Two Articles from The Atlantic explaining why Wall Street will always have bubbles and busts

The first article is about the experimental evidence.
The second is more experiential.


The Atlantic


Why asset bubbles are a part of the human condition that regulation can't

by Virginia Postrel

Pop Psychology

IN THESE UNCERTAIN economic times, we'd all like a guaranteed investment.
Here's one: it pays a 24-cent dividend every four weeks for 60 weeks, 15
dividends in all. Then it disappears. Unlike a bond, this security has no
redemption value. It simply provides guaranteed dividends. It involves no
tricky derivatives or unknown risks. And it carries absolutely no danger of
default. What would you pay for it?

Before financially sophisticated readers drag out their calculators, look up
interest rates, and compute the present value of those future payments, I
have a confession to make. You can't buy this security, and it doesn't
really pay dividends every four weeks. It pays every four minutes, in a
computer lab, to volunteers in economic experiments.

For more than two decades, economists have been running versions of the same
experiment. They take a bunch of volunteers, usually undergraduates but
sometimes businesspeople or graduate students; divide them into experimental
groups of roughly a dozen; give each person money and shares to trade with;
and pay dividends of 24 cents at the end of each of 15 rounds, each lasting
a few minutes. (Sometimes the 24 cents is a flat amount; more often there's
an equal chance of getting 0, 8, 28, or 60 cents, which averages out to 24
cents.) All participants are given the same information, but they can't talk
to one another and they interact only through their trading screens. Then
the researchers watch what happens, repeating the same experiment with
different small groups to get a larger picture.

The great thing about a laboratory experiment is that you can control the
environment. Wall Street securities carry uncertainties-more, lately, than
many people expected-but this experimental security is a sure thing. "The
fundamental value is unambiguously defined," says the economist Charles
Noussair, a professor at Tilburg University, in the Netherlands, who has run
many of these experiments. "It's the expected value of the future dividend
stream at any given time": 15 times 24 cents, or $3.60 at the end of the
first round; 14 times 24 cents, or $3.36 at the end of the second; $3.12 at
the end of the third; and so on down to zero. Participants don't even have
to do the math. They can see the total expected dividends on their computer

Here, finally, is a security with security-no doubt about its true value, no
hidden risks, no crazy ups and downs, no bubbles and panics. The trading
price should stick close to the expected value.

At least that's what economists would have thought before Vernon Smith, who
won a 2002 Nobel Prize for developing experimental economics, first ran the
test in the mid-1980s. But that's not what happens. Again and again, in
experiment after experiment, the trading price runs up way above fundamental
value. Then, as the 15th round nears, it crashes. The problem doesn't seem
to be that participants are bored and fooling around. The difference between
a good trading performance and a bad one is about $80 for a three-hour
session, enough to motivate cash-strapped students to do their best.
Besides, Noussair emphasizes, "you don't just get random noise. You get
bubbles and crashes." Ninety percent of the time.

So much for security.

These lab results should give pause not only to people who believe in
efficient markets, but also to those who think we can banish bubbles simply
by curbing corruption and imposing more regulation. Asset markets, it seems,
suffer from irrepressible effervescence. Bubbles happen, even in the most
controlled conditions.

Experimental bubbles are particularly surprising because in laboratory
markets that mimic the production of goods and services, prices rise and
fall as economic theory predicts, reaching a neat equilibrium where supply
meets demand. But like real-world purchasers of haircuts or refrigerators,
buyers in those markets need to know only how much they themselves value the
good. If the price is less than the value to you, you buy. If not, you
don't, and vice versa for sellers.

Financial assets, whether in the lab or the real world, are trickier to
judge: Can I flip this security to a buyer who will pay more than I think
it's worth? In an experimental market, where the value of the security is
clearly specified, "worth" shouldn't vary with taste, cash needs, or risk
calculations. Based on future dividends, you know for sure that the
security's current value is, say, $3.12. But-here's the wrinkle-you don't
know that I'm as savvy as you are. Maybe I'm confused. Even if I'm not, you
don't know whether I know that you know it's worth $3.12. Besides, as long
as a clueless greater fool who might pay $3.50 is out there, we smart people
may decide to pay $3.25 in the hope of making a profit. It doesn't matter
that we know the security is worth $3.12. For the price to track the
fundamental value, says Noussair, "everybody has to know that everybody
knows that everybody is rational." That's rarely the case. Rather, "if you
put people in asset markets, the first thing they do is not try to figure
out the fundamental value. They try to buy low and sell high." That
speculation creates a bubble.

In fact, the people who make the most money in these experiments aren't the
ones who stick to fundamentals. They're the speculators who buy a lot at the
beginning and sell midway through, taking advantage of "momentum traders"
who jump in when the market is going up, don't sell until it's going down,
and wind up with the least money at the end. ("I have a lot of relatives and
friends who are momentum traders," comments Noussair.) Bubbles start to pop
when the momentum traders run out of money and can no longer push prices up.

But people do learn. By the third time the same group goes through a
15-round market, the bubble usually disappears. Everybody knows what the
security is worth and realizes that everybody else knows the same thing. Or
at least that's what economists assumed was happening. But work that
Noussair and his co-authors published in the December 2007 American Economic
Review suggests that traders don't reason that way.

In this version of the experiment, participants took part in the 15-round
market four times in a row. Before each session, the researchers asked the
traders what they thought would happen to prices. The first time,
participants didn't expect a bubble, but in later markets they did. With
each successive session, however, they predicted that the bubble would peak
later and reach a higher price than it actually did. Expecting the future to
look like the past, they traded accordingly, selling earlier and at lower
prices than in the previous session, hoping to realize a profit before the
bubble burst. Those trades, of course, changed the market pattern. Prices
were lower, and they peaked closer to the beginning of the session. By the
fourth round, the price stuck close to the security's fundamental value-not
because traders were going for the rational price but because they were
trying to avoid getting caught in a bubble.

"Prices converge toward fundamentals ahead of beliefs," the economists
conclude. Traders literally learn from experience, basing their expectations
and behavior not on logical inference but on what has happened in the past.
After enough rounds, markets work their way toward a stable price.

If experience eliminates bubbles in the lab, you might expect that
more-experienced traders in the real world (or what experimental economists
prefer to call "field markets") would produce fewer financial crises. When
asset markets run into trouble, maybe it's because there are too many
newbies: all those dot-com day traders, 20-something house flippers, and
newly minted M.B.A.s. As Alan Greenspan told Congress in October, "It was
the failure to properly price such risky assets that precipitated the
crisis." People didn't know what they were doing. What markets need are more
old hands.

Alas, once again the situation is not so simple. Even experienced traders
can make big mistakes when conditions change. In research published in the
June 2008 American Economic Review, Vernon Smith and his collaborators first
ran the standard experiment, putting groups through the 15-round market
twice. Then the researchers changed three conditions: they mixed up the
groups, so participants weren't trading with familiar faces; they increased
the range of possible dividends, replacing four possible outcomes (0, 8, 28,
or 60) averaging 24, with five (0, 1, 8, 28, 98) averaging 27; finally, they
doubled the amount of cash and halved the number of shares in the market.
The participants then completed a third round. These changes were based on
previous research showing that more cash and bigger dividend spreads
exacerbate bubbles.

Sure enough, under the new conditions, the experienced traders generated a
bubble just as big as if they'd never been in the lab. It didn't last quite
as long, however, or involve as much volume. "Participants seem to be
tacitly aware that there will be a crash," the economists write, "and
consequently exit from the market (sell) earlier, causing the crash to start
earlier." Even so, the price peaks far above the fundamental value.
"Bubbles," the economists conclude, "are the funny and unpredictable
phenomena that happen on the way to the 'rational' predicted equilibrium if
the environment is held constant long enough."

For those of us who invest our money outside the lab, this research carries
two implications.

First, beware of markets with too much cash chasing too few good deals. When
the Federal Reserve cuts interest rates, it effectively frees up more cash
to buy financial instruments. When lenders lower down-payment requirements,
they do the same for the housing market. All that cash encourages investment

Second, big changes can turn even experienced traders into ignorant novices.
Those changes could be the rise of new industries like the dot-coms of the
1990s or new derivative securities created by slicing up and repackaging
mortgages. I asked the Caltech economist Charles Plott, one of the pioneers
of experimental economics, whether the recent financial crisis might have
come from this kind of inexperience. "I think that's a good thesis," he
said. With so many new instruments, "it could be that the inexperienced
heads are not people but the organizations themselves. The organizations
haven't learned how to deal with the risk or identify the risk or understand
the risk."

Here the bubble experiments meet up with another large body of experimental
research, first developed by Plott and his collaborators. This work explores
how speculative markets can pool information from lots of people ("the
wisdom of crowds") and arrive at accurate predictions-for example, who's
going to win the presidency or the World Series. These markets work, Plott
explains, because people with good information rush in early, leading prices
to reflect what they know and setting a trajectory that others follow. "It's
a kind of cascade, a good cascade, just what should happen," he says. But
sometimes the process "can go bananas" and create a bubble, usually when
good information is scarce and people follow leaders who don't in fact know

That may be what happened on Wall Street, Plott suggests. "Now we have new
instruments. We have 'leaders,' who one would ordinarily think know
something, getting in there very aggressively and everybody cuing on them-as
they have done in the past, and as markets should. But in this case, there
might be a bubble." And when you have a bubble, you will get a crash.

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The Atlantic


The magnitude of the current bust seems almost unfathomable-and it was
unfathomable, to even the most sophisticated financial professionals, until
the moment the bubble popped. How could this happen? And what's to stop it
from happening again? A former Wall Street insider explains how the
financial industry got it so badly wrong, why it always will-and why all of
us are to blame.

by Henry Blodget

Why Wall Street Always Blows It

WELL, WE DID it again. Only eight years after the last big financial boom
ended in disaster, we're now in the migraine hangover of an even bigger
one-a global housing and debt bubble whose bursting has wiped out tens of
trillions of dollars of wealth and brought the world to the edge of a second
Great Depression.

Millions have lost their houses. Millions more have lost their retirement
savings. Tens of millions have had their portfolios smashed. And the carnage
in the "real economy" has only just begun.

What the hell happened? After decades of increasing financial
sophistication, weren't we supposed to be done with these things? Weren't we
supposed to know better?

Yes, of course. Every time this happens, we think it will be the last time.
But it never will be.

First things first: for better and worse, I have had more professional
experience with financial bubbles than I would ever wish on anyone. During
the dot-com episode, as you may unfortunately recall, I was a famous
tech-stock analyst at Merrill Lynch. I was famous because I was on the right
side of the boom through the late 1990s, when stocks were storming to
record-high prices every year-Internet stocks, especially. By late 1998, I
was cautioning clients that "what looks like a bubble probably is," but this
didn't save me. Fifteen months later, I missed the top and drove my clients
right over the cliff.

Later, in the smoldering aftermath, as you may also unfortunately recall, I
was accused by Eliot Spitzer, then New York's attorney general, of having
hung on too long in order to curry favor with the companies I was analyzing,
some of which were also Merrill banking clients. This allegation led to my
banishment from the industry, though it didn't explain why I had followed my
own advice and blown my own portfolio to smithereens (more on this later).

I experienced the next bubble differently-as a journalist and homeowner.
Having already learned the most obvious lesson about bubbles, which is that
you don't want to get out too late, I now discovered something nearly as
obvious: you don't want to get out too early. Figuring that the roaring
housing market was just another tech-stock bubble in the making, I rushed to
sell my house in 2003-only to watch its price nearly double over the next
three years. I also predicted the demise of the Manhattan real-estate market
on the cover of New York magazine in 2005. Prices are finally falling now,
in 2008, but they're still well above where they were then.

Live through enough bubbles, though, and you do eventually learn something
of value. For example, I've learned that although getting out too early
hurts, it hurts less than getting out too late. More important, I've learned
that most of the common wisdom about financial bubbles is wrong.

WHO'S TO BLAME for the current crisis? As usually happens after a crash, the
search for scapegoats has been intense, and many contenders have emerged:
Wall Street swindled us; predatory lenders sold us loans we couldn't afford;
the Securities and Exchange Commission fell asleep at the switch; Alan
Greenspan kept interest rates low for too long; short-sellers spread
negative rumors; "experts" gave us bad advice. More-introspective folks will
add other explanations: we got greedy; we went nuts; we heard what we wanted
to hear.

All of these explanations have some truth to them. Predatory lenders did
bamboozle some people into loans and houses they couldn't afford. The SEC
and other regulators did miss opportunities to curb some of the more
egregious behavior. Alan Greenspan did keep interest rates too low for too
long (and if you're looking for the single biggest cause of the housing
bubble, this is it). Some short-sellers did spread negative rumors. And,
Lord knows, many of us got greedy, checked our brains at the door, and heard
what we wanted to hear.

But most bubbles are the product of more than just bad faith, or
incompetence, or rank stupidity; the interaction of human psychology with a
market economy practically ensures that they will form. In this sense,
bubbles are perfectly rational-or at least they're a rational and
unavoidable by-product of capitalism (which, as Winston Churchill might have
said, is the worst economic system on the planet except for all the others).
Technology and circumstances change, but the human animal doesn't. And
markets are ultimately about people.

To understand why bubble participants make the decisions they do, let's roll
back the clock to 2002. The stock-market crash has crushed our portfolios
and left us feeling vulnerable, foolish, and poor. We're not wiped out,
thankfully, but we're chastened, and we're certainly not going to go blow
our extra money on Cisco Systems again. So where should we put it? What's
safe? How about a house?

House prices, we are told by our helpful neighborhood real-estate agent,
almost never go down. This sounds right, and they certainly didn't go down
in the stock-market crash. In fact, for as long as we can remember-about 10
years, in most cases-house prices haven't gone down. (Wait, maybe there was
a slight dip, after the 1987 stock-market crash, but looming larger in our
memories is what's happened since; everyone we know who's bought a house
since the early 1990s has made gobs of money.)

We consider following our agent's advice, but then we decide against it.
House prices have doubled since the mid-1990s; we're not going to get burned
again by buying at the top. So we decide to just stay in our rent-stabilized
rabbit warren and wait for house prices to collapse.

Unfortunately, they don't. A year later, they've risen at least another 10
percent. By 2006, we're walking past neighborhood houses that we could have
bought for about half as much four years ago; we wave to happy new neighbors
who are already deep in the money. One neighbor has "unlocked the value in
his house" by taking out a cheap home-equity loan, and he's using the
proceeds to build a swimming pool. He is also doing well, along with two
visionary friends, by buying and flipping other houses-so well, in fact,
that he's considering quitting his job and becoming a full-time real-estate
developer. After four years of resistance, we finally concede-houses might
be a good investment after all-and call our neighborhood real-estate agent.
She's jammed (and driving a new BMW), but she agrees to fit us in.

We see five houses: two were on the market two years ago for 30 percent less
(we just can't handle the pain of that); two are dumps; and the fifth, which
we love, is listed at a positively ridiculous price. The agent tells us to
hurry-if we don't bid now, we'll lose the house. But we're still hesitant:
last week, we read an article in which some economist was predicting a
housing crash, and that made us nervous. (Our agent counters that Greenspan
says the housing market's in good shape, and he isn't known as "The Maestro"
for nothing.)

When we get home, we call our neighborhood mortgage broker, who gives us a
surprisingly reasonable quote-with a surprisingly small down payment. It's a
new kind of loan, he says, called an adjustable-rate mortgage, which is the
same kind our neighbor has. The payments will "reset" in three years, but,
as the mortgage broker suggests, we'll probably have moved up to a bigger
house by then. We discuss the house during dinner and breakfast. We review
our finances to make sure we can afford it. Then, the next afternoon, we
call the agent to place a bid. And the house is already gone-at 10 percent
above the asking price.

By the spring of 2007, we've finally caught up to the market reality, and
our luck finally changes: We make an instant, aggressive bid on a huge
house, with almost no money down. And we get it! We're finally members of
the ownership society.

You know the rest. Eighteen months later, our down payment has been wiped
out and we owe more on the house than it's worth. We're still able to make
the payments, but our mortgage rate is about to reset. And we've already
heard rumors about coming layoffs at our jobs. How on Earth did we get into
this mess?

The exact answer is different in every case, of course. But let's round up
the usual suspects:

The predatory mortgage broker? Well, we're certainly not happy with the
bastard, given that he sold us a loan that is now a ticking time bomb. But
we did ask him to show us a range of options, and he didn't make us pick
this one. We picked it because it had the lowest payment.

Our sleazy real-estate agent? We're not speaking to her anymore, either
(and we're secretly stoked that her BMW just got repossessed), but again,
she didn't lie to us. She just kept saying that houses are usually a good
investment. And she is, after all, a saleswoman; that was never very hard to
figure out.

Wall Street fat cats? Boy, do we hate those guys, especially now that our
tax dollars are bailing them out. But we didn't complain when our lender
asked for such a small down payment without bothering to check how much
money we made. At the time, we thought that was pretty great.

The SEC? We're furious that our government let this happen to us, and we're
sure someone is to blame. We're not really sure who that someone is, though.
Whoever is responsible for making sure that something like this never
happens to us, we guess.

Alan "The Maestro" Greenspan? We're pissed at him too. If he hadn't been
out there saying everything was fine, we might have believed that economist
who said it wasn't.

Bad advice? Hell, yes, we got bad advice. Our real-estate agent. That
mortgage guy. Our neighbor. Greenspan. The media. They all gave us
horrendous advice. We should have just waited for the market to crash. But
everyone said it was different this time.

Still, except in cases involving outright fraud-a small minority-the buck
stops with us. Not knowing that the market would crash isn't an excuse. No
one knew the market would crash, even the analysts who predicted that it
would. (Just as important, no one knew when prices would go down, or how
fast.) And for years, most of the skeptics looked-and felt-like fools.

Everyone else on that list above bears some responsibility too. But in the
case I have described, it would be hard to say that any of them acted
criminally. Or irrationally. Or even irresponsibly. In fact, almost everyone
on that list acted just the way you would expect them to act under the

THAT'S ESPECIALLY TRUE for the professionals on Wall Street, who've come in
for more criticism than anyone in recent months, and understandably so. It
was Wall Street, after all, that chose not only to feed the housing bubble,
but ultimately to bet so heavily on it as to put the entire financial system
at risk. How did the experts who are paid to obsess about the direction of
the market-allegedly the most financially sophisticated among us-get it so
badly wrong? The answer is that the typical financial professional is a lot
more like our hypothetical home buyer than anyone on Wall Street would care
to admit. Given the intersection of experience, uncertainty, and
self-interest within the finance industry, it should be no surprise that
Wall Street blew it-or that it will do so again.

Take experience (or the lack thereof). Boom-and-bust cycles like the one we
just went through take a long time to complete. The really big busts, in
fact, the ones that affect the whole market and economy, are usually
separated by more than 30 years-think 1929, 1966, and 2000. (Why did the
housing bubble follow the tech bubble so closely? Because both were really
just parts of a larger credit bubble, which had been building since the late
1980s. That bubble didn't deflate after the 2000 crash, in part thanks to
Greenspan's attempts to save the economy.) By the time the next Great Bubble
rolls around, a lot of us will be as dead and gone as Richard Whitney, Jesse
Livermore, Charles Mitchell, and the other giants of the 1929 crash. (Never
heard of them? Exactly.)

Since Wall Street replenishes itself with a new crop of fresh faces every
year-many of the professionals at the elite firms either flame out or retire
by age 40-most of the industry doesn't usually have experience with both
booms and busts. In the 1990s, I and thousands of young Wall Street analysts
and investors like me hadn't seen anything but a 15-year bull market. The
only market shocks that we knew much about-the 1987 crash, say, or Mexico's
1994 financial crisis-had immediately been followed by strong recoveries
(and exhortations to "buy the dip").

By 1996, when Greenspan made his famous "irrational exuberance" remark, the
stock market's valuation was nearing its peak from prior bull markets,
making some veteran investors nervous. Over the next few years, however,
despite confident predictions of doom, stocks just kept going up. And
eventually, inevitably, this led to assertions that no peak was in sight,
much less a crash-you see, it was "different this time."

Those are said to be the most expensive words in the English language, by
the way: it's different this time. You can't have a bubble without good
explanations for why it's different this time. If everyone knew that this
time wasn't different, the market would stop going up. But the future is
always uncertain-and amid uncertainty, all sorts of faith-based theories can
flourish, even on Wall Street.

In the 1920s, the "differences" were said to be the miraculous new
technologies (phones, cars, planes) that would speed the economy, as well as
Prohibition, which was supposed to produce an ultra-efficient,
ultra-responsible workforce. (Don't laugh: one of the most respected
economists of the era, Irving Fisher of Yale University, believed that one.)
In the tech bubble of the 1990s, the differences were low interest rates,
low inflation, a government budget surplus, the Internet revolution, and a
Federal Reserve chairman apparently so divinely talented that he had made
the business cycle obsolete. In the housing bubble, they were low interest
rates, population growth, new mortgage products, a new ownership society,
and, of course, the fact that "they aren't making any more land."

In hindsight, it's obvious that all these differences were bogus (they've
never made any more land-except in Dubai, which now has its own problems).
At the time, however, with prices going up every day, things sure seemed

In fairness to the thousands of experts who've snookered themselves
throughout the years, a complicating factor is always at work: the
ever-present possibility that it really might have been different.
Everything is obvious only after the crash.

Consider, for instance, the late 1950s, when a tried-and-true "sell signal"
started flashing on Wall Street. For the first time in years, stock prices
had risen so high that the dividend yield on stocks had fallen below the
coupon yield on bonds. To anyone who had been around for a while, this
seemed ridiculous: stocks are riskier than bonds, so a rational buyer must
be paid more to own them. Wise, experienced investors sold their stocks and
waited for this obvious mispricing to correct itself. They're still waiting.

Why? Because that time, it was different. There were increasing concerns
about inflation, which erodes the value of fixed bond-interest payments.
Stocks offer more protection against inflation, so their value relative to
bonds had increased. By the time the prudent folks who sold their stocks
figured this out, however, they'd missed out on many years of a raging bull

When I was on Wall Street, the embryonic Internet sector was different, of
course-at least to those of us who were used to buying staid, steady stocks
that went up 10 percent in a good year. Most Internet companies didn't have
earnings, and some of them barely had revenue. But the performance of some
of their stocks was spectacular.

In 1997, I recommended that my clients buy stock in a company called Yahoo;
the stock finished the year up more than 500 percent. The next year, I put a
$400-a-share price target on a controversial "online bookseller" called
Amazon, worth about $240 a share at the time; within a month, the stock
blasted through $400 en route to $600. You don't have to make too many calls
like these before people start listening to you; I soon had a global
audience keenly interested in whatever I said.

One of the things I said frequently, especially after my Amazon prediction,
was that the tech sector's stock behavior sure looked like a bubble. At the
end of 1998, in fact, I published a report called "Surviving (and Profiting
From)," in which I listed similarities between the dot-com
phenomenon and previous boom-and-bust cycles in biotech, personal computers,
and other sectors. But I recommended that my clients own a few high-quality
Internet stocks anyway-because of the ways in which I thought the Internet
was different. I won't spell out all those ways, but I will say that they
sounded less stupid then than they do now.

The bottom line is that resisting the siren call of a boom is much easier
when you have already been obliterated by one. In the late 1990s, as stocks
kept roaring higher, it got easier and easier to believe that something
really was different. So, in early 2000, weeks before the bubble burst, I
put a lot of money where my mouth was. Two years later, I had lost the
equivalent of six high-end college educations.

Of course, as Eliot Spitzer and others would later observe-and as was
crystal clear to most Wall Street executives at the time-being bullish in a
bull market is undeniably good for business. When the market is rising, no
one wants to work with a bear.

WHICH BRINGS US to the last major contributor to booms and busts:

When people look back on bubbles, many conclude that the participants must
have gone stark raving mad. In most cases, nothing could be further from the

In my example from the housing boom, for instance, each participant's job
was not to predict what the housing market would do but to accomplish a more
concrete aim. The buyer wanted to buy a house; the real-estate agent wanted
to earn a commission; the mortgage broker wanted to sell a loan; Wall Street
wanted to buy loans so it could package and resell them as "mortgage-backed
securities"; Alan Greenspan wanted to keep American prosperity alive;
members of Congress wanted to get reelected. None of these participants, it
is important to note, was paid to predict the likely future movements of the
housing market. In every case (except, perhaps, the buyer's), that was, at
best, a minor concern.

This does not make the participants villains or morons. It does, however,
illustrate another critical component of boom-time decision-making: the
difference between investment risk and career or business risk.

Professional fund managers are paid to manage money for their clients. Most
managers succeed or fail based not on how much money they make or lose but
on how much they make or lose relative to the market and other fund

If the market goes up 20 percent and your Fidelity fund goes up only 10
percent, for example, you probably won't call Fidelity and say, "Thank you."
Instead, you'll probably call and say, "What am I paying you people for,
anyway?" (Or at least that's what a lot of investors do.) And if this
performance continues for a while, you might eventually fire Fidelity and
hire a new fund manager.

On the other hand, if your Fidelity fund declines in value but the market
drops even more, you'll probably stick with the fund for a while ("Hey, at
least I didn't lose as much as all those suckers in index funds"). That is,
until the market drops so much that you can't take it anymore and you sell
everything, which is what a lot of people did in October, when the Dow
plunged below 9,000.

In the money-management business, therefore, investment risk is the risk
that your bets will cost your clients money. Career or business risk,
meanwhile, is the risk that your bets will cost you or your firm money or

The tension between investment risk and business risk often leads fund
managers to make decisions that, to outsiders, seem bizarre. From the fund
managers' perspective, however, they're perfectly rational.

In the late 1990s, while I was trying to figure out whether it was different
this time, some of the most legendary fund managers in the industry were
struggling. Since 1995, any fund managers who had been bearish had not been
viewed as "wise" or "prudent"; they had been viewed as "wrong." And because
being wrong meant underperforming, many had been shown the door.

It doesn't take very many of these firings to wake other financial
professionals up to the fact that being bearish and wrong is at least as
risky as being bullish and wrong. The ultimate judge of who is "right" and
"wrong" on Wall Street, moreover, is the market, which posts its verdict day
after day, month after month, year after year. So over time, in a long bull
market, most of the bears get weeded out, through either attrition or

By mid-1999, with mountains of money being made in tech stocks, fund owners
were more impatient than ever: their friends were getting rich in Cisco, so
their fund manager had better own Cisco-or he or she was an idiot. And if
the fund manager thought Cisco was overvalued and was eventually going to
crash? Well, in those years, fund managers usually approached this type of
problem in of one of three ways: they refused to play; they played and tried
to win; or they split the difference.

In the first camp was an iconic hedge-fund manager named Julian Robertson.
For almost two decades, Robertson's Tiger Management had racked up annual
gains of about 30 percent by, as he put it, buying the best stocks and
shorting the worst. (One of the worst, in Robertson's opinion, was Amazon,
and he used to summon me to his office and demand to know why everyone else
kept buying it.)

By 1998, Robertson was short Amazon and other tech stocks, and by 2000,
after the NASDAQ had jumped an astounding 86 percent the previous year,
Robertson's business and reputation had been mauled. Thanks to poor
performance and investor withdrawals, Tiger's assets under management had
collapsed from about $20billion to about $6billion, and the firm's revenues
had collapsed as well. Robertson refused to change his stance, however, and
in the spring of 2000, he threw in the towel: he closed Tiger's doors and
began returning what was left of his investors' money.

Across town, meanwhile, at Soros Fund Management, a similar struggle was
taking place, with another titanic fund manager's reputation on the line. In
1998, the firm had gotten crushed as a result of its bets against technology
stocks (among other reasons). Midway through 1999, however, the manager of
Soros's Quantum Fund, Stanley Druckenmiller, reversed that position and went
long on technology. Why? Because unlike Robertson, Druckenmiller viewed it
as his job to make money no matter what the market was doing, not to insist
that the market was wrong.

At first, the bet worked: the reversal saved 1999 and got 2000 off to a good
start. But by the end of April, Quantum was down a shocking 22 percent for
the year, and Druckenmiller had resigned: "We thought it was the eighth
inning, and it was the ninth."

Robertson and Druckenmiller stuck to their guns and played the extremes (and
lost). Another fund manager, a man I'll call the Pragmatist, split the

The Pragmatist had owned tech stocks for most of the 1990s, and their
spectacular performance had made his fund famous and his firm rich. By
mid-1999, however, the Pragmatist had seen a bust in the making and begun
selling tech, so his fund had started to underperform. Just one quarter
later, his boss, tired of watching assets flow out the door, suggested that
the Pragmatist reconsider his position on tech. A quarter after that, his
boss made it simpler for him: buy tech, or you're fired.

The Pragmatist thought about quitting. But he knew what would happen if he
did: his boss would hire a 25-year-old gunslinger who would immediately load
up the fund with tech stocks. The Pragmatist also thought about refusing to
follow the order. But that would mean he would be fired for cause (no
severance or bonus), and his boss would hire the same 25-year-old

In the end, the Pragmatist compromised. He bought enough tech stocks to
pacify his boss but not enough to entirely wipe out his fund holders if the
tech bubble popped. A few months later, when the market crashed and the fund
got hammered, he took his bonus and left the firm.

This tension between investment risk and career or business risk comes into
play in other areas of Wall Street too. It was at the center of the
decisions made in the past few years by half a dozen seemingly brilliant
CEOs whose firms no longer exist.

Why did Bear Stearns, Lehman Brothers, Fannie Mae, Freddie Mac, AIG, and the
rest of an ever-growing Wall Street hall of shame take so much risk that
they ended up blowing their firms to kingdom come? Because in a bull market,
when you borrow and bet $30 for every $1 you have in capital, as many firms
did, you can do mind-bogglingly well. And when your competitors are betting
the same $30 for every $1, and your shareholders are demanding that you do
better, and your bonus is tied to how much money your firm makes-not over
the long term, but this year, before December 31-the downside to refusing to
ride the bull market comes into sharp relief. And when naysayers have been
so wrong for so long, and your risk-management people assure you that you're
in good shape unless we have another Great Depression (which we won't, of
course, because it's different this time), well, you can easily convince
yourself that disaster is a possibility so remote that it's not even worth
thinking about.

It's easy to lay the destruction of Wall Street at the feet of the CEOs and
directors, and the bulk of the responsibility does lie with them. But some
of it lies with shareholders and the whole model of public ownership. Wall
Street never has been-and likely never will be-paid primarily for capital
preservation. However, in the days when Wall Street firms were funded
primarily by capital contributed by individual partners, preserving that
capital in the long run was understandably a higher priority than it is
today. Now Wall Street firms are primarily owned not by partners with
personal capital at risk but by demanding institutional shareholders
examining short-term results. When your fiduciary duty is to manage the firm
for the benefit of your shareholders, you can easily persuade yourself that
you're just balancing risk and reward-when what you're really doing is
betting the firm.

AS WE WORK our way through the wreckage of this latest colossal bust, our
government-at our urging-will go to great lengths to try to make sure such a
bust never happens again. We will "fix" the "problems" that we decide caused
the debacle; we will create new regulatory requirements and systems; we will
throw a lot of people in jail. We will do whatever we must to assure
ourselves that it will be different next time. And as long as the searing
memory of this disaster is fresh in the public mind, it will be different.
But as the bust recedes into the past, our priorities will slowly change,
and we will begin to set ourselves up for the next great boom.

A few decades hence, when the Great Crash of 2008 is a distant memory and
the economy is humming along again, our government-at our urging-will begin
to weaken many of the regulatory requirements and systems we put in place
now. Why? To make our economy more competitive and to unleash the power of
our free-market system. We will tell ourselves it's different, and in many
ways, it will be. But the cycle will start all over again.

So what can we learn from all this? In the words of the great investor
Jeremy Grantham, who saw this collapse coming and has seen just about
everything else in his four-decade career: "We will learn an enormous amount
in a very short time, quite a bit in the medium term, and absolutely nothing
in the long term." Of course, to paraphrase Keynes, in the long term, you
and I will be dead. Until that time comes, here are three thoughts I hope we
all can keep in mind.

First, bubbles are to free-market capitalism as hurricanes are to weather:
regular, natural, and unavoidable. They have happened since the dawn of
economic history, and they'll keep happening for as long as humans walk the
Earth, no matter how we try to stop them. We can't legislate away the
business cycle, just as we can't eliminate the self-interest that makes the
whole capitalist system work. We would do ourselves a favor if we stopped
pretending we can.

Second, bubbles and their aftermaths aren't all bad: the tech and Internet
bubble, for example, helped fund the development of a global medium that
will eventually be as central to society as electricity. Likewise, the
latest bust will almost certainly lead to a smaller, poorer financial
industry, meaning that many talented workers will go instead into other
careers-that's probably a healthy rebalancing for the economy as a whole.
The current bust will also lead to at least some regulatory improvements
that endure; the carnage of 1933, for example, gave rise to many of our
securities laws and to the SEC, without which this bust would have been

Lastly, we who have had the misfortune of learning firsthand from this
experience-and in a bust this big, that group includes just about
everyone-can take pains to make sure that we, personally, never make similar
mistakes again. Specifically, we can save more, spend less, diversify our
investments, and avoid buying things we can't afford. Most of all, a few
decades down the road, we can raise an eyebrow when our children explain
that we really should get in on the new new new thing because, yes, it's
different this time.

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[From Mike Acree (2008.12.09.1535 PST)]

Thanks, Ted. Two of the best articles I've read on the subject.