The Martingale Betting System is a strategy of doubling your bet every time you lose. Eventually, you get a win and make all your money back plus a tiny bit more. The unfortunate downside of the Martingale strategy is that eventually a run of bad luck comes along that wipes out your entire bankroll.
It seems to me that the strategies that have been tried in the financial system in the last few years amount to nothing more than an elaborate Martingale system. What happened to LTCM and Bear Stearn seems uncannily like what happens to a Martingale gambler. Everyone was convinced that nothing bad could happen to the mortgage market because historically, it’s been so safe. So people took on riskier and riskier investments with larger amounts of leverage on the assumption that a risk that was “almost zero” was indeed zero and there was a free lunch to be had.
Is this an accurate description of what’s happened?
A Martingale system is based on a simple strategy of keeping track of how much money you’ve lost in bets and then making a big enough wager so that if you win, you’ll get all your lost money back. The basic logic is that you’ll make a winning bet eventually and you only need to win once to get all your money back.
Neither the logic nor the system really applies to investments. You buy stocks at a set value and hope they’ll rise rather than decline in value over time. But there’s no fixed time when you can objectively say your “bet” has been won or lost - do you arbitrarily decide that you’re going to collect the bet in a week or a month or a year? And you don’t win or lose on a stock - they rarely do anything as dramatic as decline to zero or double in value like a roulette wheel bet would.
But the big difference is that stocks don’t move in arbitrary directions like roulette balls do. A Martingale stock system would have you constantly buying more stock in businesses with falling stock prices and cashing out on those with rising prices. It’s easy to see that a strategy of pulling your money out of growing companies in order to invest it in falling companies is not a good plan.
In other words, you are saying that a Martingale strategy is vulnerable to a “black swan”
While this is true, all investments are vulnerable to black swans. Even if you invest in a t-bill, you are taking a small risk of default, devaluation, and/or inflation.
So what’s the difference? Well, if you bet at a casino, the expected rate of return is generally negative. Is that true with a T-Bill? It’s hard to say for sure, but I would guess that’s positive.
What about Bear Stearns? Again, hard to say, but I will say this: When somebody has been hired to invest money for others, there is always a temptation to be overly aggressive, since the brunt of any downside will be born by the investors and not by their agent.
Despite all the crap written about it, investment bankers are out for themselves 1st, second, and third. They have NO compunction about stealing-and the Bear Stearns debacle is proof of that-the senior managers all dumped their stock, before the sh*t hit the fan. Setting up small investors for a fleecing is a time-honored Wall Street trick, and it has been going on for a long time. The MBAs in 3-piece suits are like the mafia-only they do their stealing legally!
Later, it will come out that these mortgage "backed’ securities were pumped up and sold for many times their worth-and as usual, thepublic is left holding the bag.
The downside of the Martingale Strategy is that it requires an exponentially larger and larger bet (your original bet x 2 ^ number of times you lost) in order to double your money and most people are generally limited by the size of their bankrole or the table limits.
Understand that the investments weren’t risky. Real estate rarely is. The LOANS were risky. A combination of greed and government pressures encouraged mortgage brokers to make loans to people who had no business taking out such a large mortgage. Many of these people lie on their applications but it doesn’t matter because no one checks anyway. The brokers don’t care because they sell off the loans to be broken up and securitized into CDOs. Bankers buy and sell these instruments, having little to no idea that they are based on bullshit.
So all of a sudent, interest rates go up and people can’t afford their house payments. The complex investment vehicles supported by those cash flows are now worthless and the banks lose money.
A better analogy would be if the casino offered lines of credit to their customers who couldn’t or wouldn’t pay it back after they lost.
Also, from what I’ve heard from friends in the business, Bear Sterns are a bunch of douchebag assholes and none of the other banks were particularly interested in helping them out.
Like ralph said, the underlying current is greed. That’s not necessarily wrong, but too much of it is a bad thing. Deregulation brought us the S&L scandals of the past, deregulation had a hand in what happened now. Wall Street types whine when the government gets involved, then make as much as they can when something goes wrong and the government has to step in. Free market my ass.
I once read, though I can’t find a cite, that the Martingale System was invented not by a gambler but by a casino owner, to encourage his customers to bet big and lose big.
And that’s not such a “black swan” either. The way a guy explained it to me, you play roulette and bet the same color all night. You start out betting the smallest amount the table allows, say $10. If you lose, your next bet is $20, then $40, and so on. And then when eventually you win – this is the important part, requiring self-discipline – you start over at $10 and repeat the process. If it goes like this:
Loss: $10
Loss: $20
Loss: $40
Win: $80.
You’re now $10 ahead. And if the process takes longer, you’re still $10 ahead, no more, no less. Do it again, you’ll come out another $10 ahead. And so on. (N.B.: You’re not betting at quite 50/50 odds because lose whenever the ball lands on a slot of the other color or in one of the House’s two green slots, but it doesn’t matter; in theory you could make this system work profitably if every slot on the wheel but one were green. Think about it.)
The problem is, your bet increases geometrically with every turn. Most casino tables have lower and upper limits on how much you can bet. Before long, you may run up against a ceiling beyond which the system cannot be applied. In fact, that almost certainly will happen. Try flipping a coin – you’ll find it comes up in a run of five heads or tails in a row a lot more often than you might expect.