The Smartest Guys in the Room

This article is dedicated to those who have had serious market and financial losses

Why would we listen to the same people who got us into this mess on how to get us out of it?    

Our natural tendency is to listen to successful people on any financial subject. They must know something that we don’t or they wouldn’t be rich. And, we feel, Rich=Smart.

Should we listen to them?

I’ve given this question a lot of thought in the past year. I’ve always been a bit of an ideologue–well not just a “bit.” I believe ideas mean something in that you’ve got to have some basis or theory through which the world makes sense to you.

To determine what’s right or wrong most of us fall back on our own judgment in areas we understand. Or think we understand. When we don’t really understand something, we listen to those whom we think do understand. In the financial world we listen to Buffet,and Paulson, and Kramer, and the like, and generally, any one we know who’s made a ton of money.

But, if they are so smart how come they have been so wrong? And I mean, really wrong. So wrong that we are in the most serious financial crisis since the Great Depression.

I don’t mean to demean the above-named gentlemen because they have been very, very successful and deserve accolades for that. But, even Berkshire is down 31%.

I think we should pause and think about how we got in this mess. More specifically: how we let ourselves be convinced that our financial leaders, public and private, were right when we now clearly see that they were very wrong.

Maybe they were just lucky

I‘ve been working on a list of all the hedge funds and investment banks who have gone broke, are about to go broke, have lost a ton of money for their clients, or the investment stars who have been fired for some of the foregoing acts. It’s a very long list. (See The Problems, below.) And I just started looking. What you see are some of the headlines I’ve pulled out of Dow Jones Financial News Online’s daily e-mail from just the last 6 weeks or so.

Let us take for granted that these are all very bright men, they have vast knowledge of the financial markets, have operated honestly and in good faith, and at some point made a lot of money for their investors and clients.

Now we find that they’ve jumped off the bridge attached to a rope that’s tied around our necks.

Why do we listen to them? Are they right about economics when they are successful and wrong when they are not?

Could it be that they were just lucky–in an up market?

I’ve decided that there are only good ideas, bad ideas, and luck. And really, it’s mostly luck.

Nasim Taleb in his books Black Swan and Fooled by Randomness has addressed this issue brilliantly. He tackles the question of “how do we know what we know” through social science discoveries that relate to this question. It is a branch of science and philosophy called epistemology. He shows that there are behavioral and statistical reasons why we all make the same mistakes. That is, the nature of the human mind and personality makes us prone to make the same mistakes over and over.

His basic premise is that financial experts underestimate risk. As such they are caught by surprise when some significant unforeseen event occurs. Such events can be good or bad, but it is the bad ones that can kill you. The surprise is that these kinds of events, he refers to them as Black Swans, occur unpredictably but regularly.

The bad Black Swans have been killing the experts for years. Yet they refuse to recognize their errors. I urge you to read Taleb’s books. They are profound, challenging, and eye-opening.

Taleb’s conclusion is that the success of most traders in hedge funds and investment banks are mostly the result of luck. Their investment philosophy just happened to coincide with the market at a given time.

He points out that if you take the investment results of the universe of investment advisers and plot them on a graph they look like a random sampling of data. Which means, based on statistics, that the investment results achieved would have occurred randomly in the investment world: a very few investors will be very successful, some will bust, and most fit in somewhere around the middle (returns somewhere around the S&P 500).

There are a few investors who have been successful over the years, but not many. But, he claims, it’s very difficult to tell under the tools of statistical analysis if it’s luck or skill. I personally would like to think it’s skill.

Why listen to guys who were just lucky?

If Taleb is correct, we should be suspicious of lucky people who offer financial advice. And, be especially suspicious of their economic advice.

I like to follow the quarterly list of economists’ predictions in the Wall Street Journal. At the end of each quarter they compare their predictions. You seldom see any economist get it right more than once. They are guessing. An educated guess to be sure, but still they are guessing and they all tend to guess in the same way.

Then there are the hedge and investment fund managers. Most managers stick to one of several known strategies, generally the ones they see other people doing. Rarely do they stick their necks out and do something different. There’s comfort in being wrong if everyone is wrong. But occasionally they get it right and pull out enough money to last forever and I congratulate them for that. But does that meant they are qualified to give economic or financial advice if they’re just lucky?

It’s my opinion that most of these people are blinded by their own success. Especially those that have pulled large amounts of personal wealth out of the system. There is a tendency of these people to universalize their own experience. That is, they believe the lessons they learned should be applied to the world as a whole and we would all be much better off. Or, if they happen to have an economic philosophy, they will attribute that to their success, and therefore, their brand of economic philosophy should be applied universally.

Maybe they confuse their good luck with success. Maybe their philosophy had nothing to do with their success.

These people are now pushing a lot of advice on our government leaders, but … Why should we listen to them? Many of these experts are the ones who lead us off the deep end.

Who got it right and why?

Why don’t we listen to those who got it right? And I’m not talking about those who called the market right and made a killing (John Paulson, George Soros, or James Simons). Why should we believe they weren’t just lucky or that they know anything about economics? Soros is one of the best at making money since he’s hit it big twice now, but his economic and political philosophy are dead wrong.

Who in the world warned us about the bubble and predicted serious consequences?

In my opinion, it was and is the free market economists. These are either Monetarists (Milton Friedman) or Austrians ((Ludwig von Mises and Friedrich von Hayek).

The Austrian School of economics (it’s founders and followers were mostly Austrian) are the guys who discovered the cause of business cycles and how to treat them. They analyzed recessions and depressions and determined how and why they were caused.

Ah, “obscure economists,” you might say. Well, leading Austrian economist Friedrich von Hayek did receive a Nobel in economics, but yes, the tide of Keynesianism swept many opponents into the minority after WWII.

But, the free market guys have been right. Correct in predicting bubbles, correct in predicting the busts, correct in predicting the effects of socialism or Keynesian policy, and correct in extolling the benefits of capitalism. Please go to The Ludwig von Mises Institute for further information.

Why don’t we listen to them?

I am amazed at the many commentators and economists who believe in the blessings of government interventionism when the results are often the opposite of what they intended. These prominent people who are now in power are advocating many of the same things today that were tried and failed during the Depression. In fact these programs they advocate actually helped cause the Depression. These thinkers are unaware of the negative consequences of their policies.

Forget economic theory for a moment and just look at the facts. Boom and bust is caused by central banks, or going back in history, the sovereign. In some way, throughout history, the people in charge of the monetary system, by flooding the economy with cheap money, create a boom. Rarely does it end well. This cycle was no different.

I recommend Amity Schlaes new book, The Forgotten Man, a new history of the Great Depression, or Murray Rothbard’s The Great Depression, perhaps one of the best economic histories ever written. If you don’t agree that the circumstances are very similar to today, then only time will tell if you’re right. Do you want to take that chance?

Here are some things we all should be thinking about

We are at a crossroad right now, not unlike the one that Hoover and FDR faced during the early 1930s. I believe that the actions taken by our leaders now have momentous consequences for us all. If they get it wrong, we could face another Great Depression or at least years of stagnation and inflation.

I can tell you, our leaders aren’t listening to the free market economists, leastwise the Austrians.

Here are some questions you should ask yourself:

  1. Do Mr. Bernanke and the Fed know what they’re doing? Bernanke’s a very smart guy (1590 on the SAT; Harvard; Ph.D at MIT). He was a student of the Great Depression. He lauded Milton Friedman on the latter’s 90th birthday by saying, don’t worry, “we won’t do it [Great Depression] again.” Like Friedman, he doesn’t seem to get the true relationship between inflation to interest rates: it’s more than just pumping the economy with money.He’s an econometrician, like Greenspan. He thinks he can tinker with the money supply and make all the bad things go away. Greenspan inflated our way out of the Long Term Capital Management collapse, the Asian currency collapse, and the collapse. Which led us to the current problem. It’s funny that we had so many bubble cycles with Greenspan. Why do we think Bernanke will be right this time?

  2. Do Mr. Hank Paulson and the people at Treasury know what they are doing?On Wednesday, November 12, 2008 they all but admitted they didn’t know what they were doing and dropped their plan to buy bad bank assets and instead invest capital into banks. This didn’t give anyone any confidence and the stock market plummeted.It is simply beyond the Treasury’s or the Fed’s ability to “solve” the problem. The problems are in the trillions of dollars and I believe Paulson and his people are just beginning to figure this out. Now securitized auto and credit card loans are in trouble. Commercial property values are dropping. Credit default swaps, potentially a $46 trillion problem, loom out there.True the recession will be nasty, but the sooner they let the market reallocate resources from the incompetent to the competent, the quicker we’ll recover. This is the opposite of what they are doing. Are they paving the way for something worse?

  3. Do Mr. Obama and his economic advisers know what they are doing?I hope so. His advisors are NY Fed president Timothy Geithner (not an economist), former Clinton advisors Larry Summers, Robert Rubin, and Robert Reich (not an economist), former Fed chairman Paul Volker, and U of Chicago Business School professor Austin Goolsbee.They are all remaining quiet until Obama is sworn in. Most of them are all Harvard or MIT trained economists. I would guess that these advisors will offer no different solutions than what we are seeing now, with the exception that we would see more fiscal stimulus. Ask yourself: would taking money (taxation) out of your pocket (i.e., the economy) and letting the government decide where it should be spent make sense in an economy starved for credit? Would bridge repair employ the hundreds of thousands of unemployed mortgage and real estate brokers, bankers, and financial workers?

  4. Do the financial leaders who got us into this mess know what they are doing?The ones that caused the problem seem to be the ones asking for government cash to bail them out. I would say that their self-interest cancels out their objectivity.

Back to Text

CalPERS 35% loss;
Quadrangle closes;
Blackstone’s GSO Capital Partners and GoldenTree Asset Management, two of the largest hedge funds investing in debt, have sought more capital from investors;
Citigroup Ousts Chairman Bischoff, big layoffs;
Morgan Stanley slashes 10% jobs;
Barclays needs to raise capital;
Julius Baer takes 10% hit;
Goldman struggles to stay intact, 5 ½ year low;
ING Group posts big quarterly loss;
GLG takes $167MM loss, suspends withdrawals;
Sweden takes over Carnegie investment bank;
KKR Financial Holdings gets new credit line, suspends dividend;
Permeira helps investors meet funding commitments;
American Capital has $548MM loss in 3rd Q;
Santander Bank raises $9.2BB at heavy discount;
Man Groups has 80% drop in 1st Half Profit;
Fidelity lays off 3% of workforce;
Henderson posts 3% decline in assets;
Farallon Capital declines 24%;
Wells Fargo raises $11BB, gets $25BB from Treasury;
Belgian bank KBC gets $4.5BB injection from government;
Blackstone has steep 3rd Q loss;
SVG lowers fees to attract capital;
Allco Finance, Australian asset manager, collapsed;
Carlyle Group warns of poor returns;
GS’s flagship hedge funds loses $989MM;
Blue Mountain Capital Management halts redemptions;
RBS raises $25BB as a result of large losses in credit markets;
Ramius Capital closes Hong Kong fund;
Société Générale has 84% drop in 3rd Q;
Reserve Primary Fund, which broke the buck in its money market fund, returns capital to investors;
Citadel Investment Group closes its $1BB fund of funds;
Evercore has sharp losses in 3rd Q;
Soros says hedge funds will shrink to one-third;
Hedge funds lose billions in VW deal;
Schroders loses clients amid losses;
Pickens’ energy fund faces massive redemptions after huge loss;
Colonial First State, Australia’s largest fund manager halts redemptions;
Numura registers $1BB loss;
Eddie Lampert (Sears Holdings) losses $5BB in funds;
US Pension Funds suffer huge losses;
Aegon, Dutch insurer, seeks $25BB in government bailout funds;
Franklin Resources posts 30% profit decline;
Centaurus Capital tries to retain investors through redemption offer;
Gottex Fund Management, Swiss fund of fund manager, has 13% decline in assets;
Fortress Investment suffers redemptions due to 3rd Q losses 

13 comments to The Smartest Guys in the Room

  • Love the stats! Why is it then that the bottom 50% are the most vocal on taxation….

  • [...] is a bit of an “I told you so” comment. My complaint has been that we shouldn’t let the people who were in charge of getting us into [...]

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  • [...] via RSSMust Read PostsThe Smartest Guys in the RoomThe Law of Unintended ConsequencesThe Japanese DiseaseWhat's Wrong With Mark-to-Market?Why the 'Do [...]

  • [...] by financial institutions, especially their analysis of the causes of business cycles (see “The Smartest Guys in the Room). It appears, like many of their counterparts, Morgan Stanley never saw it coming. Many [...]


    smart yet lost it all, had they read, they would indeed be smart and make $$ too…

  • Mike Spooner

    “Let us take for granted that these … have operated honestly and in good faith.”

    Why take it *for granted*??

  • Greg


    I’m taking your advice form a while ago and doing your suggested readings here. This way I can comment from a position of knowing YOUR position. I read the two on What is Money and will have comments on that at another time. I’d like to focus on this post now however.

    I too am a big fan of Talebs books. We share that. We are often totally unaware of our own inconsistencies and biases and how they affect our thinking, we must be on our toes. We are fools if we think we can predict very much.

    You credit the monetarists and the Austrians as those who predicted the bubble and warned us. You seem to think they were the only ones. Well look at the Chartalsts and the things theyve been saying since the 1990s when we had a govt surplus. You have a great big blind spot buddy, dont let your ideology get in the way of factual historical reporting. And btw its the monetarists Chicago school types that have been running this economy since the 1980s, ignoring the levels of private debt that Greenspan said were self regulating. Placing fiscal policy in a subjugated position and completely using monetary policy via Central Banks to regulate things has been the modern methodology, supply side thinking has replaced an emphasis on effective demand measures. You mistakenly call our modern paradigm Keynesian and show your lack of understanding of economic history.

    You have an interesting site, but you need to get out of your ideological box a little and explore things honestly. There is nothing Keynesian about using CB monetary policy, this is pure Friedmanite thinking. Yes the effort is to stimulate, which I understand that Austrians abhor, but it is a MONETARIST not Keynesian model we are operating under. Friedman did replace Keynes in the 80s and look, we had a second great depression about 25 yrs later.

    • Greg:

      Thank you for your comment.

      I think I understand history and economic theory pretty well. I don’t think I’ve been ignoring the Monetarists at all. But most Fed policy is a modern mishmash. It includes classical liberal theory, neo-Keynesianism, and Monetarism. I believe most of these economists would classify themselves as neo-Classical. I would agree that much of monetary policy is Monetarist, but it is also based on some Keynesian fundamentals. If they were truly Monetarists, they would have followed Friedman’s prescription of keeping monetary expansion steady at about 4% per year.

      We are not going to agree on Chartalism and I don’t wish to argue about it. I know you are trying to justify the theory and propound it on this blog, and others, but I don’t wish to debate it. Thank you for reading some of the material I suggested.

  • Greg

    You do undersatnd it “pretty well” but you ignore much which you find repugnant which is Chartalists not monetarists. We dont have to agree on Chartalism but Chartalists have a better record than most anyone the last 40+ yrs. They actually predicted the problems with the Euro when it was introduced over 20 yrs ago. I think its since we have been without a gold standard and have a floating exchange rate, and they actually interpret that model better. Its THEIR model.

    I never said anyone was true monetarists but monetarist ideology has been the dominant one, thats not even disputable. Even monetarists argue for govt intervention, Friedman wanted the money supply increased during the GD which can only happen with govt intervention. I dont expect to sway you but you are forcing ignorance on yourself to not understand what the MMT arguments are. They are starting to be listened to.

    btw Friedman also argued for a guaranteed or basic income. He argued for it in the form of a negative income tax I believe

    I will always read something and explore ideas, there is no other way to learn. You do write well so that makes it interesting