Don’t eat anything that your grandmother wouldn’t recognize as food

The title is courtesy of Michael Pollan and his back-to-basics food manifesto. I’d been thinking that there’s an analogous tip for personal investing:  Don’t invest in anything that you can’t understand.  So I was pleased to see award-winning writer Bethany McLean (co-author of Enron: The Smartest Guys in the Room), in a terrific interview on last night’s “Daily Show,” make just the same point:

“If you don’t understand how it’s making money, maybe it’s not making money.”

Had Bernie Madoff’s investors followed this advice, they might be $50 billion richer.  (Had all the buyers of securitized subprime mortgages followed this advice, the world might be several trillion dollars richer.)  One thing about the Madoff scandal that has me wondering was the comment from an industry participant about how it was obviously a Ponzi scheme, based on Madoff’s claim that his fund returned 8 to 12 % every year, come rain or come shine.  The participant said that was impossible, given the volatility of the markets.  Which has me thinking a few things:

(1) Isn’t that what hedge funds attempt to do — earn high returns while hedging away most of the risk?  8-12% is about what the stock market averages, and it seems like a fund could find a way, by setting excess gains aside or using put options or something much fancier (which, yes, I wouldn’t understand) to deliver a strong, steady return.  It would probably average a couple points less than the stock market averages (say, 8% versus 10%), but investors would surely flock to such high risk-adjusted returns.

(2) If, in fact, this is near-impossible to do, as the market participant said, then what sort of returns are hedge funds actually earning?  How much of that information is made public?  (Not too much, I’m guessing, since hedge funds are basically unregulated.)  How many of these funds are actually Madoff-type Ponzi schemes that haven’t been exposed yet?  Even if they’re not engaged in anything terribly crooked, shouldn’t there be more transparency as regards their holdings and returns?  Even five of the world’s biggest hedge fund managers seem to think so, based on their appearance before Congress last November.

(3) I need to learn a lot more about hedge funds.  Next on my reading list:  Roger Lowenstein’s When Genius Failed: The Rise and Fall of Long-Term Capital Management.

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One Response to “Don’t eat anything that your grandmother wouldn’t recognize as food”

  1. Senthil Says:

    The title is hilarious but with lot of truth into it…if we cant understand how to make money then why burn the finger in the fire……i guess the investors also should given their due rights to know and suggest where their money is invested..Mathematical models or no mathematical models – the present crisis is just on account of too much greed and throwing all common sense to winds.Though the growth of these funds are high in past scenarios, its downfall affected the world more.

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