July 2009

Vol. 1 No. 2

Time Portals and Other Illusions:
Some Common Trading Mistakes and Their
Unhappy Consequences


Y
OU NEVER KNOW who’s swimming naked We consider ourselves something of an authority on the
until the tide goes out.” What corporate subject of mistakes not only because we’ve seen others
chieftain said this to CNBC and its viewers on make them, but also because, over twenty-plus years,
March 13, 2007? As it happens, these were the words of we’ve made our share. Our firm’s investment process
Angelo Mozilo, CEO of mortgage giant Countrywide involves sourcing an investment idea and then trying to
Financial, as he optimistically applied Warren Buffett’s poke holes in it. We can’t prove that a given trade idea is
famous 2001 Chairman’s Letter maxim to Countrywide’s sound, so we instead try to disprove its soundness in as many
future prospects as the mortgage industry consolidated. ways as possible. The fewer apparent flaws, the better.
We’ll explore the irony of this in a bit.

First, though, the Buffett aphorism raises some
uncomfortable questions. How did finance professionals
get in the water naked without anyone noticing? What
was their plan for getting out? Why did they stay in the
water long enough for the tide to change? This Market
Insights takes a closer look at some real-world examples of
common investor mistakes like those that may have tripped
up Mr. Mozilo’s firm. By “investors,” we mean all classes
of market participant, whether amateur or professional and
whether banker, hedge fund manager, insurance company
executive, fund-of-funds operator, high-net-worth individual,
or mutual fund investor.

pdf. The first mistake we’ll discuss is what we call the are tempted by trades they view as almost certain winners if time-portal fallacy. sadly. most investors find this types of mistake. or another conceptual category. This error involves focusing excessively on held to maturity or likely to produce losses on an ultimate the terminal outcome of a trade while focusing insufficiently realized basis only in apocalyptic states of the financial world on volatility and the potential paths of profits and losses (where it seems like losing the amount of money at risk is a paltry concern). Impressions are governed by the brain’s investment and trading decisions do not snugly fit under one ability to intuit based on immediate perception. but on bottle of fancy water!”. This error arises when Uncomfortable Companions investors predict the effects of a change in the world using B efore we get into specific examples of investor logic or assumptions that likely will no longer apply when that error. we can now outline investors engage in faulty logic while thinking about a couple of specific categories of investor error that we’ve financial cataclysm. perfection is When “Can’t Miss” Trades Miss probably unobtainable. the path to the future may prove both implementation errors in the machinery of reason itself. To illustrate the risk profile of a typical trade 1 of this sort. one relating to faulty intuitive judgment and task far too complex and thus necessarily fall back on various the other to faulty rational judgment. The time-portal effect is perhaps most evident when With the aid of these insights from theory. These heuristics work well in most cases. 1 No. formal reasoning (rational judgments). 2 | Page 2 of 10 . and analytical rigor. the result is a behave as if they are trading with the benefit of a “time mistaken intuition left uncorrected by rational judgment. let’s take the simple hypothetical example of a See Daniel Kahneman. Judgments. This is the kind of trade that lecture. context. its important characteristics of a trade. investors make two elemental and the trade’s terminus. we’ve observed that investors often this policing function does not happen. When analysis in particular. just in different ways: The “Time-Portal” Fallacy either the brain has developed an intuition and its reasoning I side has implicitly approved the conclusion without further n analyzing a particular trade. actual investor behavior often defies a single impressions alone (intuitive judgments) or the application of convenient descriptor. such long and bumpy in terms of mark-to-market volatility. highly dangerous in others. MARKET INSIGHTS July 2009 | Vol. Rationality is involved in both types of judgments. an investor would ideally rational inquiry. “Maps of Bounded Rationality: A Perspective on Intuitive Judgment and Choice. are conclusions drawn either from phenomena. In his pioneering work in the field of While we’ll reference Kahneman’s work to highlight certain behavioral finance. In practice. Nobel laureate psychologist Daniel aspects of both types of errors. vigilance. Consider situations in which investors observed. as using an incorrect discount rate or performing a faulty which may be fine to ignore in many situations but could be regression. December 8. rational judgment mistakes can stem from in time. The second mistake is an error that we call the illusion of continuity. Through education. or the brain has explicitly employed rational consider all of the possible paths that the trade could methods to confirm the initial insight. “Citi is at $3! I can buy a share of Citi for less than a date. available at virtually risk-free bond that is priced at 99. many of our observations Kahneman has distinguished between human impressions about how these errors manifest themselves in actual and judgments. it may be helpful to provide a little theoretical change occurs. These might include judgment occur when reason does not correct prior calculating expected return and volatility over some time misperceptions or biased intuitions. an investor can reduce his or her exposure to both intuitive and rational judgment errors. although. With respect to scenario capital structure. As with most real-world on the other hand. and http://nobelprize. pays LIBOR.” Prize Lecture. Errors of intuitive simplifying heuristics or rules of thumb. but it’s likely that reason will soon kick occasion they may unfortunately cause investors to overlook in and demand that Citi’s number of outstanding shares. So an investor may initially frame or identifying a discrete set of scenarios as of a future think.1 take and what the consequences of those different paths might be at any given moment between the present time According to this framework. In portal” that allows them to leap effortlessly to a future point other cases.org/nobel_prizes/economics/laureates/2002/kahnemann.Time Portals and Other Illusions Intuition versus Reason: (“PnL”) along the way. however. will mature at 100 in five years. and other factors also be considered. In reality. 2002.

A common example involves financial Collecting premia by selling credit default swaps (“CDS”) on institutions selling the equivalent of put options struck on the United States will result in a loss only if the U.S. a trader might reason. this wouldn’t be because the a highly levered investor. and even if all policy that pays off only in states of the world where no one predictions ultimately prove correct.” Similar sentiments have been voiced my-world” trades while being similarly oblivious to path about selling credit protection on U. The firm freely sold credit protection on highly-rated companies in the index before the tranche representing that securities. In that case.100% tranche experience unrealized losses and have to post variation to be quite attractive. their own credit rating. And while it levers that trade up 20 times.” business proposition at any price. But whatever the reason. but instead free money may not be such a good idea. John Maynard investment-grade corporate credit offer a more concrete Keynes famously noted that “the market can stay irrational example of the dangers of the time-portal effect when longer than you can stay solvent”—but that point is overlooked investors engage in flawed “end-of-the-world” scenario from time to time.NA. generates “free money. with potentially dire consequences. so who cares?” fraudulent conveyance. And if it does. AIG is perhaps roughly a 30% recovery on defaulted credits. while ignoring mark-to-market risk. attempting to collect this consensus probability of an actual default is high.” And if an investor to be marked-to-market. The proposition that markets can temporarily Investments in so-called “super-senior” tranches of behave in strange ways is not new—in 1936. It also may be that they can manage this risk with the U. and earning money for current investors in the likely ultimate outcome. These Many investors do not consider that if the market were to indices allow investors to buy or sell credit protection on a price in even a relatively small increase in the implied basket of companies. on the make on the trade. dependency.IG 5-year 30 . can take get hit. “There’s no way that tranche is going to for the abrupt appearance of end-of-the-world risk.100% free money. In this trade. even when the premium Selling “End-of-My-World” Puts paid to sellers of credit protection was as little as 1 basis point (see Figure 1). In all likelihood. Why would institutions do this? It’s government defaults on its debt obligations. they’d immediately risk investment in the CDX. for a period of five years. thus intensifying the pain. government debt. Given that possible that the return they receive is sufficiently valuable to context. many investors over the last few years have amount to free money.NA.S. Investors seeking exposure to the corporate credit market often take positions in credit derivative indices. in effect. extreme care. of course. “It’s virtually impossible that justify it. 1 No. investors often must highest-rated tranche of an index composed of North lever such end-of-the-world credit-protection trades to make American investment-grade corporate credits. it would take the paradigmatic recent example of an institution that forgot defaults on the debt issued by more than 50 of the 125 this lesson. been tempted to go long that risk. Finally. it’s not too hard to imagine the market way to collecting their (not quite) free money. through apparent disregard along the lines of. and if it does. viewing it as a pure arbitrage difference: this hypothetical insurance policy wouldn’t need that.Time Portals and Other Illusions investors occasionally pile into. And. Many investors would consider a long probability of future financial calamity. government volatility and the possibility of many different PnL paths on the defaulting on its debt. that could end up bankrupting happening. we’re probably all dead anyway. apparently in the belief that such contracts would slice of the index would realize a loss. Assuming any real money. investors earn a premium margin equal to many multiples of what they had hoped to by selling protection.S. while CDS trades do. leaving losses for a different class of investors who will be left holding the bag in the worst-case This sort of reasoning may be fairly sound with respect to the scenario. that would be a good to the disastrous exercise of these sorts of implicit “puts. 2 | Page 3 of 10 . it’s possible that this is a subtle form of we’re all gonna be bankrupt anyway. even if the original because large risk premia or unusual technical forces—what thesis that the bond will go to 100 at maturity proved correct.IG 5-year 30 .S. analysis. But there’s an important MARKET INSIGHTS July 2009 | Vol. It’s a more narcissistic form in which investors initiate “end-of– basically free money. If the price of temporarily implying a significant chance of either the bond temporarily goes to 95. certain paths could lead is around to collect or even file a claim. Presented with such ultimately (on the other side of the mythical time portal) an instrument. then it seems like a great deal of seems difficult to imagine the CDX. government will default on its debt. academics call “noise-trader risk”—affect the market’s current level. But investors sometimes ignore mark-to-market tranche suffering a realized loss or the U. The justification for doing so has usually been Sometimes the time-portal error. If an insurance company could sell a normal state.

In other words. the firm will be covers for the CDO investors is the risk of suffering actual bankrupt and won’t have to make any payments. thereby causing Somewhat less well known is that. It may be a productive strategy for market was fine on a held-to-maturity basis may not have been fully participants in certain situations. 1 No. the substantial risk that AFP [AIG Financial Products] free money because. We have not yet incurred any realized credit losses in the capturing free money. but it was not true of the more general risk to Again. But it does underscore some of the 2 dangers of selling implied puts on oneself under the AIG made similar statements in its 2Q08 earnings call. potential volatility on the way to maturity.IG 5-year 30 – 100% 120 100 80 Premium (bps) 60 40 20 0 6/26/2006 11/29/2006 5/4/2007 10/7/2007 3/11/2008 8/14/2008 1/17/2009 6/22/2009 Figure 1 Source: J. It’s widely known that AIG sold could lead others to question the creditworthiness of the firm protection on collateralized debt obligations (“CDOs”). this That may have been narrowly true of the risk that AIG was example is more of an illustration of how some traders think than a real-world case. And MARKET INSIGHTS July 2009 | Vol. before the implosion: “Despite the marks taken. the level of defaulted assets in the underlying collateral of on itself and ultimately goes bankrupt very likely would have CDOs is very low compared to the weighted average attachment points in those structures.”2 of frequent discussion within the trading community. AIG real harm to the company. As credit markets melted down. a CDS dealer that’s short protection portfolio.Time Portals and Other Illusions Premium for CDX. Far from resilience. Further. in certain instances. but it must be managed genuine.P. if the CDS triggers. to the counterparty if its credit rating fell below a certain selling puts on oneself is particularly pernicious because it threshold. Mark-to-market losses example of this behavior. Consider a CDS GAAP is our best estimate of the fair value of the underlying dealer that believes selling CDS protection on its own firm is CDOs. Although AIG management’s repeated claims that effectively creates the conditions for an ugly self-fulfilling the portfolio of CDS contracts they had written on CDOs prophecy. AIG presents perhaps the most striking recent which the firm itself was exposed. and ultimately result in a ratings downgrade. not the variance in fair value of the CDOs. 2 | Page 4 of 10 .NA. the portfolio of CDOs is showing intoxicating influence of the time-portal potion. Morgan underwriting. management We’ll offer a last example to illustrate the time-portal fallacy indicated that “although the fair value of the CDS under as it applies to end-of-my-world trades. of course. for example. In AIG’s earnings call for the first quarter of 2008.” to make payments before going out of business. most observers could probably appreciate that AIG very carefully with a view not just to the terminal outcome. mark-to- would not need to pay out variation margin on mark-to- market losses on the swap portfolio and ratings triggers market losses but would have to make substantial payments helped push AIG to the brink of bankruptcy. As a topic realized losses. which. is exactly what structured these contracts such that the AAA-rated firm happened to AIG. focused far more on held-to-maturity forecasts than on the but also to possible paths to that outcome.

our hypothetical CDS dealer state of the world. to-market loss on the CDS. let’s ignore our old given information on the size of the property and its specific friend (from our previous Market Insights) cash-CDS basis features. gets sick. When that happens. a listing price that was 12% below the appraisal. If the bonds drop another 15 investors often anchor to the current state of the world. not is more likely to fall back on narrow framing. The proper prescription for combating such number of effects of a contemplated change begins to thinking may be to force oneself to consider the subtleties by multiply (as in many real-world trading situations). a person performing scenario analysis over different time horizons. then I’ll take out a at all about losses.Time Portals and Other Illusions conversely.” But when situations become complex and the nuanced. the buyer of the CDS protection would likely is the tendency of individuals to base estimates or predictions receive some payments rather than go completely on previously perceived baseline states. end-of-my-world trades actually lose in policy. price. and it’s hard On the day that the dealer actually defaults. The life insurance example is obviously a apparent and certain. the dealer pays out an additional 15 points. in this example the dealer actually made prior cash broader class of phenomena to which that decision or choice payments of 45 points in variation margin. intimately know the current state of the world. The agents were To see how this works in simple terms. in that individuals eliminate altogether faces significant losses because of. 1 (February 1987). It’s an extreme version of anchoring to the current supposedly free-money trade. of course. prices of similar properties recently sold. as well as a listing perfectly inverse relationship with the value of bonds. 2 | Page 5 of 10 . is that if one scenarios in which one cares the most about losses. and asking and assume that the pricing on CDS contracts has a prices for similar properties on the market. Amateurs. The associated 20-point new state. uncompensated. 1 No. Some people may be self-reinforcing quality of these trades: ironically. The general idea is that human thinking can often Decisions. So while “Narrow framing” is the tendency of individuals to isolate a it’s true that the realized loss occurs after the dealer decision or choice from the rest of the world or from the defaults. 84–97. while the rational calculation required simplistic one. We points to 55. pp.3 Likewise. and Real Estate: An Anchoring-and-Adjustment Perspective on Property Pricing settings. so I don’t producing losses only in scenarios in which one doesn’t care think I need life insurance. those bonds for us to adjust our perspective enough when thinking about a might fall another 20 points or so. Kahneman and others have observed the prevalence 3 of anchoring and narrow framing biases in experimental See Gregory B. and some were shown on itself to a client when the dealer’s bonds are at 100. The The dealer then suffers some form of financial distress. not despite. fall under what we call “illusions of continuity. In pursuing a belongs. perhaps it is because the assumptions that will no longer apply and thus leads to false ultimate outcome of these trades intuitively seems so conclusions. Vol. “I feel pretty good right now. researchers have conducted experiments that involved asking real estate agents to appraise a property. Neale.” Organizational Behavior and Human Decision Processes. No. For example.” “Anchoring” 39. Ignoring the effects of change—getting sick. Illusions of Continuity L et’s put aside the time-portal analogy and move to another category of investor mistake we see. Take of mark-to-market volatility. the effects some directly relevant issues from their calculations.” The flaw in this reasoning. and most people wouldn’t fall prey to that to analyze and truly understand the trades is much more “logic. in this case— Why do investors make this type of time-portal mistake? when planning for the future reflects reasoning from Applying Kahneman’s framework. the dealer must property’s value by anchoring to the listing price they were pay out 30 points of cash to the client to cover the mark- given rather than considering the other data. Investors can get just to the date when the trade is guaranteed to have into serious trouble when trying to predict the effects of a converged. Some agents were given a listing price that was 12% Envision a scenario in which a dealer sells CDS protection above an independent appraisal value. far from tempted to think. Northcraft and Margaret A. The pain is amplified by the the basic example of life insurance. margin payment probably will not be made then but rather will be claimed by the client in bankruptcy court. it’s much harder and costlier to get a policy. MARKET INSIGHTS July 2009 | Vol. “Experts. change in the market on the basis of logic or facts that likely will no longer apply in a world where that change has occurred. If I get sick. and researchers found that agents in each group appraised the its bonds fall to 70.

” But in a world where those loans have should after factoring in the possibility of a major change in dropped to 90. if anything. observing daily volatility that is modest formed to buy them. then mortgage lending space except the forced exit of some key this capital very well could prevent the market from competitors. subscribers to the wall-of-money argument that Countrywide had less subprime exposure than other tend to view the 20% extra capacity as a huge amount of lenders. $45 in January 2007 to $32 in March. fundamentally changed? Will investors still want to invest in CLOs. isn’t it possible that something else has fundamentals in the event of a crisis. there will be so many CLOs because the investor. (3) leverage is One of our favorite examples of the illusion of continuity is likely to be less available than before because volatility is the wall-of-money fallacy. had changed in the asset class without much else changing in the world.. and that fundamentals do not money reasoning will apply to small moves that probably change. what if investors really believed it? Even if it were true circumstances. In those press. Investors may have found it difficult to imagine a reduction in price because many of the following conditions world (i. But if the market falls precipitously. the wall-of- prices only move on noise. leveraged is large relative to the size of the cheapening. Investors often presume that higher.Time Portals and Other Illusions Consider the aforementioned statement of Countrywide’s the world changed a lot. Figure 2 to have been skinny-dipping. 2 | Page 6 of 10 . Walls of Money which reduces the desire for increased exposure to the asset class when it otherwise may look cheaper. Mozilo stated that the meltdown in the subprime Traders occasionally trot out the wall-of-money argument mortgage market “will be great for Countrywide because at when analyzing the convertible bond market. was huge demand—a “wall of money”—waiting to buy Consequently. In his remarks to leveraged loans in the past decade. for instance. After Countrywide’s stock slid from a high of cheapening too much. which will have used up much of like Countrywide could suffer considerable losses. As the price of leveraged loans CEO in March 2007 in the context of anchoring and narrow began to fall. to move outside the assumptions of their anchor are likely to be true: (1) investors have just lost a bunch of state) where the economy was so damaged that a company money on the down move. that the price will shoot right dynamics. If there is a small down move in the have assumed that little. and (4) fund managers have set aside capital to pay random noise. (2) volatility and thus risk are higher. Buffett on swimming naked when Countrywide itself seems but also became net sellers of the loans themselves. CNBC. the sidelined capital.” Let’s statement of the kind that CEOs sometimes make to the suppose convert investors are 80% invested. investors buying Countrywide stock over the two or potential demand for convertibles were they to get cheaper three months after Mozilo made these remarks very well may for whatever reason. causing investors to want to hold more buffer capital demand for some asset class or type of trade will persist no or reduce leverage rather than increase the size of their matter what. Beyond the obvious irony of Mr. investors declined to buy CLO liabilities. all of the irrational competitors will be during periods when converts are priced somewhat richly and gone. and will leverage be available to investors purchasing them outright? With the benefit of hindsight. But that loans were regarded as well-secured and were gobbled up by reasoning is likely to be wrong with respect to large moves collateralized loan obligations (“CLOs”) and other pools of because they often result from more profound shifts. even if capital. and the returns on buying them with given the operation of day-to-day supply and demand leverage will look so attractive. Mozilo’s quoting banks not only stopped wanting to lend against those loans. Mr. 1 No. recent dynamics in the market reflect noise trading because the amount of capital available for leveraged loans. particularly the end of the day. To many observers. “If these loans go to 90. may be tempted to use more leverage than he back up to 100. this view of the world essentially assumes that anticipated redemptions. If price is a function of fundamentals and portfolio. his comment may have had shows the relationship between CLO activity and pricing on substantive consequences for investors. Take. and the amount of these loans could drop in price for long periods because there capital on the sidelines may not be enough to reverse them.e. it seemed inconceivable that temporary. using the wall-of-money argument as an them if the price fell by just a small amount.” While this may just have been a self-serving yet market participants are not “fully invested. The thinking investment thesis may actually be hazardous in practice was. in financial tectonic plates. and framing. we know that MARKET INSIGHTS July 2009 | Vol. More often than not. it rebounded to $40 in this sidelined capital may not be adequate to counteract the May. A little over two years ago.

we’ll miss out. “If this stock goes Many perceived opportunities were beautiful in the abstract down to $x.” They may tell themselves. This contention has MARKET INSIGHTS July 2009 | Vol.” or.” Investors that initiate such trades and overlook other changes or risks may A final and pervasive example of the illusion of continuity can be doing so under the influence of biases such as anchoring be seen in the assumption that reputational effects in or narrow framing. after all. This slowness to adjust investor is making an assumption that the world where the to new realities—consistent with anchoring or narrow option is exercised is substantially similar to the world today. business relationships will always persist. 2 | Page 7 of 10 . the although our hypothetical investor ignores that even in those conversation sometimes went along these lines: cases he could have bought the stock more cheaply had he not sold the put—but it can’t be right in all cases.” In either case. 1 No. But if one drilled a bit deeper. for the foreseeable future? John: I can’t because no one will finance it for me. not all stocks happy to pay $x for the stock no matter what. framing—was also reflected during the past few quarters in In other words. we’ll buy it and make a ton! But if it keeps but infeasible in the real world. What if John: Cash-CDS basis is at negative 600 bps! company fraud is discovered? What if the economy goes That’s totally unsustainable. “I sold down day in the equity markets to witness investors buying some puts at $x because either the put won’t get exercised their favorite stock even though they did not think that the and I’ll collect my premium. it was not uncommon on a big price falls to $x. “If the stock change. So we’ll hedge our happiness and Hard-Won Reputations lock in some future PnL by selling a few puts. investors rely on similar thinking when and I have no cash. What an opportunity! into a tailspin and the company’s business prospects change Jane: So buy some. Sometimes. going up. I’m necessarily happy to buy. Clearly. or the put will get exercised and market overall was particularly cheap. attempting to engage in what might be termed “happiness hedging. he believes that all price movements are just frequent observations about how amazing the investment noise. There’s an inherent I’m happy to own it there. the investor is contradiction in this behavior since. Over the last year. this can be cheap relative to the market. That assumption may be correct in some cases— opportunity set seemed.Time Portals and Other Illusions $35 L+3000 $30 L+2500 $25 L+2000 Rate of Interest USD in Billions $20 L+1500 $15 L+1000 $10 L+500 $5 $0 L+0 1Q99 1Q00 1Q01 1Q02 1Q03 1Q04 1Q05 1Q06 1Q07 1Q08 1Q09 Leveraged Loan CDO Activity (left scale) First-Lie n Loans (right scale) Figure 2 Source: Standard & Poor’s The Fixed-Price Myth and Happiness Hedging This error of thinking too little about how a large change in the world might have an impact on a specific asset or trade Another form of the illusion-of-continuity mistake occurs seems to persist even in the immediate aftermath of that when an investor advances arguments such as.

2 | Page 8 of 10 . those firms may have occasionally closed A related but alternative way to view what happened is that on smaller deals that were marginally unprofitable to investors such as merger arbitrage players and companies preserve their reputational capital for larger and more that are takeover targets failed to appreciate the extent to important deals. Walking away meant that don’t break. If one assumes these considerations are not be as relevant. paradoxically. but instead because it also usually made sense deteriorate and. will break its commitment if the reward for doing so $100 = $10. blown crisis. And while we’ve focused on private equity year. the fact that many firms were similarly situated lent credence to the view that this was a systemic event beyond anyone’s control. To assign some loose numbers to this generally play a predictably constructive role when market example: if deals are underwater 20% of the time and are conditions are “normal. Clearly. (On average. profit-making standpoint to do the deal. private buyers wouldn’t walk away because benefit analysis changed as the deals became unglued. to walk away were therefore quite strong. the potential longer-term by which deals that break are underwater. there is a short-term incentive to walk which deals are underwater instead of the average amount away from it. If a private equity firm is takeover targets) that acquirers will walk away would be unlikely to do another deal for a few years.” commitments. But historically. and the importance of reputation—were highly between reputation and incentives to complete deals might correlated. The short-term incentives to other financial and trading relationships. many deals were underwater at the same transactions. the link acquisitions. Over the past of independence. as sluggish debt markets and dimmer fundraising wisdom held that even if a deal were significantly prospects rendered future deals less important. Perhaps such firms are 50% likely to break commitments in A strictly rational agent. the likelihood of future mergers and suddenly a lot less hospitable to private transactions. The cost- underwater. which raises the risk to 20% * 50% * altruism. At the same time. the risk the firm would have a tougher time doing acquisitions in the for investors or target companies that acquirers will walk future because the executives involved would be widely away increases geometrically when we relax the assumption perceived as dishonest or lacking credibility. and if firms are generally 10% likely to break business with each other for a long time—“repeated games. However. deals and will care less about reputation going forward. a misplaced belief in the persistence of those effects much because reputational incentives were the overriding may engender a degree of complacency as market conditions motivation. then the risk (for merger arbs or owners of in the parlance of game theory. The risk is probably higher than $10 because in exceeds the associated reputational damage. increase the chances of a full- from a near-term. But things are quite different if reputational cost of walking away from a given deal may these factors move together. And whether private equity firms and other potential buyers what had been viewed as a repeated game now seemed less would eventually close on committed deals. Conventional repeatable. But it can reasonably be argued that private decisions in normal markets but not as much in periods of equity firms almost always closed on acquisitions not so turmoil. so the reputational damage to individual firms was MARKET INSIGHTS July 2009 | Vol. When a deal is materially seem less significant. 1 No. independent. then the risk of a buyer walking away doesn’t Reputational and relationship effects are indeed real and seem that large. backing out would make it far harder for them to do future Because reputational effects tend to influence investment transactions. in a world where both the which all of these factors—the degree to which a deal is average deal is underwater and the larger financial system is underwater. it probably means that a private equity firm or achieve by breaking the deal is a multiple of what it would other potential buyer will have a harder time doing future expect to earn on that deal. particularly if the savings the firm would underwater. however. when a the previous calculations we used the average amount by deal is underwater. unburdened by a sense of honor or those circumstances. then the 20% * 10% * $100 = $2.) As we can see from the above analysis. Moreover.” But reputation matters the most in underwater (relative to the takeover bid) by an average of those cases in which two parties expect to continue to do $100. damage to a firm’s reputation that would result from walking deals that break will be underwater by more than deals that away was a strong disincentive. we believe this discussion of reputation applies time and by a very large amount.Time Portals and Other Illusions shaped discussions over the past couple of years about greatly diminished given the protection of the herd.

In particular. Guarding against these errors requires extreme vigilance. The decision-making heuristics that investors use seem to function well in “ordinary” times but may break down and result in considerable damage (for an individual market participant or an entire class of them) during extraordinary periods. “How broad is the range of conditions under which my model may be successful?” Selling one-day out-of-the-money put options on the S&P 500 might seem a pleasing strategy because it would make money on almost every day. E. we make a conscious effort destroying errors committed by market participants in to identify and integrate awareness of the two types of error recent years will be studied by financial practitioners that we have discussed in this commentary. Shaw group. so we may return to retest those assumptions. First. in our investment process. we haven’t always successfully implemented a regime that The literature on decision-making biases developed by protects against these errors. and. 2 | Page 9 of 10 . the modern financial system.Time Portals and Other Illusions At the D. we question the assumptions that We’ve obviously only scratched the surface of the broad undergird our investment theses. Similarly. and frequently revisit and topic of human decision-making frailty. given our past mistakes. that we trade. This commentary has attempt to carefully segregate the risk exposures that we highlighted a small sample of mistakes that we’ve actively seek from those that are either undesired or catalogued. many of our beliefs and heuristics become deeply engrained because they work on most days. over the years. unknown. These three considerations do not this subject in future Market Insights. 1 No. Second. poses a difficult test of our ability to make rational decisions. we try to regulate our own Conclusion investment decisions by following some basic principles. “How often is my model correct?” rather than. and even that may not be enough. MARKET INSIGHTS July 2009 | Vol. T he unusual number of self-defeating and value. Third. but one should not overlook that “most days” actually falls within a narrow range of a broader set of possibilities. but it really makes money on only one type of day—days when the market doesn’t crash. we and academics for a good while. sum to a perfect science. The reason for this may be that as individuals we tend to ask ourselves. But we do seek continual psychologists over the past two decades has contributed improvement in our work in these areas as we assimilate new significantly to a broader understanding of elemental information and gain additional experience in the markets investing errors of the sort identified in this commentary. and occasionally committed. with its vast scale and enormous complexity.

and may be changed or updated at any time without notice to any of the recipients of this commentary (whether or not some other recipients receive changes or updates to the information in this commentary). or agents of any of the foregoing shall be liable for any errors (to the fullest extent permitted by law and in the absence of willful misconduct) in the information. expectations. nor their affiliates. members. The views expressed in this commentary are subject to change without notice. principals. nor does it constitute an offer to sell or provide or a solicitation of an offer to buy any security. Shaw group. managers. or opinions. beliefs. Shaw group to evaluate investments or investment strategies. or for the consequences of relying on such information. Shaw group as of the date of this commentary. None of the companies in the D. This commentary does not and is not intended to constitute investment advice. 2 | Page 10 of 10 . E. This commentary is provided to you for informational purposes only. and/or opinions included in this commentary. directors. investment product. E. personnel. beliefs. and/or objectives described in this commentary would be realized or that the investment strategies described in this commentary would meet their objectives. nor any shareholders. No assurances can be made that any aims. partners. MARKET INSIGHTS July 2009 | Vol. The information contained in this commentary is presented solely with respect to the date of the preparation of this commentary.Time Portals and Other Illusions The views expressed in this commentary are solely those of the D. or service. and may not reflect the criteria employed by any company in the D. or as of such earlier date specified in this commentary. assumptions. E. This commentary does not take into account any particular investor’s investment objectives or tolerance for risk. 1 No. trustees.