My girlfriend is currently taking online courses on financial analysis for her own personal development. The content can be really dry for her at times. To spice up her learning, I recently suggested that she watch the movie, The Big Short.
The film came out in 2015 and is based on the 2010 book by renowned author Michael Lewis, The Big Short: Inside the Doomsday Machine. Both the movie and book depict the real-life experience of a few groups of investors who foresaw the 2008-09 US housing and financial crisis and profited from it.
When the movie first came out, I was so excited that I helped organise an outing to watch it with a group of friends who are also keen investors. I remember being captivated by the film.
After recommending The Big Short to my girlfriend (she loves the movie too – yay!), I decided to rewatch it last weekend. It was the first time I did so, five years after I initially saw the film. In my second run, I experienced the same captivation I did as on my first. But this time, I also came away with investing lessons that I want to share – perhaps a by-product of me having this investment blog that I love writing for.
Lesson 1: The market can remain irrational longer than you can remain solvent
The characters in The Big Short mostly used leveraged instruments – credit default swaps (CDSs) – to make their bets that the housing market and the financial instruments tied to the housing market would fall. This is a simplified explanation, but the financial instruments that were tied to the housing market were essentially bonds that were each made up of thousands of mortgage loans from across the US.
The CDSs are like insurance contracts on the bonds. If you own a CDS, its value will rise significantly, or you will receive a big payoff, if the value of the bonds fall or go to zero. But before the decline happens, you have to pay regular premiums on the swaps as long as you own it. Moreover, you have to meet margin calls on the CDS if the value of the bonds increase.
The investors depicted in The Big Short suffered temporary but painful losses to their portfolios because of the premiums and margin calls they had to pay prior to the flare up of the housing and financial crisis. Their experience reminded me of a great quote that is commonly attributed to the legendary economist John Maynard Keynes, but that is more likely to have originated from financial analyst Gary Shilling:
“The market can remain irrational longer than you can remain solvent.”
If the housing and financial crisis did not erupt when they did, the investors in The Big Short may have suffered debilitating losses if they held onto their CDSs long enough. This is a key reason why I do not short financial assets nor use leverage. Some investors can do it very successfully – the ones in The Big Short certainly did – but it’s not my game.
Lesson 2: Investing can be a lonely affair
One of the real-life investors profiled in the movie and book is Dr Michael Burry. The movie did not explore much of Burry’s earlier life before he invested in the CDSs, but his real backstory is amazing.
Growing up, Burry was somewhat of a loner. But he managed to excel academically and eventually graduated with a medical degree. He worked in a hospital for some time, but found that his real interest was in stock market investing. When he was a doctor, he spent his free hours researching stocks and writing about them on the internet. His sharing was excellent and attracted the attention of the well-known investor Joel Greenblatt (the character Lawrence Fields in the movie is based on him). Burry eventually left medicine to establish his investment firm, Scion Capital, with Greenblatt’s seed capital.
Burry’s reputation was built on his uncanny ability to pick stocks mostly through bottoms-up, fundamental analysis. In Scion’s early days, he posted tremendous returns for a few years by shorting overvalued stocks and investing in undervalued ones. But in 2005, after he discovered the house of cards that the US housing market was built on and decided to invest in CDSs, his investors started turning on him. They had no faith in his ability to find investment opportunities outside of the stock market. They wanted him to stick to his knitting.
The Big Short depicted the intense emotional loneliness that Burry felt when his investors turned their backs on him. Some even threatened to sue. Burry was vindicated in the end. In 2007, the US housing market started to collapse and the bonds that were built with the mortgage loans failed. Burry’s CDSs soared as a result. But he was so burnt out by the experience that he decided to close Scion Capital after cashing in the profits.
What was even sadder is that even though Burry made a lot of money for his investors in Scion Capital – the fund gained 489% in total, or 27% annualised, from its inception in November 2000 to June 2008 – the relationships he had with his investors, including his mentor Greenblatt, had mostly soured beyond repair.
At times in investing, we may be the only ones who hold a certain view. This could be a lonely and draining experience (although it’s probably unlikely that we will face the same level of isolation that Burry did) so we have to be mentally prepared for it.
Lesson 3: Famous investors can be very wrong at times too
This is related to Lesson 2. Joel Greenblatt produced a 40% annualised return for 20 years with his investment fund, Gotham Capital, that he co-founded in 1985. That’s an amazing track record. But Greenblatt got it wrong when he butted heads with Dr Michael Burry’s decision to invest in CDSs.
It’s very important for us as investors to know what we don’t know. As I mentioned earlier, Burry started his investing career by being a very successful stock picker who did bottoms-up fundamental analysis. Being a good stock picker does not mean that you will automatically be good at other types of investments. I believe this was Greenblatt’s concern and I sympathise with him. This is because it was a legitimate worry that Burry may have ventured into an area where he had zero expertise when he shorted the US housing market through CDSs.
This is not meant to be a criticism of Greenblatt in any way. His results are one of the best in the investing business. I would have been worried about Burry’s investment actions too if I were in Greenblatt’s shoes. What I’m trying to show is just how difficult investing in the financial markets can be at times, and that even the best of the best can get it wrong too.
Lesson 4: Luck can play a huge role in our returns
One of the central characters in the movie and the book is hedge fund manager Steve Eisman (named Mark Baum in the film) who first heard of the CDSs trade from a bond trader at Deutsche Bank, Greg Lippmann (named Jared Vennett in the film). What is amazing is that Eisman only knew about the idea because of a mistake that Lippmann made.
Lippmann wanted to introduce his idea of shorting the housing market with CDSs to hedge funds that had a certain characteristic. One hedge fund Lippmann discovered that fit his bill was Frontpoint. Eisman’s hedge fund was named Frontpoint – but the problem was Eisman’s Frontpoint was not the Frontpoint Lippmann was looking for. Lippmann only realised his mistake when he met Eisman in person. Nonetheless, Eisman saw the logic in Lippmann’s idea. He made the trade for his Frontpoint, and the rest as they say, is history.
This goes to show how important luck can be to our investment returns. Eisman only knew about the idea because Lippmann suffered a case of mistaken identity. Sure, Eisman may have eventually discovered the same idea independently. But this is a counterfactual that is impossible for us to ever know. What we do know is that Lady Luck had smiled on Eisman, and to his credit, he acted on it.
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Note: An earlier version of this article was published at The Good Investors, a personal blog run by our friends.
Disclosure: Ser Jing owns shares in any of the companies mentioned.