Victor Haghani on Death of Random Walk, and Passive, Buybacks, and LTCM

**Jack Farley** (0:00)
So I feel like we could talk about LTCM. We could talk about... I mean, you sent some great...

**Victor Haghani** (0:05)
Let's not do that. That's so boring. I mean, everybody's sick of LTCM.

**Jack Farley** (0:10)
Yeah, yeah. So what do you think the real lessons are?

**Victor Haghani** (0:13)
I think the biggest lessons are about personal risk-taking. The first big lesson has to do with skin in the game. Maybe the next lesson is that running a leverage pool of standalone capital might be a bad business structure. It might be better to do relative value trading within larger institutions where it's a small part of the activity and where it's not exposed to financing risk, et cetera, from all the counterparties that are funding that activity. So I think those are two things. I think relative value trades tend to have fatter tales than what we call Delta 1 trades, that's kind of natural. Something that we knew about, but I think that was more highlighted by that. I don't know, I think those are like three really, really big important lessons from that.
I think probably the main difference is that they run tight stop losses on all of their strategies. And so they are trying to force all of their strategies to be liquid enough that they can operate tight stops. I think that's really helped them. I think that that helps bring a positive exposure to momentum into their strategies. And I think that's probably the biggest divergence between what they're doing and how they've been more successful navigating a number of crises than what we were doing back then. We didn't have tight stop losses on our positions. It felt like relative value trading, it's hard to put tight stop losses because they tend to be kind of illiquid and they tend to look more attractive as they're starting to widen out. But yeah, and I think that probably the podshops have a greater, a broader mix of strategies than we were running at LTCM and that's also helped. But, you know, I mean, some of the podshops that were, some of the hedge funds that have done successfully had really big drawdowns, like existential drawdowns in 2008-9 and just managed to survive them, which is great.
But some of them were vulnerable and at other times, some of the basis trades have looked a little bit dicey and put some hedge funds in a precarious position, but they all worked out. And again, LTCM probably could have worked out if if LTCM had not been so much the focus of the financial markets at the time, like if LTCM had sort of been more quiet, had been quietly on the side and people didn't know that we had had such a big drawdown and that we were likely to be unwinding a lot of positions, probably LTCM would have survived, as many other relative value hedge funds survived, though with large losses in 1998 as well.

**Jack Farley** (2:58)
Joined today by Victor Haghani of Elm Wealth. He is the author of The Missing Billionaires, the author of an upcoming book. He'll tell us about that as well as he was the founding partner of Long-Term Capital Management. Victor, welcome to Monetary Matters.

**Victor Haghani** (3:11)
Thanks very much, Jack. Co-author, by the way, with my partner, James White, on that book and the forthcoming one too.

**Jack Farley** (3:18)
Tell us about Who Killed the Random Walk? What is the Random Walk? What is the work that you've been doing that shines new light on it and why does it matter?

**Victor Haghani** (3:31)
Thanks for asking that, Jack. This is something I haven't, I don't think I've talked on any really publicly about this, except we've been talking at a number of seminars about this paper. It's a piece of research that we've been working on for three or four years, and it just got accepted into the Journal of Investment Management. It's available as a working draft on SSRN.
Basically, the starting point is that everybody who follows the stock market sees a lot of behavior in the stock market that is hard to reconcile with the idea of everybody is a rational, fully-informed agent making long-term investment decisions based on expected cash flows of the stock market, which is the classical financial economics description of the stock market and asset pricing theory, to begin with, at least. And on the other hand, we have behavioral economics that came up relatively recently. And behavioral economics sheds a lot of light on the ways that we make, that people make weird decisions, but attends in its extremist form. It doesn't really give us much predictions or things that we can test in terms of market behavior. So what are these puzzles, I should say, start there? What are the different puzzles of the stock market? Well, I think the biggest puzzle of all is that why is the stock market so much more volatile than the volatility of long-term earnings, right? This is the famous Schiller-Campbell work from, I don't know, the late 80s, partly responsible for Schiller's Nobel Prize, where he pointed out that the stock market is so much more volatile. It's twice as volatile as expected earnings are. A little bit of a tricky thing to exactly measure, but I think that he did that pretty convincingly, and I think people kind of feel that way. And that's kind of become accepted within practitioners and academics alike as being the way things are, that the stock market is so much more volatile. And then some people say, well, that's just because the discount rate is also moving. Not only are people's expectations of earnings changing, but the discount rate is too. But that doesn't really answer the puzzle at all. It's just reframing the puzzle. Other puzzles that people think about with the stock market is, why is volatility so volatile itself? Why do we go through periods of extreme volatility, and then it kind of stays that way for a while, it's clustered. And then we go to periods of peacefulness. Why do we have trends? Why has momentum investing been such a good way to invest in the stock market? Why has value investing not been so great? When the PE is high, if you reduce your exposure to stocks, yeah, it tends to be okay sometimes, but a lot of times the PE is high, and the stock market just keeps on going up. Why do we get booms and busts? Maybe that should have been my first one. Why do we get booms and busts, this exuberance and kind of depression in stocks, at different times, and several more? Well, our paper, which I should say, really builds upon a lot of previous research that's been done. Our paper is titled Who Killed the Random Walk?, Why Extrapolators Explain Booms and Busts, and Other Stock Market Puzzles and Anomalies.