Jacobs, Too Smart for Our Own Good

Bruce I. Jacobs’ Too Smart for Our Own Good: Ingenious Investment Strategies, Illusions of Safety, and Market Crashes (McGraw-Hill, 2018) attempts to identify the common causes of financial crises since the 1980s. Jacobs, the co-founder of Jacobs Levy Equity Management and its co-chief investment officer and co-director of research, believes that underlying all of these crises have been “free lunch” products that, in turn, have their roots in the Black-Scholes-Merton option pricing model.

Jacobs focuses on three crises and the allegedly risk-reducing, return-increasing strategies and products that led in these cases to market instability and massive losses, at least in the short term. “Of particular interest are portfolio insurance in the 1980s, arbitrage strategies pursued by LTCM in the 1990s, and the mortgage-linked securities at the center of the 2007-2008 credit crisis.” Jacobs contends that they share certain commonalities. “These commonalities include opacity and complexity, which make it difficult to anticipate the effects of the strategies and products and to discern the relationships they forge between different market participants. They also include leverage, facilitated by derivatives and borrowing, which increases their impact on security prices, markets, and the economy. And they include the underlying, option-like nature of the strategies and products, which can make markets behave in nonlinear ways, with prices bubbling up or crashing down.”

One of the major problems with products that purport to reduce risk and increase returns is that they tend to encourage more risk-taking since people believe that, with these products, they have a safety net come what may. Moreover, as the demand increases for such products, “the level of risk that must be shifted increases. The availability of counterparties to take on the risk becomes more and more questionable. Liquidity begins to dry up.”

Jacobs does not argue against option, arbitrage, and securitization strategies in general. He recognizes that they can play a useful role in portfolios. He also recognizes that the crash-inducing strategies and products of the future will be different from those that caused problems in the past. He remains convinced, however, that they will share the same fundamental characteristics. Forewarned is forearmed.