Wall Street: fooled by randomness
"If you're so rich, why aren't you so smart?"
By Morgan Housel
In his book Fooled By Randomness, Nassim Nickolas Taleb describes "luck disguised and perceived as nonluck (that is, skill)." He explains: "It manifests itself in the shape of the lucky fool, defined as a person who benefited from a disproportionate share of luck but attributes his success to some other, generally very precise, reason."
Are you listening, Wall Street?
After the financial crisis of 2008, Wall Street earnings came roaring back. The main reason: trading profits. At Goldman Sachs (GS), revenue from trading ballooned to an all-time high in 2009, driving overall profits to a record just months after the company was bailed out.
At Citigroup (C), more of the same. Barely a year after flirting with bankruptcy, Citigroup was immensely profitable in early 2010. How? Trading profits surged.
At Bank of America (BAC), you guessed it: 2010 would have been a dreadful year if not for "record performance in sales and trading," as the bank put it.
As Bloomberg pointed out in 2010: "In a feat that would seem to defy the odds, Goldman Sachs, JPMorgan Chase, and Bank of America this week each said its trading desk made money every day of the first quarter."
Fast-forward to today. The story has flipped entirely. Goldman Sachs reported a sharp drop in earnings yesterday, driven by a 21% decline in trading revenue. Citigroup shares plunged earlier this week after reporting disappointing earnings thanks to weak trading results. JPMorgan's quarterly earnings fell significantly after … say it with me … trading revenue fell by nearly one-fifth.
As CNBC reported yesterday, "Everyone is reporting lower revenues, in part because clients were so freaked out by market volatility that many decided to park assets in cash or Treasurys and just sit out 2011."
It should be clear: Since trading profits at big banks move in the same direction -- either everyone is minting money, or everyone is hurting -- results are driven by factors outside of traders' control. If skill and prowess drove trading results, you'd see a much larger divergence in fortunes. Instead, it's likely that general market conditions and the macro environment dictate trading profits. It's far more a game of luck -- being in the right place at the right time -- than skill.
JPMorgan CEO Jamie Dimon virtually admitted as much this week, saying, "When things come back these numbers will boom again and we'll be geniuses, and it won't be because we did anything, it will be because we stayed in the game."
His sarcasm is absolutely right. The problem is that traders are treated as if they are true geniuses. When trading profits boomed in 2009, the average Goldman Sachs employee took home nearly half a million dollars. The average worker at JPMorgan's investment bank earned $379,000. While down from 2007, a large portion of the Ivy League's best and brightest still seek Wall Street jobs after graduating.
Though it's hard to quantify, the aura of Wall Street traders seeing themselves as Masters of the Universe -- smarter than doctors, wiser than lawyers, more technical than engineers, and harder-working than soldiers -- seems alive and well. If there were a way to measure a sense of entitlement Wall Street would surely rank near the top. In an article in New York magazine, one Wall Streeter put it this way: "People just don't get it. I'm attached to my BlackBerry … I get calls at two in the morning, when the market moves. That costs money."
The article's author, Gabe Sherman, responded appropriately: "Now, a lot of people in New York have BlackBerrys, and few of them expect to be paid $2 million to check their e-mail in the middle of the night."
The idea that Wall Streeters deserve to be rewarded as they are is dangerous. It is wrong to assume that success on Wall Street is always the result of skill, ingenuity, or even hard work when in reality it's often -- most often, perhaps -- driven by the privilege of having more information than their clients, being backed by a generous Federal Reserve and taxpayer bailouts, or just sheer luck.
This isn't a jealous rant. I worked at an investment bank before joining the Motley Fool. There are some smart people. And true talent should be rewarded. But when trading results are virtually identical across all major banks, whether we're witnessing true talent or the random whims of the market is up for debate. Too many on Wall Street are like the tech-stock trader in 1999 who made a fortune, and assumed that fortune was the result of skill, when in reality he was just as Taleb described: fooled by luck.
I recently noted to a friend that former MF Global CEO Jon Corzine orchestrated a disastrous bond-market bet while working at Goldman Sachs in 1994. Combined with recently guiding MF Global to collapse, I wondered whether Corzine's success during the rest of his career was the result of luck. Maybe he was fooled by randomness.
"Well, you have to remember," my friend said. "1994 was a bad year for bonds. Everyone got hit."
True, but isn't the job of a trader who makes seven or eight figures to see those bad years coming? Otherwise, they're just riding whatever the market does. And there might be merit to such a strategy, but pay should be adjusted accordingly. Too many on Wall Street take full credit for the sensational profits of bull markets, yet hide from the responsibility of falling profits when the market turns. When times are good, they, too, are fooled by randomness.
So what does explain the extraordinary pay of Wall Street traders? Warren Buffett sums it up best:
The nature of Wall Street is that, overall, it makes a lot of money relative to the number of people involved and the IQ of the people involved. They work hard. They're bright. But they don't work that much harder and aren't much brighter than someone building a dam and a whole lot of other talents. But in a market system it pays off very, very big. Boxing pays off very big now compared to what it did when the only auditorium you had was 25,000 seats at Madison Square Garden, and now you've got cable television. You can put a couple of lightweights you'll never hear of again on pay-per-view and they'll get millions for it. Market systems produce strange results. Wall Street markets are so big, there's so much money, that taking a small percentage results in a huge amount of money per capita in terms of the people that work in it.
"And they're not inclined to give it up," he adds.
Fool contributor Morgan Housel owns B of A preferred. Follow him on Twitter @TMFHousel. The Motley Fool owns shares of JPMorgan Chase, Citigroup, and Bank of America. Motley Fool newsletter services have recommended buying shares of The Goldman Sachs Group. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.
Good article. The Corzine experience demonstrates another dimension of it all too. When Wall Street Traders make lots of money, they keep a big percentage of it for themselves. When they blow up and lose more money in the markets than they could ever earn in a lifetime (even at their stratospheric salaries) their clients or shareholders take the entire hit and the trader never has to pay it back. Heads I win, tails you lose. Anyone can be successful in the long run playing by those rules. It doesn’t amaze me that they are all multimillionaires. What amazes me is that they are not all billionaires.
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The solid report comes a month after the retailer closed all of its Canadian operations.
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