Myron Scholes Robert mertonMembers of LTCMs board of directors included Myron S. Scholes andRobert C. Merton, who shared the 1997 Nobel Memorial Prize in EconomicSciences for a "new method to determine the value of derivatives".2 Nobel laureates who blew upWhy do smart people do dumb things?
Beginning of 1998: Equity: $4.72 billion Debt: $124.5 billion total assets: $129 billion debt to equity: more than 25 to 1The company used complex mathematical models to take advantage of ﬁxed income arbitrage deals (termedconvergence trades) with government bonds. Differences in the government bonds present value are minimal, so anydifference in price should be eliminated by arbitrage. Price differences between a 30 year treasury bond and a 29 andthree quarter year old treasury bond should be minimal—both will see a ﬁxed payment roughly 30 years in the future.However, small discrepancies arose between the two bonds because of a difference in liquidity. By a series of ﬁnancialtransactions, essentially amounting to buying the cheaper off-the-run bond (the 29 and three quarter year old bond)and shorting the more expensive, but more liquid, on-the-run bond (the 30 year bond just issued by the Treasury), itwould be possible to make a proﬁt as the difference in the value of the bonds narrowed when a new bond was issued.Low spread.Leverage required to make money.
The value of $1000 invested in the hedge fund Long-Term CapitalManagement, of $1,000 invested in the Dow Jones Industrial Average, andof $1,000 invested monthly in U.S. Treasuries at constant maturity.http://en.wikipedia.org/wiki/Long-Term_Capital_Management
Buffett video on LTCMLeverage is where overconﬁdence can be foundWhat models is he talking about?Overconﬁdence, Physics EnvyRecall his gun metaphor. Why do metaphors matter so much?
Would you like to jump out of this plane with this parachute which opens 99% of the time? Modern Risk Management Practices Advocate that you should jumpModern risk management practices (e.g. VAR) assume that we live in aworld best described by a bell curve where outliers are extremely rare, andthat resulted in management practices that were far more risky than waspreviously imaginedVAR: A statistical tool that roughly says most of the you won’t lose morethan x in a day or year. But its’ silent on what happens rest of the time.Also, its ﬁndings are based on history.
“Even in 1965, perhaps we could have judged there to be a 99% probability that higher leverage would lead to nothing but good.Buffett in 1989 letter.“We wouldnt have liked those 99:1 odds - and never will. A small chance of distress ordisgrace cannot, in our view, be offset by a large chance of extra returns.”Role of derivatives: ﬁnancial instruments of mass destruction.examples: Wockhardt, textile companies in south india, hedge fund blow ups, banks blowup.Role of max loss exposure in risk management.“It’s never happened before, so it can’t ever happen.”
The market can stay Irrational longer than you can stay solvent - keynesIt’s not physics.
The Mouse with one hole is quickly cornered"The mouse with one hole is quickly cornered." That is key. There are certain decisions youmake in life that are irreversible, that lead you into a path you cant get out of, and unlessyou have more than one escape clause, the adversary can gang up on you and destroy you.What else? I didnt have a proper foundation. I was not sufficiently private in my activities. Iwas playing poker with men named Doc. I mustve made a hundred errors on that one, butthose are ﬁve or six that come to mind. - Niederhoffer
Source:THE FOURTH QUADRANT: A MAP OF THE LIMITS OF STATISTICS By Nassim Nicholas Taleb
why I don’t like banksOr highly leveraged companies.Except when they are in bankruptcy
Wait Until You Shake Your HeadIt’s easy to lend money and fool yourself into believing that you’ll make a good rate ofreturn. It reminds me of a story about two men in a sword ﬁght. One of them takes abig swipe on the other one’s neck whereupon the other one says “You missed me.”The swiper says, “Wait until you shake your head.”Story as told by Charlie Munger.
The Opera House was formally completed in 1973, having cost $102 million. The originalcost estimate in 1957 was $7 million. The original completion date set by the governmentwas 26 January 1963. Thus, the project was completed ten years late and over-budget bymore than fourteen times.http://en.wikipedia.org/wiki/Sydney_Opera_HouseBe wary of grandiose projections made by managements
When the city of Montreal was selected to host the 1976 Summer Olympics, the mayorannounced that the entire Olympiad would cost $120 million and that the track and ﬁeldevents would take place in a stadium with a ﬁrst-of-its-kind retractable roof. The gameswent off as planned, of course, but the stadium did not get its roof until 1989. And oh yes:the roof ended up costing $120 million, or almost as much as was budgeted for the entireOlympics.
The Company was formed on 13 August 1986 with the objective of ﬁnancing, building andoperating a tunnel between England and France. The Company let a contract for the constructionof the tunnel to TransManche Link. The tunnel cost around £9.5bn to build, about double itsoriginal estimate of £4.7bn. The tunnel, which was ﬁnanced partly from investment byshareholders and partly from £8bn of debt, was officially opened on 6 May 1994. In its ﬁrst yearof operation the Company lost £925m because of disappointing revenues from passengers andfreight together with heavy interest charges on its £8bn of debt.
Look what overconﬁdence does.Look for leverage if you want to look for overconﬁdence.The interest on the debt was more than the gross revenues!How can you ﬁnance a project with debt where you have to make moneyfrom largely unpredictable consumer behavior? This was the ﬁrst tollbridge...Remember Feynman who remarked how difficult physics would have been ifparticles had feelings?
Recall that this is a “man on a roll” we found in a previous class.Hw just won a lot of money in the casino. What will do next? Walk out with his winnings? Hell no! He willgo back to the table and play more thinking “This is the just the beginning of my streak.” His behaviorwill ultimately ruin him.Last time when we talked of him, he was high on dopamine. Dopamine produced over-conﬁdence.
We saw these people earlier - happy people who just became rich - in the movie Dot Con
Normal human tendency 90% ofdrivers thinkthat they are better than average drivers
Why do people buy lottery tickets?Why do people buy lottery tickets? Or indulge in day trading?74% of investors in a survey said that their own funds will consistently outperform the market Reality?Only a handful actually doOnly 37% of managers believe that mergers create value for buyers. But when it came to their ownmergers and acquisitions, 58% said their deals will create value
Give high and low estimates for the average weight of an empty Boeing 747aircraft. Choose numbers far enough apart to be 90 percent certain that thetrue answer lies somewhere in between. Ans: 177 tonsIf you are 90% sure, then you should be comfortable betting $9 againstprospect of willing just $1 that the real is within your chosen range.
Give high and low estimates for the diameter of the earth’s moon in kms. Again, choose numbers farenough apart to be 90 percent certain that the true answer lies somewhere in between. Ans: 3,476 kmsIf you are 90% sure, then you should be comfortable betting $9 against prospect of willing just $1 thatthe real is within your chosen range.Because most people who attempt to answer these questions don’t recognize how little they really knowabout the subjects or how difficult it is to bracket high and low estimates so that there’s a sufficientlystrong chance that the real answer will fall somewhere in between. As a result, most people fail tospread their estimates far enough apart to account for their ignorance.
How do we demonstrate overconfidence?1. Request subjects to evaluate their conﬁdence in a statement. Group together all the statements with a given level of conﬁdence (e.g., 90%)and compare that to the actual frequency of being correct.2. Test subjects with multiple-choice questions and then elicit their level of conﬁdence in their answer on a scale from chance to 100% (totalcertainty). Compare this to the true accuracy of the answers.3. Give subjects a question with a numerical answer, and get them to choose a conﬁdence interval such that they have a particular level ofconﬁdence that the true answer is in that range; e.g., "Pick a low number and a high number such that you are 90% conﬁdent that thepopulation of Bulgaria is between those numbers." - we did this a while ago.4. Offer subjects the opportunity to bet on the correctness of their answers with chances that are favorable, if their judgements of accuracyare correct. They lose money if they are overconﬁdent. If you are 90% sure, then you should be comfortable betting $9 against prospect ofwilling just $1 that the real is within your chosen range.If human conﬁdence had perfect calibration, judgements with 100% conﬁdence would be correct 100% of the time, 90% conﬁdence correct90% of the time, and so on for the other levels of conﬁdence. By contrast, the key ﬁnding is that conﬁdence exceeds accuracy so long as thesubject is answering hard questions about an unfamiliar topic. In a spelling task, subjects were correct about 80% of the time when they were"100% certain".Put another way, the error rate was 20% when subjects expected it to be 0%.
Terrance Odean and Brad M. Barber of the University of California analyzed the trading records of more than60,000 investors at a large brokerage ﬁrm. They found that individuals who trade stocks most frequently postexceptionally poor investment results.
Its very difficult to accurately predict consumer behavior
This is Joshua Bell.http://en.wikipedia.org/wiki/Joshua_BellHe is playing Vivaldi Four Seasons.http://www.youtube.com/watch?v=iNcYT7jpH9EPeople pay hundreds of dollars to watch him play.
One day Joshua Bell played the violin at a subway station in Washington D.C- incognito - on behalf of The Washington Post.See this: http://www.youtube.com/watch?v=hnOPu0_YWhwRead this: http://www.washingtonpost.com/wp-dyn/content/article/2007/04/04/AR2007040401721.htmlNow this is not a controlled experiment. One can claim that the commuterswere busy, had other stuff on their minds etc etc.
http://en.wikipedia.org/wiki/Trading_PlacesTwo guys - one born rich - one a poor conman -were swapped by twobrothers who entered a bet...
This is one of best controlled experiments in social science I have read about..http://www.nytimes.com/2007/04/15/magazine/15wwlnidealab.t.htmlWeb-based experiment. More than 14,000 participants registered at Music Lab(www.musiclab.columbia.edu), and were asked to listen to, rate and, if they chose, download songs bybands they had never heard of. Some of the participants saw only the names of the songs and bands,while others also saw how many times the songs had been downloaded by previous participants. Thissecond group — “social inﬂuence” condition — was further split into eight parallel “worlds” such thatparticipants could see the prior downloads of people only in their own world. All the artists in all theworlds started out identically, with zero downloads — but because the different worlds were keptseparate, they subsequently evolved independently of one another.You should see the parallels with Darwin’s Theory of Evolution as you read about this story.
In all the social-inﬂuence worlds, the most popular songs were much more popular (and the least popular songs were lesspopular) than in the independent condition.At the same time, however, the particular songs that became hits were different in different worlds, just as cumulative-advantage theory would predict. Introducing social inﬂuence into human decision making, in other words, didn’t just makethe hits bigger; it also made them more unpredictable.When people tend to like what other people like, differences in popularity are subject to what is called “cumulativeadvantage,” or the “rich get richer” effect. This means that if one object happens to be slightly more popular than another atjust the right point, it will tend to become more popular stil.As a result, even tiny, random ﬂuctuations can blow up, generating potentially enormous long-run differences among evenindistinguishable competitors...Thus, if history were to be somehow rerun many times, seemingly identical universes with the same set of competitors andthe same overall market tastes would quickly generate different winners: Madonna would have been popular in this world,but in some other version of history, she would be a nobody, and someone we have never heard of would be in her place.
Oil went from $10 to $140. Who could have predicted either of theseoutcomes?The Value of ONGC is VASTLY different if you assume a $10 a barrel worldas compared to the value in a $140 a barrel world.
Excel can make you go nuts.The deﬁnition of value is very precise. There is no ambiguity about it. All one has to do is to take thefuture cash ﬂows and then bring them back to the present value using discount factor which is theopportunity cost of capital derived from a very precise model called the Capital Asset Pricing Model. Youpunch in the numbers in that model and out comes the cost of capital and then you punch that numberin another excel model containing future cash ﬂows and the precise formulas in that excel model will tellyou instantly what that business is worth.The sheer number of assumptions in a valuation model are mind boggling
Extrapolation, ignorance of diseconomies of scale, ignorance of competition, regulation.Minor changes in inputs can make a vast difference in the ﬁnal valuation numberIn some cases, most of the value is comprised in cash ﬂows which will occur several years from now. So wehave to worry about forecast degradation. Increasing the discount factor is not the way to do it!Underneath all that precision of that “precise model” is the defective man with all his biases. What biases creepinto the excel valuation models?
“It’s stupid the waypeople extrapolate the past- and notslightly stupid, but massively stupid.”
“I don’t think you can stick numbers on a highly speculative business where the whole industry is going to change in 5 years and have it mean anything.”“If you say, “I am going to stick an extra 6% on the interest rate to allow forthat” I think that’s nonsense. It may look mathematical, but itsmathematical gibberish in my view. . .”Buffett does not think about cost of capital the way academic ﬁnance thinksabout the subject.
“the test used by most CEOs – is that the cost of capital is about ¼ of 1% below the return promised by any deal that the CEO wants to do!”Thats why Excel Models can be used to rationalize almost any desiredbehavior!
“Any business craving of the leader, however foolish, will be quickly supported by detailed rate- of-return and strategic studies prepared by his troops.”Man is not a rational animal; rather man is a rationalizing one…And Excel is a beautiful tool which helps him do just that!You don’t even need “Goal Seek” function because its already built into thehuman user!
P/E Multiples in a high growth business are extremely sensitive to growth rates.What happened to Infosys?This is the best Indian company, with the best business model, with the bestmanagement which is competent, honest, and prudent. There is no debt, theearnings have grown and grown. And yet, people did not make any money frommarch 2000 over the next ten years or so. And this happened while Indiaexperienced the biggest bull market in its history. How did this happen?
the earnings did not fall but the growth rate of earnings did. And thevaluation in March 2000 implied explosive growth to continue. That did nothappen.The result?
Growth stocks are extremely vulnerable to errors in predictions aboutgrowth.
“The combination of precise formulas with highly impreciseassumptions can beused to establish, or rather to justify, practically any value one wishes,however high, for a really outstanding company.”
“People calculatetoo much and think too little.”
“If I taught a course in investments, my final exam would be to value this Internet stock.” “And if they came up with an answer, theyd ﬂunk. And if they came upwith a blank sheet of paper, Id probably give them a B. “And if they saidhow the hell could you ask something so dumb? I’d give them an A.”
Bill Maher on Think Tanks and Predictions:http://www.youtube.com/watch?v=VcJohfS4vTQSee his movie Religious. He teaches you to be skeptical.http://www.youtube.com/watch?v=fg8WlXZxAgQ
“There are two classes of forecasters:Those who dontknow and those who dont know they dont know.”- Galbraith
the statistician who drowned in water which was, on average, only 4 feet deepFinancial modelers use scenario analysis and then apply subjective probabilities to eachscenario to arrive at the “expected value”That’s the functional equivalent of the statistician who drowned in water which was, onaverage, only 4 feet deep!He forgot that the RANGE of depth was between 3 feet and 10 feet!
Nassim Taleb“The worst case scenario is often more consequential than the forecastitself.”
October 200714 December 2008 mail:What a difference a year makesJust more than 1 year ago Royal Bank of Scotland (RBS) paid $100bn for ABN Amro (80% cash).For this amount today, RBS could buy:Citibank $22.5bn,Morgan Stanley $10.5bn,Goldman Sachs $21.0bn,Merrill Lynch $12.3bn,Deutsche Bank $13.0bn andBarclays $12.7bn,And still have $8bn change !
Wealth Destruction on a Massive Scale? A Study of Acquiring-Firm ...
“Pascal’s observationseems apt: “Ithas struck methat all men’s misfortunes spring from the single cause that they are unable to stay quietlyin one room.” - Buffett
While deals oftenfail in practice, they never fail in projections - if the CEO is visibly panting over a prospective acquisition, subordinates and consultants willsupply the requisite projections to rationalize any price.
Decision Weights Gambles with modest monetary stakes estimates for gainsThe possibility effect: unlikely events are considerably overweighted. For example, thedecision weight that corresponds to a 2% chance is 8.1.
Frequency-MagnitudePeople do not focus on both the frequency AND the magnitude. But theyshould. I could be 70% sure the market would rise, and still be short themarket.Rare events get mispriced.
Kelly Criteria LinkKelly formula tells you how much of your bankroll should be invested in a givenopportunity. There are only two inputs. Edge and Odds.http://en.wikipedia.org/wiki/Kelly_criterionKelly works in bell curve situations like black jack, or dice. But the ﬁnancial world is notbest described by bell curves. In the ﬁnancial worlds we deal with extremely uncertainoutcomes, and extremely unpredictable and irrational human behavior. If you usemodels from the bell curve world in a world where black swans proliferate, you willmake errors. What will happen if you overestimate your edge? You will over invest.
There is extreme wisdom in the idea that diversiﬁcation is protection against ignorance andif you are not ignorant then your need to diversify goes down. Mr. Munger put it in thesewords:“It is not given to human beings to have such talent that they can just know everything abouteverything all the time. But it is given to human beings who work hard at it – who look andsift the world for a mispriced bet – that they can occasionally ﬁnd one. And the wise ones betheavily when the world offers them that opportunity. They bet big when they have odds. Andthe rest of the time, they dont. Its just that simple.”But what if you over-estimate your odds of success - a tendency that is pervasive?
Of course if people were rational, there wont be so many startups.“If people were not overconﬁdent, for example, signiﬁcantly fewer people would ever start a newbusiness: most entrepreneurs know the odds of success are against them, yet they try anyway. Thattheir optimism is misplaced—that they are overconﬁdent—is evidenced by the fact that more than two-thirds of small businesses fail within four years of inception. Put another way, most small-businessowners believe that they have what it takes to overcome the obstacles to success, but most of them arewrong.http://en.wikipedia.org/wiki/Animal_spirits_(Keynes)
“animal spirits - a spontaneous urge to action rather than inaction, and not as the outcome of a weighted average of quantitative benefits multiplied by quantitative probabilities.”- Keynes"Even apart from the instability due to speculation, there is the instability due to the characteristic ofhuman nature that a large proportion of our positive activities depend on spontaneous optimism ratherthan mathematical expectations, whether moral or hedonistic or economic. Most, probably, of ourdecisions to do something positive, the full consequences of which will be drawn out over many days tocome, can only be taken as the result of animal spirits - a spontaneous urge to action rather thaninaction, and not as the outcome of a weighted average of quantitative beneﬁts multiplied byquantitative probabilities."http://en.wikipedia.org/wiki/Animal_spirits_(Keynes)
The main benefit of optimism is resilience in the face of setbacks.Optimistic bias plays a role—sometimes the dominant role—whenever individuals orinstitutions voluntarily take on signiﬁcant risks. More often than not, risk takersunderestimate the odds they face, and do invest sufficient effort to ﬁnd out what the oddsare. Because they misread the risks, optimistic entrepreneurs often believe they are prudent,even when they are not. Their conﬁdence in their future success sustains a positive moodthat helps them obtain resources from others, raise the morale of their employees, andenhance their prospects of prevailing. When action is needed, optimism, even of the mildlydelusional variety, may be a good thing. - Kahneman
Optimism Bias“Optimistic bias is a signiﬁcant source of risk taking. In the standard rational model of economics,people take risks because the odds are favorable—they accept some probability of a costly failurebecause the probability of success is sufficient. We proposed an alternative idea. When forecasting theoutcomes of risky projects, executives too easily fall victim to the planning fallacy. In its grip, they makedecisions based on delusional optimism rather than on a rational weighting of gains, losses, andprobabilities. They overestimate beneﬁts and underestimate costs. They spin scenarios of success whileoverlooking the potential for mistakes and miscalculations. As a result, they pursue initiatives that areunlikely to come in on budget or on time or to deliver the expected returns—or even to be completed. Inthis view, people often (but not always) take on risky projects because they are overly optimistic aboutthe odds they face.This idea probably contributes to an explanation of why people litigate, why they start wars, and whythey open small businesses.” - Kahneman
Optimism Bias“Optimism is normal, but some fortunate people are more optimistic than the rest of us. If you are genetically endowed with an optimisticbias, you hardly need to be told that you are a lucky person—you already feel fortunate. An optimistic attitude is largely inherited, and it ispart of a general disposition for well-being, which may also include a preference for seeing the bright side of everything. If you wereallowed one wish for your child, seriously consider wishing him or her optimism. Optimists are normally cheerful and happy, and thereforepopular; they are resilient in adapting to failures and hardships, their chances of clinical depression are reduced, their immune system isstronger, they take better care of their health, they feel healthier than others and are in fact likely to live longer. A study of people whoexaggerate their expected life span beyond actuarial predictions showed that they work longer hours, are more optimistic about theirfuture income, are more likely to remarry after divorce (the classic “triumph of hope over experience”), and are more prone to bet onindividual stocks. Of course, the blessings of optimism are offered only to individuals who are only mildly biased and who are able to“accentuate the positive” without losing track of reality. Optimistic individuals play a disproportionate role in shaping our lives. Theirdecisions make a difference; they are the inventors, the entrepreneurs, the political and military leaders—not average people. They got towhere they are by seeking challenges and taking risks. They are talented and they have been lucky, almost certainly luckier than theyacknowledge.” -Kahneman
The prevalent tendency to underweight or ignore distributional information is perhaps the major source of error in forecasting. -Bent Flyvbjerg.Planning Fallacy: Plans and forecasts that1. are unrealistically close to best-case scenarios2. could be improved by consulting the statistics of similar casesUsing the “inside view” and not the “outside view”“Pallid” statistical information is routinely discarded when it is incompatible with one’s personal impressions ofa case. In the competition with the inside view, the outside view doesn’t stand a chance. The preference for theinside view sometimes carries moral overtones. I once asked my cousin, a distinguished lawyer, a questionabout a reference class: “What is the probability of the defendant winning in cases like this one?” His sharpanswer that “every case is unique” was accompanied by a look that made it clear he found my questioninappropriate and superﬁcial.Insensitivity to base rates
Identify an appropriate reference class. Obtain the statistics of the reference class Use the statistics to generate a baseline prediction. Use specific information about the case to adjust the baseline prediction, if there are particular reasons to expect the optimistic bias to be more or less pronounced in this project than in others of the same type.How to overcome planning fallacy.But what about Bugsy?
Snapshot of movie’s endBugsy last SceneHe was over-leveraged, over-conﬁdent, and dead.Watch this movie. Its about a man you would think as totally crazy. But hecreated Las Vegas. People thought he was crazy. And he was. The world needs alot of people Bugsy. They drive capitalism. Warren Buffett would never doanything as crazy as a Bugsy because Warren Buffett is RATIONAL.So what do you want to be like? Rational like Warren Buffett or crazy like WarrenBeatty (who plays the role of Bugsy in the movie)?
Why We need Bugsy“Signiﬁcant effort is required to ﬁnd the relevant reference category, estimate the baseline prediction, and evaluate the quality ofthe evidence. The effort is justiﬁed only when the stakes are high and when you are particularly keen not to make mistakes.Furthermore, you should know that correcting your intuitions may complicate your life. A characteristic of unbiased predictionsis that they permit the prediction of rare or extreme events only when the information is very good. If you expect yourpredictions to be of modest validity, you will never guess an outcome that is either rare or far from the mean. If your predictionsare unbiased, you will never have the satisfying experience of correctly calling an extreme case. You will never be able to say, “Ithought so!” when your best student in law school becomes a Supreme Court justice, or when a start-up that you thought verypromising eventually becomes a major commercial success. Given the limitations of the evidence, you will never predict that anoutstanding high school student will be a straight-A student at Princeton. For the same reason, a venture capitalist will never betold that the probability of success for a start-up in its early stages is “very high.” The objections to the principle of moderatingintuitive predictions must be taken seriously, because absence of bias is not always what matters most. A preference forunbiased predictions is justiﬁed if all errors of prediction are treated alike, regardless of their direction. But there are situationsin which one type of error is much worse than another. When a venture capitalist looks for “the next big thing,” the risk ofmissing the next Google or Facebook is far more important than the risk of making a modest investment in a start-up thatultimately fails. The goal of venture capitalists is to call the extreme cases correctly, even at the cost of overestimating theprospects of many other ventures.” - Kahneman