. 2018. Bruce I. Jacobs. McGraw Hill Education.
is a cri de coeur about investment products that lure investors with the looks of low risk and the promise of high returns, but in point of fact carry systemic risk and ultimately stock market crashes or crises. The principles that writer Bruce I. Jacobs lays out are general in nature, but he focuses intimately on three major stock market crises of the past few many years by which he believes these destructive principles were crucial components – the crash of 1987, the collapse of Long-Term Capital Management (LTCM) in 1998, and the worldwide financial crisis of 2007-2008.
The writer is co-founder, co-chief investment officer, and co-head of research at Jacobs Levy Equity Management. He has been a critic of the flawed investment theories he discusses on this book since his direct debate with the inventors of portfolio insurance within the Eighties. Jacobs wrote an earlier book (1999) that dealt exclusively with portfolio insurance, its marketing, and the implications of the widespread adoption of this strategy within the Eighties. He also wrote in regards to the role of exotic mortgage instruments within the crisis of 2007–2008. Subsequently, Jacobs was actively involved within the founding of the National Institute of Finance, which was instrumental in persuading Congress to incorporate the creation of the Financial Stability Oversight Council in its post-crisis financial reforms.
While Jacobs acknowledges that many books have been written about financial crises, he argues that too lots of them attribute the crashes to unexplained “acts of God” or the inherent randomness of capital markets. The real culprits, he believes, are identifiable. Investment professionals owe it to their clients – and to themselves – to know the actual causes of monetary disasters and to make sure they don’t recur.
The writer’s core thesis is fourfold:
- Certain investment strategies, particularly people who provide the illusion of security, “can interact with market reality and have unhealthy consequences for markets and investors.”
- The strategies are typically complex and marketed with the looks of cutting-edge sophistication.
- They typically lack transparency.
- They have excessive (albeit possibly disguised) leverage.
The book is split into five parts. Part I provides background information for readers unfamiliar with key concepts related to risk and risk management, similar to diversification, hedging, and arbitrage. Many investment professionals can safely skip this section. Part II examines the crash of 1987. In particular, it examines the role of the newly created strategy of portfolio insurance in triggering, or no less than exacerbating, that crisis. Part III similarly examines the collapse of LTCM in 1998. Here, supposedly low-risk but devilishly complex arbitrage strategies led to disaster.
Part IV covers the credit crisis and recession of 2007-2009. This time, problems got here in the shape of complex asset-backed derivatives similar to collateralized debt obligations and residential mortgage-backed securities. Part V is a grab bag of less catastrophic market crises, similar to various flash crashes, the “London Whale” event, the European debt crisis and the Greek debt crisis, and related problems similar to uncritical reliance on models. In this section, Jacobs also proposes some solutions, which primarily include more practical regulation, more disclosure, clearinghouses and adequate education.
The appendix comprises further background material:
- An introduction to bonds, stocks and derivatives.
- Documents from Jacobs’ debates with portfolio insurance providers within the Eighties.
- A discussion of a number of the biggest derivatives disasters of the Nineteen Nineties.
- The writer’s proposal for standards of research objectivity from 2002.
Also included is a discussion of the 1929 crash. One might wonder why this has been relegated to the appendix. Is it relevant to the core argument or not?
The core thesis of ought to be taken to heart not only by investment professionals, but by all investors. Free guarantees, complexity, lack of transparency and excessive leverage have all too often combined to have a toxic effect. Financial professionals particularly may gain advantage greatly from examining the market crises analyzed on this book and the important thing lessons to be learned from them. George Santayana’s famous dictum – “Those who cannot remember the past are condemned to repeat it” – is especially true of monetary markets.
The book has some flaws. Because it is split into five parts, the core thesis is restated and discussed in each part, leading to significant repetition. In Part V, the argument is diluted when the writer introduces quite a few additional issues that may contribute to market instability, similar to conflicts of interest, high-frequency trading (HFT), moral hazard, cognitive biases, and the unintended consequences of regulation. If many things can contribute to a crisis, does that mean that every crisis is complex and unique, and never all driven by a selected set of things? One may also wonder if opacity was not a good larger problem prior to now, when there was no easy dissemination of asset prices and investors needed to take their broker’s word for prices and market developments.
On a deeper level, a reader might wonder why financial crises have been occurring for several centuries, long before portfolio insurance and other fancy tools were made possible by the digital revolution. Does Jacobs imagine that financial crises are characterised by the features of his core thesis, or simply recent ones? Has the writer perhaps missed a chance to discover a more general underlying reason behind crashes, similar to the inevitable tendency of investors to turn out to be complacent and careless during prolonged periods of prosperity? One is reminded of John Templeton’s dictum that “bull markets are born of pessimism, grow of skepticism, mature of optimism, and die of euphoria.” Could the tools and attitudes Jacobs warns about be a response to the demand that arises during optimism and euphoria? And while innovations can include pain as we adapt to them, don’t many inventions also bring great advantages?
One issue Jacobs doesn’t address is the complicity of presidency policy in some crises. For example, the subprime mortgage industry was encouraged by laws and regulations designed to extend home ownership. With regard to the worldwide financial crisis, for instance, one also can argue that procyclical monetary policy often helped to strengthen euphoric phases and deepen the inevitable corrections. Finally, government policy has created moral hazard through bailouts by the Federal Reserve, the Treasury, and spending laws.
To be fair, excessive debt could have played a task in most, if not all, crises in history, and opaque innovation could have played a task in lots of them. As the writer notes in a side note, the tulip mania also played a task in options.
Certainly, the writer’s 4 horsemen – the illusion of security, complexity, opacity and leverage wrapped in a pseudo-scientific shell – have played a vital role within the worst crises of recent many years. Every investment skilled ought to be obliged to thoroughly understand these crises and their components. This book serves as a precious guide for exactly that endeavor.
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Photo credit: ©Getty Images / Ioannis Tsotras
