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Risk takers avoid risk at precisely the wrong time

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A story on CNN details an academic study of blackjack players and their reactions to betting situations.  In short, they discovered the following:

"...omission bias; that is, players being more conservative in their bets than the level which would have optimized winnings..."

The cost of omission bias is 4 times that of over-confidence.
In other words, while being over confident can cost you $100, omission bias - the failure to bet an appropriate amount given the level of risk - would cost you $400.
Titled, "Fear and Loathing in Las Vegas: Evidence from Blackjack Tables", the study concluded that risk takers display loss aversion, and this is reflected in their bet sizes.

What does this mean about the current situation w/ Wall Street and mortgages? It means that while extending risky mortgages was perhaps foolish, the greater calamity resulted when all buyers of CDOs and other repackaged mortgages securities backed away from the market simultaneously. The old saw, "A bargain at $100, risky at $50" never was so true. The quality of the underlying collateral remained the same, but with the price chopped in half, the risk/reward characteristics should have improved dramatically, enticing "rational" market players to bid on this paper.
The opposite occured. There is no market for any of this stuff. There are a few funds buy this paper - funds that can wait 2-3 years, and have done their homework on the nature of the paper they are buying. There are many many CDO tranches that are yielding 20-40% annualized, fully capitalized senior structure notes, that still trade at a discount. This is not a rational market, and the risk takers are backing away when they should be stepping up to the plate.

So what does this mean for the individual investing in this market? It means you should have a system, and stick to it. If you only buy value stocks, you would have sat out of the market for +5yrs, and are buying now. If you only buy corporate paper at yields commensurate with long term default probabilities, you also sat out the market for '05-'07 and have been having a field day since.

Have a system, and know that fears and emotions are at work among most of the "smart" money, resulting in situations like Lehman and AIG and Fannie & Freddie and Bear Stearns and...

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Guest Monday, 25 May 2020