Invcstmcnt
Sense
7}'usting sop/zistica/edjinancial
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models is tempting and dangemits
•
.JAFFE
Model Behavior and
Real World Hangovers
H
AVE
YOU EVER BEEN IN A CAR
and consistent
returns. The LTCM
not fail because
mistake or any of the other dramatic
send you the wrong way up
in finance, including two Nobel laure-
reasons that normally lead to 'Vall
Street !lame-outs. \Vhatmade LTCM's
make frustrating
circles around your
destination? \Ve all have had similar
experiences, because our
ates. The sophisticated
and complex
mathematical models they have created
principals
give them what appears to be an WlSur-
methodical
GPS
stand out was their quiet,
and totally academic
meanor.
They
de-
believed
in
was using a map that dido't
their models,
and did not
quite correlate \\;th the reality
deviate
them;
on the street. Even those who
jf markets
from
moved
rely completely on their CPS
against
for getting from one place to
kept investing.
another know that they can
them,
even
severely
they quietly
It always worked.And that
never be 100% perfect.
was their undoing. Theirquiet
Yet there is a disconnect
confidence led them to make
between how sensibly we manage the valuable but imperfect GPS in our normal lives,
and our inability to apply the
same common sense to the
a simple, avoidable and rather
mundane
oversight:
confused
their models
They
\\-;th
real life.
The LTCM partners were
valuable and imperfect tools
iebritimate geniuses,
in our investment
might forgive them for think-
lives. That
and we
siruation has led investors to consider-
passable edge versus the competition
ing that maybe they were just a bit
able griefin the past, and continues
in finding and exploiting
smarter than anyone else aJ?dtherefore
to
t~reaten us today.
It is April 1998 and Long-Term
Capital i\lanagement
stands alone on
the summit of the invesonent
u
trader's
partners are among the sharpest minds
a one-way street, or leading you to
,
of a rogue
with a CPS that is trying to
world.
opportunities.
investment
Yet four months
later
their models were that much bener as
they are history, after nearly taking
well. In fuct their models Wert a lot bet-
down the financial system \\;th what
ter than anyone else's; but at the end
rums out to be a collection of massively
of the day they were just models; that
It is the most famous and successful
overleveraged and illiquid invesonents.
is, they were abstract representati.ons
hedge fund firm on the planet, with a
LTCM did not fail because of the
hubris or greed of the partners. It did
of the real w;'r1d.
Long-Term Capital Management
four-year track record of outstanding
RESEARCH
MAGAZINE
JULY
2013
45
SENSE
INVESTMENT
Stay Grounded
Models are wonderful tools that make
might still he in existence today had
there been posted throughout its offices this wonderful piece of wisdom
from George E.P. Box: "All models are
wrong, but some are useflll."
our lives easier and more productive.
Their magic is achieved by reducing
the enormous
complexity
world into a manageable
standable form, A map is a kind of
modeL And while I doubt there is
Still Overconfident
Fifteen years after the LTCM disaster
the invesunent world is not merely ignoring the lesson, it is promoting the
mistake. Conventional v.isciom today
is that investment success is directly
related to finding and sticking to a successful model; and the more successful
the model, ~e more you need to rely
on it (and only it) as a guide for your
invesunent
of the real
and under-
anyone
who would
of New
York with the actual place,
there
confuse
is a rich history
a map
of investors
who regularly made that mistake with
their models.,;,.....and, as we see, some
of them were among
brightest
the smartest,
and most successful
inves-
tors of their time.
But they ended up making choices
decisions.
that, in retrospect, had little relation-
The model of choice over the last
30 years has been modern
ship to the facts on the ground-which
portfolio
reminds me of an old joke:
theory and its most popular iteration:
the mixing and matching of asset classes.
Asset class investing has proven itself as
all the asset class securities now available almost endless? Yes, yes, and yes.
After drinking most of the night a
man staggers out of a bar, He walks
a useful and effective tool for creating
But that model universe pales next to
towards a light pole, gets down on his
and managing portfolio risK. Yct even as
the ,'eal world universe of an investor's
hands and knees and begins to exam-
choices: tens of thousands ofinvesonem
ine the sidewalk A pedestrian stops
choices, whether individual securities
and asks, "Do you need some help?"
or funds, dozens
well furso long helping im'estors diversify
by correlation, byvolatiliry, by holding
period, by valuation, by concentration,
The drunk looks up and says, "I lost
my car keys in the parking lot," The
other guy says, "If you lost your keys in
the parking lo~ why aren't you looking
for them there?"The drunk says, "The
that even its failure during the market
even to invest or not to invest. I could
light is better here."
meltdO\\11of2008 has heen discounted
go on and on. The choices are limited
as an aberr-Jtion. On the surface, it ap-
only by our imagination.
All models are flawed in some waytbat is tbeir1Jomre. That doesn't mean
its starns
in academic
circles
is diminish-
ing, asset class investing continues to be
the de facto standard in the mainstream
of investment
phi-
investment world-recommendations
losophies,
strategies
and their varia-
for its use can be found e\'efY\"'herc.
tions; diversification
by type, by asset,
Asset class investing has worked so
pears to he he\\-ing quite reasonably to
and wide ac-
we shouldn't continue to benefit from
of the asset class model, in
their use; but our trust in even the
.The great success
the old adage "'Don't put your eggs in
ceptance
one basket." But I'm not so sure of that.
combination
with the rise and popu-
Asset class investing; driven by modem
larity of ETFs,
pertfolio theory,definesexaetlywhatthose
baskets are and what goes in them. As
increasingly
of diversification-offsetting
the very
been, Keeping one foot in the real world
a result, the very nature of what diver-
benefits they are seeking. The invest-
will make things a little messier and
sification means, and how it should be
ment industry benefits from deliv~ring
less certain-but
used, isdriven solely by modem pertfolio
similar messages because they play to
less likely that we make foolish choices
theory's vision of the world.
our normally useful instincts that con-
at critical moments-whether
clude, "If everyone
world-famous hedge fund managers,
or just poor drunks, (D
Aren't
new asset class securities
appearing
regularly?
expanding
universe
And isn't the
of asset choices
creating more possibilities
for diversi-
has led investors
pursue similar patterns
is doing
when everyone
that an investor
to make irrational choices.
ADvtSQRONE.COM
conceived
or how successful they have
it will also make it
we arc
does the same thing,
the result is herding-which
market efficiency
46
it, they
all can't be wrong." But, in investing;
fication? And aren't the permutations
could create among
to
best of them can never be total-no
matter how brilliantly they have been
reduces
and leads investors
Marshall Jaffe is managing partner of
Jaffe Asset lvlnnage11lmt, an investment
advisory firm in Beverly Hilis, Calif.