With my personal investing and with "Kirk's Lindstrom's Investment Letter Explore Portfolio" I try to take advantage of market inefficiencies. My critics say the market is efficient and small investors can not beat the efficient market. I usually cite Warren Buffett to show they are wrong:
“If I was running $1 million today, or $10 million for that matter, I'd be fully invested. Anyone who says that size does not hurt investment performance is selling. The highest rates of return I've ever achieved were in the 1950s. I killed the Dow. You ought to see the numbers. But I was investing peanuts then. It's a huge structural advantage not to have a lot of money. I think I could make you 50% a year on $1 million. No, I know I could. I guarantee that.”Now I have the Soros article to add to my response list. Soros explains what I call the "Long-Short Asymmetry" and how this broke in 2008:
Warren Buffett in June 23, 1999 to Business Week
First, there is an asymmetry in the risk/reward ratio between being long or short in the stock market. (Being long means owning a stock, being short means selling a stock one does not own.) Being long has unlimited potential on the upside but limited exposure on the downside. Being short is the reverse. The asymmetry manifests itself in the following way: losing on a long position reduces one’s risk exposure while losing on a short position increases it. As a result, one can be more patient being long and wrong than being short and wrong. The asymmetry serves to discourage the short-selling of stocks.
The second step is to understand credit default swaps and to recognise that the CDS market offers a convenient way of shorting bonds. In that market the asymmetry in risk/reward works in the opposite way to stocks. Going short on bonds by buying a CDS contract carries limited risk but unlimited profit potential; by contrast, selling credit default swaps offers limited profits but practically unlimited risks.
The asymmetry encourages speculating on the short side, which in turn exerts a downward pressure on the underlying bonds. When an adverse development is expected, the negative effect can become overwhelming because CDS tend to be priced as warrants, not as options: people buy them not because they expect an eventual default but because they expect the CDS to appreciate during the lifetime of the contract.
No arbitrage can correct the mispricing. That can be clearly seen in US and UK government bonds, whose actual price is much higher than that implied by CDS. These asymmetries are difficult to reconcile with the efficient market hypothesis, the notion that securities prices accurately reflect all known information.
The third step is to recognise reflexivity – that is to say, the mispricing of financial instruments can affect the fundamentals that market prices are supposed to reflect. Nowhere is this phenomenon more pronounced than in the case of financial institutions, whose ability to do business is dependent on confidence and trust. That means that “bear raids” to drive down the share prices of these institutions can be self-validating. That is in direct contradiction to the efficient market hypothesis.
Putting these three considerations together leads to the conclusion that Lehman, AIG and other financial institutions were destroyed by bear raids in which the shorting of stocks and buying of CDS amplified and reinforced each other. Unlimited shorting was made possible by the 2007 abolition of the uptick rule (which hindered bear raids by allowing short-selling only when prices were rising). The unlimited selling of bonds was facilitated by the CDS market. Together, the two made a lethal combination.
What is the proper role of short-selling? Undoubtedly it gives markets greater depth and continuity, making them more resilient, but it is not without dangers. As bear raids can be self-validating, they ought to be kept under control. If the efficient market hypothesis were valid, there would be an a priori reason for imposing no constraints. As it is, both the uptick rule and allowing short-selling only when it is covered by borrowed stock are useful pragmatic measures that seem to work well without any clear-cut theoretical justification.On credit default swaps, CDS:
I believe they are toxic and should be used only by prescription. They could be used to insure actual bonds but – in light of their asymmetric character – not to speculate against countries or companies.Warren Buffett has called synthetic financial instruments "weapons of financial destruction." Soros says this:
CDS are not, however, the only synthetic financial instruments that have proved toxic. The same applies to the slicing and dicing of collateralised debt obligations and to the portfolio insurance contracts that caused the stock market crash of 1987, to mention only two that have done a lot of damage. The issuance of stock is closely regulated by authorities such as the Securities and Exchange Commission; why not the issuance of derivatives and other synthetic instruments? The role of reflexivity and the asymmetries identified earlier ought to prompt a rejection of the efficient market hypothesis and a thorough reconsideration of the regulatory regime.xxx: More comments coming later.