Firehouse Effect (Groupthink) and the Cross-Sectional Problem

Lines in the Sand

The bonds Carlos held kept falling through the price levels he had treated as lines in the sand. By early August, they were trading in the thirties. By the middle of August, they were in the twenties. And he was taking no action. He felt that the price on the screen was quite irrelevant in his business of buying “value.”

Signs of battle fatigue were starting to show in his behavior. Carlos was getting jumpy and losing some of his composure. He yelled at someone in a meeting: “Stop losses are for schmucks! I am not going to buy high and sell low!” During his string of successes he had learned to put down and berate traders of the non-emerging-market variety. “Had we gotten out in October 1997 after our heavy loss we would not have had those excellent 1997 results,” he was also known to repeat. He also told management: “These bonds trade at very depressed levels. Those who can invest now in these markets would realize wonderful returns.” Every morning, Carlos spent an hour discussing the situation with market economists around the globe. They all seemed to present a similar story: This sell-off is overdone.

Carlos’ desk experienced losses in other emerging markets as well. He also lost money in the domestic Russian Ruble Bond market. His losses were mounting, but he kept telling his management rumors about very large losses among other banks—larger than his. He felt justified to show that “he fared well relative to the industry.” This is a symptom of systemic troubles; it shows that there was an entire community of traders who were conducting the exact same activity. Such statements, that other traders had also gotten into trouble, are self-incriminating. A trader’s mental construction should direct him to do precisely what other people do not do.

Toward the end of August, the bellwether Russia Principal Bonds were trading below $10. Carlos’ net worth was reduced by almost half. He was dismissed. So was his boss, the head of trading. The president of the bank was demoted to a “newly created position.” Board members could not understand why the bank had so much exposure to a government that was not paying its own employees—which, disturbingly, included armed soldiers. This was one of the small points that emerging-market economists around the globe, from talking to each other so much, forgot to take into account. Veteran trader Marty O’Connell calls this the firehouse effect. He had observed that firemen with much downtime who talk to each other for too long come to agree on many things that an outside, impartial observer would find ludicrous (they develop political ideas that are very similar). Psychologists give it a fancier name, but my friend Marty has no training in behavioral sciences.

The nerdy types at the International Monetary Fund had been taken for a ride by the Russian government, which cheated on its account. Let us remember that economists are evaluated on how intelligent they sound, not on a scientific measure of their knowledge of reality. However, the price of the bonds was not fooled. It knew more than the economists, more than the Carloses of the emerging-market departments.

Louie, a veteran trader on the neighboring desk who suffered much humiliation by these rich emerging-market traders, was there, vindicated. Louie was then a fifty-two-year-old Brooklyn-born-and-raised trader who over three decades survived every single conceivable market cycle. He calmly looked at Carlos being escorted by a security guard to the door like a captured soldier taken to the arena. He muttered in his Brooklyn accent: “Economics Schmeconomics. It is all market dynamics.”

Carlos is now out of the market. The possibility that history may prove him right (at some point in the future) has nothing to do with the fact that he is a bad trader. He has all of the traits of a thoughtful gentleman, and would be an ideal son-in-law. But he has most of the attributes of the bad trader. And, at any point in time, the richest traders are often the worst traders. This, I will call the cross-sectional problem: At a given time in the market, the most successful traders are likely to be those that are best fit to the latest cycle. This does not happen too often with dentists or pianists—because these professions are more immune to randomness.