Too smart for our own good is a shout-out to investment products that lull investors with the appearance of low risk and the promise of high returns, while in fact introducing systemic risk and, ultimately, crashes or downturns. market crises. The principles that the author Bruce I. Jacobs The presentations are general, but he focuses in detail on three major market crises of the last decades in which these destructive principles were, he believes, essential ingredients – the crash of 1987, the collapse of long-term capital management (LTCM) in 1998 and the global financial crisis of 2007-2008.
The author is co-founder, co-chief investment officer and co-director of research at Jacobs Levy Equity Management. He criticizes the flawed investment theories he discusses in this book since he debated the creators of one-on-one portfolio insurance in the 1980s. Jacobs wrote a previous book, Capital Ideas and Market Realities: Options Replication, Investor Behavior, and Stock Market Crashes (1999), focused entirely on portfolio insurance, its marketing and the consequences of the widespread adoption of the strategy in the 1980s. He also wrote about the role of exotic mortgage instruments in the crisis of 2007-2008 . Subsequently, Jacobs was actively involved in the creation of the National Institute of Finance, which helped convince Congress to include the creation of the Financial Stability Oversight Council among its post-crisis financial reforms.
Jacobs acknowledges that many books have been written about financial crises, but argues that too many attribute the price crash to inexplicable “acts of God” or the inherent randomness of capital markets. The real culprits, he believes, are identifiable. Investment professionals owe it to their clients – and themselves – to understand the real causes of financial disasters and to ensure that they don’t happen again.
The central thesis of the author is fourfold:
- Some investment strategies, especially those that offer the illusion of safety, “can interact with market realities to create unhealthy consequences for markets and investors.”
- Strategies are typically complex and marketed with an aura of cutting-edge sophistication.
- They generally lack transparency.
- They feature excessive (although perhaps disguised) leverage.
The book is divided into five parts. Part I provides background information for readers unfamiliar with important concepts related to risk and its management, such as diversification, hedging and arbitrage. Many investment professionals can safely ignore this section. The second part examines the crash of 1987. More specifically, it examines the role of the newly created strategy of portfolio insurance in triggering, or certainly aggravating, this crisis. Part III gives a similar treatment to the collapse of LTCM in 1998. Here it was supposedly low-risk but extremely complex arbitrage strategies that led to disaster.
Part IV examines the credit crisis and recession of 2007-2009. This time, the problems came in the form of complex derivatives backed by assets such as collateralized debt obligations and residential mortgage-backed securities. Part V is a compendium of less cataclysmic market crises, such as various flash crashes, the “London Whale” event, the European debt crisis and the Greek debt crisis, and related issues, such as the uncritical dependence on models. In this section, Jacobs also offers some solutions, mostly involving more effective regulation, increased disclosure, clearinghouses, and proper education.
The appendix contains additional reference material:
- An introduction to bonds, stocks and derivatives.
- Documents from Jacobs’ debates with portfolio insurance providers in the 1980s.
- A discussion of several of the major derivatives disasters of the 1990s.
- The author’s 2002 proposal for standards of research objectivity.
A discussion of the 1929 crash is also included. One might wonder why this is relegated to the schedule. Is it relevant to the main argument or not?
Too smart for our own goodThe central thesis of should be taken to heart not only by investment professionals, but by all investors. Free lunch promises, complexity, opacity and excessive leverage have too often combined to produce toxic effect. Financial professionals, in particular, could benefit greatly from studying the market crises analyzed in this book and the main lessons to be drawn from them. George Santayana’s famous maxim — “Those who cannot remember the past are doomed to repeat it” — applies forcefully to financial markets.
The book has a few flaws. Because it is organized into five parts, the basic thesis is reformulated and rediscussed in each of them, which leads to many repetitions. In Part V, the argument becomes diluted as the author introduces a variety of additional issues that may contribute to market instability, such as conflicts of interest, high frequency trading (HFT), random morale, cognitive biases and unintended consequences of regulation. . If many things can contribute to a crisis, does that mean that each crisis is complex and unique, rather than all driven by a particular set of factors? One might also wonder if opacity was not a worse problem in the past, before the instantaneous broadcast of asset prices, when investors had to take their broker’s word for price and market action.
At a deeper level, a reader might wonder why financial crises have been happening for centuries, beginning long before portfolio insurance and other sophisticated instruments were made possible by the digital revolution. Does Jacobs believe all financial crises are characterized by the characteristics of its central thesis or only the most recent ones? Did the author perhaps miss an opportunity to identify a more universal underlying cause of crashes, such as the inevitable tendency for investors to become complacent and careless during long periods of prosperity? We remember John Templeton’s adage that “bull markets are born on pessimism, grow on skepticism, mature on optimism and die on euphoria”. Could the instruments and attitudes that Jacobs warns against be a response to the demand that arises during optimism and euphoria? And while innovations can come with pain when we adapt to them, don’t many innovations also bring great benefits?
One issue that Jacobs does not address is the complicity of government policy in some crises. For example, the subprime mortgage industry has been encouraged by legislation and regulation aimed at promoting more widespread ownership. It can also be argued, with regard to the global financial crisis, for example, that procyclical monetary policy has often helped to inflate the euphoric phases and deepen the inevitable corrections. Finally, government policies have created moral hazard via bailouts from the US Federal Reserve, Treasury and spending legislation.
In fairness, excessive leverage may have played a role in most, if not all, crashes in history, and opaque innovations may have featured in many of them as well. Tulipmania offered options, as the author points out in an aside.
Certainly, the author’s four horsemen – the illusion of security, complexity, opacity and leverage, tied up in a pseudoscientific envelope – have played a crucial role in the worst crises of recent times. decades. Every investment professional should be required to fully understand these crises and their ingredients. This book serves as an invaluable guide to exactly that endeavor.
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All posts are the opinion of the author. As such, they should not be construed as investment advice, and the opinions expressed do not necessarily reflect the views of the CFA Institute or the author’s employer.
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