for property even when they know that the economy is going into recession.
Occasionally, it is suggested that some illiquid markets – where there are not many buyers and sellers – are inefficient because they can be unfairly dominated by a few players. However I will argue later that those players usually lose out.
It is possible that markets are inefficient when they are deliberately fed misleading information, as happened with Enron and Worldcom, but hopefully that type of malpractice is on the decline.
With these Strategies, I will try to identify, in a very structured and disciplined manner, where it is that I believe the market does not operate efficiently. This is where we will find opportunities to beat the market.
Unfortunately, most people do not approach trading and investing in that way. Rather, they start with an assumption that the markets are inefficient and that there are obvious buy or sell opportunities. They have vague, untested beliefs, and make comments like ‘the consensus is always wrong’, or ‘the market always overshoots’. Both of which we will see are completely untrue.
1.3 Market opportunities are disappearing
When I entered the world of finance in the mid 1980s I was fortunate enough to join the right investment bank: Bankers Trust Australia. With a reputation as the highest paying employer in Australia, it was the place to work. The people were very creative and motivated, and it operated as a genuine meritocracy with little bureaucracy or politics. At one stage, in terms of percentage return on capital, it was rated as one of the most profitable banks in the world.
I was put to work in the trading room, which I found amazing. I was a bee in a beehive – all around me there was activity. There were about a hundred of us in the room, with lots of screens and telephones and paper everywhere. There were all types of people, and most of them were very engaging and friendly. Everywhere, the mood was generally upbeat and there was a lot of joking around.
The room was divided into a number of different departments: foreign exchange, bonds, money market, options, and the area I joined, cross-markets. With a mix of clever people and abundant market opportunities, all of the departments were humming along making money.
It was a time when the winds of change were howling through the markets. By aiding their design, personal computers were allowing financial products to become far more sophisticated - the abacus and slide rule could be thrown in the bin! Improved communications such as mobile phones were making it easier to keep track of what was going on around the world.
On top of this, governments were encouraging greater competition in the financial sector. The lazy old-fashioned banker, who enjoyed boozy lunches and golf days, no longer found life so easy. Suddenly there was pressure to offer competitive prices and to be more innovative.
The search for market inconsistencies
In cross-markets, one of our roles was to look for market inconsistencies, and to take advantage of them using the bank’s own funds. We were also responsible for the pricing of swaps, (sophisticated products that can protect businesses from volatility in currencies, interest rates and other markets).
Both of these activities were slightly complicated, but they were relatively low risk because we would simultaneously buy in one type of market and sell in another, leaving us with only a small exposure to market moves. After getting a grip on the mathematics involved, we usually had some time to plan our strategies, and to allow our positions to bear fruit. This type of thing suited me. I would never have made the grade if my job was to juggle phones like the book makers, or shout at the top of my voice like the floor traders. I liked having the chance to think, and to be able to watch things unfold over time.
Due to the relatively low risk, we were able to really go for it – our trades involved very large sums of money. So, here I was in my early twenties, with a few grand in the bank, a cheap suit and no real experience, and I was on the phone doing deals worth tens and hundreds of millions. I was so happy to feel that important. I knew I’d been given a big chance, and I didn’t want to mess it up. I had to be careful and check the calculations carefully before I did anything. Even a slip of the tongue could be dangerous, because saying ‘buy’ instead of ‘sell’ could obviously cost a lot of money. Once I fretted for an entire weekend thinking I had made just that mistake. On the Monday, I found that I hadn’t. The relief was like waking from a bad dream.
I stayed in this role for three or four years, and during that time we enjoyed a lot of success despite the low risks. It was great, there were no major problems and I became accustomed to dealing in large amounts of other people’s money. It was lucrative too. I had nervously taken a pay cut when I joined Bankers Trust, but my salary took off like a rocket and continued to rise while I was at the Bank. Starting at twenty thousand dollars at the age of twenty four, it more or less doubled every year: to fifty, one hundred, two hundred and fifty, five hundred, and then to one million and beyond by the age of thirty. That was big money, especially fifteen years ago. My friends couldn’t believe it, and I couldn’t believe it would go on. So, like a squirrel, I saved just about all of it.
Not so easy now
As I look back on that era, it’s clear that a lot of the ways that our trading room made money have simply disappeared. The markets have become relentlessly more sophisticated as the changes that started in the early 80s have continued. Nowadays, everyone is extremely well qualified, there are computer programs everywhere and there are instant communications. The market has evolved, like bacteria against antibiotics, to beat out opportunities. This has happened as people have spotted opportunities and exploited them till they no longer exist.
So over the years, as my career progressed, I have looked for high quality opportunities which are somehow resilient. I will present these in later chapters and explain why I believe they have persisted while others have been eliminated.
1.4 The markets can overwhelm government intervention
In September 1985 the world's biggest governments met at the Plaza Hotel in New York and reached an agreement: the US dollar was over-valued and needed to fall.
The effect was stunning. With the market aware of the new “official” preference for a weaker dollar, and some ten billion worth of dollars sold into the market by the governments as a show of force, the dollar dropped dramatically. In the following two years or so, it halved in value versus the other major currencies. An astonishing success for government policy.
However, this success was more of an exception than a rule. In fact, markets are normally too big to be bullied.
Countries of all sizes have often been tempted to try to dictate the value of their currency by intervening in the markets. Sometimes they want to lower a strong currency, but more often they want to prop up a weak currency. In some cases a falling exchange rate can be seen as an embarrassing assessment of political integrity and economic performance.
So governments enter the market with one thing in mind: to move the price. They buy or sell aggressively, and may add to the drama with a big announcement about government policy and commitment. The effect is immediate. Like a shark at a beach they cause widespread panic. Speculators and dealing rooms all over the world scramble to adjust their positions, and the media give the news top priority.
It was in the middle of one such episode a few years ago, when I had the idea to investigate the longer term effect of government intervention. The government was intervening aggressively in the
