'Beware of geeks bearing formulas'

That’s something to bear in mind to avoid a financial meltdown of investment portfolios according to Warren Buffett in his annual letter to the stockholders of Berkshire Hathaway. It is a lesson this crisis should teach investors who Buffett said, blissfully ignored the perils of relying on mathematical models devised without worst-case situations in mind. When investing, pessimism is your friend, euphoria the enemy, the Oracle of Omaha advised.

Too often, he wrote, Americans have been enamored of “a nerdy-sounding priesthood, using esoteric terms such as beta, gamma, sigma and the like.” Some skepticism about these models is overdue, he added. Derivatives… for example.

Mr. Buffett was scathing on the subject of derivatives. He had likened derivatives to weapons of mass destruction long before they started wrecking havoc on the balance sheets of banks around the world. In his letter, Mr. Buffett explained that the danger of derivatives was not merely the difficulty in assessing their value; rather, it was the “web of mutual dependence” they create among financial institutions.

Derivatives contracts, he pointed out, keep various parties entangled for years, which, he explained, can create real hazards once those assets start deteriorating. “Participants seeking to dodge troubles face the same problem as someone seeking to avoid venereal disease,” he wrote. “It’s not just whom you sleep with, but also whom they are sleeping with.”

The Oracle had more interesting observations to make about what went wrong. I got the impression from the way the Oracle cut down people and conventional investment wisdom that most of it is because of hubris. People wanted to be seen as sophisticated investors. As it turned out, almost everyone didn’t fully understand the investment models they were betting billions on but just didn’t want to let on… sort of the scene straight out of that fairy tale about the emperor’s new clothes.

That was also along the lines of what Yale economist Robert Shiller observed when he blamed mainstream economists for failing to warn that a crisis was on its way. It seems, the Yale economist observed, that concerns about professional stature may blind economists to the possibility that they are witnessing a market bubble. “We all want to associate ourselves with dignified people and dignified ideas. Speculative bubbles, and those who study them, have been deemed undignified.”

Speculative bubbles, he explained, are caused by contagious excitement about investment prospects. “I find that in casual conversation, many of my mainstream economist friends tell me that they are aware of such excitement, too. But very few will talk about it professionally.”

He tried to explain why economists always seem to find concerns with bubbles to be overblown or unsubstantiated. “It must have something to do with the tool kit given to economists (as opposed to psychologists) and perhaps even with the self-selection of those attracted to the technical, mathematical field of economics. Economists aren’t generally trained in psychology, and so want to divert the subject of discussion to things they understand well. They pride themselves on being rational. The notion that people are making huge errors in judgment is not appealing.”

Thus, Shiller does not buy the defense of former Fed Chairman Alan Greenspan that the Fed’s own computer models and economic experts simply “did not forecast” the current financial crisis. It is not true, he said, that no one in the world could have predicted the crisis. Lots of people were worried about the housing boom and its potential for creating economic disaster. It’s just that the Fed and most mainstream economists did not take them very seriously because it may professionally tar them.

It is not surprising that once the market failure was upon us, hardly anyone was there to take responsibility. Even former Fed Chairman Alan Greenspan who is most culpable for his failure to regulate, appears to be washing his hands off any responsibility.

That is why Mr. Buffett seemed so refreshing. He readily took the blame for some of the declines in Berkshire Hathaway’s fortunes, candidly admitting he “did some dumb things.” He lamented in particular about an ill-timed bet on oil and the purchase of shares in two Irish banks, which have fared poorly. Yet, overall, he still did better than the S&P 500.

The Oracle’s advice going forward: Approval of your peers and the public is not the goal of investing. In fact, approval is often counter-productive because it sedates the brain and makes it less receptive to new facts or a re-examination of conclusions formed earlier. Beware the investment activity that produces applause; the great moves are usually greeted by yawns.

And when the unthinkable happens as it is happening now, take your lumps... allow the system to cure itself. James Grant editor of Grant’s Interest Rate Observer and the author, most recently, of “Mr. Market Miscalculates” wrote in an op/ed piece for the New York Times that reading the right signals from the market is key to recovery. “Hope sustains life, but misplaced hope prolongs recessions.”

Being in a state of denial for too long... wishing that the difficulties of the current crisis weren’t happening to them only makes the bad times last longer, Grant observes. That’s because hopeful business people and homeowners resist making necessary adjustments. Some refuse to sell the house they can’t afford. Others won’t think of selling the stocks for which they paid what seemed a reasonable price only last year but which are one-half of that reasonable price today. Today’s low prices, painful though they may be, are the market’s own shovel-ready stimulus.

How long will we be in trouble? Buffet predicts that fallout from the credit crisis would leave the stock market a shambles through 2009. Other economists asked by the NYT to briefly answer that same question are certain only about the crisis being long drawn.

Nobel Prize winning economist A. Michael Spence who is an emeritus professor of management at Stanford wrote “if governments are quick and clear in their intentions and intervene in a coordinated way in both the real economy and the financial sector, we will probably have an unusually long and deep global recession through 2010. If they don’t, it is likely to be worse than that.”

Nouriel Roubini, a professor of economics at the New York University Stern School of Business and among the few who dared go against conventional wisdom among economists and predicted the crisis wrote that “things could get worse. We now face a 1 in 3 chance that, if appropriate policies are not put in place, this ugly U-shaped recession may turn into a more virulent L-shaped near-depression or stag-deflation (a deadly combination of economic stagnation and price deflation) like the one Japan experienced in the 1990s after its real estate and equity bubbles burst.”

Locally, I asked former Citibanker Ramon “Ray” Orosa what his best guess is of when it will all end. His answer: “I think it is no longer worth disputing the fact that it will be a prolonged recession.  The most optimistic looks at late 2010 while others see a likelihood of 2011 or even 2012 for the economy to begin to show signs of recovery. Obviously, there might be some false starts which hopeful investors, always looking for a quick fix, may jump at and probably lose some more of their investable funds.”

I guess we all have to learn the lesson about “geeks bearing formulas”, economists eager to be seen as prophets of boom and of course, be wary of greedy Wall Street bankers. According to Nobel prize winning economist Paul Krugman, these bankers in particular, “led the world in finding sophisticated ways to enrich themselves by hiding risk and fooling investors.” Keep in mind the view of the Oracle of Omaha that when investing, pessimism is your friend and euphoria, your enemy.

New study

 Jack Gesner sent this one.

There is a new study just released about women and how they feel about their asses. The results are pretty shocking:

1) Only five percent of women surveyed feel their ass is too big.

2) Ten percent of women surveyed feel their ass is too small.

3) The remaining 85 percent say they don’t care; they love him; he’s a good man and they would have married him anyway.

Boo Chanco’s e-mail address is [email protected]