Book Review: Too smart for our own good

Too smart for our own good: intelligent investment strategies, security illusions, and market crashes. 2018. Bruce I. Jacobs. McGraw Hill Education.

Very smart for our own good A cry de quier about investment products that persuades investors with the appearance of low risk and the promise of high returns, when in fact introduces systemic risk and eventually market crash or crisis. Author Bruce I. The policies that Jacobs outlined are general, but he details the three major market crises of recent decades, including those destructive policies, critical elements in his view – the 1987 crash, Long’s collapse, and the 1998 term capital management (LTCM). And the global financial crisis of 2007-2008.

Author Jacobs Levy is co-founder, co-chief investment officer and co-director of research at Equity Management. He has been critical of the flawed investment theory discussed in the book since he debated with portfolio insurance makers in the 1980s. Jacobs wrote an earlier book, Capital concepts and market realities: alternative replicas, investor behavior and stock market crashes (1999), focusing entirely on portfolio insurance, its marketing, and the consequences of widespread adoption of the strategy in the 1980s. He also wrote about the role of foreign mortgages in the 2007-2008 crisis. Subsequently, Jacobs was active in creating the National Institute of Finance, which helped Congress to include the creation of the Financial Stability Monitoring Council in its post-crisis financial reforms.

Jacobs admits that many books have been written about the financial crisis but argues that many of them are responsible for the indescribable “acts of God” or the underlying chaos of the capital market. He believes the real culprits are identifiable. Investment professionals ow their clients and themselves to help them understand the real causes of financial disasters and ensure that they do not recur.

Four times the author’s original thesis:

  1. Some investment strategies, especially those that provide security illusions, “may interact with market realities to create unhealthy consequences for the market and investors.”
  2. Strategies are usually marketed with a hint of complex and sophisticated practice.
  3. They usually lack clarity.
  4. They exhibit excessive (though possibly camouflage) leverage.
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The book is divided into five parts. The first part provides a background for readers unfamiliar with important concepts related to risk and its management, such as diversity, hedging, and arbitration. Many investment professionals can safely avoid this category. The second part examines the 1987 crash. In particular, it examines the role of newly created strategies in portfolio insurance, to trigger or, of course, exacerbate that crisis. In the case of the fall of LTCM in 1 III, the third part gives the same treatment.

Part IV looks at the 2007-2009 credit crisis and recession. During this time, problems arise in the form of complex asset-backed derivatives such as collateral debt obligations and residential mortgage-backed securities. Part V is a possession bag of less severe market crises, such as various flash crashes, the “London Whale” event, the European debt crisis, and the Greek debt crisis, as well as related problems such as uncertain reliance on models. In this section, Jacobs proposes some solutions, primarily involving more effective control, enhanced disclosure, clearinghouses, and proper education.

The appendix contains additional background elements:

  • A primer in bonds, stocks, and derivatives.
  • Documents of Jacobs’ controversy with portfolio insurance payers in the 1980s.
  • A discussion of some of the major derivatives disasters of the 1990s.
  • Author’s 2002 proposal for criteria for research objectivity.

Also included is a discussion of the 1929 crash. One may question why it has been dropped in the appendix. Is it relevant to the main argument?

Book jacket in the history of financial markets: a reflection of the past for investors

Very smart for our own goodIts core thesis should be considered not only by investment professionals, but by all investors. Free-lunch promises, complications, opacity and excessive leverage are often combined with toxic effects. Financial professionals in particular can benefit greatly from studying the market crisis analyzed in this book and what lessons should be learned from them. George Santana’s famous quote – “Those who cannot remember the past are condemned for repeating it” – applies with vengeance in the financial markets.

The book has some errors. Since it is organized into five parts, the original thesis is re-ated and re-discussed in each, resulting in considerable repetition. In Part V, the argument becomes blurred when the author comes up with a variety of additional issues that could contribute to market instability, such as conflict of interest, high-frequency trading (HFT), moral hazards, cognitive bias, and the unintended consequences of control. If so many things can contribute to a crisis, does that mean each crisis is complex and unique, but all driven by a specific factor? One might even think that in the old days if opacity was not a worse problem before the immediate spread of asset prices, when investors had to accept their brokers talking about prices and market moves.

On a deeper level, one reader may ask why the financial revolution has been causing the financial crisis for centuries, long before portfolio insurance and other fancy devices became possible. What does Jacobs believe? All Are financial crises characterized by features of his original thesis or just the most recent? Perhaps the author has lost the opportunity to identify the more universally underlying cause of the crash, as the inevitable tendency of investors to become satisfied and neglected in the long run of prosperity? John Templeton’s proverb reminds us that “bull markets are born of pessimism, grow into skepticism, mature into optimism, and die in exile.” Couldn’t instruments and attitudes be a response to the demands raised during Jacobs optimism and exuberance? And while inventions can be painful to adapt to, many innovations do not bring great benefits.

The problem that Jacobs does not solve is the complexity of government policy in some crises. The subprime industry, for example, was encouraged by laws and regulations aimed at promoting home ownership more widely. A lawsuit can also be filed in the event of a global financial crisis, for example, procyclic monetary policy often helps to increase the volatile stages and deepen the inevitable correction. Ultimately, U.S. policies have created moral hazards through bailouts by the U.S. Federal Reserve, Treasury, and Expenditure Act.

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To be fair, excessive leverage may have played a role in most of the crashes in history, and opaque innovations may also seem to many. Tulipmania features alternatives, as the author points out on the one hand.

Of course, the author’s four horsemen – safety, complexity, opacity and the illusion of leverage, bound in a pseudo-scientific twist – have played a key role in the worst crisis of recent decades. Every investment professional should be compelled to better understand those crises and their components. This book serves as a valuable guide to exactly that venture.

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All posts are the author’s opinion. As such, they should not be construed as investment advice, or the opinions expressed do not necessarily reflect the views of the CFA Institute or the author’s employer.

Image Credit: © Getty Images / Ionis Totras

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Nick Ronald, CFA

Nick Ronald, Managing Director, CFA, ASIFMA (Asia Securities Industry and Financial Markets Association), Hong Kong.

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