The elusive value of past investment mistakes



LONDON (Reuters Breakingviews) - Last week, a new business and finance library opened its doors in Edinburgh’s New Town. The Library of Mistakes was named by its founder, the investment strategist Russell Napier, in the fond belief that the study of history can improve financial understanding, as he says, “one mistake at a time.” Appropriately enough Alistair Darling, Britain’s Chancellor of the Exchequer during the global financial crisis of 2008, inaugurated the library. Judging by recent events, investors haven’t learned much from that earth-shattering event.

The Library of Mistakes takes as its motto a comment by James Grant that whereas progress in the physical sciences is linear, in finance it is cyclical. As the founder of Grant’s Interest Rate Observer likes to say, “we keep on stepping on the same rakes.” In an ideal world, knowledge of earlier financial debacles would steer investors away from those noisome garden implements. In practice, there’s no substitute for personal experience. Professional investment is a game of trial and error. Mistakes are expensive lessons whose bills, in terms of underperformance, are paid by clients.

The best investors learn from their mistakes. Even the most successful are wrong nearly half the time, which gives them plenty of material to dwell upon. A willingness to admit to errors, says Napier, indicates an open mind. Richard Oldfield, an experienced British fund manager, opens his witty and wise book on investment, “Simple But Not Easy”, with a chapter on his personal howlers. Theinvestment adviceimparted by Oldfield’s former employer, the merchant banker Siegmund Warburg, was to “always cry over spilt milk.” Every mistake makes one a fractionally better investor, says Oldfield.

George Soros places mistakes at the heart of his investment process. The Hungarian-born billionaire claims to have an acute sense of his own fallibility. “To others, being wrong is a source of shame,” Soros wrote. “To me recognising my mistakes is a source of pride. Once we realise that imperfect understanding is the human condition, there is no shame in being wrong, only in failing to correct our mistakes.” Soros’s approach as a hedge fund manager was to first establish a position and then consider how he might be wrong. In his view, the recognition and rectification of mistakes constitute the hard job of investing. The rest is a cinch.

The opening of the new library was accompanied by a weeklong “Festival of Mistakes”. At one event, seasoned investors discussed their career-defining blunders. Former emerging markets fund manager Angus Tulloch confessed that he’d failed to anticipate the disruption that the internet would bring to so many businesses and advised younger investors to spend at least 15 minutes a day writing down their mistakes. Another retired investor admitted to owning a large stake in Northern Rock when the British mortgage lender collapsed in 2007. His mistake was not to have considered what would happen to the bank if wholesale money markets dried up. He compounded the error by failing to sell when Northern Rock first alerted shareholders to its funding problems. When an investment thesis is exposed as fundamentally flawed, it’s never a good idea to tarry.

“Leverage and illiquidity are the kiss of death,” writes Oldfield, citing a former colleague. Yet too many investors ignored this sound advice in the years before the global financial crisis. They also turned a blind eye to frothy conditions in the U.S. housing market, just as, a few years earlier, they’d ignored sky-high stock market valuations. Another age-old blunder involves attempting to enhance returns by taking excessive risk at times of abnormally low interest rates. Wall Street created securities backed by subprime mortgages to meet investors’ demand for extra yield after the Federal Reserve led by Alan Greenspan adopted its easy money policy at the turn of the century.

There’s scant evidence the disastrous errors revealed by the financial crisis imparted any lasting lessons. In fact, most recent high-profile investment disasters involve some mixture of illiquidity and excessive leverage. In 2019, the British investor Neil Woodford shut up shop after an outsized bet on unlisted securities meant his investment firm couldn’t meet redemption requests from clients. A year earlier, a fixed income fund run by GAM closed after investors became concerned about its exposure to illiquid securities.

Meanwhile, investors have been using leverage to enhance returns like never before. U.S. margin debt soared during the market frenzy of the past couple of years. Last year, Archegos Capital Management, a family office run by former hedge fund manager Bill Hwang, collapsed after making extremely leveraged bets on a handful of American and Chinese listed companies. Archegos’s failure cost its lenders around $10 billion. Hwang last month pleaded not guilty to U.S. criminal changes that he lied to the banks and used derivatives to manipulate share prices.

Nor have investors paid much attention of late to market valuations. At the start of this year, U.S. stocks were trading at their highest multiple of earnings, adjusted for the economic cycle, since the dot-com bust of 2000. Shares in cloud computing companies, special purpose acquisition companies (SPACs), and anything to do with electric vehicles soared into the stratosphere. Walter Bagehot’s comment that the “good times … of high price almost always engender much fraud” seems apt for the frantic activity in SPACs and cryptocurrencies.

Why have investors learnt so little from past errors? The obvious answer lies in human nature. There may be no permanent laws of investment, Napier says, but our mistakes are eternal. Professional investors are forced to keep up with the crowd, despite their better judgment. As they say on Wall Street, to be early is to be wrong.

Meanwhile, the extraordinary monetary policies of recent years have helped to induce a kind of collective amnesia in financial markets. Zero interest rates boosted market valuations and created a most desperate search for yield among investors. Easy money also encouraged excessive leverage. Now interest rates are rising and the errors of the recent market frenzy are being exposed. In due course they will be written up, providing more volumes to that ever-expanding institution, the Library of Mistakes.

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- Edward Chancellor’s “The Price of Time: The Real Story of Interest” will be published by Penguin on July 7.

(Editing by Peter Thal Larsen and Oliver Taslic)

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.


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