Investor Behavior Following Large Gains & Losses

The following is a passage from The Quants by Scott Patterson:

Meanwhile, a fund with ties to Nassim Taleb, Universa Investments, was also hitting on all cylinders. Funds run by Universa, managed and owned by Taleb’s longtime collaborator Mark Spitznagel, gained as much as 150 percent in 2008 on its bet that the market is far more volatile than most quant models predict. The fund’s Black Swan Protocol Protection plan purchased far out-of-the-money put options on stocks and stock indexes, which paid off in spades after Lehman collapsed as the market tanked. By mid-2009, Universa had $6 billion under management, up sharply from the $300 million it started out with in January 2007, and was placing a new bet that hyperinflation would take off as a result of all the cash unleashed by the government and Fed flooding the economy.

The book was published in early 2011 but spends a fair amount of time chronicling the winners and the losers during the financial crisis. This one paragraph has plenty to say about poor investor behavior. It’s less about Taleb-style strategies which are predicated on extreme, one-off events, and more about the behavior investors exhibit after seeing large gains and losses. Here are some of the issues I picked out of this paragraph:

People are often rewarded for being right once in a row in the finance industry. Nothing draws attention in the investment world like making a bold call and being right about it. Pundits and investors can coast off of one extreme call for years. You can be wrong every single time before finally making a bold forecast that sticks, but once you get that one call right, all past sins are forgiven. Just think about how many pundits there are out there who received adulation for calling the real estate bubble that have since been proven to be frauds. Has anyone that predicted the crisis been left unscathed in subsequent recovery?

One extreme bet often leads to more in the future. After John Paulson’s fund made $15 billion in 2007 betting against subprime mortgage bonds, investors quickly rushed out to find the next extreme scenario to profit from. I know of a few funds that were set up for this specific purpose following the crisis. It made for a great marketing tool as the wounds were still fresh from the crash. The hyperinflation idea was a popular one that has been dead wrong for years. You should always plan on volatility in the markets. But the 2008-world-is-coming-to-an-end-type of volatility is actually quite rare.

There was an enormous performance chase following the crash. This is merely one example, but the fact that almost $6 billion piled into this firm following one year of strong performance tells you how fickle investors can be about their investment choices. There were plenty of funds that raised billions of dollars based solely on their performance in 2008. How many of those investors considered the investment process or future market opportunities when making that allocation decision? Now how many do you think looked at the performance during a crisis and used that as their sole determining factor?

Investors are constantly investing in the rearview mirror. Tail risk strategies became all the rage for professional investors only after the crisis had occurred. Many investors that didn’t hedge before the crash looked to buy insurance only after they experienced large losses. The absolute worst time to hedge your portfolio is following a crash but that’s exactly what many did. This kind of buy high, sell low behavior is typically thought to be seen exclusively in mom and pop investors, but even professionals make horrible timing decisions. Investors always claim they’re making fund choices based on process, but the first thing everyone looks at is past returns –and the focus tends to be on the most recent performance — when judging a potential investment.

The Quants

Further Reading:
Buying Insurance After a Disaster Strikes
Enduring Lessons From the Financial Crisis

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    • Ben commented on Mar 05

      Good catch. I missed that one. I never realized they paired their puts with longs. I guess they must have made the switch from the hyperinflation trade to the deflation trade. Good for them. Thanks for pointing this out.

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