Did you know that one third of lottery winners lose their entire fortunes? People also score big wins in the stock market, but unlike lottery winners, they don’t attribute the results to just good luck.
In his 2018 book, “Big Mistakes: The Best Investors and Their Worst Investments”, Michael Batnick issued this warning, “While it's nice to make money by chance, the downside of getting lucky in the market is that we tend to attribute the success more to skill than we do to randomness.”
Having scored a big win, we rush off to make another investment, confident that we are proven winners, “And wanting to experience the feel of the rush again, we keep pushing as we hope that lightning will strike twice. Investors can learn a great lesson from John Paulson (Trades, Portfolio), who struck lightning like nobody else before or since.”
Born in 1955, Paulson started his own hedge fund, Paulson & Co. in 1994, using his own $2 million. He took the step after working in merger arbitrage at Bear Stearns. Merger arbitrage involves buying and short-selling stocks in the two companies that plan to merge, with positions determined by the probability the deal will be consummated and the length of time it will take to complete it.
But Paulson did not make his big money, nor his name, using this strategy. Instead, it was his huge bet that the American housing bubble of the early 2000s would collapse. As you may recall, in the years after the tech bubble burst, another bubble was building: the housing, or subprime lending bubble. Batnick recalled:
“If you wanted a mortgage in 2005, all you had to do was ask for one. In one instance, a mariachi singer claimed to have a six”figure income and, despite having little knowledge of what such a singer earned, the lender agreed to the loan. In lieu of official proof of income, it included a photo of him in his performance outfit.”
Paulson and his “star” analyst Paolo Pellegrini firmly believed such lending could not be sustained and wanted to bet against it. The question was: What to bet against?
The answer was credit default swaps (CDS), which were essentially insurance contracts allowing them to bet against the debt of companies. In their first foray using this strategy, Paulson and Pellegrini bought $100 million worth of insurance against the debt of MBIA (MBI, Financial) for $500,000. MBIA insured mortgage bonds. Next up, Paulson bought CDSs on Countrywide Financial (now owned by Bank of America (BAC, Financial)) and Washington Financial (now private), two very large lenders.
It was a courageous and contrarian position; almost everyone in the housing and mortgage industries thought everything was going well and scoffed at a mergers and arbitrage guy going off in the opposite direction, alone. Batnick reported:
“Paulson was confident that his team's analysis was correct, but how did he know he was right? How could anyone possibly know that? Everybody he spoke with outside of his team told him he was crazy. That is the emotional price that most people who say they're contrarians aren't willing to pay.”
Among the skeptics were many of Paulson’s investors, clients who sat watching their fund bleed as they waited for a housing correction that might not come. But, of course, it did come. In February 2007, New Century Financial had to restate its earnings, and the stock plunged 36% (the company folded in August 2008). Also, the ABX index, which tracks the value of mortgages made to subprime borrowers dropped from 100 to 60. Very quickly, Paulson was $1.25 billion richer.
While the index did recover to 77, it was what Batnick called a “dead-cat bounce” and recovered no further. Meanwhile, defaults among subprime borrowers continued to grow. When the subprime market crashed later that year, the two credit funds run by Paulson were up 590% and 350%. The firm earned $15 billion, while Paulson personally made $4 billion. Batnick quoted sources saying, “Nobody had ever made more in a single year in the history of financial markets.”
After this huge success, Paulson wanted more: more big deals, more big payoffs and more big adrenaline rushes. He is quoted as saying, “It's like Wimbledon. When you win one year, you don't quit; you want to win again.”
But Batnick warned that once you have a fantastic success it is very difficult to “keep your ego in check. We're all overconfident to begin with, and huge gains make our feet levitate off the ground.”
Paulson was ready to go again; after watching the crisis unfold and the Federal Reserve commit to its quantitative easing program, he expected inflation to return. So, he went searching for an asset or assets that would not be affected by inflation and might even gain value in an inflationary economy.
That’s how he found gold. He plunged right into the precious metal, buying $5 billion worth of gold-related assets in the summer of 2010. As we know in hindsight, inflation did not make a comeback and investments in gold did not make anyone’s fortune. Batnick listed these outcomes:
- Gold lost 30% of its value after hitting a high in 2011.
- Paulson’s Advantage Fund gave up a third of its value in 2011, slipped another 14% in the following year, had a 26% gain in 2013, then had three straight years of losses.
The following price chart for gold shows what Paulson and his hedge fund faced:
And recent years have not been kind to Paulson either, as this TipRanks’ chart demonstrates:
In wrapping up the chapter, Batnick observed that everyone hopes to buy the next huge success while it’s still cheap. But there are hurdles. First, you’re competing against some very smart people and as he noted, the smallest of the 50 largest hedge funds spends $100 million a year buying information. Second, after you’ve had a big success you almost become addicted.
Finally, “You only need to get rich once. If you've worked hard or just got lucky and now find yourself in the top 1%, stop trying to hit home runs, you've already won.”
Disclosure: I do not own shares in any company listed, and do not expect to buy any in the next 72 hours.
