What's Really Wrong with Wall Street

A common belief in Wall Street is that risk avoidance is incompatible with investment success. This view holds that high return is attainable only by incurring high risk and that investment success is attainable only by seeking out, rather than avoiding, risk.

I believe that this erroneous definition of risk is the root of the problem in Wall Street, and what has encouraged investment banks in Wall Street to pursue excessive risk taking for years. Firms like AIG and Bear thought that by having high leverage and engaging in higher risk, the probability of return would consequentially be higher. But how wrong were they.

Wall Street erroneously equates risk with volatility. It is absurd to think that volatility measures risk while failing to take business fundamentals into the equation. Warren Buffett has written about this issue several times on his shareholder letters, and his view is clear: risk management should not be based on market fluctuations. On the other hand, several TV personalities have ridiculed Mr. Buffett for buying stocks during this “risky” and volatile economic environment, and are quickly to point out Mr. Buffett’s current unrealized losses as evidence. So who is right? To answer this question, we propose a thought experiment that takes us back to October 2007.

At this point in time, the DJIA was at 14,000 and volatility was low. Coincidentally, investors were buying more than now, so their perceived risk was at least lower than now. Returning to the present, the DJIA is now 50% lower than it was during this “safe” period. Massive losses, some of which are permanent, have crippled the financial markets. Nevertheless, a lot of investors are now refusing to buy at these lower prices, claiming that the market is currently riskier. So obviously, the perceived risk is now at a higher level, even after a 50% market drop, than in 2007. I find this very wrong. If prices go down, an investment is seen risky regardless of business fundamentals, but if it goes up then it is safe to invest at the higher price levels. This is the reason why many investors believe that the market as a whole is riskier now than it was just a couple of years ago.

On the other hand, the Webster dictionary defines risk simply as the probability of loss. I would argue that the markets are actually less risky now, because the probability of loss that would result from overpaying for an investment is lower. Statistically, there is also a lower chance of experiencing another 50% drop in the markets, just as the odds of being struck by lightning twice are lower than once. We absolutely believe that the probability of loss in our investments is statistically lower than in 2007. Therefore, we find Mr. Buffett’s bullish call to buy stocks during this period both rational and logical. By investing at times of lower investment risk, we are also assuring our future returns are not only higher but also protected.

Mr. Harry Markowitz received a Nobel Prize in economics in 1990 for developing the theory which states that higher returns are only possible by incurring higher risks. We think AIG and Wall Street banks would have been better served if they had not listened to Mr. Markowitz. In our view, the theory is closer to a hypothesis and the market has proven that it has no merit.

Comments

[blkmtnbear:]

Convoluted Logic
14,000-7,000 = 50% Loss
& 7,000 - 3,500 = 50% Loss

Mar 22 09:38 AM

[jvdplate:]

What's very wrong in this market is that it no longer offers anything of worth to investors. Traders, with megabucks in programs that move the market in drastic short-lived spasms, make any position lasting more than a few weeks "long-term." This is, of course, ridiculous.

For the markets to function as they ought in a capitalist world, investors should out-number short-term traders by a considerable margin. Otherwise, what you end up with is a house of cards which, like the housing market, will be driven to radical extremes based on the effects of those moves rather than the causes of those moves.

I'd like to hear at least a couple of our politicians get serious about regulating our capital markets in a whole new way - a way which would make the markets an inviting place for investors. This will take "out-of-the-box" thinking, which does not get the job done if re-election is goal. I guess it won't happen.

Back to day trading.

Mar 22 09:40 AM

[Skinnyfrom ...:]

Yes convoluted logic. Everything else being equal, market was riskier at 14000. But everything is not equal. And once lightning has struck, odds of it happening again are the same as they were for it to strike the first time. True, extent of potential loss is less, but probability it will occur is higher. Step off the roof of a 14 story building without looking (with the possibility there is a safety net or a stairway further up) or jump out of a 7 story window when you have looked down and there is not one there. Risk also needs to be measured by time horizon. Risk of loss over next 50 years is different than risk of loss over next 50 days, in many respects. This is just a way more complex issue than has been presented.

Mar 22 09:55 AM

[Skinnyfrom ...:]

You're on the 14th floor and you reach out and grab the ledge above you and swing out the window. Maybe there is a window above, maybe there is a safety net below. But your arms are about to give out. Or, you are on the seventh floor and you think you can see a ledge above but it is slippery, and you look down and you can't see a safety net. Do you jump out and grab for the ledge, or go back down the stairs from floor to floor, hoping for an open window with a net, a non-injurious drop, or a ledge above you can grab, but knowing when you get all the way down you will be too weak to go back up the stairs. How different are the risks and rewards? Of course there is no simple answer, which is what is wrong with the original post.

Mar 22 10:04 AM

[ValueHuntr:]

What's convoluted? That is precisely what I meant. It is more likely that the supply and demand balance for stocks is near 7500 than 3500.

On Mar 22 09:38 AM blkmtnbear wrote:

> Convoluted Logic
> 14,000-7,000 = 50% Loss
> & 7,000 - 3,500 = 50% Loss

Mar 22 02:02 PM

[socrateazz:]

You made valid points about the actual market risk based on probabillities of prices. But the real problem is with probabillities of most of those companies making more money or going under have changed. Obama thinks propaganda can change fundamentals for the better. Reality becomes evident when you concider each action individually along with the probable result. Many of Obama's actions will cause even more reductions in business overall. If I want to make more money, and I decide to create a business and take all I recognize into account. what do I concider? 1) My making more money will return less in ultimate earnings to me because of taxes 2) The encouraging of Unions make it harder to control costs...Look at GM or Ford if you think unions look after their own Cake. 3) More unemployment and underemployment means fewer people to buy my product. 4) If my product caters to the wealthy, the desire to keep from flaunting their wealth will cause fewer to buy my product. 5) How easy can I get loans? 6) How much natural risk is involved in the product? 7) If my product is successful will a law suit suck away the profit before I can have it? Some lawsuits are little more than controled redistribution from the producer to whoever complains most. So what are the positives? Would you Start a business after concidering all of the above? If the government needs more money for whatever, Then the money comes from somewhere! The poor do not pay it. The laws help the rich keep what they have. The middle class are under duress. The businesses is where Obama really believes the money will come from. Much wealth has already been squeezed from them. Reality says Obama believes the wealth is where it is not. You can not just invent wealth other than causing inflation. And with that businesses need more return to survive. Devaluing the dollar will help restore some balance, But at what cost to the consumer? Hold on the roller coaster is just starting. You get a six flags ride for only the cost of your wealth, freedom, beliefs and sanity. Maybe a few other incidentals too.

Mar 22 02:19 PM

[logicalthought:]

Dear "MADE IN W.GERMANY",

After reading your racist comment, I first thought you were simply being facetious, but after looking at your web site and blog, I realize that you are actually simply INSANE (and, also, a really crappy trader: www.updown.com/member/...)

Mar 22 04:07 PM

[conceptwizard:]

The Russian/American governments are recommending that the G20 summit in London in April should seriously consider creating a “super-reserve currency” which would eventually inevitably become a one world currency.

The Itar-Tass news agency is reporting that the Kremlin's website is calling for “the creation of a supra-national reserve currency that will be issued by international financial institutions.”. But Russia is not alone. Kazakhstan's President Nursultan Nazarbayev is also openly calling for a one world currency. Nazarbayev's view is echoed by Canadian economist and Nobel prize winning professor Robert Mundell. Mundell, who was a key intellectual force behind the creation of the Euro, is also actively promoting the idea of one world currency.The idea is for the IMF to issue at least $250 billion in Special Drawing Rights, or SDRs, to IMF member states as a method of placing a safety net under developing countries that might otherwise have to declare bankruptcy. Mundel has called for a worksop at the G20 on the World currency issue. many other G20 countries are on board.

The idea gained momentum Tuesday when the Moscow Times published an article revealing that the Kremlin intended to use the G-20 meeting, beginning April 2, to push for the IMF to utilize SDRs as "a super-reserve currency widely accepted by the whole of the international community.". U.S. Treasury Secretary Tim Geithner is on the record calling for the G-20 to support "substantially increasing emergency IMF resources" by up to $500 billion to deal with the global economic crisis. "SDRs under the IMF proposal before the G-20 are going to end up being a newly invented one-world currency manufactured by a one-world organization, created to ease nations out of failed fiat currencies like the dollar,".The Washington and Kremlin-backed proposal would issue SDRs to central banks of IMF member states far in excess of any gold or currency reserves the member states have on deposit with the IMF.
This something to watch in my opinion. There is a good argument right now for a new world currency as the dollar is increasingly under scrutiny as the place for foregn investment, and inflationary concerns, not to mention trade inbalances worldwide. This will dirve the stock market down to new lows due to the devaluation process of the greenback in relation to the new currency. We have to look at more than normal evalutions as nothing as we know it is the same anymore. DO NOT TRUST THE MARKET YET! THE WORLD AS WE KNOW IT IS CHANGING.

Mar 22 08:29 PM

[notsosmart:]

wall st killed capitalism.i dont know what "ism" we have currently.wall st is like a cancer that kills its host.it wasponzi for a long time.made-off is a piker compared to wall st.dont trust anybody about anything. the thievery is stll going on with the option resets & the sec wont do a thing.ethics& transparency are gone.the american dumb-dumbs are getting what they deserve.

Mar 23 10:15 AM

[Sailorman:]

Jon Stewart hit the nail on the head the other night talking about long term investors and 401k's and the short mentality of the current market investors. Puts and Calls need to be eliminated and stocks need to be held for longer periods. I one want to gamble go to Vegas or one of the many casinos around the dountry. Why should they get to play off our 401k's and long term retirement investments?


On Mar 22 09:40 AM jvdplate wrote:

> What's very wrong in this market is that it no longer offers anything
> of worth to investors. Traders, with megabucks in programs that
> move the market in drastic short-lived spasms, make any position
> lasting more than a few weeks "long-term." This is, of course, ridiculous.
>
>
> For the markets to function as they ought in a capitalist world,
> investors should out-number short-term traders by a considerable
> margin. Otherwise, what you end up with is a house of cards which,
> like the housing market, will be driven to radical extremes based
> on the effects of those moves rather than the causes of those moves.
>
>
> I'd like to hear at least a couple of our politicians get serious
> about regulating our capital markets in a whole new way - a way which
> would make the markets an inviting place for investors. This will
> take "out-of-the-box" thinking, which does not get the job done if
> re-election is goal. I guess it won't happen.
>
> Back to day trading.

Mar 23 12:02 PM

[ain't no fo...:]

and while we're at it perhaps we should legislate that all stocks must always go up?

if your 401K or retirement funds are in stocks, and you were not aware of the risks of being in stocks, and you did not reduce your stock weightings when you had the chance (and the markets gave PLENTY of warnings that bad times were ahead), I would submit that you should look to yourself for the cause of your pain, not to Puts and Calls that have been around for many decades (and which are TRANSPARENT and serve many legitimate hedging strategies) or the time duration that others chose to hold stocks for (I for one went from being an investor to being a daytrader when it became apparent that holding overnight was a fools game in this sucking chest wound market, and I will go back to being an investor when conditions tell me it is "safe" to extend my risk duration). So does becoming a "daytrader" make me a bad person?

In my opinion it makes me a survivor.

If you want a disneyland ride, go to disneyland.

If you want to be in the stock market, learn what the risks are and either accept them or go to disneyland.




On Mar 23 12:02 PM Sailorman wrote:

> Jon Stewart hit the nail on the head the other night talking about
> long term investors and 401k's and the short mentality of the current
> market investors. Puts and Calls need to be eliminated and stocks
> need to be held for longer periods. I one want to gamble go to Vegas
> or one of the many casinos around the dountry. Why should they get
> to play off our 401k's and long term retirement investments?

Mar 23 01:27 PM

[henarl:]

If you have the opportunity to bet someone else's money on a 100 to 1 long shot at the horse track and collect a ten percent fee (bonus) if that horse wins but break even if he loses, you are going to bet every long shot on every race. That describes the way Wall St. was working. The only idiot in this scenario is the person whose money you are betting and he probably didn't even know the game was on.

Mar 23 03:34 PM

[ValueHuntr:]

Henarl,

Exactly. As Warren Buffett has said before: "If you've been playing poker for half an hour and you still don't know who the patsy is, you're the patsy"


On Mar 23 03:34 PM henarl wrote:

> If you have the opportunity to bet someone else's money on a 100
> to 1 long shot at the horse track and collect a ten percent fee (bonus)
> if that horse wins but break even if he loses, you are going to bet
> every long shot on every race. That describes the way Wall St. was
> working. The only idiot in this scenario is the person whose money
> you are betting and he probably didn't even know the game was on.

Mar 23 05:07 PM