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Did Overconfidence Cause The Financial Crisis? at Trader’s Narrative





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Here’s an interesting video from the recent The New Yorker Summit featuring Malcolm Gladwell talking about the financial crisis:



After Gladwell’s recent book “Outliers: The Story of Success” which inspired the Definitive Guide to Trading Mastery & Success - I was hoping that he would turn his considerable attention to the current financial crisis. What are the underlying forces behind it, how did it happen, why did so many things go wrong in a cascade effect?

We get a glimpse of that in his brief talk but I’m rather disappointed at his shallow take on things. He suggests three possible reasons why things happened as they did:

  1. Regulatory Failure: A lack of rules or the absence of their enforcement
  2. Cognitive Failure: Dumb people making dumb mistakes
  3. Psychological Failure: Overconfidence

He brushes aside the first option and then the second, saying that the players on Wall St. are anything but dumb. Then he zeroes in on the third, concluding that overconfidence is the real culprit.

Gladwell defines overconfidence as “certainty in the presence of expertise” which leads to two main fallacies: miscalibration and illusion of control. Referring heavily to William D. Cohan’s book House of Cards: A Tale of Hubris and Wretched Excess on Wall Street, Gladwell builds his case that at the root of the financial crisis is the culture of overconfidence on Wall St.

While I don’t doubt that this is the prevalent culture of finance today, I think Gladwell has missed the mark and in doing so, perhaps inadvertently, treated the guilty parties with undeserved deference.

The weakening of the regulatory framework, such as the repealing of the Glass Steagles Act, as well as regulators who were for the most part, incompetent, ineffective and chummy with the financial industry played a major role. It was the frayed fabric of regulation that failed to keep the ‘cowboy’ culture of Wall St. from running roughshod over Main St.

Believe it or not, there was a time when banking was a staid, boring job. There was no way you could pick up a hot chick by flaunting your job as an investment banker. Of course, that was before you could leverage your equity 40 times or more and pretend you were running a hedge fund, instead of a vital service for society.

The failure of government to properly guard the industry from rot created a “tails I win, heads you lose” game. Who wouldn’t be overconfident to play such a rigged game? If you can nuke a whole industry and take the global financial system to the precipice… and then still walk away with hundreds of millions of dollars in salary and bonuses… would you be overconfident? Of course!

If every time you got into a jam, you knew from precedent (S&L crisis, LTCM, etc) that the government would always be there to socialize your losses, wouldn’t you want to take as much risk to gain the maximum private profits? Of course! You would be an idiot not to. So it clearly isn’t a case of ‘overconfidence’ but rather a rigged game from the get go.

Here’s a more substantive take on things from Prof. Shiller and the enfant terrible of this bear market, Nassim Taleb, author of The Black Swan:

Shiller mentions his recent book: Animal Spirits: How Human Psychology Drives the Economy, and Why It Matters for Global Capitalism which dovetails nicely with Gladwell’s thesis but unfortunately it is only Roubini who ends up making real sense. As always, Roubini is unapologetically abrasive. If we want our progeny to avoid a similar fate down the line we need more Roubinis making decisions and fewer insiders like Paulson and Geithner.

Lincoln said it best 172 years ago:

These capitalists generally act harmoniously, and in concert, to fleece the people, and now, that they have got into a quarrel with themselves, we are called upon to appropriate the people’s money to settle the quarrel.

Finally I’ll leave you with this ditty which was written by Colin Negrych:

Yea though I walk through the Valley of the Shadow of Debt
I shall fear no default rates; for thou art with me
Thy printing presses and thy stress tests comfort me
Thou preparest a bull market for me in the presence of Roubini, Taleb, and Grant
Thou anointest my portfolio with liquidity; my wallet runneth over

Surely bonuses and bailouts shall follow me all the days of my life
And I will dwell in the house in Greenwich forever.
A-Ben

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14 Responses to “Did Overconfidence Cause The Financial Crisis?”  

  1. 1 Colin Negrych

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    Hi. A few things: I am not now, nor have I ever been, a stock broker; I didn’t forward the poem to Nick, I wrote it and sent it to him. He was unable to shoehorn it into his New Yorker article becuase it arrived to close to press time. It’s meant to capture, and mock, the remarkably carefree and confident attitude, which I do not share, of many investors and Wall Street employees about the extant economic and financial environment. Cheers.

  2. 2 Dave

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    Colin,

    Thank you. Loved it. Is the Valley of the Shadow of Debt west of the Hudson ? http://voxtango.com/bmind/plate1.jpg

  3. 3 Babak

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    Colin, thanks for pointing that out, I edited the post. So you’re a fund manager with Barclay? And how in the world did you find yourself mentioned so quickly?! are you a regular reader?

    Dave, lol, it is a brilliant re-working of a classic. Perhaps Colin missed his true calling as a writer.

  4. 4 Dave

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    Colin & Babak,

    I’ve also thought that NYC investment bankers did not really understand the real estate folly that was going on in the San Fernando Valley; the Valley of the Sun (Phoenix); & Polyester Valley (Florida) {send the hate mail to Babak -LOL}.

    Babak, i also loved & was impressed by your Lincoln quote. Are you sure 140 yrs have passed ? - apparently not from that quote.

    Regards,
    dave

  5. 5 Avi

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    gladwell is a putz,,,, overconfidence is just a bi-product of greed,,, and that is what caused the current crisis.

    kinda like his tipping point idea…. as people saw others getting rich, they wanted in as well… though this time it was with stupid american home buyers, $100M wall street traders and and stupid pension funds trying to beat their benchmarks by 0.5% in order to get a bonus and therefore buying all the crap ABS and CDO’s

    oh and greenspan should be mentioned somewhere there too

  6. 6 Arthur Шарикович Преображенский

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    Mr. Negrych,

    To be fair Nick wrote it here himself.
    Colin Negrych, a broker who calls himself “a macroeconomic and geopolitical….”

    Nevertheless, great article, thanks for your input. This is an example of true philanthropy, educating anyone who is willing to listen, without pushing your own agenda (That way you actually know there is a positive impact on the society, rather than giving money to charity that will later invest it with Madoff, or pay their workers exuberant salaries)…

    It is hard to say that highly intelligent people didn’t know what they were doing, when even an idiot like me saw the crash and credit squeeze coming. Also, after reading a famous 2002 speech by A-Ben, his nomination seems less accidental. It leads me to believe that those that had to know, knew by early 2006 the state of our economy.

  7. 7 Dave

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    Arthur, Arthur…the art of the incomplete quote. The quote that you cite ends with “disguised as a bond salesman,” A bond salesman is hardly a stock broker.

  8. 8 Arthur Шарикович Преображенский

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    You are right! My apologies (bond brokers always sit one floor above stock brokers, how could I). Could you post more videos from the forum? I loved the Taleb and Shiller video.

  9. 9 JoEllen Weiss

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    Dear Mr. Negrych,

    Thank you for the intellectual honesty shared with Nick Paumgarten that gave such depth to his recent New Yorker article. I hope to read more of your comments on finance, as you draw back the screen of complexity and self-importance that Wall Street has drawn across itself.

    Regards,
    JoEllen Weiss

  10. 10 Arthur Шарикович Преображенский

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    Remember those late day low volume rallies. Hah today would be a great example. Check!

  11. 11 Babak

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    Arthur, yeah, Friday’s ramp up was really something. And this mornings? Suddenly Wall St. is a one way thoroughfare.

  12. 12 Arthur Шарикович Преображенский

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    idiots are piling on, lets see what happens in September.

  13. 13 Leslie

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    That’s not Roubini in the video– it’s Nassim Taleb, author of The Black Swan.

  14. 14 Babak

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    Leslie, thanks! fixed now

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