3 Lessons From "The Big Short"

By Markets Fool.com

The blockbuster movie The Big Short tells the story of the financial crisis, including those who saw the crash coming and got insanely rich from it. The movie was a critical and financial success, bringing in over $130 million in theaters, netting five Academy Award nominations, and winning an Oscar for best adapted screenplay.

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But is there value in the movie beyond entertainment? I think so, particularly as a reminder for investors of what we shouldn't do. Here are three in particular.

Lesson one: Shorting the market is riskier than The Big Short makes it seem
The first lesson actually flies in the face of how the characters in The Big Short made their billions. Yes, some people got super-rich shorting the market as the housing bubble grew, and as the market crashed their bets paid off. Many of these investors did earn ridiculous multiples on their investments. But does that mean you should start shorting stocks like these elite financiers? Hardly.

Shorting the market is very difficult to do with consistency. It requires you to first correctly assess the market and then get the timing right. Neither is easy; doing both routinely is next to impossible.

Famed economist Robert Shiller saw the housing bubble growing in 2005. He told The New York Times in August of that year that prices could fall 40%. Also in 2005, The Economist called the housing boom the "biggest bubble in history."

Had the heroes of The Big Short made their short bets on the market in 2005 when these sources started sounding the warning bell, their positions would have been bankrupted as the market continued to charge higher in 2006 and 2007. The thesis would have been correct -- the housing market was in full on bubble mode -- but their timing would have been off and their bets would have lost all their value.

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Going short is a bet that can run out of time. Even with a simple options strategy, your options will eventually expire. Sticking with a long term, value-based approach eliminates that problem. A quality company will generate profits, dividends, and market returns over the long term, without ever expiring.

Lesson two: Don't blindly follow "the professionals" without doing your own homework
If you asked a manager on the mortgage desk of a Wall Street company in 2004 or 2006 if the housing market was in a bubble, he or she probably would have told you that your question was ridiculous.

These are the professionals involved day-to-day in mortgage process. They'd have access to all the data indicating a bubble. They'd see the low credit scores, poor cash flow numbers, and no-down-payment mortgages coming across their desk every day. Of all the people in the world, these professionals should be the most likely to see the problem developing. But they didn't.

Research after the crisis has found that most of these individuals were not malicious or evil, but simply blind to the pending disaster. Economists with the American Economic Association found that mid-level managers involved in the mortgage securitization process "neither timed the market nor were cautious in their [own] home transactions, and did not exhibit awareness of problems in overall housing markets." In the years and months leading up to the crisis, these individuals were still pouring their own money into the bubble.

How could they have missed such a massive problem sitting right under their noses? The researchers point to the incentive systems that paid these managers' salary. In 2004 and 2005, everyone was making money hand over fist as the mortgage market expanded -- particularly these Wall Streeters. Their optimism and exuberance overwhelmed their ability to see the forest for the trees. New York Fed economist Andreas Fuster quoted novelist Upton Sinclair to explain this humanistic problem:

"It is difficult to get a man to understand something, when his salary depends on his not understanding it."

Be wary of how investment advisors earn their own salary and where their incentives may be conflicted with yours or with their ability to see the market for what it is. At the end of the day, it's your money. Make sure you do your own homework.

Lesson three: High risk and high reward sounds great, but don't underestimate how high the risk really is
In the lead-up to and during the financial crisis, borrowers with lower credit scores defaulted on their loans at higher rates than borrowers with better credit scores. That shouldn't come as a surprise to you, me, or the banks making the loans, and in retrospect, it seems crazy that banks would have exposed themselves to subprime borrowers at the high levels they ultimately did.

The question we must ask is, why did they do it?

The answer is that these high-risk borrowers offered high-rewards as well, at least at first.

Before home prices imploded and the labor market tanked, banks were able to charge sufficiently high interest rates on loans to subprime borrowers to more than overcome the costs of their slightly higher default rates. Throw in the banks' ability to securitize these loans and sell them, and the table for disaster was set. Banks thought their risks were mitigated with securitization, so they focused on how those higher, subprime interest rates could boost their margins and profits.

However, as we all now know, those default rates eventually grew far, far too high for any interest rate to justify the risk, and the entire system nearly collapsed.

Last year, Bank of America CEO Brian Moynihan broke down just how much his bank lost as a result of the crisis. Between legal settlements, regulatory fines, litigation expenses, and loan losses, the price tag for B of A ultimately exceeded $195 billion. That's 34% more than the bank's entire market cap today.

The story is similar at other major U.S. banks. In the first quarter of 2008, Citigroup reported $827 billion in troubled assets in its "bad bank" division, Citi Holdings. The idea was to isolate those assets and gradually work them out of the bank. That $827 billion looks huge, and it is. At the time, Citi Holdings alone would have been the seventh largest U.S. bank by assets.

The strategy has been successful, though today the bank still has $78 billion in the division today, eight years later.

The lesson for your investing is to focus just as much on the risk as on the rewards, particularly when you're talking about assets as important as your retirement and long term savings. It can be tempting to chase a particularly high dividend yield or high-growth stock, but before you do make sure you take the time to understand what could go wrong. The market is usually pretty good at pricing in risks and rewards -- that means any investment with above market rewards probably comes with above market risks. Make sure you understand it.

As investors, we can't forget the lessons of the financial crisis.
For many of you, The Big Short may be the most detailed and understandable explanation for the financial crisis you've seen. In the end, that may be the movie's greatest success: helping the American public truly understand the complex forces that combined to spark the largest economic collapse since the great depression.

As investors, the movie is yet another reminder of power of the markets to both create and destroy wealth. Let's take advantage of this to consider the mistakes made and how we can avoid them in the future.

The article 3 Lessons From "The Big Short" originally appeared on Fool.com.

Jay Jenkins has no position in any stocks mentioned. The Motley Fool recommends Bank of America. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.