Of all the insulting labels lobbed at Wall Street over the past two years, you wouldn't expect "overconfident" to be the one that hurt. But it has. This week's New Yorker article by Malcolm Gladwell on Wall Street's "psychology of overconfidence" struck a nerve.
To an outsider, the idea that the financial crisis was caused in part by overconfidence is uncontroversial. An overconfident person is one who does not accurately evaluate the risk of his own failure, and isn't that what led banks to swallow billions in sketchily credentialed sub-prime mortgages? But discuss the theory with finance professionals, and eyes narrow and voices tighten.
One bank official commented to me that Gladwell was "full of it," engaging in "pop science," and that "you can make sweeping generalizations sound true if you tap the entirety of scientific and literary history to find sources." Gladwell's primary Wall Street example of overconfidence, former Bear Stearns chairman Jimmy Cayne, was hardly a revelation for many on Wall Street. "Jimmy is a colorful character, so that's too easy," one trader told me. "If the point was about overconfidence, then the story should have touched upon situations that Bear encountered when they said, 'We know better than the market.' That wasn't in there." Two others were surprised that Gladwell became distracted by the unrelated tale of military history at Gallipoli and didn't touch upon the classic Wall Street tale of overconfidence: the collapse of hedge fund Long-Term Capital Management, in 1998, a firm that was founded and run by Nobel Prize–winning economists. LTCM was leveraged close to 26 times, meaning it had 26 times more debt than cash to pay it off.
Carping about obvious examples and sweeping generalizations? Wall Street's critique of Malcolm Gladwell is not unfamiliar. But dig deeper, and it becomes clear that these traders weren't threatened by the charge that they had lost their touch at the game; it was Gladwell's attack on the game itself that bothered them. The kernel of Gladwell's argument is in this sentence: "Because ability makes a difference in competitions of skill, we make the mistake of thinking that it must also make a difference in competitions of pure chance."
The trading industry is built on the premise that the markets have a logic. Fund managers judge themselves by "benchmarks" that tell them how close they were to getting the market right. To say that Wall Street is a game of pure chance, as Gladwell does, is to imply that the market is a casino, and nothing gets a financier's blood boiling like the idea that he's a glorified croupier. A few months ago, a prominent bank executive upbraided me because I said his firm had made a good bet on some securities. "Look right there," he chided. "It's not a bet! You reporters are always writing about 'bets' in the market! We don't bet! We're not out there playing roulette. These are educated, considered decisions." A securities lawyer pointed out that "the odds are always with the house in a casino. If that were so, Bear and Lehman would still exist."
Oddly enough, just as Wall Street is vehement about its ability to make decisions, the market does in fact more closely resemble a spinning roulette wheel. On Thursday and Friday, Reuters, Bloomberg, and the New York Times all ran items critical of "high-frequency trading," in which computer programs scan markets and buy and sell stocks on behalf of some firms in milliseconds. That beats the market significantly enough to get people worried about firms "frontrunning," or profiting by trading before their clients do. If that's not the sound of the house winning, then what is?
Cocksure [The New Yorker]