Risk & Reputation

The biggest news this month was the meltdown of the Crypto Exchange – FTX. FTX was not just any Crypto Exchange but at the peak was the second largest exchange and backed by the who’s who in Venture financing. Venture finance is risky with very few outliers making up for the losses of the majority of ventures that are backed. This is something that is understood both by those who run the funds as much as the investors themselves.

But what hurts more than loss of money is loss of reputation. Sequoia Capital is one of the most respected venture capitalists in the industry and was an investor in one of their funds in FTX. The exposure, just around 3%.. Even post a total write off, the fund itself would not be majorly affected. Yet, the narrative that is being spun around makes it as if Private Equity / Venture Capital Investors have no clue on their investments. 

Annie Duke in her book, Thinking in Bets writes that we often decide whether a decision is good or not based on its outcome. It’s what poker players call “resulting”. In other words, if something works out well, we think that the strategy was great, else it’s ridiculed. The foundational reason for this behavior is well explained by Daniel Kahneman who talked about System 1 vs System 2. 

To others, being wrong is a source of shame; to me, recognizing my mistakes is a source of pride. Once we realize that imperfect understanding is the human condition, there is no shame in being wrong, only in failing to correct our mistakes.

~ George Soros

Most fund managers are risk averse. This is actually very good for clients. While we can crib about paying fees for posting Index returns, it’s better than no return of capital which is what happens to the small number of fund managers who for the glory of returns (and fees that accompanies the growth in AUM if they get it right) are willing to take risks that can boomerang badly on clients.

Compared to say a couple of decades back, the information availability in terms of understanding finance has gone up infinite times. Between Twitter / Blogs / Podcasts / Books / Research Reports, there are more resources out there (and a lot of it free) than the time we have to spend.

But human nature doesn’t change as fast. If one looks at the shareholding pattern of winning stocks vs losing stocks, the dominant feature is that losing stocks have their shareholding dominated by Retail while Institutions dominate the shareholding list of winning stocks.

In the 90’s, the primary source of information was from stock brokers. India had plenty of regional stock exchanges and with each of them having hundreds of brokers, there were plenty of brokers to seek advice from (though most clients stuck with one or two). In hindsight even though the brokers were clueless most of the time, they had a reputation to protect. 

On Twitter Bios, one thing I observe is “Not SEBI Registered” but whose entire timeline is filled with advice on what to buy / sell, etcetera. Many of them have breached the 100K mark in terms of the number of followers. On the other hand, there are real fund managers managing thousands of crores of funds and having a followership of a few thousands. 

In the good old days, Reputation took time to build. A newbie could not become a stock broker (and hence an influencer) without being involved full time in markets (and succeeding) for a few years. A SEBI registration in itself doesn’t mean any guarantee of success but to get a SEBI registration means then as it is today that one has been either professionally qualified or full time acquainted with the markets. 

Today reputations are built on the Internet, on Twitter, on Facebook, on Instagram. A twitter handle @TikTokInvestors provides us Indians who aren’t able to access Tik Tok a glimpse of the absurdity in finance we see on Tik Tok. 

The thing about influencers is that there is a cost. If an influencer is trying to sell you a lipstick, the cost is limited because regardless of how much one loves that influencer, one won’t spend all his savings on it. A financial influencer on the other hand can devastate savings built over a long period of time.

A long but excellent read on Influencers and the role they play.

https://nymag.com/intelligencer/2022/11/the-rise-of-influencer-capital.html

Recently I was given the opportunity to give a talk on Technical Analysis to undergraduate students who were pursuing finance as specialization. While I am not a good talker, I could see that 80% were uninterested by the time I ended. 

As I found out later, most were expecting me to talk about trading and teach them how to make money trading intraday. Digging further (with a student), I found that they were active on Social Media and saw that big money could be made easily. 

Stock markets for long were seen by most as nothing but gambling. But with the advent and growth of mutual funds, investing in the markets is not seen as gabling but basically another asset class which can deliver decent returns in the long run. Unfortunately for most new investors, there is no easy way to jump and understand investing.

These days reputations are built on Social Media. More the followers you have, more the belief that you know something. As much as long term investing in Index funds may yield the best return for the buck for most investors, today’s social media icons are mostly engaged in talking about how easy money can be made trading derivatives. 

FOMO, lack of adequate knowledge and of course our hope that we can push to the path of destruction which in the financial markets today is seen as Crypto but really exists in the world of derivatives.

The push has meant an astounding growth in the derivative markets in India. When compared to the first 6 months of 2012, in the first 6 months of 2022, we have seen the number of Index Option Contracts traded increase by a humongous 4,475%. Stock Options follow with a growth of 1,615%. Stock futures have seen growth of 134% while Index Futures have increased by just around 15%.

One reason for the massive growth in Index Options – introduction of Weekly settlement. In many ways, this reminds me of the daily lottery Bangalore once used to have and one that ruined many a family before the lottery as a whole was banned in Karnataka (and continues to be banned). 

Derivatives is a negative sum game. Between the broker and the government, they take away a chunk of the money. Yet, the appeal is huge and influencers add to fire. What interests me is how many of the influencers these days are young chaps in their 20’s. The 20’s are the time when we want to conquer the world. 

Outside of Options, another favorite area for many is Nano Caps. Stocks are talked up with stories that seem to suggest that this is the next best thing only for many to crumble in the coming months / years. Nothing new this one is and I was reminded of a 15-year kid in the US who used Message boards to propagate the goodness of a stock that he had sell orders ready for the sheep who bit into the story (Link).

Reading the financial history of even a couple of hundred years back, one observation is that the more things change, the more they stay the same. In some ways I think I can consider myself lucky. 

Back to FTX and the question that has been raised. How did so many people fail to notice the scam that was brewing under the surface. Most are professionals who would have climbed up the ladder thanks to their ability to differentiate between good and bad deals and yet many have climbed to the worst possible deal with very little fact checking.

Writing in Frankensteins of Fraud, Joseph Wells says this about the way Ivar Kreuger operated.

“Ivar Kreuger kept people guessing. At the negotiating table he answered any queries flatly, if not directly, his brittle tone indicating that the answer was final. If a financier badgered too much about audits and verification of funds, he’d simply stop doing business with that man. People knew that Ivar walking out of the door meant lots of money trailing in his wake, they learned to relax their standards when the Swede came calling. If Ivar said he had collateral, he had collateral”

When something is going well, questioning is never easy. Other than in hindsight, it’s never easy to sit out either for the longer a fad runs, the longer one feels stupid. Costly errors are made because we, despite all that we know and understand, want to be part of the herd. 

It’s been years since I have watched Business Channels, years since my last subscription to pink papers and on Twitter I try to avoid anyone who seems to suggest that easy money can be made. 

Elimination I have felt is easier than absorbing all the noxious content and then thinking I won’t fall prey to the same thing that everyone else is. One isn’t wired any differently from others and hence easy to make the same mistakes as others.