Book Review: Too Smart for Our Own Good

Too Smart for Our Own Good: Ingenious Investment Strategies, Illusions of Safety, and Market Crashes. 2018. Bruce I. Jacobs, CFA. McGraw Hill Education.

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Too Smart for Our Own Good is a cri de coeur about investment products that lull investors with the appearance of low risk and the promise of high returns, while actually introducing systemic risk and, ultimately, market crashes or crises. The principles that author Bruce I. Jacobs, CFA, lays out are general ones, but he focuses in detail on three major market crises of recent decades in which those destructive principles were, in his view, critical ingredients — the crash of 1987, the collapse of Long-Term Capital Management (LTCM) in 1998, and the global financial crisis of 2007–2008.

The author is co-founder, co-chief investment officer, and co-director of research at Jacobs Levy Equity Management. He has been a critic of the flawed investment theories that he discusses in this book since debating the creators of portfolio insurance head-to-head in the 1980s. Jacobs wrote a previous book, Capital Ideas and Market Realities: Option Replication, Investor Behavior, and Stock Market Crashes (1999), focused entirely on portfolio insurance, its marketing, and the consequences of the strategy’s wide adoption in the 1980s. He also wrote about the role of exotic mortgage instruments in the 2007–2008 crisis. Subsequently, Jacobs was active in creating the National Institute of Finance, which was instrumental in convincing Congress to include the creation of the Financial Stability Oversight Council among its post-crisis financial reforms.

Jacobs acknowledges that many books have been written on financial crises but contends that too many of them attribute the price collapses to inexplicable “acts of God” or the inherent randomness of capital markets. The true culprits, he believes, are identifiable. Investment professionals owe it to their clients — and themselves — to understand the true causes of financial disasters and help ensure that they do not recur.

The author’s core thesis is fourfold:

1. Certain investment strategies, especially those that offer the illusion of safety, “can interact with market realities to create unhealthy consequences for markets and investors.”
2. The strategies are typically complex and marketed with an aura of cutting-edge sophistication.
3. They typically lack transparency.
4. They exhibit excessive (though perhaps disguised) leverage.

The book is divided into five parts. Part I provides
background for readers unfamiliar with important concepts relating to risk and
its management, such as diversification, hedging, and arbitrage. Many
investment professionals can safely skip this section. Part II examines the
1987 crash. Specifically, it scrutinizes the role of the newly created strategy
of portfolio insurance in triggering, or certainly exacerbating, that crisis.
Part III gives similar treatment to the collapse of LTCM in 1998. Here,
allegedly low-risk but wickedly complex arbitrage strategies are what led to
disaster.

Part IV looks at the credit crisis and recession of 2007–2009.
This time, trouble came in the form of complex asset-backed derivatives such as
collateralized debt obligations and residential mortgage-backed securities.
Part V is a grab bag of less cataclysmic market crises, such as various flash
crashes, the “London Whale” event, the European debt crisis, and the Greek debt
crisis, as well as related issues, such as uncritical reliance on models. In
this section, Jacobs also proposes some solutions, primarily involving more-effective
regulation, increased disclosure, clearinghouses, and proper education.

The appendix contains additional background material:

• A primer on bonds, stocks, and derivatives.
• Documents from Jacobs’s debates with purveyors of portfolio insurance in the 1980s.
• A discussion of several of the major 1990s derivatives disasters.
• The author’s 2002 proposal for research objectivity standards.

Also included is a discussion of the 1929 crash. One might question why this is relegated to the appendix. Is it relevant to the core argument or not?

Too Smart for Our Own Good’s core thesis should be taken to heart not only by investment professionals but by all investors. Free-lunch promises, complexity, opacity, and excessive leverage have too often combined to toxic effect. Financial professionals in particular could benefit greatly from studying the market crises analyzed in this book and the key lessons to be drawn from them. George Santayana’s famous dictum — “Those who cannot remember the past are condemned to repeat it” — applies with a vengeance to financial markets.

The book has some flaws. Because it is organized in five parts, the core thesis is restated and rediscussed in each one, leading to considerable repetition. In Part V, the argument gets diluted when the author introduces a variety of additional issues that can contribute to market instability, such as conflicts of interest, high-frequency trading (HFT), moral hazard, cognitive biases, and the unintended consequences of regulation. If many things can contribute to a crisis, does that mean every crisis is complex and unique, rather than all driven by one particular set of factors? One might also wonder if opacity was not a worse problem in the old days before the instant dissemination of asset prices, when investors had to take their broker’s word on prices and market action.

At a deeper level, a reader might ask why financial crises have
been occurring for several centuries, beginning long before portfolio insurance
and other fancy instruments were made possible by the digital revolution. Does
Jacobs believe all financial crises
are characterized by the features in his core thesis or just the most recent
ones? Did the author perhaps miss an opportunity to identify a more universal
underlying cause of crashes, such as the inevitable tendency of investors to
become complacent and careless during extended periods of prosperity? One is
reminded of John Templeton’s adage that “bull markets are born
on pessimism, grow on skepticism, mature on optimism, and die on
euphoria.” Could the instruments and attitudes Jacobs warns against be a
response to the demand that arises during optimism and euphoria? And although
innovations can be accompanied by pain as we adapt to them, do not many
innovations also bring great benefits?

An issue Jacobs does not address is the complicity of government policy in some crises. For example, the subprime industry was encouraged by legislation and regulation aimed at promoting more widespread homeownership. A case can also be made, with respect to the global financial crisis, for example, that procyclical monetary policy often helped inflate euphoric phases and deepen the inevitable corrections. Finally, government policies have created moral hazard via bailouts by the US Federal Reserve, the Treasury, and spending legislation.

In fairness, excessive leverage may well have played a part
in most, if not all, of history’s crashes, and opaque innovations may have
figured into many as well. Tulipmania featured options, as the author points
out in an aside.

Certainly, the author’s four horsemen — the illusion of safety, complexity, opacity, and leverage, tied up in a pseudoscientific wrapper — played crucial roles in the worst crises of recent decades. Every investment professional should be obligated to thoroughly understand those crises and their ingredients. This book serves as a valuable guide for exactly that undertaking.

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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.

Image credit: ©Getty Images / Ioannis Tsotras