September 11, 2020
My $5,000 Could Have Grown to $1 Million in Nine Years… It Didn’t
I was 22 and fresh out of university. My father had given me $5,000 left over from a college savings account. His single condition was that I invest it in the stock market.
Armed with a liberal arts education and a few months’ worth of scanning the Wall Street Journal – qualifying me as a grizzled veteran by today’s Robinhood trader standards – I was ready to earn my fortune in the stock market.
Then, like now, tech was hot… Personal-computer (“PC”) companies were the high-growth tech darlings of the market. In particular, PC maker Dell was the can’t-miss FAANG of the day.
But I was young and impatient. I didn’t have time for a boring large cap. So I skimmed a few computer magazines my roommate had left on the coffee table. There, I came across my stock: Zeos International.
It had been named by Fortune magazine in 1991 as the fastest-growing public company in the United States… and had beaten big and slow Dell by rolling out laptops using the latest chip. It even had a palmtop pocket PC on the market.
The clincher for my research process was that the computer magazines were full of Zeos advertisements. Surely, this was a near-guarantee of continued strong sales. There was no online trading back then, so I called Charles Schwab and plowed my $5,000 into Zeos.
Unfortunately, it turned out that Zeos made a lousy product. Its computers broke down frequently, and getting them fixed was next to impossible. Customers were uniformly unimpressed.
Zeos’ marketing blizzard – and gimmicky measures like 24/7 customer service – temporarily hid the fact that it wasn’t making computers that people wanted to buy. Later, my computer-savvy roommate even explained that the quality of the newsprint of Zeos ads in computer magazines was inferior to that used by Dell and other PC makers. I asked him to next time pass on this kind of critical insight before I pulled the trigger.
The share price of Zeos International slowly melted…
Two years after my enthusiastic purchase, loss-making Zeos was bought by a rival, which the next year stopped making Zeos computers altogether. I eventually sold my shares for a small fraction of my initial capital.
In the meantime, shares of Dell rose from a split-adjusted $0.25 per share in late 1991… to $50 per share by the end of the decade. If I had kept it simple with my $5,000 and bought Dell, I would have earned a compounded 80% a year to reach $1 million by 2000.
At Least I Didn’t Lose Billions…
But of course, keeping it simple is just one way to keep from making stupid mistakes…
For example, take the anonymous back-office administrator at Citibank who mistyped a few numbers last month, resulting in the repayment of a $900 million dollar bond – rather than submitting to investors only an interest payment of around 1% of that sum.
As luck would have it, the loan to cosmetics maker Revlon had been the subject of an extended dispute between Citi and the hedge-fund lenders. And now, some of them are refusing to return the overpayment.
The Revlon bond had been trading at around 30 cents on the dollar, suggesting that (bar a fat-finger accident) there was a slim chance that it was going to be repaid. So it was Christmas in August for holders when the full repayment suddenly appeared in their accounts. Now everyone is suing each other, and Citi is trying to figure out how it could do something so, well, stupid.
While the concentration of stupid employees at global banks may be similar to that of the general population, the cost of stupid is a lot higher when it’s combined with testosterone, bad judgment, and poorly supervised derivatives traders with access to multibillion-dollar balance sheets.
Fortunately, the stupidity of traders at banks isn’t a complete waste. There’s a lot we can learn from them. Below are two more of my favorites…
Jérôme Kerviel was a junior derivatives trader at Société Générale (“SocGen”) in 2007, a big international bank headquartered in Paris. Kerviel’s focus was on arbitrage opportunities. This happens when two securities that should be the same price are temporarily priced differently. The idea is to buy the cheaper security, sell short the more expensive one, and then wait for their prices to converge – whether that’s by the cheaper security rising or the more expensive security falling.
Kerviel had earned a reputation as a hotshot moneymaker on the SocGen trading floor. He later said that his bosses had turned a blind eye to the growing size of his positions and would ask him, “Hey, cash machine, how much did you earn today?” (Unfortunately, as I wrote a few months ago, SocGen isn’t the only European bank where managers have exceptionally damaging lapses of judgment.)
In early 2008, Kerviel bought futures contracts on a broad European index worth €30 billion, €18 billion of Germany’s DAX futures, and €2 billion euros of London’s FTSE futures.
His total exposure was nearly 10 times the 2006 net income of SocGen. Still, the actual risk of his positions could have been limited if Jérôme had hedged with offsetting positions… like by selling short similar securities.
But he didn’t… And he’d hacked into SocGen’s risk surveillance and management software to make the system show that he had a far smaller, low-risk, safely hedged arbitrage position – while in reality, he only had one side of a Mount Everest-plus-Kilimanjaro trade.
As it happened, Jérôme was smart, or lucky (if you’re not sure which, go with your gut), for a while in 2007 – and he had been up the equivalent of nearly $2 billion. But he was concerned that his outlandish trading success would be discovered, and he’d be fired for the astronomical risk he’d been taking on. He knew SocGen would not reward his prowess with an outsized bonus for skirting all of the safety mechanisms, management oversight, fancy software, hedges, and everything else designed to prevent precisely this sort of thing from happening.
So he ramped up his positions in early 2008 to try to intentionally reduce the profitability of his scheme. In other words, he wanted to lose money with his €50 billion position.
Most of us can lose money without even trying. And sure enough, Jérôme was even better at losing money than he was at making it… in fact, too good.
The losses on his monster positions quickly swamped his prior gains.
As the extent of the fraud became apparent to SocGen’s senior management, Kerviel was fired. But sending the boy with the matchbox away to juvie doesn’t stop the forest fire… They still had to deal with the equivalent of around $73 billion of long futures, which at that point had lost the bank – on paper – around $1.4 billion.
It looked like markets on the following Monday were going to open down – weakness that was exacerbated by concerns that SocGen was in trouble. So bank executives were faced with a question that all investors face at some point – sell a losing position, or hold on and hope that it recovers? The fate of the world’s seventh-largest bank by assets, with 130,000 employees, was in the balance.
Not surprisingly – better to suffer a large but survivable loss, than a catastrophic one (which would also likely have ended the careers of many of the bank’s foie gras-fed senior executives) – SocGen liquidated Kerviel’s positions. That drove prices of the futures even lower and compounded the bank’s losses.
When the last of the unauthorized positions was sold, Kerviel had lost SocGen US$7.2 billion. He was later sentenced to three years in prison for fraud.
Then there’s Nick Leeson, the trader who in 1995 broke Barings Bank, a 250-year-old British financial institution. He was hiding enormous positions on the Japanese stock market… just before a massive earthquake tanked stocks.
Like Kerviel, Leeson was a trading floor hotshot, and he reportedly single-handedly delivered 10% of Barings’ profits in 1992. Leeson, in his mid-20s at the time, was given a lot of space on the bank’s trading floor in Singapore to work his magic.
Too much, in fact… He not only made the trades, he also settled them – which meant that he could manipulate the trading accounts and hide his losses.
Leeson was like the top chef at a fancy Michelin-starred restaurant… But then he hit a cold streak and couldn’t tell the sugar from the salt. Lucky for him, he was also the restaurant critic for the local newspaper. So he could write himself glowing reviews to keep customers coming through the door…
But it couldn’t last indefinitely. By late 1994, Leeson was $352 million in the hole. To try to make it back, the next month, he put a big bet on futures on the Japanese stock market. But a massive earthquake in the Japanese city of Kobe crushed Japan’s stock market… and Leeson’s positions.
So Leeson, sitting on losses big enough to wipe out his employer’s balance sheet, threw a Hail Mary by doubling down. It didn’t work. Earthquakes play for keeps. And soon, Leeson fled town with his wife, leaving behind a note reading, “I’m sorry.”
Leeson had hidden his losses from his bosses and colleagues – as well as his wife, who didn’t know that he had just lost $1.2 billion and put Barings out of business.
Leeson was arrested in Germany after a brief global manhunt. He was extradited back to Singapore and was sentenced to six and a half years for forgery and fraud. (His wife left him, too.) He served four years and was released for good behavior.
As it happens, Leeson was in jail just a few miles from where I lived in Singapore. In law-and-order Singapore, prison is no fun. As Leeson told the Guardian newspaper last year…
“You’re locked up 23 hours a day; you sleep on a rough, uneven floor; everybody else is a Triad gang member. It’s 100 degrees when you get up in the morning and gets hotter during the day.” [Leeson still loathes the heat.]
There are some important lessons here that anyone who handles money can learn from…
Check the details. As the cliché goes, the devil is in the details. An extra zero or two could be a life-altering mistake. So could not bothering to review the work of your subordinate – especially if he seems too brilliant for his own good. Look at the newsprint. Check twice before you hit enter. The boring stuff is also the most important stuff.
Remember the Infinite Monkey Theorem… and the difference between skill and luck. Given enough time, a roomful of monkeys randomly hitting keys on a typewriter will produce a work of Shakespeare. But note my personal corollary to this theorem… Given enough time, some junior derivatives trader on a trading floor will produce outsized profits, and everyone will think him a genius. Don’t confuse brains with luck – in others, or in yourself.
If you’re a man, ask a woman to help you with your money. Most traders and money managers are men. But studies have shown that women are actually better investors. Men tend to trade too much and are more likely to be the “dumb money” that sells low and buys high. Women are better at sticking to an investment plan. An April 2019 review in the Financial Times of studies on the topic found that female investors significantly outperform their male counterparts.
Why? One big reason: testosterone (which can lead to overconfidence) and stupidity. In caveman times, overconfidence helped the man get the woman and slay the tiger. But the primitive instincts triggered by testosterone can be downright dangerous on the trading floor, where aggression and overconfidence aren’t helpful.
If it must be a man, older is better. After the age of 35, testosterone levels start to decline. By the time the average man reaches age 60, he has 30% less testosterone than a 30-something male. As a result, older men’s trading decisions are less influenced by testosterone.
Seeking the thrill of a risky trade is replaced by a different objective: Living to fight another day. Older investors also have a lot more experience to draw from… and might realize that, say, doubling down after an earthquake rattles a market might be a bad idea.
Don’t double down… use stop losses. Some gamblers are seduced by the strategy of doubling down – when you have a loss, double your bet to get back what you lost (it’s called the Martingale strategy). The best way to remove the temptation is to establish a stop loss level – that is, a price point on the way down at which you sell, no matter what. It would have helped Kerviel and Leeson (and me). Waiting for the rebound is a terrible strategy.
Handle derivatives with care. Used properly, they can reduce risk… In the hands of a novice, they can blow off your fingers. Channel self-help guru Dale Carnegie’s timeless advice and “awfulize” by imagining the worst thing that could happen with a position and plan accordingly. No one can anticipate (say) an earthquake, but your portfolio – and your brain – should be ready for one, just in case.
And with any luck, you’ll avoid these critical mistakes when it comes to your own portfolio.
Now here are some of the stories we’re reading…
America Doesn’t Have Enough Monkeys for COVID-19 Vaccine Research
Before drug companies call on human volunteers, monkeys are used in preclinical trials to test a vaccine’s safety and effectiveness. But with more than 100 vaccines in development around the world, there aren’t enough monkeys to go around.
The End of Minimalism
Having too much stuff might sound like a problem of affluence, but the country’s clutter tends to accumulate in the homes of working people, for whom the dangling carrot of financial stability and the lurking possibility of ruination are always present, the procuring and the keeping an attempt to attend to both.
Rebuilt after 9/11, World Trade Center threatened anew by coronavirus
As the 19th anniversary of 9/11 approaches, the grand vision set forth after its destruction has largely been realized. But the rebuilt World Trade Center complex is under threat anew – this time, from a microscopic virus.
‘I have no desire to wipe out humans,’ robot writes in ominous op-ed
In an op-ed for The Guardian – yes, robots write op-eds now – GPT-3 was told to write an essay convincing readers that the machines come in peace. No “Terminator,” just benevolent technology for a rosy future.
And let us know what you’re reading at firstname.lastname@example.org.
Chaos Chronicles Editor, American Consequences
With P.J. O’Rourke and the Editorial Staff
September 11, 2020
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