The idea of wholesale shifts is for various reasons impracticable and indeed undesirable. Most of those who attempt it sell too late and buy too late, and do both too often…. I believe now that successful investment depends upon three principles:
A careful selection of few investments having regard to their cheapness in relation to their probable actual and potential intrinsic value over a period of years ahead and in relation to alternative investments at the time.
A steadfast holding of these in fairly large units through thick and thin, perhaps for several years, until they have fulfilled their promise or it is evident that they were purchased on a mistake;
A balanced investment position, i/e, a variety of risks in spite of individual holdings being large, and if possible opposed risks.26
The intellectual flexibility for a macro economist, one with a huge ego no less, to shift from top‐down to bottom‐up is truly remarkable. He surrendered to the reality that forecasting investor's moods is nearly impossible and mostly a waste of time.
Everybody likes to think they're long‐term investors, but we don't pay enough attention to the fact that life is lived in the short term. In A Tract on Monetary Reform, Keynes wrote, “This long run is a misleading guide to current affairs. In the long run we are all dead.”27 Long‐term returns are all that matters to investors, but our portfolios are marked to market every day, so when short‐term turbulence arrives, long‐term thinking flies out the window. Keynes referred to our tendency to get swept up by short‐term thinking as animal spirits, which he described as “a spontaneous urge to action rather than inaction, and not as the outcome of a weighted average of quantitative benefits multiplied by quantitative probabilities.”28 Keynes is one of the rare investors that was not only aware of his cognitive biases but was able to effectively combat them.
From 1928 to 1931, King's College's assets fell nearly 50%, compared to just a 30% decline for the UK stock market. But from 1932 to 1945, Keynes grew the fund by 869%. The UK market for comparison had grown by just 23% over the same time!29 The change from short‐term speculation to long‐term investing made all the difference. The portfolio turnover averaged 56% during the first half of this period and fell to only 14% in the second half.30
Before Thaler's Nudge, Shiller's Irrational Exuberance, and Kahneman and Tversky's Prospect Theory, there were Keynes's animal spirits. He realized that he could have all the information in the world, but without the ability to control his own behavior, and predict the behavior of others, it was less than meaningless.
Keynes was able to deliver remarkable investment results in a period that encompassed the crash of 1929 and the subsequent Great Depression, as well as World War II. He was able to achieve these results because he stopped trying to play the impossible game of outthinking everybody else in the near term. Figuring out what the average opinion expects the average opinion to be was beyond even one of the most brilliant men to ever lace 'em up. The lesson for us mortals is obvious: Do not play this game! Think long term and focus on asset allocation.
Successful investors construct portfolios that allow them to capture enough of the upside in a bull market without feeling as if they're getting left behind, and a portfolio that allows them to survive a bear market when everyone around them is losing their mind. This is no small feat, simple as this sounds; this is a very difficult exercise.
The most disciplined investors are intimately aware of how they'll behave in different market environments, so they hold a portfolio that is suited to their personality. They don't kill themselves trying to build a perfect portfolio because they know that it doesn't exist. Rather, they embrace what Keynes is incorrectly attributed to have said: “It is better to be roughly right than precisely wrong.”
Notes
1. Kathryn Vasel, “It Costs $233,610 to Raise a Child,” CNN Money, January 9, 2017.
2. Jessica Dickler, “The Rising Cost of Raising a Child,” CNN Money, September 21, 2011.
3. Trader, Public Broadcasting Service (PBS), 1987.
4. Odds Shark, odds calculator.
5. Steven Crist, “Steven Crist on Value,” ValueWalk, September 10, 2016.
6. John Maynard Keynes, General Theory of Employment, Interest, and Money (New York: Harvest/Harcourt, 1964), Chapter 12. (Originally published in 1935.)
7. John C. Bogle, “Keynes the Investor,” foreword to Way to Wealth by John F. Wasik (New York: McGraw‐Hill Education, 2013), x.
8. Quoted in John Wasik, “Warren Buffett's Secret Sauce,” Forbes, February 26, 2014.
9. George Soros, The Alchemy of Finance (Hoboken, NJ: Wiley, 2003), 372. (Originally published in 1987.)
10. Peter L. Bernstein, Against the Gods (New York: Wiley, 1996), 217.
11. Louis M. Hacker, “John Maynard Keynes: He Casts a Long Shadow, but Was He Right?,” New York Times, June 28, 1959.
12. John K. Galbraith, “‘Came the Revolution,’ Review of Keynes' General Theory,” New York Times Book Review, May 16, 1965.
13. “John Maynard Keynes – Timeline,” MaynardKeynes.org, December 2017.
14. John Maynard Keynes, The Economic Consequences of the Peace (New York: HarperCollins, 1971). (Originally published in 1919.)
15. Liaquat Ahamed, Lords of Finance (New York: Penguin, 2009), 165.
16. John F. Wasik, Way to Wealth (New York: McGraw‐Hill Education, 2013), 19.
17. Ahamed, Lords of Finance, 165.
18. Nitin Mehta, “Keynes the Investor: Lessons to Be Learned,” 2017 CFA Institute European Investment Conference, Berlin, Germany, November 16–17, 2017.
19. MaynardKeynes.org, “Keynes the Investor,” December 2017.
20. Quoted in Polly Hill. Lydia and Maynard (New York: Scribner, 1990), 17.
21. Wasik, Way to Wealth, 48.
22. Letter to the chairman of the Provincial insurance company, 1942.
23. Keynes, General Theory of Employment, Interest, and Money, Chapter 12.
24. Wasik, Way to Wealth, 109.
25. Ibid.
26. John Maynard Keynes, “Memorandum for the Estates Committee, Kings College,” Cambridge, UK, 1938.
27. John Maynard Keynes, A Tract on Monetary Reform (New York: Macmillan, 1924).
28. Keynes, General Theory of Employment, Interest, and Money, Chapter 12.
29. Author's calculations using data from MaynardKeynes.org, “Keynes the Investor.”
30. Mehta, “Keynes the Investor.”
CHAPTER 13
John Paulson
You Only Need to Win Once
Quit while you're ahead. All the best gamblers do.
—Baltasar Gracian
Ask somebody what they would wish for if a genie appeared before them and having a lot of money would be a top answer. But “be careful what you wish for” is a cliché for a very good reason.
William “Bud” Post III won $16.2 million in the Pennsylvania lottery in 1988 and upon his death in 2006, he was living off Social Security payments of about $450 per month.1 Evelyn Adams also won the lottery. Twice. Despite winning a total of $5.4 million, 20 years later she was broke and living in a trailer.2 These stories are not just anecdotal. They are far more common than you would think; nearly one‐third of all lottery winners lose it all.3 Winning the lottery is 100% luck. Successful investing on the other hand is a combination of good fortune and superior skill.
The stock market is the biggest casino in the world, and there is no shortage of ways to cash in. With options, levered ETFs, and futures contracts, there are thousands of different tables for investors to sit at. And the best thing about getting lucky in the market, aside from the obvious, is that your brokerage account doesn't put you on trial. “Did the stock double for reasons you thought it would? What was the basis of your decision!?!” Money earned by luck is indistinguishable from money earned by skill.
Investing is a fierce game of brains and desire. The people you're competing with have endless resources and unlimited access to information, so it
's far more likely for you to get lucky than it is to consistently run faster than the competition.
While it's nice to make money by chance, the downside of getting lucky in the market is that we tend to attribute the success more to skill than we do to randomness. We then transfer this confidence into our next investment. If one‐third of all lottery winners go bust, then three‐thirds of lucky investors revert to the mean. On this very issue, Michael Mauboussin said: “The main issue is that putting yourself in a position to enjoy good luck also puts you in a position to lose.”4 Once you've achieved a great deal of success, failure is usually not far behind. When investors catch a lucky break, it's rare that people walk to the cashier, hand in their chips, and ride off into the sunset. It's natural for us to feel like we're playing with “house money.” And wanting to experience the feel of the rush again, we keep pushing as we hope that lightning will strike twice. Investors can learn a great lesson from John Paulson, who struck lightning like nobody else before or since.
John Paulson started his hedge fund, Paulson & Co., with $2 million of his own money in 1994. He previously spent time at the investment bank Bear Stearns, where he specialized in merger arbitrage. This strategy involves simultaneously buying and selling short the stocks of two merging companies. The trade is executed based on the likelihood that the deal will close. But merger arbitrage is a relatively boring slice of the hedge fund world, and this strategy is not what put John Paulson on the map. Rather it was his massive wager, a full‐on assault against the United States housing bubble. After the implosion of the housing market, his assets ballooned up to $36 billion and gave him control of the second largest hedge fund in the world. But not content with one massive trade, he kept searching for the next big score. It's been 10 years since he became the highest earning hedge fund manager ever, and since that time, he's lost nearly 75% of his assets. Today, he manages less than $10 billion, with 80% of it belonging to him and his staff.5
In the mid‐2000s, while the rest of the country was taking out second mortgages and flipping houses, John Paulson took a less optimistic view. With the help of his star analyst Paolo Pellegrini, it became more and more likely that a bubble was inflating in the US real estate market.
If you wanted a mortgage in 2005, all you had to do was ask for one. In one instance, a mariachi singer claimed to have a six‐figure income and, despite having little knowledge of what such a singer earned, the lender agreed to the loan. In lieu of official proof of income, it included a photo of him in his performance outfit.6 Alberto and Rosa Ramirez, strawberry pickers earning $300 a week, pooled their resources with another couple, mushroom farmers who earned $500 a week. Together, with a combined salary of $3,200 a month, they got a mortgage for $3,000 a month. Strawberry pickers who earned $15,000 a year “qualified” for a $720,000 mortgage. This was the bubble in a nutshell.7
By 2005, $625 billion of mortgages were taken out by subprime borrowers, a fifth of all home mortgages that year, and 24% of all mortgages were originated without the borrower putting any money down.8 Paolo Pellegrini, who was integral to the idea that there was a bubble in residential real estate, told Paulson that home prices were about to plummet. Until 2000, housing prices hadn't kept up with inflation for 25 years, averaging a 1.4% increase per year. Then, during what turned out to be the housing bubble, started inflating prices at a rate of five times their annual average. By 2005, prices had soared, and Pellegrini was convinced it was only a matter of time before they took a serious nosedive to get them back in line with their 25‐year trend. With this information, Paulson was ready to go to work.9
The problem was that you can't short a house, so they had to figure out a different way to bet against the market. They learned about credit default swaps, insurance contracts that allow you to bet against the debt of companies. His first foray into shorting the housing market was purchasing credit default swaps on MBIA Inc., which insured mortgage bonds. For $500,000 a year, Paulson could purchase $100 million worth of insurance against the debt of MBIA Inc.10 In 2005, he bought more credit default swaps, this time on two big lenders, Countrywide Financial and Washington Financial.
But if he thought that one of the biggest scores of all time would be easy, he quickly realized how long it could take for these things to play out. Home prices stopped rising in September 2005,11 but his credit default swaps kept losing money.
If you're going to win the equivalent of the lottery, with returns of 1,000% or more, you have to bet against consensus. And I don't mean that one or two of your friends disagree with you. I mean everybody disagrees with you to the point that they think you're insane. Imagine, for example, that you think Apple is worth zero. That the entire operation is a fraud, and that the $240 billion worth of cash they say they have doesn't exist. And your belief in this is so strong that you plow your entire life savings into put options that bet against the most successful company of all time. This is what Paulson was doing in the housing market a decade ago. One hedge fund investor said, “Paulson was a merger‐arb guy and suddenly he has strong views on housing and subprime. The largest mortgage guys including Vranos at Ellington, one of the gods of the market, were far more positive on subprime.”12 But Paulson didn't care about all that. He just kept buying credit default swaps like there was no tomorrow. Other traders thought Paulson was crazy and that this could be the folly that shuts him down. Interested in hearing from housing experts, Paulson brought in an analyst from Bear Stearns who assured them that they used sound models to predict mortgage solvency and housing prices. They had been carefully studying the market for two decades, and they were untroubled by Pellegrini's assessment of the housing bubble.
Paulson was confident that his team's analysis was correct, but how did he know he was right? How could anyone possibly know that? Everybody he spoke with outside of his team told him he was crazy. That is the emotional price that most people who say they're contrarians aren't willing to pay. People don't like to have their judgment questioned, but you can't achieve Brobdingnagian returns without people thinking you have a few screws loose.
Finally, in February 2007, Paulson received an inkling of confirmation that he was on the right side of the trade. New Century Financial, the nation's second biggest subprime lender, saw its stock free fall by 36% after announcing that it would restate its earnings for the first three quarters of 2006. As the ABX index, which measures the value of mortgages made to subprime borrowers, plummeted from 100 to 60, Paulson quickly found himself sitting on $1.25 billion of gains.
It's one thing to be right on a thesis, but to profit off of it in real time is incredibly difficult, especially if you're managing other people's money. Paulson's investors weren't happy watching him bleed, month after month and quarter after quarter. These insurance payments were going out the window with nothing to show for it in return. And then when they started to see signs that he was right and the insurance started to pay off, they pleaded with him to take profits.13
Investors are told to “let their winners run,” but can you imagine sitting on $1 billion in profits and not selling? Could you sleep at night? What if this was just a hiccup and the index snapped back? Would giving up $1 billion of gains leave a permanent scar?
The ABX index rebounded to 77, and Paulson's gains were cut in half. But this proved to be nothing more than a dead‐cat bounce, and the defaults from subprime borrowers picked up momentum. In 2007, when the subprime market imploded, Paulson's two credit funds gained 590% and 350%. Paulson & Co. earned $15 billion, and his personal rake was $4 billion. Nobody had ever made more in a single year in the history of financial markets.14
There are a few problems, problems that all of us hope for, when you win big in the market. After a huge score, ordinary gains no longer move the emotional needle. Paulson, like most people who experience gigantic success, quickly went searching for his next big trade. “It's like Wimbledon. When you win one year, you don't quit; you want to win again.”15 The other issue is that it's virtually i
mpossible to have fantastic success and keep your ego in check. We're all overconfident to begin with, and huge gains make our feet levitate off the ground.
In the aftermath of the financial crisis and the Federal Reserve's quantitative easing program, Paulson turned to a new asset. He firmly believed the future would bring inflation, so he looked for something that would not be negatively impacted – in fact, he wanted to buy something that could become even more valuable in an inflationary environment. The answer was gold. So in the summer 2010, Paulson plowed $5 billion into gold‐related investments, becoming the largest owner of gold in the world.
Paulson hasn't been able to repeat the success he experienced during the great financial crisis. Gold has lost 30% since its high in 2011, and Paulson & Co.'s Advantage Fund, its most high‐profile offering, lost more than one‐third of its value that year. The following year, the fund slipped another 14%, and it still hasn't recovered. After a 26% boost in 2013, Advantage has suffered losses three years in a row. In 2016, many of Paulson's other funds also declined. An Advantage sister fund that relies on leverage to generate steeper returns also suffered losses totaling 49% of its value. A fund specializing in mergers and arbitrage, considered Paulson's area of expertise, lost 25% of its value in 2016 alone.16
In 2010, Paulson was the highest‐paid hedge fund manager, earning $4.9 billion.17 That's $13.4 million a day, $559,000 an hour, $9,000 a minute, $155 a second – at least before taxes. Not that $4.9 billion needs any further context, but in 2010, the most valuable sports franchise in the world was Manchester United, coming in at $1.83 billion.18
At least 40 US stocks (in the Russell 3000) have doubled in each of the past five years, so there are plenty of opportunities to earn large returns. It's in our nature to look for shortcuts. Everyone wants to find the next Microsoft. But there a plethora of problems come with swinging for the fences. First of all and most obviously, they are incredibly difficult to come by. The 50 largest hedge funds do 50% of all NYSE listed stock trading, and the smallest one spends $100 million annually buying information.19 Imagine that you were physically exchanging stock certificates with Jim Simons of Renaissance Technologies every time you went to buy or sell a stock. This is who you're playing against. The idea that you will stumble upon riches by dumb luck alone is possible, but a little naive. The second problem, and this is a problem we all wish for, is that once you've experienced outsized success in the stock market, you crave a similar rush. Earning 4% tax free in municipal bonds doesn't quite have the same feeling as earning a multithousand return.
Big Mistakes Page 13
