Too smart for our own good: innovative investment strategies, security illusions, and market crashes. 2018. Bruce I. Jacobs. McGraw-Hill Education.
Too clever for our own good It is a discussion of investment products that lull investors with the appearance of low risk and the promise of high returns, while introducing systemic risk and, ultimately, market crashes or crises. The principles laid out by author Bruce I. Jacobs are general, but he focuses in detail on the three major market crises of recent decades in which those destructive principles were, in his view, critical components—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 the Co-Founder, Co-Chief Investment Officer, and Co-Director of Research at Jacobs Levy Equity Management. He has been a critic of the flawed investment theories he discusses in this book ever since discussing the creators of portfolio insurance face-to-face in the 1980s. Jacobs previously wrote a book, Capital ideas and market realities: option iteration, investor behavior, and the stock market crash (1999), focused entirely on portfolio insurance, its commercialization, and the consequences of the strategy’s widespread adoption in the 1980s. He also wrote about the role of exotic mortgage vehicles in the 2007-2008 crisis. Subsequently, Jacobs was active in creating the National Institute of Finance, which was instrumental in persuading Congress to include the creation of the Financial Stability Oversight Board among its post-crisis financial reforms.
Jacobs acknowledges that many books have been written about financial crises, but he maintains that many attribute the collapse of prices to inexplicable “works of God” or the randomness inherent in capital markets. It is believed that the real perpetrators can be identified. Investment professionals owe it to their clients — and themselves — to understand the real causes of financial disasters and help ensure they don’t happen again.
The author’s fourfold core thesis:
- Some investment strategies, especially those that offer the illusion of security, “can interact with market realities to create unhealthy consequences for markets and investors.”
- Strategies are usually complex and marketed with an aura of cutting edge sophistication.
- It usually lacks transparency.
- They show excessive influence (although it may be disguised).
The book is divided into five parts. Part 1 provides background information for readers unfamiliar with important concepts related to risk and management, such as diversification, hedging, and arbitrage. Many investment professionals can safely skip this section. Part Two examines the crash of 1987. Specifically, it examines the role of the newly created strategy of portfolio insurance in triggering or certainly exacerbating that crisis. Part Three offers a similar treatment of the LTCM crash in 1998. Here, low-risk but wickedly complex arbitrage strategies allegedly led to the disaster.
Part four looks at the credit crunch and recession of 2007-2009. This time, the trouble came in the form of complex asset-backed derivatives such as collateralized debt obligations and residential mortgage-backed securities. The fifth part is a bag of less catastrophic market crises, such as several flash crashes, the “London whale” event, the European debt crisis, the Greek debt crisis, as well as related issues, such as non-monetary dependence on models. In this section, Jacobs also proposes some solutions, which primarily include more effective regulation, increased disclosure, clearinghouses, and appropriate education.
The supplement contains additional essential materials:
- A primer on bonds, stocks and derivatives.
- Documents from Jacobs’ debates with portfolio insurance providers in the 1980s.
- Discussion of several major disasters derivatives of the 1990s.
- The author’s 2002 proposal for research objective criteria.
Also included is a discussion of the 1929 crash. One might ask why that was relegated to the appendix. Is it relevant to the main discussion or not?
Too clever for our own goodThe basic thesis must be taken seriously not only by investment professionals but by all investors. Promises of free lunch, complexity, obfuscation and excessive leverage have often combined to toxic effect. Financial professionals in particular can benefit greatly from examining the market crises analyzed in this book and the key lessons that can be learned from them. George Santayana’s famous aphorism – “Those who cannot remember the past are doomed to repeat it” – applies with a vengeance to financial markets.
The book has some flaws. Because it is organized in five parts, the basic thesis is paraphrased and re-discussed in each part, resulting in significant repetition. In Part V, the argument is softened when the author presents a variety of additional issues that could contribute to market instability, such as conflicts of interest, high-frequency trading (HFT), moral hazard, cognitive biases, and unintended consequences of regulation. If so many things can contribute to a crisis, does that mean that each crisis is complex and unique, and not all of them are driven by one particular set of factors? One might also wonder if opacity wasn’t a worse problem in the good old days before immediate publication of asset prices, when investors had to take the broker’s word for prices and market action.
On a deeper level, the reader may wonder why financial crises have occurred for centuries, which began long before wallet insurance and other luxury items became possible thanks to the digital revolution. Jacobs believes everyone Financial crises are characterized by the features of his basic thesis or only in the most recent? Did the author perhaps miss an opportunity to identify a more global underlying cause of crashes, such as the inevitable tendency of investors to become complacent and apathetic during prolonged booms? One is reminded of John Templeton’s statement that “bullish markets are born on pessimism, grow on skepticism, mature on optimism, and die on euphoria.” Could the tools and attitudes that Jacobs warn 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?
The issue that Jacobs did not address is the complicity of government policy in some crises. For example, the mortgage industry has been encouraged by legislation and regulations aimed at promoting widespread home ownership. An argument can also be made, with regard to the global financial crisis, for example, that procyclical monetary policy has often served to amplify the euphoric phases and deepen the inevitable corrections. Finally, government policies have created a moral hazard through bailouts by the US Federal Reserve and Treasury and spending legislation.
In fairness, excessive leverage may have played a role in most, if not all, of history’s crashes, and mysterious innovations may have featured in many as well. Tulipmania offered options, as the author points out in an aside.
To be sure, the author’s four horsemen—security, complexity, obfuscation, and leverage, shrouded in a pseudoscientific wrapper—have played critical roles in the worst crises of recent decades. Every investment professional must be committed to fully understanding these crises and their components. This book is an invaluable guide for exactly this task.
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All posts are the opinion of the author. As such, it should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of the CFA Institute or the author’s employer.
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