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Shorting The Big Short

The Big Short is getting rave reviews from both critics and audiences.  While I enjoyed the movie I did feel as though it played up to two very powerful biases that overshadowed the quality of the film making.  Specifically, the movie played up survivorship and political bias.  As a result I came away from the film thinking that it gave the viewer what the viewer thinks they want to hear as opposed to the truth about the financial crisis.

Survivorship bias is the tendency to focus excessively on the participants of a catastrophic event who survived the event and conclude that these survivors were necessarily smarter than those who didn’t survive the event.  This is probably the most common bias found in active fund management and usually the most destructive.

I think there’s no doubt that the people who predicted the crisis were highly intelligent and skilled investors.  But the movie also shows how close many of these fund managers came to failing because their timing was early.  That is, while their macro thesis was dead right, the timing of the trade was precariously close to being wrong.  This has played out time and time again in the financial markets over the course of history where a fund manager has a thesis that is very smart, but the timing is very wrong.

I have no doubt that these fund managers are “skilled”, but as Michael Maubboussin has detailed, the financial markets are filled with millions of very savvy and intelligent people.  In a field so filled with intelligence there is actually a tendency for luck to play a bigger role than skill.  This is why most fund managers can’t outperform a correlated index and why those who do tend to become future underperformers.¹  This movie glorifies high fee hedge fund managers creating the illusion that these traders were smart rather than lucky.  I have no doubt that these traders were smart, but I think we should be careful glorifying investment managers who generate outsized returns because this fuels the tendency to believe that paying higher fees is consistent with higher returns.  Luck plays a much bigger role here than we are led to believe. The evidence clearly shows this that luck plays a much bigger role in investing than many tend to think.²

The other strong bias in the film was political bias.  The film plays to the emotions of the audience who doesn’t understand the true causes of the crisis and the monetary system.  By pegging the banks as the main culprits of the financial crisis they’ve established an apolitical antagonist.  But by trying to take this politically correct view they actually end up avoiding the nasty politics behind the cause of the financial crisis.

At one point in the film there is a fantastic scene with Richard Thaler and Selena Gomez explaining how a synthetic CDO works.  They set the scene in a casino where Thaler and Gomez are playing blackjack.  They describe how a mortgage bond is a bit like the blackjack player and a synthetic CDO is like someone who makes a bet on the player playing the blackjack game.  This can go on and on as more synthetic CDOs are created by people betting on the bettors all leveraged off the bet at the blackjack table.  They ignore one important detail, however – the fact that the analogy only works if the blackjack players are homeowners.

In other words, MBS and CDOs only fail if the homeowners get involved in a game that they’re unlikely to win.  So, by being unable to pay their mortgages it was actually the homeowners who lit the match that created the crisis.  The flaw in playing blackjack is that the house always has the edge.  Betting on that bet is unlikely to be a consistent winner in the long-run.  Likewise, the homeowners who misunderstood adjustable rate mortgages, falsified loan docs or speculated on an asset that doesn’t typically generate real returns, were playing a game they were unlikely to win.  Wall Street magnified this consumer error by being complicit in the fraud and securitizing the loans that made the crisis much worse than it should have been.

There’s no doubt that there was lots of blame to go around.³ Many homeowners were speculating on houses, misunderstanding adjustable rate mortgages, falsifying loan docs.  The banks were complicit in the speculation, fraud and misunderstandings about the potential risks.  And the government failed to properly regulate these actions while often encouraging much of it.  While we should be furious about the bailouts and the actions of many Wall Street firms, we shouldn’t forget that the blame for the crisis was widespread.

The Big Short was a fine film as far as Wall Street movies go, but as an industry insider I couldn’t get over the two biases that perpetuate so many of the myths that lead people to misunderstand the economy and the financial markets….


¹ – Quantifying the Impact of Chasing Past Fund Performance, Vanguard

² – Shopping for Alpha: You Get What You Don’t Pay For, Vanguard

³ – For some reason it’s become controversial to say banks weren’t the only cause of the crisis, but it’s true – there was unprecedented housing speculation, consumer debt accumulation, loan doc falsification, bank fraud, bank ignorance about future home prices, a lack of government regulation and encouragement of homeownership….