As is usually the case when rumors run rampant, early reports at the beginning of 2012 were vehemently denied and downplayed by JPMorgan. In May 2012, the first confirmation came that a giant CDS derivatives position might have caused a $2 billion loss by top management. On July 13, 2012, the total loss was updated to $5.8 billion, and a spokesman for the firm claimed that projected total losses could be more than $7 billion. So from a non-existent problem at the beginning of the year, it quickly ballooned to an estimated loss of about $7 billion. Since we all know, that derivatives are the real zero-sum game, those rival banks and hedge funds had a significant payout.
On the company's emergency conference call, JPMorgan Chase’s CEO Jamie Dimon said their derivatives strategy was "flawed, complex, poorly reviewed, poorly executed, and poorly monitored." Since then, the episode has been investigated by the Federal Reserve, the SEC, and the FBI. The $6 to $7 billion one-time loss might have been minor, relative to JPMorgan’s large capital base of more $200 billion and $2.4 trillion in total assets at that time, but it hurt JPMorgan's price and their shareholders’ performance.
And as is usually the case, experts and regulators had been asking themselves how much risk is too much, until the discussions faded out without any appropriate actions. I believe that this is a farce, and the wrong question to begin with. The real issue goes back to what risk means. If you don't know or ignore the fact of real potential losses, how can you even measure it correctly? If you leverage yourself 28 times or more, and your mathematical model spits out zero risks and you believe it, I can only say that you are totally irresponsible or completely incompetent. If you load up on financially engineered products that are as complex and devastating as creating real nuclear weapons, and you believe that society profits from these, I recommend putting a few positions in your private portfolio backed by your entire personal net worth.
Key Takeaways
Ponzi schemes, insider trading, market manipulation, and frontrunning have all been around since the emergence of the first exchanges. It's a combination of advanced knowledge, preying on the psychological fabric of “gullible” players, what we know as psychological misjudgments and cognitive biases. It gives a small group of players the ultimate edge over all others when placing their bets. In history, it has always been considered a necessary evil – an additional hidden tax on the system. However, we could argue that since the Milken/Boesky Mafia who pioneered a new culture of winner-takes-all, we have entered a new level of fraud, open aggression, and greed. It culminated in 2008 with the bankruptcy of Lehman Brothers, but it did not stop there. Insider trading, front running, and price manipulation have continued. Yet, a vast majority of other players consistently underestimate the real impact it has on their bets, their capability on assessing the future, and their odds of winning. It seems most are incapable of drawing the right conclusions... and that includes governments and their regulators.
Over the centuries public financial markets evolved and so did the games and their dominant players. The difference between the early aristocrats of the 1800s, the robber barons of about 100 years ago, and dominant market players today is that the new generation of predatory players has become more subtle, more organized, and more institutionalized. Rather than a small, but powerful group of aristocratic backgrounds or individuals with street smarts, today we deal with Ivy League MBAs, people with an average IQ north of 130, and occasionally even actual rocket scientists. They have surrounded themselves with armies of enormously capable sales and marketing individuals with questionable incentives.
Then there are the think tanks, rating agencies, law firms, and lobby activists always eager to support any quest of Wall Street might be pursuing. All professionals with high incentive payouts have mastered and honed their skills to perfection. That makes them the perfect accomplices and props to any elaborate long con, whether they are aware of it or not. The result of all this is that the few who understand how to rig the system, place big bets with other people’s money, reap big profits, and their armies of minions follow. But being gamblers at heart, they never stop when they are on a winning streak; then all goes kaboom!
In the final chapter, I will discuss how to draw the right conclusions and how to take the right path in a game that doesn’t leave much room for mistakes.
CHAPTER 10
YOUR CHOICES
“A man's GOT to know his limitations.”
– Harry Callahan, Magnum Force
So far, this book has described the actual nature of investing and the real risks of playing the money game. We have seen some side effects of a flawed financial system that is dominated by gamblers and charlatans. If a small group of gamblers takes it too far, it could jeopardize the stability of the entire financial system. They overbet and overplay their hands, and the fact that they do it on a regular basis, should be clear from this book and a personal study of Wall Street’s history. From the insight you gained from the previous chapters, you should have realized that the odds of playing the money game are very much stacked against you. You must have also realized that regularly playing the money game will lead to losses and Wall Street is counting on it.
In this chapter, I will demonstrate that there are alternatives to playing the money game on Wall Street’s terms and that you can still make the right decisions to build, grow, and protect your personal wealth.
Decision 1: Your First Investment
Before we go any further, let’s acknowledge two simple truths about investing:
Any decision involving money contains risk, and hence, includes some elements of gambling.
Our decision-making is as much influenced by our subconscious, as it is affected by rational thinking.
The bottom line is that when making decisions about money, we always run the risk of losing it, and we are constantly influenced by powerful cognitive biases. That brings us to the first decision that we have to make about investing: what money should we use for investing, and what should be our first (and most significant) investment?
The answer is simple: we should source every investment with cash that we don’t need to use in the foreseeable future. Money that isn’t necessary to our daily lives. Money that is not already allocated for another future event, such as a vacation, new car, or another investment project. Hence it is a paradox– we should aim to make money with money that we don't intend ever to consume. There is logic in this. Any investor will find himself in hot water if he needs his money back sooner than expected. The result is substantial losses because fair prices are not able to be negotiated.
It’s comparable to the situation you would find yourself in, if you needed to move to another state or country and needed cash quickly. You may have to sell all of your possessions, including your house and car, in a hurry. Under these circumstances, you would not be able to find a reasonable market price in such a short timeframe. Even worse would be if we found ourselves in the middle of a recession with generally depressed market prices for houses and cars. Thus, we can conclude that investors should use the money they don’t need.
No doubt some of you will be thinking, “Yeah but I want to invest to make money—what’s the point in investing if I already have it? And how am I supposed to get to the point where I have extra money to invest anyway?”
Your Cash Engine
The answer to the previous questions is simple: We are all, in a way, our own “cash engines,” and the most valuable asset on our personal balance sheet. That is to say that we are by far our most important investment. Anybody can earn money, and if you end up spending less than you make, you have a positive cash flow. This cash inflow accumulates with each month and builds the basis of our personal wealth and future investments. But there is more to it. With each future investment you make, you should be able to increase your free cash flow through investment income and capital gains, reinforcing the positive cycle of income growth and wealth accumulation. It all starts with your primary cash engine.
Quite log
ically, it is in any investor’s self-interest to make sure that this primary engine runs smoothly for an extended period, which includes living a healthy and balanced life. As corny as it may sound, your first investment should be in yourself. There is a reason why education and training is so highly valued. You can increase your own earning power through various personal investments, such as higher education, an old fashioned apprenticeship or specialized training. But make no mistake, even these investments have their risks: overpayment, failure to capitalize on skills, etc. Be that as it may, the risk is simple to assess and manageable for all. Follow the advice of Australian television presenter, Paul Clitheroe: “Invest in yourself. Your career is the engine of your wealth."
Decision 2: To Play, or Stay Away?
From what we now know about the money game and Wall Street, there are only two logical choices:
Stay away from the money game entirely and focus on the traditional ways of building wealth.
Do pretty much the same as above, but only take the best bets, with the odds in your favor, and diversify over time.
Let me elaborate on point one. The best risk management policy in the world is to not take unnecessary risks in the first place. If you don't understand the games, don’t want to spend the time to learn them and don’t want to let other gamblers play with your money, you eliminate risk by not participating. We always have choices and still enjoy the freedom to make our own. If your choice is to stay away from it all, don’t despair. There are plenty of investment opportunities the old-fashioned way that offers adequate and, often, an even better risk-return profile with less complexity.
For example, in the past, who you shared your money with and who benefited from your earnings were intimately tied up with the ideas of family, class, and race. These social structures still exist all around the world. There is plenty of proof that countless individual entrepreneurs and family businesses have become independently wealthy without having dealt once with stock markets, fund investments, or financial markets experts, through the “traditional” route of a well-paying job or entrepreneurship. In its most extreme manifestations, large communities of the Amish (an ultra-orthodox Christian denomination) have followed this path with much success, even though they limit themselves to only a few possible professions and businesses with the total absence of technology.
What they all have in common is a simple strategy of accumulating cash and investing in opportunities relevant to them. They either continue investing in their own cash flow operations, in real estate, or keep excess cash in gold and safe liquid assets. This structure enables them to develop the right mindset: the mindset of wealthy, independent people who don’t need to play the money game.
Decision 3: Speculator or Investor
So, you’ve decided to play the game. Great! To start, let’s get something straight: there are only three ways to make adequate and consistent returns worthwhile compared to the risk you take when playing the money game:
You get in early and sell when interest is rising: the “First in, first out” approach.
You make use of great market inefficiencies that includes structural flaws and mistakes committed by others: the opportunistic approach.
You cheat and lie and get yourself an unfair edge: the Bernie Madoff approach.
You decide which category you want to fall into.
Next, you need to make a decision as to whether you want to become a full-time speculator or dedicated investor. As we saw in Chapter 4, investors enjoy some decisive advantages over speculators, both structural and psychological in nature. As one of my friends working on Wall Street noted: “An investor can be both speculator and investor at the same time. If a speculation doesn’t work out, he can still be an investor with a long-term horizon. A full-time speculator doesn't have that luxury.” As an investor, you have to make sure that you understand the underlying asset and its realistic earning potential. You want to avoid overpaying for something that might be a disappointment and could cause substantial losses when pie in the sky dreams deflate and vanish into thin air. Also, get ready for some excruciating pain of waiting for something that fits all your criteria. It surely isn’t easy to reject all those promising investment ideas thrown at you over time. Very dull stretches of inactivity can test even the most patient investors when they see their cash increase month after month from their savings and existing investments. In the end, many succumb to speculation and risky bets.
To be clear, there is nothing wrong with being a speculator. As a matter of fact, many famous financial players among them Bernard Baruch, George Soros or Paul Tudor Jones II, considered themselves foremost speculators rather than investors. If you asked them why they were doing it, the answer would be because they loved it and were good at it. Their personal track records and financial successes are a testimony to their claims. But, there are many, many more who have failed miserably being speculators. Benjamin Graham himself lost fortunes betting on stock markets with leveraged bets early in his career. He had this to say about speculation: “Outright speculation is neither illegal, immoral, nor (for most people) fattening to the pocketbook.”
Developing a Strategy
If you made the conscious choice of being an investor playing the money game, Graham would continue to advise the principles of any successful investment strategy:
“To enjoy a reasonable chance for continued better than average results, the investor must follow policies which are (1) inherently sound and promising, and (2) not popular on Wall Street.”
Mike Burry, the famous hedge fund manager who made a fortune on betting against subprime, went one step further by emphasizing, “You have to be spectacularly unusual.” Combining this with the findings from the last chapters, we can establish some fundamental principles for any investment strategy.
An investment strategy should:
Obey the laws and principles of investing.
Be concentrated on the investor's strengths and individual advantages.
Be unpredictable and somewhat random– in other words, unconventional.
Be flexible and adjustable in nature to adapt to changing market conditions.
The first principle is self-explanatory. Protection of capital and a demand for adequate returns is the simple definition of investing. Foremost, it means paying attention to underlying assets, rather than getting distracted by price fluctuations.
The second principle implies that opportunities always vary from person to person. An individual who loves tech and internet businesses may not understand opportunities in mining or health care and vice versa. Paying attention to your own strengths also has a psychological component. It contributes to that all-important “mental detachment” and the reduction of cognitive biases sneaking in. Playing home games are always easier than playing away.
The third could come right out of Sun Tzu's Art of War– there is never need to act conventional and predictable to any party– and that includes Wall Street. Holding your cards close to your chest is always a prudent idea.
The fourth principle about flexibility suggests that any long-lasting strategy is not set in stone, but shows elements of adaptability to changing environments and personal conditions. As John Maynard Keynes said, “When the facts change, I change my mind. What do you do, sir?" It's an antidote to the rear-view mirror fallacy that forces you to look ahead through the windshield instead of constantly looking back. When the prevailing interest rate environment is more or less zero around the world, it’s only natural that the entire investment climate has changed. Hence, we need to adapt our investment strategy accordingly.
One to Rule Them All
Among professional investors, there is always a heated discussion about which strategy is best. Value, Growth, Momentum or GARP? It is a futile discussion and a waste of time. The best strategy is the one who ensures you don’t lose money, and you get compensated adequately for the risks you take.
In a speech at the University of Southern California’s
Marshall School of Business, Charlie Munger further clarified this strategy:
“The wise ones bet heavily when the world offers them that opportunity. They bet big when they have the odds. And the rest of the time, they don’t. It’s just that simple.”
Mohnish Pabrai, the famed investor and author of The Dhandho Investor, agreed and called it “placing few bets, big bets, infrequent bets.” Winning the money game requires you to overcome the house advantage (i.e. all the fees, all the skulduggery, and all the predators in suits). The only way to do this is to place bets where you have a substantial edge yourself. They are rare, but they do exist. Your edge could be based on personal experience and training, financial models, pure psychology, or even better, a combination of them all. In the end, all that counts are the odds of winning and your own edge.
An Edge for the Little Guy
There is one edge we all enjoy as individual players, regardless of background or professional training. Something that is often forgotten downplayed and outright criticized as market timing. It is the freedom to pick the time and place of our bets. It is based on one option that we all enjoy: the optionality of cash. It is a permanent option that either keeps cash or invests it in any asset class within any industry at any time. In other words, we can wait for something that interests us at the right price. If nothing else is available, we have the option to say, “No, thank you,” and wait.
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