3. Myron Scholes Robert merton
Members of LTCM's 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?
4. 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 ļ¬xed 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 minimalāboth will see a ļ¬xed 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 ļ¬nancial
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 proļ¬t as the difference in the value of the bonds narrowed when a new bond was issued.
Low spread.
Leverage required to make money.
5. The value of $1000 invested in the hedge fund Long-Term Capital
Management, of $1,000 invested in the Dow Jones Industrial Average, and
of $1,000 invested monthly in U.S. Treasuries at constant maturity.
http://en.wikipedia.org/wiki/Long-Term_Capital_Management
6. Buffett video on LTCM
Leverage is where overconļ¬dence can be found
What models is he talking about?
Overconļ¬dence, Physics Envy
Recall his gun metaphor. Why do metaphors matter so much?
7. Would you like to jump out of this plane
with this parachute which opens 99% of
the time?
Modern Risk Management Practices
Advocate that you should jump
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 wonāt lose more
than x in a day or year. But itsā silent on what happens rest of the time.
Also, its ļ¬ndings are based on history.
8. āEven in 1965,
perhaps we
could have
judged there to
be a 99%
probability that
higher leverage
would lead to
nothing but
good.
Buffett in 1989 letter.
āWe 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.ā
Role of derivatives: ļ¬nancial instruments of mass destruction.
examples: Wockhardt, textile companies in south india, hedge fund blow ups, banks blow
up.
Role of max loss exposure in risk management.
āItās never happened before, so it canāt ever happen.ā
9. The market can
stay Irrational
longer than
you can stay
solvent -
keynes
Itās not physics.
10. Victor
Niederhoffer
http://en.wikipedia.org/wiki/Victor_Niederhoffer
11. 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 can't 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 ļ¬ve or six that come to mind. - Niederhoffer
13. why I donāt like banks
Or highly leveraged companies.
Except when they are in bankruptcy
14. Wait Until
You Shake
Your Head
Itās easy to lend money and fool yourself into believing that youāll make a good rate of
return. It reminds me of a story about two men in a sword ļ¬ght. One of them takes a
big swipe on the other oneās neck whereupon the other one says āYou missed me.ā
The swiper says, āWait until you shake your head.ā
Story as told by Charlie Munger.
15. The Opera House was formally completed in 1973, having cost $102Ā million. The original
cost estimate in 1957 was $7Ā 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
16. When the city of Montreal was selected to host the 1976 Summer Olympics, the mayor
announced that the entire Olympiad would cost $120 million and that the track and ļ¬eld
events would take place in a stadium with a ļ¬rst-of-its-kind retractable roof. The games
went off as planned, of course, but the stadium did not get its roof until 1989. And oh yes:
the roof ended up costing $120 million, or almost as much as was budgeted for the entire
Olympics.
17. The Company was formed on 13 August 1986 with the objective of ļ¬nancing, building and
operating a tunnel between England and France. The Company let a contract for the construction
of the tunnel to TransManche Link. The tunnel cost around Ā£9.5bn to build, about double its
original estimate of Ā£4.7bn. The tunnel, which was ļ¬nanced partly from investment by
shareholders and partly from Ā£8bn of debt, was officially opened on 6 May 1994. In its ļ¬rst year
of operation the Company lost Ā£925m because of disappointing revenues from passengers and
freight together with heavy interest charges on its Ā£8bn of debt.
19. Look what overconļ¬dence does.
Look for leverage if you want to look for overconļ¬dence.
The interest on the debt was more than the gross revenues!
How can you ļ¬nance a project with debt where you have to make money
from largely unpredictable consumer behavior? This was the ļ¬rst toll
bridge...
Remember Feynman who remarked how difficult physics would have been if
particles had feelings?
20. Recall that this is a āman on a rollā we found in a previous class.
Hw just won a lot of money in the casino. What will do next? Walk out with his winnings? Hell no! He will
go back to the table and play more thinking āThis is the just the beginning of my streak.ā His behavior
will ultimately ruin him.
Last time when we talked of him, he was high on dopamine. Dopamine produced over-conļ¬dence.
21. We saw these people earlier - happy people who just became rich - in the movie Dot Con
22. Normal human
tendency
90% of
drivers think
that they are
better than
average
drivers
23. Why do
people buy
lottery
tickets?
Why do people buy lottery tickets? Or indulge in day trading?
74% of investors in a survey said that their own funds will consistently outperform the market Reality?
Only a handful actually do
Only 37% of managers believe that mergers create value for buyers. But when it came to their own
mergers and acquisitions, 58% said their deals will create value
24. Give high and low estimates for the average weight of an empty Boeing 747
aircraft. Choose numbers far enough apart to be 90 percent certain that the
true answer lies somewhere in between. Ans: 177 tons
If you are 90% sure, then you should be comfortable betting $9 against
prospect of willing just $1 that the real is within your chosen range.
25. Give high and low estimates for the diameter of the earthās moon in kms. Again, choose numbers far
enough apart to be 90 percent certain that the true answer lies somewhere in between. Ans: 3,476 kms
If you are 90% sure, then you should be comfortable betting $9 against prospect of willing just $1 that
the real is within your chosen range.
Because most people who attempt to answer these questions donāt recognize how little they really know
about the subjects or how difficult it is to bracket high and low estimates so that thereās a sufficiently
strong chance that the real answer will fall somewhere in between. As a result, most people fail to
spread their estimates far enough apart to account for their ignorance.
26. How do we demonstrate
overconfidence?
1. Request subjects to evaluate their conļ¬dence in a statement. Group together all the statements with a given level of conļ¬dence (e.g., 90%)
and compare that to the actual frequency of being correct.
2. Test subjects with multiple-choice questions and then elicit their level of conļ¬dence in their answer on a scale from chance to 100% (total
certainty). Compare this to the true accuracy of the answers.
3. Give subjects a question with a numerical answer, and get them to choose a conļ¬dence interval such that they have a particular level of
conļ¬dence that the true answer is in that range; e.g., "Pick a low number and a high number such that you are 90% conļ¬dent that the
population of Bulgaria is between those numbers." - we did this a while ago.
4. Offer subjects the opportunity to bet on the correctness of their answers with chances that are favorable, if their judgements of accuracy
are correct. They lose money if they are overconļ¬dent. If you are 90% sure, then you should be comfortable betting $9 against prospect of
willing just $1 that the real is within your chosen range.
If human conļ¬dence had perfect calibration, judgements with 100% conļ¬dence would be correct 100% of the time, 90% conļ¬dence correct
90% of the time, and so on for the other levels of conļ¬dence. By contrast, the key ļ¬nding is that conļ¬dence exceeds accuracy so long as the
subject is answering hard questions about an unfamiliar topic. In a spelling task, subjects were correct about 80% of the time when they were
"100% certain".
Put another way, the error rate was 20% when subjects expected it to be 0%.
27. Terrance Odean and Brad M. Barber of the University of California analyzed the trading records of more than
60,000 investors at a large brokerage ļ¬rm. They found that individuals who trade stocks most frequently post
exceptionally poor investment results.
29. This is Joshua Bell.
http://en.wikipedia.org/wiki/Joshua_Bell
He is playing Vivaldi Four Seasons.
http://www.youtube.com/watch?v=iNcYT7jpH9E
People pay hundreds of dollars to watch him play.
30. One day Joshua Bell played the violin at a subway station in Washington D.C
- incognito - on behalf of The Washington Post.
See this: http://www.youtube.com/watch?v=hnOPu0_YWhw
Read this: http://www.washingtonpost.com/wp-dyn/content/article/
2007/04/04/AR2007040401721.html
Now this is not a controlled experiment. One can claim that the commuters
were busy, had other stuff on their minds etc etc.
32. This is one of best controlled experiments in social science I have read about..
http://www.nytimes.com/2007/04/15/magazine/15wwlnidealab.t.html
Web-based experiment. More than 14,000 participants registered at Music Lab
(www.musiclab.columbia.edu), and were asked to listen to, rate and, if they chose, download songs by
bands they had never heard of. Some of the participants saw only the names of the songs and bands,
while others also saw how many times the songs had been downloaded by previous participants. This
second group ā āsocial inļ¬uenceā condition ā was further split into eight parallel āworldsā such that
participants could see the prior downloads of people only in their own world. All the artists in all the
worlds started out identically, with zero downloads ā but because the different worlds were kept
separate, they subsequently evolved independently of one another.
You should see the parallels with Darwinās Theory of Evolution as you read about this story.
33. In all the social-inļ¬uence worlds, the most popular songs were much more popular (and the least popular songs were less
popular) than in the independent condition.
At the same time, however, the particular songs that became hits were different in different worlds, just as cumulative-
advantage theory would predict. Introducing social inļ¬uence into human decision making, in other words, didnāt just make
the hits bigger; it also made them more unpredictable.
When people tend to like what other people like, differences in popularity are subject to what is called ācumulative
advantage,ā or the ārich get richerā effect. This means that if one object happens to be slightly more popular than another at
just the right point, it will tend to become more popular stil.
As a result, even tiny, random ļ¬uctuations can blow up, generating potentially enormous long-run differences among even
indistinguishable competitors...
Thus, if history were to be somehow rerun many times, seemingly identical universes with the same set of competitors and
the same overall market tastes would quickly generate different winners: Madonna would have been popular in this world,
but in some other version of history, she would be a nobody, and someone we have never heard of would be in her place.
34.
35. Oil went from $10 to $140. Who could have predicted either of these
outcomes?
The Value of ONGC is VASTLY different if you assume a $10 a barrel world
as compared to the value in a $140 a barrel world.
36. Excel can make you go nuts.
The deļ¬nition of value is very precise. There is no ambiguity about it. All one has to do is to take the
future cash ļ¬ows and then bring them back to the present value using discount factor which is the
opportunity cost of capital derived from a very precise model called the Capital Asset Pricing Model. You
punch in the numbers in that model and out comes the cost of capital and then you punch that number
in another excel model containing future cash ļ¬ows and the precise formulas in that excel model will tell
you instantly what that business is worth.
The sheer number of assumptions in a valuation model are mind boggling
37. Extrapolation, ignorance of diseconomies of scale, ignorance of competition, regulation.
Minor changes in inputs can make a vast difference in the ļ¬nal valuation number
In some cases, most of the value is comprised in cash ļ¬ows which will occur several years from now. So we
have to worry about forecast degradation. Increasing the discount factor is not the way to do it!
Underneath all that precision of that āprecise modelā is the defective man with all his biases. What biases creep
into the excel valuation models?
38. āItās stupid the way
people extrapolate
the past- and not
slightly stupid, but
massively stupid.ā
39. āI donāt think
you can stick
numbers on a
highly
speculative
business
where the
whole
industry is
going to
change in 5
years and
have it mean
anything.ā
āIf you say, āI am going to stick an extra 6% on the interest rate to allow for
thatā I think thatās nonsense. It may look mathematical, but its
mathematical gibberish in my view. . .ā
Buffett does not think about cost of capital the way academic ļ¬nance thinks
about the subject.
40. āthe test
used by most
CEOs ā is that
the cost of
capital is
about Ā¼ of 1%
below the
return
promised by
any deal that
the CEO
wants to do!ā
Thats why Excel Models can be used to rationalize almost any desired
behavior!
41. āAny business
craving of the
leader,
however
foolish, will
be quickly
supported by
detailed rate-
of-return and
strategic
studies
prepared by
his troops.ā
Man is not a rational animal; rather man is a rationalizing oneā¦
And Excel is a beautiful tool which helps him do just that!
You donāt even need āGoal Seekā function because its already built into the
human user!
42. P/E Multiples in a high growth business are extremely sensitive to growth rates.
What happened to Infosys?
This is the best Indian company, with the best business model, with the best
management which is competent, honest, and prudent. There is no debt, the
earnings have grown and grown. And yet, people did not make any money from
march 2000 over the next ten years or so. And this happened while India
experienced the biggest bull market in its history. How did this happen?
43. the earnings did not fall but the growth rate of earnings did. And the
valuation in March 2000 implied explosive growth to continue. That did not
happen.
The result?
44. Growth stocks are extremely vulnerable to errors in predictions about
growth.
45. āThe combination
of precise
formulas with
highly imprecise
assumptions can be
used to establish,
or rather to
justify,
practically any
value one wishes,
however high, for
a really
outstanding
company.ā
47. āIf I taught a
course in
investments,
my final exam
would be to
value this
Internet
stock.ā
āAnd if they came up with an answer, they'd ļ¬unk. And if they came up
with a blank sheet of paper, I'd probably give them a B. āAnd if they said
how the hell could you ask something so dumb? Iād give them an A.ā
48. Bill Maher on Think Tanks and Predictions:
http://www.youtube.com/watch?v=VcJohfS4vTQ
See his movie Religious. He teaches you to be skeptical.
http://www.youtube.com/watch?v=fg8WlXZxAgQ
49. āThere are two classes of
forecasters:Those who don't
know and those who don't know
they don't know.ā- Galbraith
50. the statistician
who drowned in
water which was,
on average, only
4 feet deep
Financial modelers use scenario analysis and then apply subjective probabilities to each
scenario to arrive at the āexpected valueā
Thatās the functional equivalent of the statistician who drowned in water which was, on
average, only 4 feet deep!
He forgot that the RANGE of depth was between 3 feet and 10 feet!
52. October 2007
14 December 2008 mail:
What a difference a year makes
Just more than 1 year ago Royal Bank of Scotland (RBS) paid $100bn for ABN Amro (80% cash).
For this amount today, RBS could buy:
Citibank $22.5bn,
Morgan Stanley $10.5bn,
Goldman Sachs $21.0bn,
Merrill Lynch $12.3bn,
Deutsche Bank $13.0bn and
Barclays $12.7bn,
And still have $8bn change !
54. āPascalās
observation
seems apt: āIt
has struck me
that all menās
misfortunes
spring from
the single
cause that
they are
unable to
stay quietly
in one room.ā
- Buffett
55. While deals often
fail in practice, they
never fail in
projections - if the
CEO is visibly
panting over a
prospective
acquisition,
subordinates and
consultants will
supply the requisite
projections to
rationalize any
price.
56. Decision Weights
Gambles with modest monetary stakes
estimates for gains
The possibility effect: unlikely events are considerably overweighted. For example, the
decision weight that corresponds to a 2% chance is 8.1.
57. Frequency-Magnitude
People do not focus on both the frequency AND the magnitude. But they
should. I could be 70% sure the market would rise, and still be short the
market.
Rare events get mispriced.
58. Kelly Criteria Link
Kelly formula tells you how much of your bankroll should be invested in a given
opportunity. There are only two inputs. Edge and Odds.
http://en.wikipedia.org/wiki/Kelly_criterion
Kelly works in bell curve situations like black jack, or dice. But the ļ¬nancial world is not
best described by bell curves. In the ļ¬nancial worlds we deal with extremely uncertain
outcomes, and extremely unpredictable and irrational human behavior. If you use
models from the bell curve world in a world where black swans proliferate, you will
make errors. What will happen if you overestimate your edge? You will over invest.
61. There is extreme wisdom in the idea that diversiļ¬cation is protection against ignorance and
if you are not ignorant then your need to diversify goes down. Mr. Munger put it in these
words:
āIt is not given to human beings to have such talent that they can just know everything about
everything all the time. But it is given to human beings who work hard at it ā who look and
sift the world for a mispriced bet ā that they can occasionally ļ¬nd one. And the wise ones bet
heavily when the world offers them that opportunity. They bet big when they have odds. And
the rest of the time, they don't. It's just that simple.ā
But what if you over-estimate your odds of success - a tendency that is pervasive?
62. Of course if people were rational, there wont be so many startups.
āIf people were not overconļ¬dent, for example, signiļ¬cantly fewer people would ever start a new
business: most entrepreneurs know the odds of success are against them, yet they try anyway. That
their optimism is misplacedāthat they are overconļ¬dentāis evidenced by the fact that more than two-
thirds of small businesses fail within four years of inception. Put another way, most small-business
owners believe that they have what it takes to overcome the obstacles to success, but most of them are
wrong.
http://en.wikipedia.org/wiki/Animal_spirits_(Keynes)
63. āanimal spirits - a spontaneous
urge to action rather than
inaction, and not as the outcome
of a weighted average of
quantitative benefits multiplied by
quantitative probabilities.ā- Keynes
"Even apart from the instability due to speculation, there is the instability due to the characteristic of
human nature that a large proportion of our positive activities depend on spontaneous optimism rather
than mathematical expectations, whether moral or hedonistic or economic. Most, probably, of our
decisions to do something positive, the full consequences of which will be drawn out over many days to
come, can only be taken as the result of animal spirits - a spontaneous urge to action rather than
inaction, and not as the outcome of a weighted average of quantitative beneļ¬ts multiplied by
quantitative probabilities."
http://en.wikipedia.org/wiki/Animal_spirits_(Keynes)
66. The main
benefit of
optimism is
resilience in
the face of
setbacks.
Optimistic bias plays a roleāsometimes the dominant roleāwhenever individuals or
institutions voluntarily take on signiļ¬cant risks. More often than not, risk takers
underestimate the odds they face, and do invest sufficient effort to ļ¬nd out what the odds
are. Because they misread the risks, optimistic entrepreneurs often believe they are prudent,
even when they are not. Their conļ¬dence in their future success sustains a positive mood
that helps them obtain resources from others, raise the morale of their employees, and
enhance their prospects of prevailing. When action is needed, optimism, even of the mildly
delusional variety, may be a good thing. - Kahneman
67. Optimism
Bias
āOptimistic bias is a signiļ¬cant source of risk taking. In the standard rational model of economics,
people take risks because the odds are favorableāthey accept some probability of a costly failure
because the probability of success is sufficient. We proposed an alternative idea. When forecasting the
outcomes of risky projects, executives too easily fall victim to the planning fallacy. In its grip, they make
decisions based on delusional optimism rather than on a rational weighting of gains, losses, and
probabilities. They overestimate beneļ¬ts and underestimate costs. They spin scenarios of success while
overlooking the potential for mistakes and miscalculations. As a result, they pursue initiatives that are
unlikely to come in on budget or on time or to deliver the expected returnsāor even to be completed. In
this view, people often (but not always) take on risky projects because they are overly optimistic about
the odds they face.
This idea probably contributes to an explanation of why people litigate, why they start wars, and why
they open small businesses.ā - Kahneman
68. Optimism
Bias
āOptimism is normal, but some fortunate people are more optimistic than the rest of us. If you are genetically endowed with an optimistic
bias, you hardly need to be told that you are a lucky personāyou already feel fortunate. An optimistic attitude is largely inherited, and it is
part of a general disposition for well-being, which may also include a preference for seeing the bright side of everything. If you were
allowed one wish for your child, seriously consider wishing him or her optimism. Optimists are normally cheerful and happy, and therefore
popular; they are resilient in adapting to failures and hardships, their chances of clinical depression are reduced, their immune system is
stronger, they take better care of their health, they feel healthier than others and are in fact likely to live longer. A study of people who
exaggerate their expected life span beyond actuarial predictions showed that they work longer hours, are more optimistic about their
future income, are more likely to remarry after divorce (the classic ātriumph of hope over experienceā), and are more prone to bet on
individual stocks. Of course, the blessings of optimism are offered only to individuals who are only mildly biased and who are able to
āaccentuate the positiveā without losing track of reality. Optimistic individuals play a disproportionate role in shaping our lives. Their
decisions make a difference; they are the inventors, the entrepreneurs, the political and military leadersānot average people. They got to
where they are by seeking challenges and taking risks. They are talented and they have been lucky, almost certainly luckier than they
acknowledge.ā -Kahneman
69. The prevalent tendency to underweight or ignore
distributional information is perhaps the major
source of error in forecasting. -Bent Flyvbjerg.
Planning Fallacy: Plans and forecasts that
1. are unrealistically close to best-case scenarios
2. could be improved by consulting the statistics of similar cases
Using the āinside viewā and not the āoutside viewā
āPallidā statistical information is routinely discarded when it is incompatible with oneās personal impressions of
a case. In the competition with the inside view, the outside view doesnāt stand a chance. The preference for the
inside view sometimes carries moral overtones. I once asked my cousin, a distinguished lawyer, a question
about a reference class: āWhat is the probability of the defendant winning in cases like this one?ā His sharp
answer that āevery case is uniqueā was accompanied by a look that made it clear he found my question
inappropriate and superļ¬cial.
Insensitivity to base rates
70. Identify an appropriate
reference class.
Obtain the statistics of the
reference class
Use the statistics to generate a
baseline prediction.
Use specific information about
the case to adjust the baseline
prediction, if there are
particular reasons to expect the
optimistic bias to be more or less
pronounced in this project than
in others of the same type.
How to overcome planning fallacy.
But what about Bugsy?
72. Snapshot of movieās end
Bugsy last Scene
He was over-leveraged, over-conļ¬dent, and dead.
Watch this movie. Its about a man you would think as totally crazy. But he
created Las Vegas. People thought he was crazy. And he was. The world needs a
lot of people Bugsy. They drive capitalism. Warren Buffett would never do
anything as crazy as a Bugsy because Warren Buffett is RATIONAL.
So what do you want to be like? Rational like Warren Buffett or crazy like Warren
Beatty (who plays the role of Bugsy in the movie)?
73. Why We need
Bugsy
āSigniļ¬cant effort is required to ļ¬nd the relevant reference category, estimate the baseline prediction, and evaluate the quality of
the evidence. The effort is justiļ¬ed only when the stakes are high and when you are particularly keen not to make mistakes.
Furthermore, you should know that correcting your intuitions may complicate your life. A characteristic of unbiased predictions
is that they permit the prediction of rare or extreme events only when the information is very good. If you expect your
predictions to be of modest validity, you will never guess an outcome that is either rare or far from the mean. If your predictions
are unbiased, you will never have the satisfying experience of correctly calling an extreme case. You will never be able to say, āI
thought so!ā when your best student in law school becomes a Supreme Court justice, or when a start-up that you thought very
promising eventually becomes a major commercial success. Given the limitations of the evidence, you will never predict that an
outstanding high school student will be a straight-A student at Princeton. For the same reason, a venture capitalist will never be
told that the probability of success for a start-up in its early stages is āvery high.ā The objections to the principle of moderating
intuitive predictions must be taken seriously, because absence of bias is not always what matters most. A preference for
unbiased predictions is justiļ¬ed if all errors of prediction are treated alike, regardless of their direction. But there are situations
in which one type of error is much worse than another. When a venture capitalist looks for āthe next big thing,ā the risk of
missing the next Google or Facebook is far more important than the risk of making a modest investment in a start-up that
ultimately fails. The goal of venture capitalists is to call the extreme cases correctly, even at the cost of overestimating the
prospects of many other ventures.ā - Kahneman
