You ever played the Madden NFL video game? For years, EA Sports put a top player on the cover. And then something funny kept happening. The cover athlete would have a terrible next season. Injuries, bad stats, team losses. Fans started calling it the Madden Curse. Some players actively tried to avoid being on the cover.
Every day you make decisions based on past data. What to eat for breakfast. How to approach your boss with a question. You look at what happened before and try to predict what will happen next.
If you ever invest in a private equity fund, don’t panic when you look at your statement after the first year. It’s probably going to show that you’ve lost money. This is what we call the J-Curve.
If you hold a bond and the issuer might default, you want insurance. That is the basic idea behind credit derivatives. You pay someone a regular premium, and if the bad thing happens, they pay you. Chapter 41 of Wilmott’s book walks through the main types of credit derivatives, from simple default swaps to the multi-name products that helped blow up the global financial system in 2008.
Michael Lewis starts “Flash Boys: A Wall Street Revolt” with one of the best ironies I’ve seen in a finance book. After the 2008 financial crisis, after everything Goldman Sachs did, the only Goldman employee who got arrested was a guy who took something FROM Goldman. Not someone who helped crash the economy. A Russian programmer named Sergey Aleynikov who copied some code.
We like to think of ourselves as independent thinkers. The “American Dream” is built on the idea that you can do anything if you just try hard enough. But in Chapter 3, Tim Richards shows us that we’re heavily influenced by the situation we’re in, often without even knowing it.
In Chapter 39 we valued default risk by modeling the firm’s assets, earnings, and cash. That is the “look inside the company” approach. Chapter 40 takes a completely different path. Instead of trying to understand why a company might default, just model default as a random external event. Roll a die. If you get a 1, the company defaults. Simple.
So I just finished re-reading Flash Boys by Michael Lewis, and honestly, it hits different every time. This book came out in 2014 and people are still arguing about it. That tells you something.
People are sticky. Not physically. Mentally. We stick to whatever we already have, whatever is already happening, whatever is the default. And this stickiness costs investors real money every single day.
Picking up from where we left off in Chapter 2. We’ve established that we’re all overconfident. Now let’s look at how that overconfidence turns into specific, expensive mistakes.