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When an intrepid commodities player negotiated the purchase of the Russian government’s entire stock of non-gold precious metals, leverage mattered less than the security around the armored train that was to bring the palladium from Siberia.
Hedge funds are the vehicles for loners and contrarians, for individualists whose ambitions are too big to fit into established financial institutions.
“Out of all the research that we’ve done with top players, we haven’t found a single player who is consistent in knowing and explaining exactly what he does,” the legendary tennis coach Vic Braden once complained. “They give different answers at different times, or they have answers that simply are not meaningful.”7
Banks that have been rescued can expect to be rescued all over again the next time they blow up; because of that expectation, they have weak incentives to avoid excessive risks, making blowup all too likely. Capitalism works only when institutions are forced to absorb the consequences of the risks that they take on. When banks can pocket the upside while spreading the cost of their failures, failure is almost certain.
what is striking about Jones, given his youthful adventures with the undercover Left, is that he emerged from this turmoil more levelheaded than before.
Jones believed that investor emotions created trends in stock prices. A rise in the stock market generates investor optimism, which in turn generates a further rise in the market, which generates further optimism, and so on; and this feedback loop drives stock prices up, creating a trend that can be followed profitably. The trick is to bail out at the moment when the psychology turns around—when the feedback loop has driven prices to an unsustainable level, and greed turns to fear, and there is a reversal of the pendulum.
IN 1952, THREE YEARS AFTER JONES HAD LAUNCHED HIS FUND, modern portfolio theory was born with the publication of a short paper titled “Portfolio Selection.” The author was a twenty-five-year-old graduate student named Harry Markowitz, and his chief insights were twofold: The art of investment is not merely to maximize return but to maximize risk-adjusted return, and the amount of risk that an investor takes depends not just on the stocks he owns but on the correlations among them. Jones’s investment method crudely anticipated these points. By paying attention to the velocity of his stocks,
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All new markets are inefficient at first, and the inefficiency means profits for early adapters.
Block traders had figured out a new approach: They weren’t engaged in the overcrowded business of analyzing company data and picking the stocks that would do well; instead, they aimed to make money by supplying something that other investors needed—liquidity.
Weymar’s rethink began with a new approach to risk taking. The most dangerous people in the world, he now liked to say, were very smart traders who had never gotten their teeth kicked in.
In moments of self-awareness, he probably acknowledged that the wildest trader at the company might be none other than himself; a colleague once suggested that putting Weymar in charge of risk controls was like putting Evel Knievel in charge of road safety.
If the price of a commodity headed up past its high point of the previous day, there was a decent chance that it would keep riding upward on a wave of excitement; so Marcus would take a large position at those crossover moments, protecting himself with a stop-loss order that would kick him out of the market if the trade went against him. Either the market took off and ran or Marcus was out: It was like mounting a surfboard, ready for the wave; if your timing was off, you just plopped back into the water. Like the storied hedge-fund traders who emulated this method later, Marcus reckoned that
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As the traders watched the price charts, looking for waves that could be profitably surfed, they recognized recurring patterns. Market bottoms tended to be rounded, because a bumper harvest not only drives the price down but causes excess produce to be held in storage; this inventory overhang keeps prices low for an extended period. By contrast, market tops tend to be spike shaped: If there is a sudden shortage in a crop, consumption has to fall sharply and prices shoot up; but if the next harvest is good, the shortage goes away and prices quickly shoot down again.
Market bottoms tended to be rounded, because a bumper harvest not only drives the price down but causes excess produce to be held in storage; this inventory overhang keeps prices low for an extended period. By contrast, market tops tend to be spike shaped: If there is a sudden shortage in a crop, consumption has to fall sharply and prices shoot up; but if the next harvest is good, the shortage goes away and prices quickly shoot down again.
following the logic of currency speculators who later attacked exchange-rate pegs everywhere from Britain to Thailand, Marcus saw that, whether or not revaluation happened, devaluation was inconceivable. This made betting on the Saudi currency a hugely attractive one-way gamble: There could be no guarantee of winning, but there was a near guarantee of not losing. So Marcus took huge positions in the riyal, leveraging himself up with borrowed money and sleeping perfectly soundly. In March 1975, Saudi Arabia abandoned its dollar link and revalued. Marcus made another killing.38
the truth is that innovation frequently depends less on grand academic breakthroughs than on humble trial and error—on a willingness to go with what works, and never mind the theory that may underlie it.
Exactly what Taleb says in Antifragile
Financial markets are mechanisms for matching people who want to avoid risk with people who get paid to take it on: There is a transfer from insurance seeker to insurance seller.
market was bound to profit the insurance sellers—that is to say, the speculators. The farmers and the food companies were buying and selling futures because they needed to shed risk, not because they had a sophisticated view on the direction of prices; speculators who did have such a view were bound to have the upper hand in trading with them.
Michael Marcus, who had once studied psychology, noticed something about Kovner early on: He had a physical and psychological strength that set him apart from his colleagues. Kovner knew how to let go of distractions; he did not overthink his trades and had no trouble sleeping. Other traders might make money faster, but they would lose it faster too; Kovner was consistent, and he had a sort of nerveless temperament. One time Kovner took a hit on a silver position, suffering the sort of loss that would have left most traders vomiting in the bathroom. He showed up that same day at an
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He could get the best out of ordinary people: He employed an ex-librarian to monitor the relationship between interest rates and gold futures; whenever the relationship showed an unusual blip, the librarian had instructions to bet on normalcy’s return, a formula that generated handsome profits.
Kovner once argued that the most profitable opportunities arise when you have no fundamental information.52 If a market is behaving normally, ticking up and down within a narrow band, a sudden breakout in the absence of any discernible reason is an opportunity to jump: It means that some insider somewhere knows information that the market has yet to understand, and if you follow that insider you will get in there before the information becomes public.
In 1947, when he was barely seventeen, Soros had left Hungary for a better future in London, bidding good-bye to his parents, whom he expected not to see again. He took jobs as a dishwasher, a house painter, a busboy; a headwaiter told him that, provided he worked hard, he might one day end up as his assistant.
Popper’s central contention was that human beings cannot know the truth; the best they can do is to grope at it through trial and error.
Soros had arrived at a conclusion that was at odds with the efficient-market view. Academic finance assumes, as a starting point, that rational investors can arrive at an objective valuation of a stock and that when all information is priced in, the market can be said to have attained an efficient equilibrium. To a disciple of Popper, this premise ignored the most elementary limits to cognition.4
“The conventional method of security analysis is to try to predict the future course of earnings,” he began; but in the case of these investment trusts, future earnings would themselves depend on investors’ perceptions about them. If investors were bullish, they would pay a premium for a share in a successful trust, injecting it with cheap capital. The cheap capital would boost earnings, which would in turn reinforce the appearance of success, persuading other investors to buy into the trust at an even greater premium. The trick, Soros insisted, was to focus neither on the course of earnings
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When Soros sensed a game-changing moment, he was not afraid to bet the store on it.
He was willing to take the plunge without waiting for conclusive evidence that he was right. If he found an investment idea attractive on cursory examination, he figured that others would be seduced too; and since he believed that perfect cognition was impossible, there was no point in sweating the details.
Soros’s motto was “Invest first, investigate later.”
Like Michael Marcus of Commodities Corporation, who abandoned his seat on the floor of the cotton exchange to become a generalist trader, Soros saw no point in knowing everything about a few stocks in the hope of anticipating small moves; the game was to know a little about a lot of things, so that you could spot the places where the big wave might be coming.
Soros’s investment decisions were often balanced on a knife edge. The truth is that markets are at least somewhat efficient, so most information is already in the price; the art of speculation is to develop one insight that others have overlooked and then trade big on that small advantage.
Soros had understood that nothing more substantial than slippery perceptions had driven up the dollar, and therefore that a trigger could set off a sudden reversal. Because he had grasped the system’s instability, he had understood the Plaza accord’s meaning faster than others. Plaza was the trigger, and it didn’t even matter that the details of the new policy had yet to be filled in. A political jolt had kick-started a new trend, which would now feed on itself and become self-sustaining.
The larger the funds grew, the harder it became to jump in and out of markets without disrupting prices and damaging themselves in the process. If Quantum had been smaller, Soros might have bailed out on Monday as swiftly as Druckenmiller had; and he could have sold his position on Thursday without causing prices to crater. Soros’s trading style assumed the ability to turn on a dime, and when that assumption proved wrong, Soros was in trouble.
the postmortems on the crash found that of the $39 billion worth of stock sold on October 19 via the futures and the cash markets, only about $6 billion worth of sales were triggered by portfolio insurers.
corporate America had bounced around like a pachinko ball; there was nothing efficient about this, nor was there any sign of equilibrium. “The theory of reflexivity can explain such bubbles, while the efficient market hypothesis cannot,” Soros wrote later, and broadly, he was right.
It was surely no coincidence that efficient-market thinking had originated on American university campuses in the 1950s and 1960s—the most stable enclaves within the most stable country in the most stable era in memory. Soros, who had survived the Holocaust, the war, and penury in London, had a different view of life;
Eugene Fama, the father of efficient-market theory, who got to know Mandelbrot at the time, conducted tests on stock-price changes that confirmed Mandelbrot’s assertion. If price changes had been normally distributed, jumps greater than five standard deviations should have shown up in daily price data about once every seven thousand years. Instead, they cropped up about once every three to four years.
The trouble with Mandelbrot’s insight was that it was too awkward to live with; it rendered the statistical tools of financial economics useless, since the modeling of non-normal distributions was a problem largely unsolved in mathematics.
“Mandelbrot, like Prime Minister Churchill before him, promises us not utopia but blood, sweat, toil and tears. If he is right, almost all of our statistical tools are obsolete— least squares, spectral analysis, workable maximum-likelihood solutions, all our established sample theory, closed distribution functions. Almost without exception, past econometric work is meaningless.”
Efficient-market theory assumed investors always had the means to act: If they knew that a share of IBM was worth $90 rather than the prevailing price of $100, they would sell it short until the weight of their trading moved the price down by $10. This assuming away of institutional frictions involved a number of heroic leaps. You had to presume that the knowledgeable speculators could find enough IBM stocks to borrow in order to be able to sell them short. And you had to gloss over the fact that, in real life, the “knowledge” that IBM was worth $90 would be less than certain. Speculation
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When the whole world is selling, it doesn’t matter whether sophisticated hedge funds believe that prices have fallen too far. Buying is crazy.
Thus a small investor can have a behavioural edge over institutional money managers
He once summed up his approach to investing in a letter to Robert Karr, Tiger’s man in Tokyo, and the sheer blandness of his message underlined the mystery of his success. A Tiger should manage the portfolio aggressively, removing good companies to make room for better ones; he should avoid risking more than 5 percent of capital on one bet; and he should keep swinging through bad times until his luck returned to him.12
Robertson introduced one young analyst to Jerry Reinsdorf, the owner of the Chicago Bulls, saying, “This man is my Michael Jordan.”
Tiger’s roster of investors was crammed with captains of industry and finance, and Robertson never hesitated to call on them for insights. His letters to his partners frequently encouraged them to call in ideas, “or, particularly in the case of ladies, intuition.” In the early 1980s Tiger tripled its money in a stock called Mentor, which a Tiger investor had recommended. In the early 1990s the fund’s best stock picks included General Instrument Corporation and Equitable Life Insurance; in both cases Tiger friends who were connected to those firms had urged Robertson to buy them. Around the
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Robertson’s competitive expansion involved risks, however. It forced him to diversify beyond his core strengths: There were too few opportunities in the U.S. equity markets to sustain a fund worth several billion dollars. Small-cap stocks, in particular, became virtually off limits: An analyst might identify a promising small company and figure that its value could double over three years, but if there was only $20 million worth of shares available to buy, it was hardly worth bothering with.
Same as Buffett - hard to keep finding ways to meaningfully grow such a large pool of capital
Value investors generally buy stocks using little or no leverage, and they hold them for the long term; if the investment moves against them, they typically buy more, because a stock that was a bargain at $25 is even more of a bargain at $20. But macro investors take leveraged positions, which make such trend bucking impossibly risky; they have to be ready to jump out of the market if a bet moves against them. Similarly, value investors pride themselves on rock-solid convictions. They have torn apart a company balance sheet and figured out what it is worth; they know they have found value.
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if you aimed to survive as a floor trader, it was less important to understand the news than to foresee the pit’s reaction to it. The story is told of a floor operator who made $10 million in a spasm of trading following the release of a government inflation report. When the pandemonium had subsided he walked out of the ring and asked, “By the way, what was the number?”3
“When you take an initial position, you have no idea if you are right,” he once confessed, undermining the notion that any long-range analysis could explain his success. Rather, as he explained in his more candid moments, his method was “to write a script for the market,” setting out how it might behave; and then to test the hypothesis repeatedly with low-risk bets, hoping to catch the moment when his script became reality.
As with all bubbles, the challenge with Japan was not so much to see that it would crash but to anticipate the moment. Shorting the Tokyo market aggressively in the wake of NTT’s flotation would have been tantamount to suicide: Over the next two years, the Nikkei stock index gained an astonishing 63 percent, proof that there are few things more costly than tilting against a bubble.
Jones’s real achievement was not just to predict that Japan would fall, nor even how it would experience brief rallies on the way down. It was to spot a situation in which the odds were so good that they warranted a bet, even in the absence of predictive certainty.
