The Justice Department filed criminal charges yesterday against SAC Capital Advisors, accusing the multi-billion dollar hedge fund of securities and wire fraud.
What’s interesting is that even though the investigation has been going on for the past decade, until recently it hasn’t had much of an effect on investors’ willingness to invest in the firm. Consider that even during 2010 and 2011 as the insider trading investigation was gathering steam, investors added $1.6bn in new funds to SAC’s flagship fund.
So why did investors ignore a federal investigation, mounting rumors about insider trading, and an SAC trading culture that was so aggressive employees may have been pressured to the point of breaking the law?
Nobel prize winner Daniel Kahneman describes human’s “System 1” as a mode of thinking that involves intuitive, “fast” thinking, which is a useful evolutionary adaptation that saves time and effort and helps us make sense of incomplete or ambiguous information in a complex world. It is, as Kahneman has humorously described it, “a machine for jumping to conclusions.” So what drives these conclusions?
Kahneman suggests that our degree of certainty is often based on how good a story we can concoct based on the information available to us. In the case of SAC, the dominant story, with intuitive appeal to System 1, involved SAC’s dazzling success, and stellar track record. Since information was limited and no specific information about what was going on behind the scenes that enabled these returns, System 1 ignored the investigation and rumors since they were irrelevant to the central narrative of hedge fund success. Kahneman had an acronym for this: WYSIATI, or “what you see is all there is.” If all you see is high returns, then you may not realize how little information you really have.
And some may pay a high price for this. If you have your capital in SAC you may face lock ups as the firm struggles to return capital. You may suffer collateral damage to your reputation as you have to justify why you were invested with a firm that was indicted – what kind of fiduciary is it that is seen to be investing with a firm accused of a crime? Ultimately you may even be liable for fines.
So how do you combat System 1 and WYSIATI? Slow down. Think critically. Give your System 2, the more analytical side of your brain, a chance to weigh in. In the future, when you see many years of dramatic outperformance achieved with huge pools of capital you should be skeptical.
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