Lessons from "The Big Short"

So much has been written about the credit crisis caused by the real estate bubble and the government’s reaction to the resulting recession that it may be difficult to even consider reading a book on the subject, but “The Big Short” by Michael Lewis is worth the time.

Most books written on the subject provide a timeline of events and try to determine who was to blame. Instead, Mr. Lewis chose to focus on the few people who saw the crisis forming and bet against Wall Street, based on the strength of their convictions. The book isn’t a ‘get rich quick’ instruction manual, but it provides a fascinating look inside Wall Street thought the eyes of a few unusual people, and several important lessons for investors in the process:

Don’t believe that something is right just because so many people are doing it.

I know, it sounds like something your mother would say. But history is crowded with examples of investment booms and busts that were caused by the pressure of the crowd. In the last 40 years we’ve experienced energy tax shelters in the 80’s, the dot-com stocks of the late 90’s and the recent real estate boom. It’s easy to recognize how ridiculous prices were AFTER the fact, but in the height of a boom it’s tough to watch your brother-in-law get rich flipping Florida condos and your friends making money overnight without feeling you’re a sucker for staying out. But the last man standing when the music stops can lose it all.

Brokerage firms are rife with conflicts of interest that damage the wealth of individual investors.

In the credit boom leading up to the bust, brokerage firms made bets on bonds for their own accounts and created new investment vehicles by pooling together low quality mortgages. Bonds the firms no longer wanted to keep for themselves were dumped onto unsuspecting investors. We need to move to a fiduciary standard in the industry where all investment firms have to act in the best interest of their clients. Investors, in the meantime, need to pay attention to how their advisor is compensated and where his loyalty lies.

It takes guts to maintain your course of action when so many people tell you you’re wrong.

I actually felt sorry for the man who made $100 million for himself and $700 million for the investors who stuck with him. Michael Burry created a hedge fund, Scion Capital, and began betting against the real estate bubble in 2003, before the rest of the world caught on. Because he was early, real estate and mortgage backed investments continued to go up in value, and his hedge fund suffered losses. In 2006, when the S&P 500 was up more than 13%, he lost 18.4% for his clients. He was physically threatened and harassed, and some of his investors organized to sue him in the fall of 2006. By June of 2007, the real estate house of cards began falling in the credit markets, and his bets paid off spectacularly. But Burry was so traumatized by all the years of harassment and doubt that he closed his fund.

If you have an investment plan in place to reach your goals, it’s emotionally difficult to stick with it when you feel the sky is falling or everyone is getting rich and you aren’t. But don’t allow CNBC’s Jim Cramer or a friend at a holiday party cause you to doubt yourself.

If you have some time over the holidays, I recommend you spend it with “The Big Short.” You might even walk away with a few more lessons of your own.

Jeannette A. Jones, CPA, CFP®
jjones@taaginc.com
http://www.taaginc.com