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Updated: June 16, 2010 14:08 IST

Lessons from three market masters

D. Murali
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The current global economic debacle has discredited almost all the captains of the finance industry, the regulators of most nations, and the gurus in academia, observes Charles R. Morris in ‘The Sages’ (www.landmarkonthenet.com). But the three ‘sages’ – viz. George Soros, Warren Buffett, and Paul Volcker – stand taller than ever, he adds. “There is a lesson there, and one hopes the world will learn it.”

All the three are wise, and humble about what they don’t know, notes the author. None of them, he says, carries around a definitive ‘model’ of the world. “None would ever insist that ‘only money’ or ‘only demand’ is the driving force of the economic universe. They navigate, instead, by relying on their great experience, a sense of history, and their common sense.”

George Soros

Bubbles are like trees, reads a quote of Soros, cited in the book. “It takes time for them to take their full, beautiful shapes. But bubbles are just one element in markets. In forests, a tree almost never takes its natural shape, because it’s hemmed in by so many other trees.”

To Soros, the notion of markets as a hyper-rational optimisation machine is wrong. Why so? Because of ‘reflexivity,’ a characteristic of human behaviour, ‘the product of multiple unpredictable mutual interactions, with none of the law-governed regulations of physics.’

Financial markets, Morris explains, occupy an ambiguous position between the world of hard science and the reflexive world of humans. “In settled times, markets frequently do appear to be governed by law-like statistical rules, which enamour economic modellers. But those regularities break down dramatically in times of stress because of the reflexive, or mutual, interactions between human expectations and actual market behaviour.”

When reflexivity tends to dominate, unsettled markets are ripe for bubble formation, argues Soros. And he says bubbles being created all the time, though most of them are choked off before they build up much momentum. “During his investing career, he guesses there were only ‘six to ten’ long-run bubbles, plus an overall ‘superbubble’ in credit and debt that he estimates has been inflating since the end of the last world war.”

Warren Buffett

Buffett’s investment style does not fit a mould, finds Morris. “His success is grounded in a unique talent set: the rare ability to size up managements and companies, and the capacity to gather and synthesise prodigious amounts of information and then laser in on a business’s heart.”

An interesting section in the Buffett chapter is about how John Meriwether of LTCM, backed by Nobel Laureates Robert Merton and Myron Scholes, had wanted to rope in the ‘Oracle of Omaha’ as an investor, in 1994.

“LTCM’s strategy was to bet on small misalignments in pricing of similar standard instruments, which almost always came back to normal in the near term. The winnings from such bets were small, but they were short-term and you could amplify them with leverage. The math showed that you would take a substantial loss only once a century or so.”

Despite being impressed with the LTCM partner smarts, Buffett declined, as per a policy of not investing in other people’s funds. LTCM was a classic case of ‘fat tails’ in finance, elaborates Morris. Portfolio math, he says, mimics diffusion physics – a scattergram of the outcomes from trillions of small random movements maps smoothly onto a bell curve.

“In well-behaved markets, finance looks much the same. But markets are rarely well-behaved for long, and big deviations from the norm happen very frequently in finance – the finance bell curve, that is, has fat tails. When Russia defaulted on its sovereign bonds in 1998, it was a fat tail for LTCM, and it was on the wrong side of the trade, with very heavy leverage.”

To Buffett, the LTCM episode is an example of what happens when you get four things, as the chapter informs: “(1) A dozen people with an average IQ of 160; (2) working in a field in which they collectively have 250 years of experience; (3) operating with a huge percentage of their net worth in the business; and (4) employing a tonne of leverage.”

Paul Volcker

The former head of Federal Reserve Board has spent almost his entire professional life dealing with financial crises – bank failures, currency collapses, global imbalances, economic crashes – recounts Morris.

The crises that defined Volcker’s career can almost all be understood as part of the backwash from the breakdown of the ‘Bretton Woods’ system of international finance created at the close of World War II, and the failure to construct a reliable replacement system, the author instructs.

The real Volcker brand outweighing all his financial accomplishments is his reputation for rock-solid integrity and utter incorruptibility, avers Morris. “If a major company or an international organisation had a credibility or corruption problem that it wanted to fix, one way was to induce Paul Volcker to head up an investigative committee. The downside was that he took his reputation very seriously. He would dig deeply and call the shots as he saw them, and the results could be embarrassing.”

What was his reaction to the financial crisis? Blistering, as evident from this quote from a February 2009 speech at a symposium in London: “We’re in the middle of a massive economic crisis… We’re going to hear the reverberations about this for a long time to come.”

He scoffed at the notion that clamping down on banks, hedge funds, and other players would stifle ‘innovation,’ narrates Morris. “The only innovation that real people cared about for the previous twenty or thirty years, he said, was ‘the automatic teller machine.’”

Role of economists

The concluding chapter of the book, titled ‘Economics, markets, and reality,’ acknowledges that economists do a great deal of useful work, such as tracking trade flows, or trying to trace the effects of currency revaluations. But the field is far too immature to encompass the operations of a whole economy, or as the record shows, even make accurate forecasts of gross tendencies, the author cautions.

Economics is not a science, like physics, he reminds. “Its methods are primarily analogical and metaphorical. Its data are gross and error-prone, and its models of economic interactions bear only a distant relationship to those in the real world.”

The theoretical apparatus of economics – its ‘laws’ – are mostly imaginative constructs that can rarely be confirmed with any precision, Morris continues. Their content and structure, moreover, are as often developed from ideological premises as from observation, he alerts. “That’s one of the reasons that highly qualified economists can always be found on almost any side of a question – rather like eighteenth-century physicians sniffing a patient’s urine and arguing whether the black or the yellow bile is the culprit.”

Insightful read for the serious investor.

**

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