his bet yet it wouldn’t have represented more than 10% of his total fund for example. That way, there would be less tension and pressure on Burry to close his position in the event that it was going to take so long to come good. What’s more, it would have still made him and the investors in his fund a lot of money when that day would eventually arrive.

This brings me to another well worn adage in the investment world of never having all your eggs in one basket. Although this may be a cliché it is so very true. Although enormous fortunes are made by putting all one’s huevos in one single basket, it is also the fastest way to blow up a portfolio. Burry’s enormous bet came good and he was rewarded, but he could also have been fooled by randomness by some unusual twist of fate.

Over the last few years many investors, including some well known names, lost a lot of money shorting Tesla. Although the rationale behind their decision to short the company was completely understandable, namely that the market capitalisation of the company was not reflective of it’s fundamentals, the share price has nonetheless continued to climb even higher. This right there should be a warning in the perils of going for that ‘big short’. As I already stated, it is ok if such a position is not so great that it poses a serious risk to an entire portfolio. But one can only imagine those legions of investors having a Michael Burry style moment with Elon Musk’s company.

Interestingly, it seems that Burry himself has now thrown his hat in the Tesla Short ring. I may be wrong, but it appears that his fund is betting against Tesla to the tune of 40% of the entire weighting of the fund. I wish him luck. Will his bet come good again? Or will he join the scores of other investors who got badly burnt betting against Elon?

By Nicholas Peart

10th August 2021

Image: thewrap.com

Real Talent Is Rare And Not So Cheap

Posted on June 21, 2021June 23, 2021 by Nicholas Peart

A few years ago I wrote a post entitled ‘Talent Is Cheaper Than Table Salt’. In this post I outline how talent is actually not so rare and rather it is hard work that matters when it comes to finding success.

I’ve often thought about this post, especially as it is one of my most viewed posts. Yet since I first wrote it, I’ve increasingly began to question it, even though, at least at a logical and basic level, it may be correct. But what if, just what if, I may have got it completely wrong regarding talent? Maybe genuine talent is actually rather scarce. To be clear, when I say this, I mean a kind of talent that is just so special and very hard to replicate.

The quote in my original article by the writer Stephen King goes like this; “Talent is cheaper than table salt. What separates the talented individual from the successful one is a lot of hard work.”

King is correct, especially if one also takes into account the second sentence of his quote. It is all true. Yet talent and hard work are two different things. Anyone can develop a hard work ethic, but not everyone has real god given supernatural talent. I think we need to really reassess how we define talent. I also dispute this notion that if you work hard you will automatically be rewarded. We fall victim to something called ‘Survivorship Bias’ – only looking at success stories and overlooking all the failures.

There are countless stories of those who worked extremely hard and didn’t ‘make it’. Yet those stories seem to be lost on us. But that doesn’t mean that one should not work hard. Absolutely not. Hard work, unexpected challenges and multiple failures are an important part of one’s character building. Saying that hard work is a waste of time sets a bad example.

As a whole, we often neglect to take into account just how random the world can be. Please see my other post Fooled By Randomness. Life is not as linear as we think it is. There are some things that are simply beyond our control.

But getting back to the subject of talent. When I look at the people I admire throughout history one thing they all have in common was that they were special. They were not like everybody else. They had talent in spades and often there was hardly any chasm between their life and their art. Now THAT is rare.

By Nicholas Peart

June 21st 2021

Image: storypic.com

Posted on December 9, 2018December 9, 2018 by Nicholas Peart

dice - luck

In one of my previous posts I talk about how hard work is more important than talent when it comes to achieving success. As much as I don’t want to believe it there is a kernel of truth to this. But is it the whole truth? What if it is the power of randomness that is the principle factor in all this? At least this is what the Lebanese-American writer and former financial trader Nassim Nicholas Taleb believes whose seminal books Fooled By Randomness and The Black Swan expand on this idea.

One of the most interesting aspects of success, especially in creative fields, is that it often comes to people we least expect it to. It is not unusual to watch an unknown band live and think ‘what on earth is this crap’. Then several months later that same band is flying high in the charts and many people are fawning over them. On the other hand, you can see an unknown band live who you are totally blown away by and are convinced the band will go on to greater things but success sadly eludes them and they continue to drift into obscurity. These typical scenarios give a lot of weight to Taleb’s theory of randomness.

Even though, at least at a practical level, hard work seems to be the best way to increase one’s chances of getting lucky is that really where it’s all at? Again in the context of musicians, some singer/songwriters worked their butts off on the open-mic night circuit playing at everyplace they could get a gig and then slowly after years of toil and sweat, they were rewarded. The supremely successful singer/songwriter Ed Sheeran is a perfect example here. But he does not escape the laws of randomness. Many other singer/songwriters also break their backs for years trying to make it, but alas their time never comes.

On the other side of the scales one can look at the pre-fame story of Oasis. They’d barely been going for a year or two before they were discovered in 1993 by the head of Creation records, Alan McGee, at a gig in Glasgow. From that point on success came to the band almost overnight. It was as if their success and destiny were written in the stars. The Oasis story is a perfect one of randomness and demolishes the adage of ‘if one works hard one will be rewarded’. Whether one likes Oasis or not, one cannot deny the powerful magnetism the Gallagher brothers possessed; something that seemed God-given and effortless, and millions of people lapped it up.

Life is never linear. Our predictions regarding the life trajectory of others often collapse like a house of cards. Random events beyond our control destabilizes these paths. When we look at the following world events; the Chernobyl nuclear explosion, the 1987 Black Monday stock market crash, 9/11, the recent Genoa bridge collapse etc; they are examples of events which weren’t anticipated and took people by surprise. Taleb calls them Black Swan events.

It is not uncommon to weave a narrative around these events and try to rationalise and justify them, but the truth is they were ruled by randomness and caught everyone off-guard.

By Nicholas Peart

image: PIRO4D