Our Big Lesson From “The Big Short”
The story of Michael Burry and his clients is a case study in what it takes to be on the right side of financial history. Spoiler alert: it’s not easy…for anyone.
If you don’t know who Burry is, then you’ve failed to consume Michael Lewis’s The Big Short in either book or movie form. Burry was one of the more interesting characters, and one of the small band of investors who bet against the mortgage market prior to the 2008 meltdown. In doing so, he obviously made a killing. And yet, the status as a historically great trade notwithstanding, his story deeply resonates with us for a different reason: the emotional dynamic that existed between Burry and his clients.
It’s fair to say that there was some tension. According to Michael Lewis (author of The Big Short):
And so in January 2007… Michael Burry sat down to explain to his investors how, in a year when the S&P had risen by more than 10 percent, he had lost 18.4 percent.
“OK,” you’re probably saying to yourself, “that seems like a reasonable thing to have to answer for.” Except that:
A person who had had money with him from the beginning would have enjoyed gains of over 186 percent over those six years, compared to 10.13 percent for the S&P 500 Index.
Burry’s firm, Scion Capital, focused on deep value investments. In other words, they sought to both buy long-term investments at depressed prices and sell short those that were overhyped. It is worth noting that from 2000 through 2005, most of Scion’s investment returns were derived from going long value stocks. Clients could wrap their minds around this investment concept – buying stocks “on sale” – and it had payed off. But in 2005, Burry found a far more attractive trade: shorting mortgage bonds. It’s easy to recognize the discomfort an investor might feel when the execution of an otherwise consistent investment philosophy changes dramatically. But that’s exactly what happened: after five years buying undervalued stocks, Burry decided he was going to short a specific segment of the mortgage market. And not only that, his weapon of choice was a new-fangled derivative called credit default swaps (CDS).
The mechanics of a CDS are beyond the scope of this article, but it’s easiest to think of it as “bond insurance.” Effectively, Burry convinced Goldman Sachs to sell him a contract that would pay off handsomely in the event that the underlying mortgage bonds defaulted. These contracts, it must be said, were not inexpensive; during a period where Scion managed roughly $555 million, the contracts required that the Scion’s portfolio pay premiums amounting to about 8 percent of the portfolio, every year, for the lifetime of the underlying loans. Investors were not happy about the performance drag this caused from 2005-2007.
And yet, acknowledging that a cause for angst exists doesn’t necessarily justify it. From both the world of academia and our first-hand knowledge, we know that investors tend to respond adversely to even the shortest bouts of underperformance. Whatever the bias – anchoring, prospect theory, or the deleterious effects of herding – investors tend to have short memories and an inability to give well-reasoned investment strategies the appropriate amount of time to prove out their value. Burry himself asked for three to five years for his thesis to bear fruit, a reasonable period given that his CDS positions were designed to profit during the bearish half of the market cycle. And yet in his book Lewis describes just how difficult it was for investors to focus on process when short term returns aren’t positive:
When he opened his fund in 2000 he only released his quarterly returns and told his investors that he planned to tell them next to nothing of what he was up to. Now they were demanding monthly and even fortnightly reports.
And lest you think that things were easier from Burry’s perspective:
[Burry] was now undeniably miserable. “It feels like my insides are digesting themselves,” he wrote to his wife…
Indeed, the period from 2005 to mid-2008 was so stressful for Burry that at one point he required treatment for bleeding ulcers. This might seem extreme until you recall your own, very-likely-ulcer-inducing emotional state from late 2008 to early 2009. These were the very definition of difficult times: Burry suffered for being short too early, while most suffered from being long too late.
At ReSolve, our investment processes are in no way close to those of Burry from The Big Short; the degree of concentration of his wager is completely antithetical to our emphasis on diversification. Rather, what resonates is just how difficult it is for investors to focus on process over short-term outcomes. In that regard, there is much both professional and individual investors can learn from the story.
First, try to have a long-term orientation in terms of decision making and results analysis. Second, embrace contrarian thinking. Third, before investing a single dollar, make sure you fully understand and have strong conviction in the investment process. And fourth, make sure to have the prerequisite self-discipline, patience and fortitude for persistent implementation of your chosen approach.
In these increasingly uncertain times, plagued by crashing commodity prices, expensive stock markets, generationally low interest rates, and global currency volatility, periods of loss are to be expected. Risk management isn’t about eliminating losses nearly as much as it’s about eliminating impairments that can call into question the viability of your financial goals.
Losses never feel good, especially when accompanied by the social exclusion of doing something different. But that is a burden we gladly carry in order to be – at some point in the not too distant future – on the right side of history.