Book Review: Too Smart for Our Own Good

Too Smart for Our Own Good: Ingenious Investment Strategies, Illusions of Safety, and Market Crashes. 2018. Bruce I. Jacobs. McGraw Hill Education.

Too Sensible for Our Personal Good is a cri de coeur about funding merchandise that lull buyers with the looks of low threat and the promise of excessive returns, whereas truly introducing systemic threat and, finally, market crashes or crises. The ideas that creator Bruce I. Jacobs lays out are basic ones, however he focuses intimately on three main market crises of current many years during which these damaging ideas have been, in his view, vital components — the crash of 1987, the collapse of Lengthy-Time period Capital Administration (LTCM) in 1998, and the worldwide monetary disaster of 2007–2008.

The creator is co-founder, co-chief funding officer, and co-director of analysis at Jacobs Levy Fairness Administration. He has been a critic of the flawed funding theories that he discusses on this e-book since debating the creators of portfolio insurance coverage head-to-head within the Nineteen Eighties. Jacobs wrote a earlier e-book, Capital Ideas and Market Realities: Option Replication, Investor Behavior, and Stock Market Crashes (1999), centered completely on portfolio insurance coverage, its advertising, and the implications of the technique’s huge adoption within the Nineteen Eighties. He additionally wrote in regards to the function of unique mortgage devices within the 2007–2008 disaster. Subsequently, Jacobs was lively in creating the Nationwide Institute of Finance, which was instrumental in convincing Congress to incorporate the creation of the Monetary Stability Oversight Council amongst its post-crisis monetary reforms.

Jacobs acknowledges that many books have been written on monetary crises however contends that too lots of them attribute the worth collapses to inexplicable “acts of God” or the inherent randomness of capital markets. The true culprits, he believes, are identifiable. Funding professionals owe it to their shoppers — and themselves — to grasp the true causes of economic disasters and assist make sure that they don’t recur.

The creator’s core thesis is fourfold:

1. Sure funding methods, particularly people who provide the phantasm of security, “can work together with market realities to create unhealthy penalties for markets and buyers.”
2. The methods are sometimes advanced and marketed with an aura of cutting-edge sophistication.
3. They sometimes lack transparency.
4. They exhibit extreme (although maybe disguised) leverage.

The e-book is split into 5 components. Half I gives
background for readers unfamiliar with vital ideas regarding threat and
its administration, similar to diversification, hedging, and arbitrage. Many
funding professionals can safely skip this part. Half II examines the
1987 crash. Particularly, it scrutinizes the function of the newly created technique
of portfolio insurance coverage in triggering, or definitely exacerbating, that disaster.
Half III provides related remedy to the collapse of LTCM in 1998. Right here,
allegedly low-risk however wickedly advanced arbitrage methods are what led to
catastrophe.

Half IV seems on the credit score disaster and recession of 2007–2009.
This time, bother got here within the type of advanced asset-backed derivatives similar to
collateralized debt obligations and residential mortgage-backed securities.
Half V is a seize bag of much less cataclysmic market crises, similar to varied flash
crashes, the “London Whale” occasion, the European debt disaster, and the Greek debt
disaster, in addition to associated points, similar to uncritical reliance on fashions. In
this part, Jacobs additionally proposes some options, primarily involving more-effective
regulation, elevated disclosure, clearinghouses, and correct schooling.

The appendix accommodates extra background materials:

• A primer on bonds, shares, and derivatives.
• Paperwork from Jacobs’s debates with purveyors of portfolio insurance coverage within the Nineteen Eighties.
• A dialogue of a number of of the most important Nineteen Nineties derivatives disasters.
• The creator’s 2002 proposal for analysis objectivity requirements.

Additionally included is a dialogue of the 1929 crash. One would possibly query why that is relegated to the appendix. Is it related to the core argument or not?

Too Sensible for Our Personal Good’s core thesis ought to be taken to coronary heart not solely by funding professionals however by all buyers. Free-lunch guarantees, complexity, opacity, and extreme leverage have too typically mixed to poisonous impact. Monetary professionals particularly may benefit vastly from finding out the market crises analyzed on this e-book and the important thing classes to be drawn from them. George Santayana’s well-known dictum — “Those that can not bear in mind the previous are condemned to repeat it” — applies with a vengeance to monetary markets.

The e-book has some flaws. As a result of it’s organized in 5 components, the core thesis is restated and rediscussed in every one, resulting in appreciable repetition. In Half V, the argument will get diluted when the creator introduces a wide range of extra points that may contribute to market instability, similar to conflicts of curiosity, high-frequency buying and selling (HFT), ethical hazard, cognitive biases, and the unintended penalties of regulation. If many issues can contribute to a disaster, does that imply each disaster is advanced and distinctive, quite than all pushed by one explicit set of things? One may also surprise if opacity was not a worse drawback within the previous days earlier than the moment dissemination of asset costs, when buyers needed to take their dealer’s phrase on costs and market motion.

At a deeper stage, a reader would possibly ask why monetary crises have
been occurring for a number of centuries, starting lengthy earlier than portfolio insurance coverage
and different fancy devices have been made attainable by the digital revolution. Does
Jacobs imagine all monetary crises
are characterised by the options in his core thesis or simply the newest
ones? Did the creator maybe miss a possibility to determine a extra common
underlying explanation for crashes, such because the inevitable tendency of buyers to
develop into complacent and careless throughout prolonged intervals of prosperity? One is
reminded of John Templeton’s adage that “bull markets are born
on pessimism, develop on skepticism, mature on optimism, and die on
euphoria.” Might the devices and attitudes Jacobs warns in opposition to be a
response to the demand that arises throughout optimism and euphoria? And though
improvements will be accompanied by ache as we adapt to them, don’t many
improvements additionally carry nice advantages?

A problem Jacobs doesn’t deal with is the complicity of presidency coverage in some crises. For instance, the subprime trade was inspired by laws and regulation aimed toward selling extra widespread homeownership. A case can be made, with respect to the worldwide monetary disaster, for instance, that procyclical financial coverage typically helped inflate euphoric phases and deepen the inevitable corrections. Lastly, authorities insurance policies have created ethical hazard by way of bailouts by the US Federal Reserve, the Treasury, and spending laws.

In equity, extreme leverage might effectively have performed an element
in most, if not all, of historical past’s crashes, and opaque improvements might have
figured into many as effectively. Tulipmania featured choices, because the creator factors
out in an apart.

Actually, the creator’s 4 horsemen — the phantasm of security, complexity, opacity, and leverage, tied up in a pseudoscientific wrapper — performed essential roles within the worst crises of current many years. Each funding skilled ought to be obligated to totally perceive these crises and their components. This e-book serves as a worthwhile information for precisely that enterprise.

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All posts are the opinion of the creator. As such, they shouldn’t be construed as funding recommendation, nor do the opinions expressed essentially mirror the views of CFA Institute or the creator’s employer.

Picture credit score: ©Getty Pictures / Ioannis Tsotras

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