Tailgaters think the view that their behaviour is dumb is based on a purely theoretical analysis, which is refuted by the tailgater’s practical experience. And so the culture of self-confident, self-congratulatory tailgaters perpetuates itself.
Some people have described the process as picking up dimes in front of a steamroller. A more vulgar account refers to a creature that “eats like a bird and shits like an elephant”. There is a more academic description: a strategy based on writing options that are substantially out of the money. But the analogy I prefer is tailgating, the practice of driving close to the bumper of the car in front at high speed.
However described, it is the same thing: a distribution of returns that produces frequent small profits punctuated by occasional very large losses. A high proportion of trading – and business – strategies in financial markets have this tailgating characteristic. I call it the Taleb distribution, after the author of Fooled by Randomness (an earlier, and better, book than the more widely read Black Swan), which gives numerous instances.
The distribution has been central to recent financial crises. Buying emerging market debt was a seemingly profitable activity with a remote possibility, eventually realised, of large losses. So was holding internet stocks of no fundamental value in the (usually correct, but ultimately false) belief that they could be sold on at a profit to a greater fool. The creation of bogus synthetic securities of investment grade, which offered a higher yield than genuinely good credits because their inherent risk was underestimated, led to the credit crunch. The issue was not just that these distributions displayed Taleb characteristics: these market activities were devised with Taleb characteristics in mind.
The power of the tailgating metaphor is that it captures other essential aspects of the process – above all, the self-satisfaction of the tailgaters, a self-satisfaction that is mirrored in financial markets. These guys have talent, or so they believe. They get to their destination faster than other people because of their driving skill and finely judged risk control. Such self-delusion is possible because cognitive dissonance separates the occasional accident from the frequent success. When an incident occurs, it is someone else’s fault. The driver in front made an unexpected move, there was an obstruction on the road ahead that no one could have anticipated.
There is always an element of truth in these accounts of disaster. Most tailgating drivers will never be involved in an accident. A few will end their journey at the mortuary. This means the pool of people who have learnt by experience that tailgating is dumb is therefore small. Tailgaters think the view that their behaviour is dumb is based on a purely theoretical analysis, which is refuted by the tailgater’s practical experience. And so the culture of self-confident, self-congratulatory tailgaters perpetuates itself.
You might think that the sight of the worst highway pile-up in half a century would be followed by safer driving, but you would be wrong. The sight of an accident does lead drivers to be more careful for a short time, but it is often observed that this effect wears off very quickly. And so it is in financial markets.
The investment banks currently reporting their profits and bonuses are able to reassure us that tailgating still pays. In fact tailgating has become even more rewarding, because governments are making special efforts to keep the roads clear, and the traffic police are all at conferences on safer driving.
Governments themselves have become infected by tailgating behaviour. Some officials think that government guarantees of private sector liabilities don’t cost anything, because they probably won’t be called on. Others tell you that governments will make a profit on their injections of emergency funds into financial institutions. These are precise analogues of the tailgater who congratulates himself on his skilful driving. The nature of guarantees and capital injections is that they often cost you nothing, but when they do cost you they cost you loads. The taxpayers who are paying for Icelandic banks and Fannie Mae have discovered that, but the wider lesson has not been grasped. Tailgating gets you to your destination faster – except when it doesn’t.