Men in general judge more by the sense of sight than by the sense of touch, because everyone can see but only a few can test by feeling. Everyone sees what you seem to be, but few know what you really are; and those few do not dare take a stand against the general opinion. Niccolo Machiavelli, The Prince
“You are proof that some people are born to be customers,” a seasoned trader said to a trainee in response to a failed attempt to impress him. This mocking outburst captures the spirit of Wall Street in the 1980s, which Michael Lewis describes wonderfully in his first book, Liar’s Poker. The book intertwines the story of Lewis’s own experience at Salomon Brothers in the late 1980s with the story of the creation of Salomon’s mortgage bond department, which would become their marvelous money machine. While the book is an entertaining read, Lewis also makes several shrewd observations on human nature.
The illusion of desirability
Before he could begin working for Salomon Brothers, Lewis had to go through a lengthy training program. This involved a large group of recruits taking classes and watching traders on the trading floor. After graduating, you couldn’t simply pick a department to work in, you had to be picked by a managing director. The demand for positions wasn’t equal: some were sought after, others avoided at all cost. To get hired by the department you wanted, a trainee had to make themselves visible and make friends. Most important, they had to create “the illusion of desirability”:
A managing director grew interested only if he believed you were widely desired. Then there was a lot in you for him. A managing director won points when he spirited away a popular trainee from other managing directors. The approach of many a trainee, therefore, was to create the illusion of desirability. Then bosses wanted him not for any sound reason, but simply because other bosses wanted him. The end result was a sort of chain-letter scheme of personal popularity, that had its parallels in the markets. To build it required a great deal of self-confidence, and faith in the gullibility of others; this was my chosen solution to the job problem. A few weeks into the training programme I made a friend on the trading floor, though not in the area in which I wanted to work. That friend pressed for me to join his department. I let other trainees know I was pursued. They told their friends on the trading floor, who in turn became curious. Eventually, the man I wanted to work for overheard others talking about me and asked me to breakfast.
This is an example of what’s known as the Matthew effect, the principle of the rich getting richer and the poor getting poorer, or, in the words of Matthew (25:29): “For unto every one that hath shall be given, and he shall have abundance: but from him that hath not shall be taken away even that which he hath.” The effect can be seen everywhere, from academia to business. It works this way because the person distributing a resource of some kind will tend to give it to those who have already shown some promise, rather than to those who may need it most—e.g. it’s much easier to get a book deal with a large publisher if you are a bestselling author than if you are making your debut. The presence of past success is seen as an indicator of future success.
But, as Lewis discovered, the very things that fuel the effect can be used to take advantage of it. In Lewis’s case, the task was to create the illusion of desirability by getting a single recruiter interested in you and making this fact known. In another situation, for example that of a new author, you could create a number of “credibility indicators,” a strategy Tim Ferriss touches on in The 4-Hour Workweek (I’ve previously covered the Matthew Effect in more detail here). The point is this: when it comes to resource distribution, the appearance of previous success can be just as important, if not more important, than actual success (or lack thereof).
Second order consequences
Robert Dall had a problem. He wanted to borrow money, but the market kept raising its rates:
… one day earlier in his career Dall was in the market to buy (borrow) 50 million dollars. He checked around and found the money market was at 4 per cent–4.25 per cent, which meant he could buy (borrow) at 4.25 per cent, or sell (lend) at 4 per cent. When he actually tried to buy 50 million dollars at 4.25 per cent, however, the market moved to 4.25 per cent–4.5 per cent. The sellers were scared off by a large buyer. Dall bid 4.5. The market moved again, to 4.5 per cent–4.75 per cent. He raised his bid several more times with the same result, then went to Bill Simon’s office to tell him he couldn’t buy money. All the sellers were running like chickens.
“Then you be the seller,” said Simon.
So Dall became the seller, although he actually needed to buy. He sold 50 million dollars at 5.5 per cent. He sold another 50 million dollars at 5.5 per cent. Then, as Simon had guessed, the market collapsed. Everyone wanted to sell. There were no buyers. “Buy them back now,” said Simon, when the market reached 4 per cent. So Dall not only got his 50 million dollars at 4 per cent, but took a profit on the money he had sold at higher rates. That was how a Salomon bond trader thought: he forgot whatever it was that he wanted to do for a minute and put his finger on the pulse of the market. If the market felt fidgety, if people were scared or desperate, he herded them like sheep into a corner, then made them pay for their uncertainty.
The efficient-market hypothesis assumes that asset prices in a market accurately reflect all available information. There may be some truth to this over the long term. Traders, however, are people (at least until they’re replaced by machines), and their actions are influenced by greed and fear as much as they are by reason. Benjamin Graham, the man who taught Warren Buffett, famously described the market as a person called Mr. Market. Mr. Market, Graham wrote, is moody and irrational, exhibiting manic-depressive characteristics. One day he’s in a good mood and values a stock very highly. The following day he’s pessimistic and wants to get rid of the very same stock. Greed pushes Mr. Market to overvalue a stock. Fear makes him want to sell it. In moments of panic, the price rises or sinks beyond its rational valuation.
Traders know this and use it to their advantage by pushing a market in a certain direction if they sense that it is on the edge. On a higher level, the lesson here is that people’s actions aren’t necessarily reactions. What seems reactive may in fact be proactive, that is, aimed not at the achievement of its direct goal, but at provoking a certain reaction, which the actor hopes to use to their advantage. Thus, sometimes it’s not the action itself that matters, but its second order consequences, e.g. how the market reacts to a high volume trade.
People need excuses
A successful trader, whom Lewis calls Alexander, taught the author his strategy for making successful trades. Sometimes you must do the opposite of everyone else:
Many of the trades that Alexander suggested followed one of two patterns. First, when all investors were doing the same thing, he would actively seek to do the opposite. The word stockbrokers use for this approach is contrarian. Everyone wants to be one, but no one is, for the sad reason that most investors are scared of looking foolish. Investors do not fear losing money as much as they fear solitude, by which I mean taking risks that others avoid. When they are caught losing money alone, they have no excuse for their mistake; and most investors, like most people, need excuses. They are, strangely enough, happy to stand on the edge of a precipice as long as they are joined by a few thousand others. But when a market is widely regarded to be in a bad way, even if the problems are illusory, many investors get out.
Lewis illustrates this principle with the crisis at the US Farm Credit Corporation. At one point, there were signs that Farm Credit might go bankrupt. Investors began dumping their bonds. Farm Credit was an 80-billion-dollar institution, involved in lending money to distressed farmers. The actual possibility that the US Government would let such a large and important institution collapse was very slim. Investors knew this, and yet they sold their bonds. As Lewis writes, they “weren’t necessarily stupid. They simply could not be seen holding them.” Alexander, who wasn’t afraid of standing alone, capitalized on their pusillanimity.
People are constrained by appearances. Take, for example, rating agencies, which provide credit ratings for bonds. These ratings are very useful for institutional investors because they absolve them of the responsibility of making bad decisions. Even if the fund loses money, as long as such investors buy highly rated assets, they have their excuse. They cannot be accused of being imprudent. On the other hand, if an investor does something completely different from everyone else, their failure will stand out and be harshly criticized. There are no excuses for making a contrarian decision that doesn’t succeed. And yet, it is these contrarian positions that offer the greatest opportunities—if only you can overcome the fear of being alone.