I have play a lot of poker in my day...a whole lot. I used to sit around and watch the World Series of Poker on ESPN when I didn't have a game going. I marveled at the skill of the poker pros, the ones who made it time and time again to the final table. They carried an enormous amount of respect from the growing number of amateurs who found their way into the tournament. The commentators would profile the pros, tell us why they were so good at the game. Some of them were mathematical geniuses, they told us. They could figure the odds of winning at the drop of a hat. Some of them had an uncanny ability to see into the thoughts of their opponent, reading the twitch of an eye, or betting patterns, or some ephemeral glow about them that told the pro exactly what that person was holding.
I too once suffered from the hubris of believing myself to be a good player. I approached the table with an air of confidence, pushed more and more money into the pot until I came out ahead. But over time I learned something about poker. Players have varying degrees of skill that allow them to gain certain advantages, but ultimately, to win you have to have the cards.
Let's shift gears for a moment. The gambler's fallacy is the false belief that as a certain result occurs more and more over time, the gambler believes that the probability of that event happening again rises. The classic example is the coin flip. If I flip a coin 20 times and it comes up heads twenty times then, if I fall prey to the gambler's fallacy, I begin to believe that the probability that the coin will land on heads again is greater than 50%. The problem is that no matter if I flip a coin every minute until the day I die and it always lands on heads, the probability of it landing on heads never rises above 50%. However, my confidence that it will land on heads goes up each time, causing me to believe more and more that the coin is destined to land on heads no matter what.
It's the same thing with derivatives. The contracts were structured in such a way as to allow for such a small probability that their inherent risks would manifest themselves that the people engaging in these agreements began to fall prey to the gambler's fallacy. The problem with derivatives is the same problem with any investment: greater risk = greater (possible) reward. Thus, the companies entering into derivative contracts made enormous profits from them and managed to avoid the risk factors. But then home prices began to decline and the risk reared its ugly head.
We can only hope that our government learns that if it looks like a security, and quacks like a security, then it needs to be regulated like a security. There is a reason that the SEC was formed in the 1930s. There is a reason that we still abide by the Securities Act of 1933 and 1934. We learned a lot about the pitfalls of unconstrained finance in those years. Let's not forget those lessons.
