Thoughts on the SEC's short sale actions

Short selling has been on the receiving end of public scrutiny and outrage for the past few quarters, as many believe hedge funds are to blame for the financial crisis. While hedge funds may have added fuel to the fire, their use of short selling did not cause the problems we are experiencing today. In my view, short selling is extremely useful because it allows market participants more ways to express their views on the value of a security, and thereby profit. It also acts as a counter-balance against the undue optimism sometimes present in a security, and can bring that security's price back to reality.

Whether you are for or against short selling, I think all of us can agree that the SEC's monitoring and regulation of short selling, and in particular naked short selling, has been poor at best. Just to clarify, naked short selling is the act of short selling when you do not have the "borrow" available. It is a particularly pernicious activity because it can allow someone to manipulate the market for a security.

Yesterday, the SEC announced several measures designed to better regulate and disclose the act of short selling (http://www.sec.gov/news/press/2009/2009-172.htm).

The measures are three-fold:

1. Brokers must purchase or borrow securities to deliver on a short sale. While this rule was already in place, it is being made permanent in order to curtail naked short sales.
   
2. A plan for SRO's to publicly disclose price and volume information regarding short sales. They are also continuing to review proposals on short sale price tests and circuit breakers for individual stocks.
   
3. A roundtable will be held on September 30th to discuss new measures including "securities lending, pre-borrowing, possible additional short sale disclosures, the potential impact of a program requiring short sellers to pre-borrow their securities, possibly on a pilot basis, and adding a short sale indicator to the tapes to which transactions are reported for exchange-listed securities".
   

I believe these measures are extremely positive for the market. I do applaud the SEC's efforts in (hopefully) regulating short sales the way they should be regulated, and increasing short sale transparency through more public disclosure. The only real negative to come from all of this is that all of this new regulation requires resources - resources that could be put to better use. In particular, it will increase the costs involved for short sellers - most likely legal and compliance.

Societal Implications Of The Market Collapse

As I am MBA bound in mid-August, I thought it was a good idea to present Bloomberg's recent article (http://www.bloomberg.com/apps/news?pid=20601109&sid=aQn_Cxyu99xY) on how the market rout of the past two years has affected Universities throughout the world. Most University endowments lost 20-30% from their peaks in (roughly) June 2008, and I believe the results achieved by the endowments will have prolonged effects on North America. It is well documented that we are past the industrial revolution and that we are well into the technological revolution. For North America to continue its lead on the world stage, we must continue to grow our technological lead, because this is where the future lies. At its most basic level, future growth will come from investment in the educational infrastructure of our society. These investments are designed to help spur innovation, eventually leading to impactful changes on our society (scientific, commercial, etc). Simply put, this is a requirement for the success of our society.

As pointed out in the article, many of our higher educational institutions that produce these breakthroughs have been forced to cut back on funding - postponement of the construction of buildings, lowering of professor salaries, halting program expansions, shrinking programs and research projects, etc. Furthermore, these cuts will be long-lived, because Universities generally derive a large chunk of their funding from endowments. However, to protect from outlier year's returns affecting funding, universities generally smooth the asset values of their endowments over three years to attain an average from which to draw a percentage of said funds for spending purposes. While this approach works the majority of the time, a problem really arises in times of distress where the endowment suffers multiple down years. Universities have already cut back on spending to compensate for an inevitable decline in their income stream; however, this decline will almost certainly be semi-permanent in nature. In fact, the larger and more prominent endowments are predicting that they will not be able to achieve their peak endowment size for anywhere from ten to fifteen years. To me, this means restricted growth in University funding, which may translate into slower long-term growth in our society - something that we cannot allow to happen.

While few organizations saw the market correction coming, I believe most endowment's investment strategies have actually aggravated their losses in this downturn. To understand how this occurred, you must understand that endowments were founded on the Prudent Man Rule, which basically states that they must manage their assets as a "prudent man" would, focusing on capital preservation primarily, followed by the earning of a respectable return. By that definition, most endowments have failed miserably over the past two years. As the purpose of an endowment is to fund long-duration liabilities (the maintenance and growth of the income stream of a University into perpetuity), the natural thing to do is to match those liabilities with long-duration assets. The first iteration of endowment investment strategy involved their assets being invested in long-term government bonds and high-quality corporate credits. This continued until equities started becoming a viable institutional asset class (again) in the 1950's and 1960's. During that time-period, Modern Portfolio Theory was created which was then incorporated in the endowment world - most famously by David Swensen, Yale's endowment manager. Swensen pioneered the use of MPT in endowment asset management starting in 1985, and focused on diversification as a way of achieving higher alpha. However, he did not simply diversify based on credit rating or sector. Swensen diversified into unconventional and uncorrelated asset classes such as hedge funds, real estate, venture capital, private equity, commodities, and timberland. Yale's endowment benefited handsomely from this approach to asset management for years, generating double-digit returns (http://www.yale.edu/investments/Yale_Endowment_08.pdf) which other endowments envied and eventually imitated. Although, this approach was like a double-edged sword, as the common link amongst all those investment asset classes is that they are illiquid and have high frictional costs. For example, hedge funds often have lock-up periods of two or more years. Private equity funds have lock-up periods of 7 to 10 years. Real estate and timberland can be notoriously illiquid, especially at the wrong time and price. Endowments embraced these asset classes and increased their portfolio weightings throughout the 1990's and 2000's. The additional alpha generated from investing in unloved and uncovered areas helped produce +15% returns for most endowments over this period. However, when the liquidity-seeking panic selling began in mid-to-late 2008, endowments were caught offside, losing billions in the process. These funds are not nimble and cannot turn their strategies on a dime. Their actions affect the market because, in essence, they are the market, and this is especially true when you consider that the size of the market for these strategies can be small. They are also inefficient, resource intensive, volatile, hard to enter and exit, and expensive to enter and exit. Furthermore, as the Bloomberg article pointed out, these areas have been slow to rebound, and it is very difficult to say whether or not they will reach the level of popularity they achieve pre-credit crisis. Some of these endowments are now stuck in these illiquid investments, and have been forced to raise cash for funding requirements via debt issues (Harvard issued $2.5bn in debt in 2008). In short, the acceptance of illiquidity has now caused long-term structural issues in terms of asset and liability matching. These funds, supposedly conservative in nature, are having a difficult time meeting their mandates - providing stable streams of income to match their Universities funding requirements.

As they say, hindsight is 20-20, which is why I believe it is actually hard to fault these managers for pursuing such strategies. The investment world is complex and competitive. These managers had the proverbial gun to their heads and were involved in a dual - the pursuit of the highest alpha. The truth is that if they did not pull the trigger in employing these alpha-seeking strategies, somebody would come along and pull the trigger at their expense. Furthermore, it is hard to fault them for being unable to change what has worked for so long. As humans, we are susceptible to hindsight bias. Seeing a competing manager consistently earn +15% returns with low volatility for years will often fool us into believing that that strategy is sustainable. This is clearly not always the case, and certainly brings into question the wisdom of maintaining an investment policy of effectively static portfolio weightings in asset classes over the long-term.

It makes one wonder whether straying from the essence of the Prudent Man Rule was so wise? Does the pursuit of return trump the pursuit of capital preservation? Although my investing career has been relatively short, the longer I am in this game, the more I think that capital preservation is the essence of investing. Wealth accumulation is, after all, path dependent. Simple arithmetic tells us that losing X% requires us to produce a return greater that X% for us to simply get back to even, and more importantly, it robs us of the time (read: opportunity cost) that our funds could be employed in an investment producing positive returns.

Opportunity Costs Really Grind My Gears...

Do you want to know what really grinds my gears? Opportunity costs. That moment we have all experienced - when a stock that has been on your watch list for the past year suddenly receives an offer to be acquired or jumps +20% in a day. That moment when you realize that all that work you did in the interim seemingly goes down the tubes because you can no longer act on your research at an attractive price. For me, that moment has been replayed over and over in the past five months, as so many of the stocks that I wish I had bought have doubled and / or tripled. The last stock to contribute to the continued crushing of my spirit was Cossette Communications Group (TSX: KOS), a stock that I have been following for quite a while. It has been in a downward spiral for years, and I have been watching it fall further and further, knowing that one day its fortunes would rebound. Aside from the cheap valuation which initially attracted me, I saw KOS as a company with several corporate governance issues (dual class share structure, insider dealings, and board independence issues specifically) and a business under temporary pressure given its economically sensitive revenue streams. If the corporate governance issues could be fixed and advertising spending stabilized, I believed that we could easily see the stock in the high single-digits. While none of that has played out, the day of reckoning came yesterday, as the company received an unsolicited proposal to be acquired by Cosmos Capital by way of Takeover Bid for C$4.95 per subordinate voting share - a 52% premium over the previous day's closing price.




Cosmos Capital is an entity controlled by Mr. François Duffar, a former director of KOS, who resigned effective June 1st, 2009. Other investors include George Morin, Jean Monty, Daniel Bernard, and an un-named multi-billion dollar private equity group. Mr. George Morin, another KOS director, officially tendered his resignation as of July 18th, which just became known yesterday by way of a KOS press release. Together with Mr. Claude Lessard and Mr. Pierre Delagrave, the four members of the Board held all of the multiple voting shares, which essentially gave them an 85.9% voting interest in the firm, but only 37.9% economic ownership. However, once Duffar and Morin left the board, their MVS were automatically converted into SVS, leaving the main ownership structure as follows:




Now, with Duffar and Morin owning 3.1mm SVS, their voting interest is 6.5%, but their economic interest is 18.6%, which represents the second largest block of shares after Lessard and Delagrave (assuming they are aggregated). On a side note, Burgundy Asset Management owns 1.9mm SVS, representing a 3.99% voting interest and 11.37% economic ownership.


Now this is interesting, as you can see a power struggle emerging between four colleagues who have (had) high positions in management and on the board, and who essentially control the firm via their MVS. Given that the stock has traded at the C$4.95 Takeover Bid price on announcement day (and in fact traded at C$5.15 to close the day) shows that the market and specifically merger-arbitrage players believe that there is more upside to this story. In fact, today, the stock traded mostly above C$5.00, and closed at C$5.20, albeit on small volume (72,000 shares traded). This may indicate that speculative retail players are buying up here. I would expect higher volume created from arbitrageurs buying below the C$4.95 level.


The truth is that it does not take a genius to figure out that Cosmos Capital is trying to pick up the company on the cheap, as one only has to take a cursory look at the facts to see this (http://www.cossette.com/investors/pdf/inv_Factsheet_KOS_20090506.pdf). Looking at EV / normalized EBITDA shows that Cosmos Capital is proposing to pay ~3x. If you factor in cap-ex to get a basic FCF, we are looking at 3 to 4x EV / FCF, which is still extremely cheap. It is reasonable to assume that the range of EPS in a normalized operating environment is anywhere from $0.50 to $0.90, which implies that Cosmos is attempting to pay anywhere from 5.5x to 9.9x earnings, which despite the high premium on 30 day VWAP and previous day closing price, is not much of a valuation premium. While not entirely comparable due to size and geographic diversity, the comps (Interpublic, WPP, and Omnicom) are trading at 11 to 12x trailing EPS. It is also important to keep in mind that these are bottom cycle EPS numbers as well, so there is certainly room for upside for any acquiror. Aside from these basic valuation measures, the best information to look at in this situation would be media (specifically advertising company) acquisition premiums and valuation metrics, however I am not a media analyst, so I do not have enough historic information to do a proper analysis. My gut instinct and the information I do have tells me that this proposal is inadequate, and we will see the newly formed special committee either force a higher bid from Cosmos or another party (likely Lessard) via an auction process.


While I do believe a higher bid will be forthcoming, there are a few caveats for anybody wishing to play this from a merger-arbitrage perspective. First off, this is only a proposed Takeover-Bid, which means this is a risk because no deal is actually on the table as of yet. In addition, because Cosmos Capital technically already owns an 18.7% position in the stock, you must be aware that they have already benefited from the jump in the stock price, and this is before anything other than the proposal has occurred. Therefore, they may have ulterior motives and it wise to be aware of that possibility. Secondly, Burgundy Asset Management owns an 11.1% economic interest in the firm, and Cosmos has convinced them to sign a "hard lock-up" agreement, meaning that they cannot sell their shares below the C$4.95 bid, unless a higher bid is tabled. This is important because it means that 30% of the shares, yet only 10.4% of the votes, are in favor of the deal from the get-go. Although I have never been in favour of the dual class share structure, this is exactly why it was created, as Lessard and Delagrave now have an extremely valuable blocking position. Finally, my biggest hesitation in playing this deal is that I do not have a read on what Lessard is thinking. He is the largest shareholder, and he was clearly kept out of Cosmos Capital's bid, which may have irritated him and may cause him to reject their bid outright. This is important because he controls a 47.4% voting interest in the company, and therefore can block any proposal he wants. (66 2/3% is the generally the required amount for a Takeover Bid to close). It is also important to note that the firm is essentially his baby, as he started his career at KOS in 1972 as President & CEO, and has built it into what it is today. So, does he actually want to sell the firm now and at the price Cosmos is offering? Also, does he want to sell to ex-colleague's that went behind his back with a Takeover Bid in an attempt to "steal" his company from him? My guess is no. He is also the most incentivized person in terms of seeing a higher stock price, so my guess is that he will 1) have the special committee search for a higher bid (this is obvious) or 2) emerge as a bidder himself. From 1996 to 2008 he has received salary and bonus compensation of anywhere from $600,000 to $1,000,000 per annum, and as he has held his same position since 1972, he likely had a similar compensation scheme from 1972 to 1996 (adjusted for inflation). My point is that he is likely wealthy enough to arrange his own bid in some way, shape, or form.


Regardless of the risks to this proposal, I am still positive on a deal materializing, however, at the +C$5.00 level, buying shares now leaves no room for error. Given that KOS is now a risk-arb situation as opposed to just a cheap stock, the risk / return parameters have changed. As such, I would remain on the sidelines until this becomes an official bid, and until you have a chance to read the Takeover Bid circular. In addition, I would be a buyer at a positive spread - likely at the C$4.75 level. This is equivalent to a 21% annualized return according to my deal timeline assumptions, and it takes into account the risk of Lessard using the "just say no" defense. Unfortunately, it does not look like KOS is going to get to that level anytime soon.


So, to circle back to the beginning of this post, the best thing we can do is learn from our mistakes and move on. So the question becomes what did I learn from this missed opportunity?

My take-aways are three-fold:

1. When you do your homework, you must believe in your analysis, and must be ready to pull the trigger when an opportunity comes your way.


2. The sense of loss I felt upon finding out about the Takeover Bid for KOS was natural. It is only human nature to feel remorse over a potential gain when I had the desire and ability to buy KOS, but did not. It is also natural that this feeling is stronger than an actual monetary loss on a stock, because as humans, we feel that once we have made the decision to buy, the "fate" of the stock is now out of our control, and therefore we attribute this loss to the markets and not ourselves. Conversely, it is interesting that should that stock have gone up after our purchase, the majority of us would attribute it to our savvy investment skills, and not the stock's "fate". Regardless, these feelings are behavioral in nature, and we have to learn to combat them because they can and will lead to mistakes.


3. The physical matters. By this, I mean it is vitally important that as analysts, we look through the DCFs and EPS and all the other investment jargon. We have to look at the tangible aspects of a business, because sometimes there are physical clues that sit right in front of our eyes. With respect to KOS, this clue emerged on March 2nd, 2009 when KOS issued a press release announcing that Mr. Francois Duffar, the Vice-Chairman of the Board of Directors and a member of the management team of KOS since 1972, decided to terminate his employment with the firm as of June 1st. While management turnover is normal (especially for someone who has had a 37 year career with the same firm), it is the fact that this action caused his MVS to be automatically converted to SVS. This is what should have tipped me off that something was in the works. In my view, no rational person would willingly give up the control premium that typically comes with MVS, and certainly not without getting something in return. On May 11th, it was announced that Duffar would step down from the Board of Directors, effective that day. This was another hint that I should have picked up on instantly. Fast-forward 70 days, and the stock is up 65.5%, which on Duffar's 2.09mm SVS, represents a paper gain of C$4.1mm, and in my view, the recouping of the control premium he rightfully possessed on his MVS. The physical matters...

Life in the M&A deal market?

Thomson Reuters recently released first-half 2009 M&A deal statistics, which seems to indicate that we have, in fact, turned the corner in the M&A market. At the very least, activity is picking up in terms of small and mid-market deals.

As indicated in the Thomson Reuters blog (below), first half deals are down 45.7% in dollar terms YoY. However, while second quarter mid-market deals were down 43% YoY in dollar terms, they came in 20% ahead of the first quarter, which is stability at the very least.

http://blogs.reuters.com/reuters-dealzone/2009/07/13/keeping-score-signs-of-life-in-the-mid-market/

As I have maintained throughout downturn, small and mid-market deals are where we will see strength first, as large-cap and mega-cap deals require huge amounts of financing, which requires significant primary debt market demand - something that is not fully back.

Although this information is definitely positive, it does remain to be seen whether or not this is the end of the pain in the deal market, as there are various views on whether or not we are fully out of the woods yet. The consensus amongst M&A professionals, as per a recent WSJ DealJournal blog post (below), is a firm no.

http://blogs.wsj.com/deals/2009/07/10/ready-to-call-bottom-in-the-ma-market/

1st Half 2009 Hedge Fund Returns

Courtesy of Credit Suisse / Tremont Hedge Index (http://www.hedgeindex.com/)

As we are now a little past half way through the year, I believe it is important to take a quick glimpse at how the markets are doing. Overall, the S&P 500 is up ~1.7%, the DJIA is down ~3%, and the NASDAQ is up ~14%. Mixed results, overall, but it is a welcomed trend given the destruction that occurred last year. Markets have also been buoyed over the past few days due to the much anticipated Goldman Sachs and Intel results - both of which came in above expectations earlier this week.

While the overall markets have remained flat (albeit, with significant volatility), hedge fund strategy returns have been extremely mixed. As I had predicted earlier this year, convertible arbitrage would come back strongly after the debt market was flooded with primary market issuance earlier this year. Convertible arbitrage is up an astounding 24% YTD, as credit markets continued to heal, while opportunities for shorting equities were abundant in the earlier part of this year. Given the massive rallies in all equities since the March lows, I am not surprised that dedicated short funds were down an average of 10% as well. What is an aberration, however, is the fact that equity market neutral funds are down an astounding 14% YTD.

Looking forward in the mid-term (+1 year), I do see three strategies doing well. First off, Global Macro should continue to do well, as there is still significant volatility in essentially all asset classes, and there will continue to be as long as there is the perception of risk in the markets and as long as world-wide governments, central banks, and various regulatory agencies continues to interfere in natural market mechanisms. One simply has to look at what has gone on in base metals, precious metals, energy commodities, equities, distressed debt, real estate, currencies, interest rates, etc. This playing field is a bonanza for Global Macro managers as they have access to essentially every asset class that is displaying huge, albeit, declining volatility.

Secondly, I expect Long / Short Equity managers to do well in this environment, because I do expect the VIX to be quite active in the near future, albeit in a trading range of 20 - 40 (it is currently at 26). Note that I view the VIX as the market's perception of current risk, and not future risk. With every market participant's heightened sense of risk and this economic crisis continuing, we are definitely not going back to below 20 on the VIX anytime in the near future. With Long / Short managers finally starting to catch their bearings after last years market rout, directional short-term trading and stock picking will be the main source of returns in the near future. Assuming most Long / Short managers have the wherewithal to stomach volatility and take advantage of short-term market swings, I do see this strategy performing as it has always been marketed to perform.

Finally, Event-Driven / Distressed Debt funds will also benefit in the coming years. Although M&A deal volumes and values are hitting all-time lows, it is only a matter of time before this market turns the corner and deals starts hitting the tape again. Risk-Arbitrage will be back when the deal market and hedge funds stabilize. Note that this is also dependent on the securities lending market and prime brokerage financing stabilizing as well. A separate, yet related strategy is the Distressed Debt strategy, and I strongly believe that we will see that come back as corporate bankruptcies (14,319 in the 1st quarter of 2009 - a number we have not seen since www.abi.org began recording in 1994) and restructurings continue to proliferate. We have already seen major funds flow into the sector, along with new restructuring funds being opened up. This type of activity will only increase, and therefore I do see numerous opportunities in this sector. However, these workouts will take time, and therefore returns will take longer to achieve.

New Venture Capital Fund - Andreessen Horowitz

Yesterday, Marc Andreessen, the founder of Netscape, announced the formation of a new VC firm called Andreessen Horowitz, with his partner Ben Horowitz. Andreessen has also been involved in Facebook, Twitter, and NetScape. This new tech focused fund is unique in that it has limited its scope to tech investments solely based in America. The $300mm fund will also focus on investments ranging in size from $50,000 up to $50mm.

http://dealbook.blogs.nytimes.com/2009/07/06/netscape-founder-starts-silicon-valley-venture-firm/

The Venture Capital Journal website posted a fantastic interview with Andreessen (http://www.vcjnews.com/story.asp?sectioncode=26&storycode=47879), and I thought it would be important to post this because it covers so many topics ranging from the VC industry, to Andreessen's experiences, to investment strategy. I do believe that the mindset of a VC investor is very similar to that of a value investor in the sense that they search for the best upside / downside ratio in investments, whether they are early stage or late stage. However, VC investors are also product / industry focused, with an emphasis on operational abilities, whereas value investors tend to have a more financial focus. Regardless, it will be beneficial to learn a few lessons from an investor of Marc Andreessen's caliber.

I think one of the main things that surfaces early in the interview is Andreessen's discipline. He closed the fund at $300mm (albeit, this is a large sum now), selected only a limited number of GP's (general partners), and has set a strict limit in terms of the fund's sector focus - information technology. Not only that, but they have defined exactly what they will not invest in - green-tech, nanotech, biotech, etc. I venture to say that his past success is likely attributable to his ability to specify exactly what they will invest in - what Buffett calls a "circle of competence". This is readily apparent when Andreessen says "it's necessary to understand the product....Everything in the domain I described we can really get our heads around the product in detail." It is interesting to point out that Andreessen is so focused on the product of each of the companies he invests in. To a lesser extent, he focuses on valuation. This seems to be much different from other VC funds that have the "cash burning a hole in my pocket" syndrome, and who are willing to get deals done just to get the cash invested. Both of these last points highlight again, how important discipline is in terms of understanding what you are investing in.

A realistic, long-term model is something that Andreessen also focuses on, as he has opted to elongate the typical 5-7 year VC investment model into a 10 year fund, and even talks about 12-15 years if necessary. This is atypical, and shows his ability to think long-term while also thinking outside of the box, two traits of successful investors / operators.

Throughout the interview, it becomes readily apparent that Andreessen has a very clear understanding of what his vision and mission is, and to me, this is the starting point of investing success.

Risk Management = Risky Business

I came across an interesting video on the McKinsey website, in which the recently deceased Peter Bernstein gives a thirteen minute talk on risk in the real world and in the financial markets.

http://www.mckinseyquarterly.com/Organization/Strategic_Organization/Peter_L_Bernstein_on_risk_2211

Risk, in modern portfolio theory, is essentially the volatility of an asset price. This definition of risk is debatable, as Bernstein and most successful investors believe is that risk is uncertainty, in the sense that we do not know what the future holds. Realistically, there are a range of outcomes to any investment situation, and as investors, we do not know where the eventual outcome will lie in that range, what the actual range truly is, and when that outcome will occur. MPT fails in the sense that it says that risk occurs is a nice smooth normal curve. Our experiences in the real world tell us otherwise. We are continually getting 3 and 4 standard deviation events every couple of years - something that should not occur often according to MPT. The reason why there is this discrepancy is because the risk model is wrong. In fact, most risk models and therefore risk management tools are wrong because they attempt to do the impossible - predict the future and insure against it.

Bernstein goes on to say mistakes will be part of the investment process, and that the successful risk mitigation does not depend on determining when a particular risk will come to fruition, nor what type of risk will occur, but in how well we are prepared to deal it. Most risk management tools fail because they ignore their own fallibility, create a sense of security in their users, which eventually leads to these massive failures we read about in the WSJ each morning. Take LTCM for example. LTCM used sophisticated techniques such as fixed income arbitrage, statistical arbitrage, and pairs trading, and it did so in obscure markets such as Russian bonds. While this can, and did lead to good returns for LTCM initially, LTCM relied heavily on its risk models. Models that did not foresee the liquidity crisis in Russia, and did not foresee how LTCM's simple involvement in the game changed other players actions, and therefore the usefulness of their risk model. In short, they were ill prepared to deal with this outcome because their risk models did not, and in fact, could not tell them that this outcome would occur and that it would occur at that point in time. Another prime example is the crash of 1987, in which portfolio insurance was the main culprit. With markets in the midst of crashing, the portfolio insurance (puts) of most large institutional investors kicked in en-masse. This caused major investment funds to aggravate the situation by essentially selling large amounts of stock all at the same time, further pushing the indices down and causing a feedback loop. In this situation, risk management's new creation (portfolio insurance), misled investors once again because it simply could not foresee the actions of other investors, and it did not have the option to correct itself.

What is the lesson from all of this? The lesson is that risk models and risk management tools simply cannot work in every scenario. First off, it is important to understand that you and your decision making process are fallible, and that you will never be 100% correct, nor be able to see all of the potential outcomes - both positive and negative. Therefore, it is important to focus on the worst-case scenarios, and then protect yourself as much as possible in these scenarios, because the worst-case scenarios are the ones that matter the most to your long-term investment success. This involves having a good understanding of probability theory, as pertains to the magnitude of potential losses. Most investors protect against loss by hedging, which is a good option, although it involves you taking a position in another instrument with potentially disastrous outcomes (see LTCM and portfolio insurance). Value investors protect against loss by buying instruments that have limited downside in even the worst-case scenarios. Even though you may not know how one position will work out, when combining several of these positions, the portfolio should have limited downside as a whole. As for the upside, the sky is the limit.

I would also like to point out that it is very refreshing to see somebody of Bernstein's stature bringing up a very simple yet effective concept of risk mitigation. When you do not know or do not understand an investment, then using the "run like hell" approach may simply be the best way to avoid that particular risk. Good players realize when they do or do not have an edge, and pick their shots accordingly.