How You Can Be Right and yet Still Be Wrong

The Big Short is a recently released movie based on the real life investments of three US hedge funds and their managers:  Michael Burry, Mark Baum and Charlie Geller/Jamie Shipley.  All three funds bet against the US subprime debt market which collapsed in 2008, propelling all three funds’ portfolio values to astounding heights as the rest of the US market crashed and burned.

Michael Burry who ran Scion Capital LLC was the first to discoverin as early as 2005 how certain bonds that were supposed to be conservative, low-risk investments were actually based on subprime mortgage dealsthat had an inherently high risk of default. Convinced of this fact, he went about to createan instrument by which he can bet against those subprime deals.  He was able to persuade Goldman Sachs to sell him credit default swaps that would enable him to profit from a collapse of specific deals he considered particularly susceptible.

At that time, Goldman Sachs agreed to sell him the credit default swaps because they thought he was likely to be wrong.  Burry’sbet went against commonly accepted valuations at that time.  And for the next few years it seemed Goldman Sachs was right.  Mortgage bonds continued to rise up until 2008.

For an agonizing while, Michael Burry was wrong. Before his fund posted any gains, it first sank in the deepest of reds. It got so bad that his investors threatened to sue him already.  Burry even started questioning his model, thinking that the whole US financial system was rigged as the bond values he expected fall, even rose in seeming defiance of logic.

Fortunately, however agonizing though it was, Burry stuck with his guns.  Finally, his predictions came true and the subprime debt crisis exploded in 2008.  Burry’s investors, no doubt suffering excruciating distress over the past few years since the fund bet against the mortgage bond market, finallybegan to see their gains. As the bond market started to free fall, their hedge fund’s average gains skyrocketed, reaching as high as 489% as of 2008.

What can we learn from Michael Burry’s story? You can be right and yet still be wrong.

Right Decision, Wrong Decision Road SignIn Burry’s case, he was dead right about the collapse of the bond market.  But what he couldn’t predict was the exact timing of the collapse.  As John Maynard Keynes said, the markets can stay irrational longer than you can stay solvent.  A lot of Burry’s clients, as they began to lose confidence in their hedge fund’s strategy, already wanted out. Scion Capital almost became insolvent before the bond market started to actually act rational about the subprime debt situation.  In such cases where you are right about a fact but not exactly right about the timing, you better be sure you have the stomach and the funding needed to stick it out until the end – until the event you are betting on actually takes place.

Michael Burry isn’t alone in falling into such a predicament. Some reputable names in the investment world are actually, currently in the same situation.

Take the famous investor Jim Rogers, for example. Rogers motorcycled around the world to find the best investment opportunities.  He sold his New York apartment and relocated to Singapore mainly because he believes that the US economy is facing an impending collapse.  Jim was bullish on emerging markets, especially China and so has most of his portfolio tied up in that market. However, the Chinese economic growth toutedby everyone actually ended with a crash last year, with the Chinese market collapsing in late 2015 and again just a few days into 2016.  Rogers might still be right.  But for now, he’s wrong.

Marc Faber is another example. Known for his gloom and doom outlook for the US economy, he invested in gold and recommended againstinvesting in bonds. Unfortunately, the market went against him for a while as gold prices dropped and bond prices performed well in 2015.  This year, Faber has said that he thinks investing in bonds is now a better option than investing in the stock market.  Is Faber right about his gloomy outlook for the US economy?  Will gold actually become a brilliant investment if Faber’s prognosis comes true – leading to multiple gains that would far outweigh all current unrealized losses?  Possible.  But for now, he’s wrong.

goldman sachsWhat should you do if you find yourself in the same situation?  If these legendary investors found themselves wrong for a time, how much more the typical, ordinary individual.

Like these brilliant men, what we advise at LOM, is you should revisit your model and assumptions.  If you find that some factors did not turn out as expected, then you should adapt.  Be a dynamic investor. You can’t be “married” to your investment.  You have to cut your losses if you are wrong.

But if you believe that your model and investment assumptions are still solid and it’s only a matter of timing, then you need to brave it out.  Of course, solvency is a key factor that will determine if you can last.  If you are highly leveraged, then you might not have the luxury of waiting it out.  You need guts and a stable source of funding so you can wait it out when you are right – but just wrong at the moment.

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