July 2009Vol. 1 No. 2

Time Portals and Other Illusions:
Some Common Trading Mistakes and Their
Unhappy Consequences“Y

OU NEVER KNOW who’s swimming naked

We consider ourselves something of an authority on theuntil the tide goes out.”

What corporate

subject of mistakes not only because we’ve seen others

chieftain said this to CNBC and its viewers on

make them, but also because, over twenty-plus years,

March 13, 2007? As it happens, these were the words of

we’ve made our share.

Angelo Mozilo, CEO of mortgage giant Countrywide

involves sourcing an investment idea and then trying to

Financial, as he optimistically applied Warren Buffett’s

poke holes in it. We can’t prove that a given trade idea isfamous 2001 Chairman’s Letter maxim to Countrywide’ssound, so we instead try to disprove its soundness in as many

future prospects as the mortgage industry consolidated.

ways as possible. The fewer apparent flaws, the better.

We’ll explore the irony of this in a bit.
First,

though,theBuffett

uncomfortable questions.

aphorismraisessome

How did finance professionals

get in the water naked without anyone noticing? What
was their plan for getting out? Why did they stay in thewater long enough for the tide to change? This Market
Insights takes a closer look at some real-world examples ofcommon investor mistakes like those that may have tripped
up Mr. Mozilo’s firm. By “investors,” we mean all classesof market participant, whether amateur or professional andwhether banker, hedge fund manager, insurance company
executive, fund-of-funds operator, high-net-worth individual,
or mutual fund investor.

Our firm’s investment process

Time Portals and Other Illusions
Intuition versus Reason:
Uncomfortable Companions

B

efore we get into specific examples of investor
error, it may be helpful to provide a little theoreticalcontext. In his pioneering work in the field of
behavioral finance, Nobel laureate psychologist Daniel
Kahneman has distinguished between human impressions
and judgments. Impressions are governed by the brain’s
ability to intuit based on immediate perception. Judgments,on the other hand, are conclusions drawn either from
impressions alone (intuitive judgments) or the application offormal reasoning (rational judgments). Rationality is
involved in both types of judgments, just in different ways:
either the brain has developed an intuition and its reasoningside has implicitly approved the conclusion without further
rational inquiry, or the brain has explicitly employed rational
methods to confirm the initial insight.1
According to this framework, investors make two elemental
types of mistake, one relating to faulty intuitive judgment andthe other to faulty rational judgment. Errors of intuitive
judgment occur when reason does not correct priormisperceptions or biased intuitions. So an investor may initiallythink, “Citi is at $3! I can buy a share of Citi for less than abottle of fancy water!”, but it’s likely that reason will soon kickin and demand that Citi’s number of outstanding shares, its
capital structure, and other factors also be considered. When
this policing function does not happen, however, the result is a
mistaken intuition left uncorrected by rational judgment. In
other cases, rational judgment mistakes can stem from
implementation errors in the machinery of reason itself, suchas using an incorrect discount rate or performing a faulty
regression. Through education, vigilance, and analytical rigor,
an investor can reduce his or her exposure to both intuitiveand rational judgment errors, although, sadly, perfection isprobably unobtainable.
With the aid of these insights from theory, we can now outline
a couple of specific categories of investor error that we’ve
observed. The first mistake we’ll discuss is what we call thetime-portal fallacy. This error involves focusing excessively on
the terminal outcome of a trade while focusing insufficiently
on volatility and the potential paths of profits and losses
1

See Daniel Kahneman, “Maps of Bounded Rationality: A Perspective on
Intuitive Judgment and Choice,” Prize Lecture, December 8, 2002, available at
http://nobelprize.org/nobel_prizes/economics/laureates/2002/kahnemannlecture.pdf.

MARKET INSIGHTS(“PnL”) along the way. The second mistake is an error that
we call the illusion of continuity. This error arises wheninvestors predict the effects of a change in the world using
logic or assumptions that likely will no longer apply when thatchange occurs.
While we’ll reference Kahneman’s work to highlight certain
aspects of both types of errors, many of our observations
about how these errors manifest themselves in actual
investment and trading decisions do not snugly fit under one
or another conceptual category. As with most real-world
phenomena, actual investor behavior often defies a single
convenient descriptor.

The “Time-Portal” FallacyIn analyzing a particular trade, an investor would ideallyconsider all of the possible paths that the trade could
take and what the consequences of those different paths
might be at any given moment between the present time
and the trade’s terminus. In practice, most investors find thistask far too complex and thus necessarily fall back on various
simplifying heuristics or rules of thumb. These might include
calculating expected return and volatility over some timeframe or identifying a discrete set of scenarios as of a futuredate. These heuristics work well in most cases, but on
occasion they may unfortunately cause investors to overlook
important characteristics of a trade. With respect to scenario
analysis in particular, we’ve observed that investors often
behave as if they are trading with the benefit of a “timeportal” that allows them to leap effortlessly to a future point
in time. In reality, the path to the future may prove both
long and bumpy in terms of mark-to-market volatility,
which may be fine to ignore in many situations but could behighly dangerous in others.
When “Can’t Miss” Trades Miss
The time-portal effect is perhaps most evident wheninvestors engage in faulty logic while thinking about
financial cataclysm. Consider situations in which investors
are tempted by trades they view as almost certain winners if
held to maturity or likely to produce losses on an ultimate
realized basis only in apocalyptic states of the financial world(where it seems like losing the amount of money at risk is apaltry concern). To illustrate the risk profile of a typical tradeof this sort, let’s take the simple hypothetical example of avirtually risk-free bond that is priced at 99, pays LIBOR, andwill mature at 100 in five years. This is the kind of trade that
July 2009 | Vol. 1 No. 2 | Page 2 of 10

Time Portals and Other Illusions
investors occasionally pile into, viewing it as a pure arbitrage
that, in effect, generates “free money.” And if an investor
levers that trade up 20 times, then it seems like a great deal of
free money. But investors sometimes ignore mark-to-market
volatility and the possibility of many different PnL paths on theway to collecting their (not quite) free money. If the price ofthe bond temporarily goes to 95, that could end up bankrupting
a highly levered investor. In that case, attempting to collect thisfree money may not be such a good idea, even if the original
thesis that the bond will go to 100 at maturity proved correct.
Investments in so-called “super-senior” tranches ofinvestment-grade corporate credit offer a more concrete
example of the dangers of the time-portal effect wheninvestors engage in flawed “end-of-the-world” scenario
analysis. Investors seeking exposure to the corporate credit
market often take positions in credit derivative indices. These
indices allow investors to buy or sell credit protection on abasket of companies. Many investors would consider a longrisk investment in the CDX.NA.IG 5-year 30 - 100% tranche
to be quite attractive. In this trade, investors earn a premiumby selling protection, for a period of five years, on thehighest-rated tranche of an index composed of North
American investment-grade corporate credits. Assuming
roughly a 30% recovery on defaulted credits, it would takedefaults on the debt issued by more than 50 of the 125
companies in the index before the tranche representing thatslice of the index would realize a loss. Presented with suchan instrument, many investors over the last few years havebeen tempted to go long that risk, even when the premium
paid to sellers of credit protection was as little as 1 basis point(see Figure 1). The justification for doing so has usually beenalong the lines of, “There’s no way that tranche is going to
get hit. And if it does, we’re probably all dead anyway. It’s
basically free money.” Similar sentiments have been voiced
about selling credit protection on U.S. government debt.
Collecting premia by selling credit default swaps (“CDS”) on
the United States will result in a loss only if the U.S.
government defaults on its debt obligations. Given that
context, a trader might reason, “It’s virtually impossible that
the U.S. government will default on its debt, and if it does,
we’re all gonna be bankrupt anyway, so who cares?”This sort of reasoning may be fairly sound with respect to thelikely ultimate outcome. If an insurance company could sell apolicy that pays off only in states of the world where no one
is around to collect or even file a claim, that would be a goodbusiness proposition at any price. But there’s an important

MARKET INSIGHTS

difference: this hypothetical insurance policy wouldn’t need
to be marked-to-market, while CDS trades do. And while itseems difficult to imagine the CDX.NA.IG 5-year 30 - 100%
tranche suffering a realized loss or the U.S. government
defaulting on its debt, it’s not too hard to imagine the market
temporarily implying a significant chance of either
happening. In all likelihood, this wouldn’t be because theconsensus probability of an actual default is high, but instead
because large risk premia or unusual technical forces—what
academics call “noise-trader risk”—affect the market’s
current level. The proposition that markets can temporarily
behave in strange ways is not new—in 1936, John Maynard
Keynes famously noted that “the market can stay irrational
longer than you can stay solvent”—but that point is overlookedfrom time to time, with potentially dire consequences.
Many investors do not consider that if the market were to
price in even a relatively small increase in the implied
probability of future financial calamity, they’d immediately
experience unrealized losses and have to post variation
margin equal to many multiples of what they had hoped tomake on the trade. And, of course, investors often mustlever such end-of-the-world credit-protection trades to makeany real money, thus intensifying the pain. AIG is perhaps
the paradigmatic recent example of an institution that forgot
this lesson. The firm freely sold credit protection on highly-rated
securities, apparently in the belief that such contracts would
ultimately (on the other side of the mythical time portal)amount to free money, while ignoring mark-to-market risk.
Selling “End-of-My-World” Puts
Sometimes the time-portal error, through apparent disregard
for the abrupt appearance of end-of-the-world risk, can takea more narcissistic form in which investors initiate “end-of–
my-world” trades while being similarly oblivious to pathdependency. A common example involves financial
institutions selling the equivalent of put options struck on
their own credit rating. Why would institutions do this? It’s
possible that the return they receive is sufficiently valuable tojustify it. It also may be that they can manage this risk withextreme care. Finally, it’s possible that this is a subtle form offraudulent conveyance, leaving losses for a different class ofinvestors who will be left holding the bag in the worst-casescenario, and earning money for current investors in thenormal state. But whatever the reason, and even if all
predictions ultimately prove correct, certain paths could leadto the disastrous exercise of these sorts of implicit “puts.”

July 2009 | Vol. 1 No. 2 | Page 3 of 10

Time Portals and Other Illusions

Premium for CDX.NA.IG 5-year 30 – 100%120

Premium (bps)

100

80

60

40

20

0
6/26/2006

11/29/2006

5/4/2007

10/7/2007

Figure 1

Again, AIG presents perhaps the most striking recent
example of this behavior. It’s widely known that AIG soldprotection on collateralized debt obligations (“CDOs”).
Somewhat less well known is that, in certain instances, AIG
structured these contracts such that the AAA-rated firm
would not need to pay out variation margin on mark-tomarket losses but would have to make substantial payments
to the counterparty if its credit rating fell below a certain
threshold. Although AIG management’s repeated claims thatthe portfolio of CDS contracts they had written on CDOs
was fine on a held-to-maturity basis may not have been fully
genuine, most observers could probably appreciate that AIG
focused far more on held-to-maturity forecasts than on thepotential volatility on the way to maturity. In AIG’s earnings
call for the first quarter of 2008, for example, management
indicated that “although the fair value of the CDS under
GAAP is our best estimate of the fair value of the underlying
CDOs, the substantial risk that AFP [AIG Financial Products]
covers for the CDO investors is the risk of suffering actual
realized losses, not the variance in fair value of the CDOs.”2
That may have been narrowly true of the risk that AIG was

2

AIG made similar statements in its 2Q08 earnings call, before theimplosion: “Despite the marks taken, the portfolio of CDOs is showing
resilience. We have not yet incurred any realized credit losses in theportfolio. Further, the level of defaulted assets in the underlying collateral of
CDOs is very low compared to the weighted average attachment points in
those structures.”

MARKET INSIGHTS

3/11/2008

8/14/2008

1/17/2009

6/22/2009

Source: J.P. Morgan

underwriting, but it was not true of the more general risk towhich the firm itself was exposed. Mark-to-market losses
could lead others to question the creditworthiness of the firm
and ultimately result in a ratings downgrade, thereby causing
real harm to the company, which, of course, is exactly what
happened to AIG. As credit markets melted down, mark-tomarket losses on the swap portfolio and ratings triggers
helped push AIG to the brink of bankruptcy. In other words,
selling puts on oneself is particularly pernicious because it
effectively creates the conditions for an ugly self-fulfilling
prophecy. It may be a productive strategy for market
participants in certain situations, but it must be managed
very carefully with a view not just to the terminal outcome,but also to possible paths to that outcome.
We’ll offer a last example to illustrate the time-portal fallacy
as it applies to end-of-my-world trades. Consider a CDS
dealer that believes selling CDS protection on its own firm is
free money because, if the CDS triggers, the firm will bebankrupt and won’t have to make any payments. As a topic
of frequent discussion within the trading community, thisexample is more of an illustration of how some traders think
than a real-world case. But it does underscore some of thedangers of selling implied puts on oneself under the
intoxicating influence of the time-portal potion. Far from
capturing free money, a CDS dealer that’s short protection
on itself and ultimately goes bankrupt very likely would haveto make payments before going out of business. And
July 2009 | Vol. 1 No. 2 | Page 4 of 10

Time Portals and Other Illusions
conversely, the buyer of the CDS protection would likely
receive some payments rather than go completely
uncompensated.
To see how this works in simple terms, let’s ignore our old
friend (from our previous Market Insights) cash-CDS basis
and assume that the pricing on CDS contracts has aperfectly inverse relationship with the value of bonds.
Envision a scenario in which a dealer sells CDS protection
on itself to a client when the dealer’s bonds are at 100.
The dealer then suffers some form of financial distress, andits bonds fall to 70. When that happens, the dealer must
pay out 30 points of cash to the client to cover the markto-market loss on the CDS. If the bonds drop another 15
points to 55, the dealer pays out an additional 15 points.
On the day that the dealer actually defaults, those bonds
might fall another 20 points or so. The associated 20-point
margin payment probably will not be made then but rather
will be claimed by the client in bankruptcy court. So whileit’s true that the realized loss occurs after the dealer
defaults, in this example the dealer actually made prior cash
payments of 45 points in variation margin. In pursuing a
supposedly free-money trade, our hypothetical CDS dealer
faces significant losses because of, not despite, the effects
of mark-to-market volatility. The pain is amplified by the
self-reinforcing quality of these trades: ironically, far fromproducing losses only in scenarios in which one doesn’t care
at all about losses, end-of-my-world trades actually lose in
scenarios in which one cares the most about losses.
Why do investors make this type of time-portal mistake?
Applying Kahneman’s framework, perhaps it is because theultimate outcome of these trades intuitively seems soapparent and certain, while the rational calculation required
to analyze and truly understand the trades is much morenuanced. The proper prescription for combating suchthinking may be to force oneself to consider the subtleties byperforming scenario analysis over different time horizons, notjust to the date when the trade is guaranteed to have
converged.

Illusions of ContinuityLet’s put aside the time-portal analogy and move toanother category of investor mistake we see.
Kahneman and others have observed the prevalenceof anchoring and narrow framing biases in experimental
settings. The general idea is that human thinking can often
fall under what we call “illusions of continuity.” “Anchoring”

MARKET INSIGHTS

is the tendency of individuals to base estimates or predictions
on previously perceived baseline states. For example,
researchers have conducted experiments that involved asking
real estate agents to appraise a property. The agents were
given information on the size of the property and its specificfeatures, prices of similar properties recently sold, and asking
prices for similar properties on the market, as well as a listing
price. Some agents were given a listing price that was 12%
above an independent appraisal value, and some were showna listing price that was 12% below the appraisal. The
researchers found that agents in each group appraised theproperty’s value by anchoring to the listing price they were
given rather than considering the other data.3 Likewise,
investors often anchor to the current state of the world. We
intimately know the current state of the world, and it’s hardfor us to adjust our perspective enough when thinking about a
new state.
“Narrow framing” is the tendency of individuals to isolate adecision or choice from the rest of the world or from thebroader class of phenomena to which that decision or choicebelongs. It’s an extreme version of anchoring to the current
state of the world, in that individuals eliminate altogether
some directly relevant issues from their calculations. Take
the basic example of life insurance. Some people may be
tempted to think, “I feel pretty good right now, so I don’t
think I need life insurance. If I get sick, then I’ll take out apolicy.” The flaw in this reasoning, of course, is that if one
gets sick, it’s much harder and costlier to get a policy.
Ignoring the effects of change—getting sick, in this case—when planning for the future reflects reasoning fromassumptions that will no longer apply and thus leads to false
conclusions. The life insurance example is obviously asimplistic one, and most people wouldn’t fall prey to that“logic.” But when situations become complex and thenumber of effects of a contemplated change begins tomultiply (as in many real-world trading situations), a person
is more likely to fall back on narrow framing. Investors can get
into serious trouble when trying to predict the effects of achange in the market on the basis of logic or facts that likely will
no longer apply in a world where that change has occurred.

3

See Gregory B. Northcraft and Margaret A. Neale, “Experts, Amateurs, andReal Estate: An Anchoring-and-Adjustment Perspective on Property Pricing
Decisions,” Organizational Behavior and Human Decision Processes, Vol.
39, No. 1 (February 1987), pp. 84–97.

July 2009 | Vol. 1 No. 2 | Page 5 of 10

Time Portals and Other Illusions
Consider the aforementioned statement of Countrywide’s
CEO in March 2007 in the context of anchoring and narrowframing. Beyond the obvious irony of Mr. Mozilo’s quoting
Buffett on swimming naked when Countrywide itself seems
to have been skinny-dipping, his comment may have hadsubstantive consequences for investors. In his remarks to
CNBC, Mr. Mozilo stated that the meltdown in the subprime
mortgage market “will be great for Countrywide because at
the end of the day, all of the irrational competitors will begone.” While this may just have been a self-serving
statement of the kind that CEOs sometimes make to thepress, what if investors really believed it? Even if it were truethat Countrywide had less subprime exposure than other
lenders, investors buying Countrywide stock over the two or
three months after Mozilo made these remarks very well may
have assumed that little, if anything, had changed in themortgage lending space except the forced exit of some key
competitors. After Countrywide’s stock slid from a high of$45 in January 2007 to $32 in March, it rebounded to $40 inMay. Investors may have found it difficult to imagine aworld (i.e., to move outside the assumptions of their anchor
state) where the economy was so damaged that a company
like Countrywide could suffer considerable losses.
Walls of Money
One of our favorite examples of the illusion of continuity is
the wall-of-money fallacy. Investors often presume thatdemand for some asset class or type of trade will persist no
matter what. If price is a function of fundamentals andrandom noise, this view of the world essentially assumes thatprices only move on noise, and that fundamentals do notchange. Take, for instance, recent dynamics in the market
for leveraged loans. A little over two years ago, leveragedloans were regarded as well-secured and were gobbled up bycollateralized loan obligations (“CLOs”) and other pools ofcapital. To many observers, it seemed inconceivable thatthese loans could drop in price for long periods because there
was huge demand—a “wall of money”—waiting to buy
them if the price fell by just a small amount. The thinking
was, “If these loans go to 90, there will be so many CLOs
formed to buy them, and the returns on buying them withleverage will look so attractive, that the price will shoot rightback up to 100.” But in a world where those loans have
dropped to 90, isn’t it possible that something else has
fundamentally changed? Will investors still want to invest in
CLOs, and will leverage be available to investors purchasing
them outright? With the benefit of hindsight, we know that

MARKET INSIGHTS

the world changed a lot. As the price of leveraged loans
began to fall, investors declined to buy CLO liabilities, andbanks not only stopped wanting to lend against those loans,but also became net sellers of the loans themselves. Figure 2
shows the relationship between CLO activity and pricing onleveraged loans in the past decade.
Traders occasionally trot out the wall-of-money argument
when analyzing the convertible bond market, particularly
during periods when converts are priced somewhat richly andyet market participants are not “fully invested.” Let’s
suppose convert investors are 80% invested. In thosecircumstances, subscribers to the wall-of-money argument
tend to view the 20% extra capacity as a huge amount ofpotential demand for convertibles were they to get cheaper
for whatever reason. If there is a small down move in theasset class without much else changing in the world, thenthis capital very well could prevent the market fromcheapening too much. But if the market falls precipitously,
this sidelined capital may not be adequate to counteract the
reduction in price because many of the following conditions
are likely to be true: (1) investors have just lost a bunch ofmoney on the down move, which will have used up much of
the sidelined capital; (2) volatility and thus risk are higher,
which reduces the desire for increased exposure to the asset
class when it otherwise may look cheaper; (3) leverage islikely to be less available than before because volatility ishigher, causing investors to want to hold more buffer capitalor reduce leverage rather than increase the size of theirportfolio; and (4) fund managers have set aside capital to pay
anticipated redemptions. More often than not, the wall-ofmoney reasoning will apply to small moves that probably
reflect noise trading because the amount of capital available
is large relative to the size of the cheapening. But thatreasoning is likely to be wrong with respect to large moves
because they often result from more profound shifts, even if
temporary, in financial tectonic plates, and the amount of
capital on the sidelines may not be enough to reverse them.
Consequently, using the wall-of-money argument as aninvestment thesis may actually be hazardous in practicebecause the investor, observing daily volatility that is modest
given the operation of day-to-day supply and demand
dynamics, may be tempted to use more leverage than heshould after factoring in the possibility of a major change infundamentals in the event of a crisis.

July 2009 | Vol. 1 No. 2 | Page 6 of 10

Time Portals and Other Illusions$35

L+3000$30

L+2500
L+2000$20
L+1500$15
L+1000$10Rate of Interest

USD in Billions

$25

L+500

$5
$0

L+0
1Q99

1Q00

1Q01

1Q02

1Q03

1Q04

1Q05

1Q06

Leveraged Loan CLO Activity (left scale)

1Q07

Another form of the illusion-of-continuity mistake occurs
when an investor advances arguments such as, “If the stock
price falls to $x, I’m necessarily happy to buy,” or, “I soldsome puts at $x because either the put won’t get exercised
and I’ll collect my premium, or the put will get exercised andI’m happy to own it there.” In either case, the investor is
happy to pay $x for the stock no matter what. Clearly, thisinvestor is making an assumption that the world where theoption is exercised is substantially similar to the world today.
In other words, he believes that all price movements are justnoise. That assumption may be correct in some cases—
although our hypothetical investor ignores that even in thosecases he could have bought the stock more cheaply had henot sold the put—but it can’t be right in all cases. What if
company fraud is discovered? What if the economy goes
into a tailspin and the company’s business prospects change
for the foreseeable future?
Sometimes, investors rely on similar thinking whenattempting to engage in what might be termed “happinesshedging.” They may tell themselves, “If this stock goes
down to $x, we’ll buy it and make a ton! But if it keeps
going up, we’ll miss out. So we’ll hedge our happiness andlock in some future PnL by selling a few puts.” Investors that
initiate such trades and overlook other changes or risks may
be doing so under the influence of biases such as anchoringor narrow framing.

MARKET INSIGHTS

1Q09

First-Lie n Loans (right scale)

Source: Standard & Poor’s

Figure 2

The Fixed-Price Myth and Happiness Hedging

1Q08

This error of thinking too little about how a large change inthe world might have an impact on a specific asset or trade
seems to persist even in the immediate aftermath of thatchange. Over the last year, it was not uncommon on a big
down day in the equity markets to witness investors buying
their favorite stock even though they did not think that themarket overall was particularly cheap. There’s an inherent
contradiction in this behavior since, after all, not all stocks
can be cheap relative to the market. This slowness to adjust
to new realities—consistent with anchoring or narrowframing—was also reflected during the past few quarters infrequent observations about how amazing the investment
opportunity set seemed. But if one drilled a bit deeper, theconversation sometimes went along these lines:
John: Cash-CDS basis is at negative 600 bps!
That’s totally unsustainable. What an opportunity!
Jane: So buy some.
John: I can’t because no one will finance it for me,
and I have no cash.
Many perceived opportunities were beautiful in the abstract
but infeasible in the real world.
Hard-Won Reputations
A final and pervasive example of the illusion of continuity canbe seen in the assumption that reputational effects inbusiness relationships will always persist. This contention has
July 2009 | Vol. 1 No. 2 | Page 7 of 10

Time Portals and Other Illusions
shaped discussions over the past couple of years about
whether private equity firms and other potential buyers
would eventually close on committed deals. Conventional
wisdom held that even if a deal were significantly
underwater, private buyers wouldn’t walk away because
backing out would make it far harder for them to do futuretransactions. But it can reasonably be argued that private
equity firms almost always closed on acquisitions not somuch because reputational incentives were the overriding
motivation, but instead because it also usually made sensefrom a near-term, profit-making standpoint to do the deal.
At the same time, those firms may have occasionally closed
on smaller deals that were marginally unprofitable topreserve their reputational capital for larger and more
important deals. However, in a world where both theaverage deal is underwater and the larger financial system issuddenly a lot less hospitable to private transactions, the link
between reputation and incentives to complete deals might
not be as relevant.
Reputational and relationship effects are indeed real andgenerally play a predictably constructive role when market
conditions are “normal.” But reputation matters the most in
those cases in which two parties expect to continue to dobusiness with each other for a long time—“repeated games,”in the parlance of game theory. If a private equity firm isunlikely to do another deal for a few years, then the
reputational cost of walking away from a given deal may
seem less significant, particularly if the savings the firm would
achieve by breaking the deal is a multiple of what it would
expect to earn on that deal.
A strictly rational agent, unburdened by a sense of honor or
altruism, will break its commitment if the reward for doing so
exceeds the associated reputational damage. Clearly, when adeal is underwater, there is a short-term incentive to walkaway from it. But historically, the potential longer-term
damage to a firm’s reputation that would result from walking
away was a strong disincentive. Walking away meant thatthe firm would have a tougher time doing acquisitions in the
future because the executives involved would be widely
perceived as dishonest or lacking credibility. Over the past
year, however, many deals were underwater at the sametime and by a very large amount. The short-term incentives
to walk away were therefore quite strong. Moreover, thefact that many firms were similarly situated lent credence tothe view that this was a systemic event beyond anyone’s
control, so the reputational damage to individual firms was

MARKET INSIGHTS

greatly diminished given the protection of the herd. And
what had been viewed as a repeated game now seemed lessrepeatable, as sluggish debt markets and dimmer fundraisingprospects rendered future deals less important. The costbenefit analysis changed as the deals became unglued.
Because reputational effects tend to influence investment
decisions in normal markets but not as much in periods ofturmoil, a misplaced belief in the persistence of those effects
may engender a degree of complacency as market conditions
deteriorate and, paradoxically, increase the chances of a fullblown crisis.
A related but alternative way to view what happened is thatinvestors such as merger arbitrage players and companies
that are takeover targets failed to appreciate the extent towhich all of these factors—the degree to which a deal isunderwater, the likelihood of future mergers andacquisitions, and the importance of reputation—were highly
correlated. If one assumes these considerations are
independent, then the risk of a buyer walking away doesn’t
seem that large. To assign some loose numbers to thisexample: if deals are underwater 20% of the time and areunderwater (relative to the takeover bid) by an average of$100, and if firms are generally 10% likely to breakcommitments, then the risk (for merger arbs or owners of
takeover targets) that acquirers will walk away would be
20% * 10% * $100 = $2. But things are quite different if
these factors move together. When a deal is materially
underwater, it probably means that a private equity firm orother potential buyer will have a harder time doing future
deals and will care less about reputation going forward.
Perhaps such firms are 50% likely to break commitments in
those circumstances, which raises the risk to 20% * 50% *$100 = $10. The risk is probably higher than $10 because in
the previous calculations we used the average amount bywhich deals are underwater instead of the average amountby which deals that break are underwater. (On average,
deals that break will be underwater by more than deals that
don’t break.) As we can see from the above analysis, the risk
for investors or target companies that acquirers will walkaway increases geometrically when we relax the assumptionof independence. And while we’ve focused on private equity
transactions, we believe this discussion of reputation applies
to other financial and trading relationships.

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Time Portals and Other Illusions
ConclusionT

he unusual number of self-defeating and valuedestroying errors committed by market participants inrecent years will be studied by financial practitioners
and academics for a good while. This commentary has
highlighted a small sample of mistakes that we’ve
catalogued, and occasionally committed, over the years.
We’ve obviously only scratched the surface of the broad
topic of human decision-making frailty, so we may return tothis subject in future Market Insights.
The literature on decision-making biases developed bypsychologists over the past two decades has contributed
significantly to a broader understanding of elemental
investing errors of the sort identified in this commentary.
Guarding against these errors requires extreme vigilance, andeven that may not be enough. In particular, the modern
financial system, with its vast scale and enormous
complexity, poses a difficult test of our ability to makerational decisions. The decision-making heuristics thatinvestors use seem to function well in “ordinary” times but
may break down and result in considerable damage (for anindividual market participant or an entire class of them)during extraordinary periods. The reason for this may bethat as individuals we tend to ask ourselves, “How often is
my model correct?” rather than, “How broad is the range ofconditions under which my model may be successful?”
Selling one-day out-of-the-money put options on the
S&P 500 might seem a pleasing strategy because it would
make money on almost every day, but it really makes money
on only one type of day—days when the market doesn’t
crash. Similarly, many of our beliefs and heuristics become
deeply engrained because they work on most days, but one
should not overlook that “most days” actually falls within anarrow range of a broader set of possibilities.

MARKET INSIGHTSAt the D. E. Shaw group, we try to regulate our own
investment decisions by following some basic principles.
First, in our investment process, we make a conscious effort
to identify and integrate awareness of the two types of errorthat we have discussed in this commentary. Second, we
attempt to carefully segregate the risk exposures that we
actively seek from those that are either undesired or
unknown. Third, we question the assumptions that
undergird our investment theses, and frequently revisit andretest those assumptions. These three considerations do not
sum to a perfect science, and, given our past mistakes, wehaven’t always successfully implemented a regime that
protects against these errors. But we do seek continual
improvement in our work in these areas as we assimilate new
information and gain additional experience in the markets
that we trade.

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Time Portals and Other Illusions
The views expressed in this commentary are solely those of
the D. E. Shaw group as of the date of this commentary. The
views expressed in this commentary are subject to change
without notice, and may not reflect the criteria employed byany company in the D. E. Shaw group to evaluate
investments or investment strategies. This commentary isprovided to you for informational purposes only. This
commentary does not and is not intended to constituteinvestment advice, nor does it constitute an offer to sell orprovide or a solicitation of an offer to buy any security,
investment product, or service. This commentary does nottake into account any particular investor’s investment
objectives or tolerance for risk. The information containedin this commentary is presented solely with respect to thedate of the preparation of this commentary, or as of suchearlier date specified in this commentary, and may bechanged or updated at any time without notice to any of therecipients of this commentary (whether or not some otherrecipients receive changes or updates to the information inthis commentary).
No assurances can be made that any aims, assumptions,
expectations, and/or objectives described in thiscommentary would be realized or that the investment
strategies described in this commentary would meet theirobjectives. None of the companies in the D. E. Shaw group;
nor their affiliates; nor any shareholders, partners, members,
managers, directors, principals, personnel, trustees, or agentsof any of the foregoing shall be liable for any errors (to thefullest extent permitted by law and in the absence of willful
misconduct) in the information, beliefs, and/or opinions
included in this commentary, or for the consequences ofrelying on such information, beliefs, or opinions.

MARKET INSIGHTS

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