Investment Professionals Built The Titanic

This article was originally published for RC Peck’s Fearless Wealth Newsletter in April 2005.
The markets are making people happy this week because, typically, the markets rise just before a holiday. I’m not sure why this happens, but you could probably pay some economist a big bag of money and be told what you want to hear. This Thanksgiving does not seem to be any different from the last 30 Thanksgivings; the markets are up only a few hours before the day before the biggest shopping day of the year. Hopefully, the busiest shopping day of the year can help Wal-mart’s stock, whose value is still down 10% from three weeks ago.

A Bit of History

On April 10, 1912 a ship named the RMS Titanic ‘set sail’ from Southampton, England. The professional designers, builders and financiers who produced this ship called it the Ship of all Ships. The Titanic was the most sophisticated (strongest, fastest, biggest) ship ever built. It was going to be amazing.

And it should have been amazing—the best professionals in the world had designed and built it, and the results were truly staggering. We all know what happened to this Ship of all Ships. (I know we all saw the movie, and some of you may even be able to hum the Celine Dion theme song).

Four days into the Titanic’s maiden voyage the ship received no less than six separate ice warnings on April 14th alone. So what did the crew do? Nothing. They didn’t slow the ship or change course. This was the Titanic after all, and so it was full steam ahead. Why? Because this was the most sophisticated ship ever built.

On April 14, 1912, at approximately 11:40 pm, the Titanic hit an iceberg and the ship sank throughout the early hours of the next morning. What is interesting about this incident is not that it was the best ship ever built, nor that it was built by professionals, but how the crew and passengers reacted (or didn’t) when the ship crashed into an iceberg.

The crew told passengers not to worry; after all, this was the unsinkable ship (sound familiar?). What gets me is that the passengers did nothing for hours; nothing, mind you, while the ship was sinking. It wasn’t until hours later that the crew and passengers finally panicked. Sound familiar with people and their money? Yes, I know this is all hindsight, but people don’t change. We all somehow become part of the group.

Fast forward 82 years

Enter John Meriwether, a bond trader, who spent 20 years at Salomon Brothers and became famous by hiring the best PhD’s and economists in the field to build his own arbitrage group with Salomon (arbitrage is a “hedging” strategy designed to minimize the possibility of loss while gaining profits on every trade). Simply put, the best and the brightest worked for him.

When he was asked to leave Salomon he started the world’s greatest hedge fund (the one that would end all hedge funds). No it was not called the Titanic but close.

John went out and hired the best professionals in the investment world. He even brought on two Nobel Prize-winning economists to work for him, not to mention a former vice chairman of the US Federal Reserve — we’re talking heavy hitters here. John had the best of the best and the brightest of the brightest.

John named his hedge fund Long Term Capital Management (LTCM). It started trading in 1994 after raising $1.25 billion (yes, that’s a “b”). In the first two years, LTCM profited over 40% for their investors and had some $140 billion in assets under management. That’s a huge number, in case you don’t know.

What do you think happens when you have so many professional, smart, talented people with a can’t-fail attitude in one room? Failure is the only option left.

About two years after they started the fund (in 1996), LTCM started acting very Titanic-like; ignoring warnings and not changing course. After all, who knew more than they did? They had Nobel Prize winners, vice-chairmen, top-of-their-field economists, not to mention the best bond traders in the business.

Enter the Iceberg

This time, the iceberg was Russia defaulting on its loans. The professionals weren’t prepared (I guess you can’t predict the unpredictable). LTCM’s super-safe portfolio imploded, with over $100 billion, ready to bring down the entire world market.

Luckily for other traders around the world the Federal Reserve bailed them out. LTCM was dead. John’s career lasted six short years at the helm of the Titanic of hedge funds. The captain of LTCM went from the envy of Wall Street to the shame of the industry.

So why did this happen? No plan is perfect. No professional is perfect. There is no perfect system. When humility is traded in for hubris, and when money is involved, you can be sure that the loss of money is not far behind.

Everybody believed John Meriwether and his band because they were the best and we were living in the midst of the biggest bull market in history. What was there not to like?

It seems that humans don’t change. We are the same today as we were in 1912, 1812, and so on. Nothing has changed. We still don’t want to miss out on great opportunities. We still want to think we are better than others. We still think we can beat the system. And yet, century after century, we are still the same. Fear and greed run our lives.

If you’d like to read more about LTCM’s short life, there’s a great book by Roger Lowenstein entitled When Genius Failed.  But IF you’d like to learn how to be part of every major move in history, without losing money, then you need to learn only one lesson. And that one lesson is how to read a trend line. You don’t need to be a professional to do it.

Throughout history the only thing that has never failed is planning to follow the trend and getting out when it’s over: very simple to implement, but difficult to execute.

Here’s why the trend is so important. The trend pulls 75% of stocks with it; up, down and sideways. So if the market is going up, then 75% of stocks are going up with it. The same goes for down and sideways. All that is left is to figure out which way the trend is going (clue: look at a price chart and plot a moving average).

If the moving average of the market is going up, then the market is going up and 75% of stocks are going up with it. Sideways or down, the moving average still pulls 75% of stocks with it. There is nothing random about these statistics; they have been dead-on forever.

There’s a book titled A Random Walk Down Wall Street by Burton G. Malkiel. Burton believes that everything is random, and that a monkey throwing darts at a piece of paper can get the same results as professionals. I both agree and disagree.

The monkey has as good a chance as any professional trying to mimic the market, as long as the monkey is throwing the dart at a list of stocks that are moving up with the market. If the market is trending up, both the monkey and the rest of the professionals have similar chances. The only remaining concern is how to exit the trade. The monkey might be the professional here.

What I don’t believe is that markets are random. There is nothing random about a trend. There is nothing random about a stock that has been going up for two straight years. It would be random if this stock were the only one in its sector going up, but that rarely happens.

Sectors, industries and countries all move in unison. So once they are trending, get on board. Since March of this year the markets have been trending [up] and, as far as I can see, there is no end in sight.

This doesn’t mean the overall market is a buy and hold. The market as a whole is very expensive. The S&P 500 is the most valued it’s ever been (and it’s never been more expensive than it is today), but the trend is our indicator, and the indicator is going up. Very simply, you should buy when the trend is going up and sell when the trend is going down.

I realize this advice might sound way too simple, but if you add your own second-guessing, self-doubt and emotions to the mix, you may be in for a Titanic-type ride.

Lessons:

  1. Professional doesn’t always mean “I know what’s best for your money.” A professional is someone who has passed some exams and gets paid for his or her work.
  2. Professionals who do not follow trends lose their clients’ money. Non-professionals who don’t follow trends lose their own money.
  3. When someone offers you a “can’t lose” investment, be wary or put a stop-loss in place.
  4. There is nothing random about a trend on a price chart; it’s the purest information available.

To listening to the price charts,
RC’s Signature

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