January 27, 2008
Another myth of the last decade was that using financial models in dynamic asset allocations could improve performance. The Yale and Harvard endowment funds used dynamic asset allocation to invest in private equities, hedge funds, real estate and timber. Other endowments followed their lead to “diversify” and “rebalance” their portfolio whenever dictated by their computer models. But they failed to realize that most of those assets are illiquid, and when everyone is dumping them at the same time, it is a downward spiral or worse, and there may be no way out. Computers are notoriously bad at modeling liquidity. This was a critical lesson of the program trading and dynamic hedging that caused the 1987 Black Monday market crash. As Jeremy Grantham of GMO has said, in the long run, human beings learn nothing from history, and 1987 is just two decades ago.
In a certain sense, the liquidity crisis of the last six months was inevitable. Wall Street got complacent with computer models, and nature came back to punish them (and the rest of us) for shrugging off the resistance to modeling of a key factor: liquidity. Computer models depend on the assumption of a continuous market, with a balanced equilibrium between buyers and sellers. A situation where all the liquidity is sucked out of the market destroys the value of all those exotic paper products. We do not need a bunch of highly paid math geeks to run millions of Monte-Carlo simulations to tell us that. A computer can never replace common sense.
Now we have another Fed Chairman who only knows how to print more money, then print some more, and expand the Fed’s balance sheet ever-wider. Bernanke drops the money at only one location, Wall Street. Being an economist and renowned monetarist, he must know that excessive printing will eventually lead to zero value of the fiat currency, the US dollar, just as low cost of capital eventually leads to zero ROE. If that is the inevitable outcome, the government should drop money to the middle class and the poor, not the super-rich bankers on Wall Street. Since ten times zero is still zero, what difference does it make? In addition to being a politically popular move, this might even avoid a few incidents of social unrest.
So-called “extreme” events with “low” probability happen more often than people perceive in risk management. When they occur, an unforeseen tsunami of incalculable magnitude results, destroying wealth on a scale from which it may take a generation or two for the economy to fully recover. Meanwhile, you can pretty much throw risk management out the window. It does more harm than good.
Thomas Tan, CFA, MBA
www.investorwalk.com
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