I was at a public library sale the other day and picked up a few decent investing related books for a buck a piece — one on commodity futures trading from the 60s, and the other a decent overview of the strategies and issues of Long Term Capital Management, aka LTCM, aka the fund that last broke the financial system until a huge round of bailouts. Basically, like Ecclesiastes says, ain’t nothing new under the sun. I’m paraphrasing.
One of the things that was really clear from the latter book was that LTCM was using massive amounts of leverage to get their returns. They’d borrow money very cheaply, and throw it behind trades that would normally return about 2% or so, but due to the scale of their bets, they’d get a massive return on equity (if a piddling return on assets). It’s only when those “sure bets” started to fail — once again, the problem of induction rearing its ugly head, and in fact, this book went into a fair bit of detail on it for a book from 2000, before the recent success of the Black Swan — that everything went to pot.
This is essentially how hedge funds do their business, and make their spectacular returns, and equally gigantic flameouts. It really makes you wonder if the party line being sold to people, that you just sock away your money in a well-diversified fund and cross your fingers that everything does about the same as it always has (for the last hundred years), is really all that effective. It works until it doesn’t. I just find it asinine how people will recommend this strategy over learning about individual stocks, like it’s getting your teeth cleaned or grocery shopping — I don’t think it’s ever really possible to make it as staid as all that.
In any case, it also reminds me of ideal betting strategy, except in the case of blackjack you tend to have a better sense of the odds (as some people have described it, the known unknown) versus investing (the unknown unknown) and can feel comfortable raising your bet accordingly. Of course, this’ll get you thrown out of the casino if you do it enough times and start winning big, and in investing it’s all but impossible to get that level of comfort, without applying a little judicious ignorance. Sort of like creating a “pseudo-known unknown” by having a myriad of blind spots.
Posted by Nelson Yee
