Another Silly Theory About Dumb Traders

I find this story from mathematician Jordan Ellenberg on Slate, a publication I write for perplexing, but ththat goes for an awful lot of the explanations that have been floated for what's going on in the market. Ellenberg compares Wall Street's investment strategies to an old (and delusional) gambler's system called the martingale, which involves increasing your bet after every loss. I think that the point Ellenberg wants to make is that banks and fund managers took the risk of a catastrophic loss in the pursuit of smaller gains.

That much is true. But it has very little--well, nothing--to do with the martingale. Andrew Lo, a professor at MIT and one of my favorite writers on these subjects discusses options strategies that take these kinds of risks. In one article--no longer available online but you can read about it here he creates a model fund, Capital Decimation Partners that keeps reinvesting what look like fantastic returns until it suddenly blows up. But Capital Decimation Partners' strategy doesn't look anything like the martingale; CDP increases its bet when it wins, not when it loses. That's a lot closer to how actual hedge funds and trading desks work.

Everybody has their pet theory of what went wrong, and many of the theories oversimplify Wall Street to the point of absurdity. Nobody can doubt that all the risk management ideas went horribly awry. Hedging strategies that work in ordinary times can blow up when the system is pushed to the breaking point and investments that seem to have little to do with each other suddenly all fall apart simultaneously. Beware, however, of the temptation to believe that all those idiots on Wall Street just made obvious investing mistakes. Every generation of investors has started out with this assumption, and each one has been proved wrong in some new and spectacular way.