September 23, 2008
Keep It Simple
Posted by Karl Okamoto

When I meet someone who claims to live by just a few “tried and true” simple rules, I tend to wrinkle my nose. How unsophisticated! Un-nuanced! Anti-intellectual, even! After all, the world is a complicated place. Life by platitude must, therefore, oversimplify, over-generalize and exclude the gray areas that matter.

Oddly, though, many of the most successful people I know – successful in all kinds of ways – from making fortunes to finding inner peace—share a certain certainty about things. They have a few simple rules, and they live by them.

So, for example, over the last few days I am quite certain the boring certainty of a John Bogle (of Vanguard Group fame) is looking pretty sophisticated. While not completely unscathed, if you followed the standard asset diversification advice given by such unsophisticated, old-fashioned guys like Mr. Bogle, your volatility these last few days would have been quite tolerable. More importantly, you would be in a position to hold on, play another day (or decade for that matter) and see your portfolio recover and indeed prosper as good times return. In fact, counter-intuitive as it may feel, assuming you didn’t “lose your seat” last week, you should be looking at your nest egg with an even greater sense of ease. Last summer your nest egg was much less likely to grow as a source of wealth for your needs than it is from here. While I now have less of it, I am much more confident that the money I do have will be adequate for the job I expect it to perform.

Of course, this is precisely why the Fannie Mae’s, Lehman’s and AIGs of the world have gone to heck. Instead of making certain that they would always “keep their seats” and “live to play another day,” they piled the chips on double zero and rolled the dice. They did that because along the way they forgot to “keep it simple.” Higher returns require higher risk. “Absolute return strategies” that offer returns above that of government bonds do not offer “absolute” returns by definition. A simple rule tells us that. No risk, no reward. Ask any hedge fund manager how he makes money after the world quickly discovered the easy money one could make in the early days of arbitrage or currency trading. He’ll tell you, he takes risk.

So let me offer one more anti-intellectual suggestion. As we ponder the regulatory solutions to the current mess, my suggestion is we keep it simple. The reason why financial institutions blow up is the same reason houses go into foreclosure. People take risks they cannot fully insure. Normally people are pretty good about avoiding such extreme positions because they understand the downside and wisely avoid it. So if I am going to lose my 20% down payment on this condo if I can’t support next year’s mortgage payments, I’ll buy a cheaper one where I am certain I can “keep my seat” in a down-turn. By appealing to human’s natural optimism and avarice while at the same time masking or often eliminating the downside cost, the home lending market created a “heads I win, tails who cares” environment for home buyers that eliminated the “old fashioned” calculus that defined prudent home buying and finance.

Similarly, both a hedge fund manager and the CEO of an investment bank or multi-line insurer (both being not much more than a hedge fund in some other drag), face a similar temptation. If I take cheap and plentiful financing (put simply, borrowed money), put it into so-called “absolute return” investments (put simply, those complicated deals that some Math PhD can demonstrate will not lose money in any scenario within a standard deviation of x and certainty level of y, blah, blah, blah), I get to keep 20% of the upside (which the model and my own natural optimism tell me is very likely to be big) or take early retirement (or hit the beach until the next cycle of mania comes) if it all blows up (which it probably won’t). Well, hindsight bias tells us that it was obvious this was a bad choice for Fannie, Freddie, Lehman, Bear, etc. But put yourself into their position ex ante if you can. It’s a “no brainer.” I for one, would swing and swing hard, just like they did. Black Scholes tells me that the option value alone of the proposition means a rational person would put as many chips as possible on the most volatile positions he can get away with. And that is exactly what they did.

So how do we keep it simple if we are going to “regulate” this problem? We change this equation. Make people play with their own money, and lose it if they are wrong. That means, for one, no bail outs. It also means that the new transparency the world needs through regulation is the means to better understand whether the people on the other side of a trade have any skin in the game. It turns out, as a simple rule has told us all along, it makes a big difference when we deal with people with something to lose.

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