Sanjay Bakshi: The Psychology Of Human Misjudgment [Part V]

The Psychology Of Human Misjudgment Part V by Sanjay Bakshi

Bias # 8: Overoptimism & Overconfidence

Members of LTCMs board of directors included Myron S. Scholes and Robert C. Merton, who shared the 1997 Nobel Memorial Prize in Economic Sciences for a “new method to determine the value of derivatives”.

2 Nobel laureates who blew up

Why 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 1

The company used complex mathematical models to take advantage of fixed income arbitrage deals (termed convergence trades) with government bonds. Differences in the government bonds present value are minimal, so any difference in price should be eliminated by arbitrage. Price differences between a 30 year treasury bond and a 29 and three 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 financial transactions, 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), it would 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 Capital Management, 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 LTCM

Leverage is where overconfidence can be found

What models is he talking about?

Overconfidence, Physics Envy

Recall his gun metaphor. Why do metaphors matter so much?

Modern risk management practices (e.g. VAR) assume that we live in a world best described by a bell curve where outliers are extremely rare, and that resulted in management practices that were far more risky than was previously imagined

VAR: A statistical tool that roughly says most of the you won’t lose more than x in a day or year. But its’ silent on what happens rest of the time.Also, its findings are based on history.

Buffett in 1989 letter.

“We wouldn’t have liked those 99:1 odds – and never will. A small chance of distress or disgrace 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 – keynes

It’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 you make in life that are irreversible, that lead you into a path you cant get out of, and unless you have more than one escape clause, the adversary can gang up on you and destroy you.What else? I didn’t have a proper foundation. I was not sufficiently private in my activities. I was playing poker with men named Doc. I must’ve made a hundred errors on that one, but those are five or six that come to mind. – Niederhoffer

Or highly leveraged companies.

Except when they are in bankruptcy

Wait Until You Shake Your Head

It’s easy to lend money and fool yourself into believing that you’ll make a good rate of return. It reminds me of a story about two men in a sword fight. One of them takes a big 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 original cost estimate in 1957 was $7 million. The original completion date set by the government was 26 January 1963. Thus, the project was completed ten years late and over-budget by more than fourteen times.

http://en.wikipedia.org/wiki/Sydney_Opera_House

Be wary of grandiose projections made by managements

See full slides below.