Russ Roberts

Justin Fox on the Rationality of Markets

EconTalk Episode with Justin Fox
Hosted by Russ Roberts
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Justin Fox, author of The Myth of the Rational Market, talks about the ideas in his book with EconTalk host Russ Roberts. Fox traces the history of the application of math and economics to finance, particularly to the question of how markets and prices process information, the so-called efficient markets hypothesis in its various forms. The conversation includes discussions of systemic risk, the current financial crisis and the lessons for policy reform.

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0:36Intro. [Recording date: June 18, 2009.] Book is history of risk, reward, and delusion on Wall Street, but also intellectual history, how economists and finance scholars have tried to use the tools of economics and statistics to try to understand finance and the stock market. Highlight: claim that markets are efficient, or rational. Different version. In taxonomy developed at U. of Chicago starting in the 1960s, talked about weak form efficiency, semi-strong, and strong--all about the kind of information you were using to try to beat the market. Started with weak form: claim that if you looked at past movements of market or just that stock's price, it wouldn't tell you anything about future movement. Semi-strong: any publicly available information about a company. Strong: any information wouldn't enable to beat the market--not even private information. Other issue: If that's true, you can't beat the market, must mean that all information that matters is embedded in the price of stock. Next step, never clearly defined: assumption that if that were true, the prices available in a stock market, and particularly the U.S. stock market which is huge, transparent liquid market, fully reflected all available information and to some extent were right, or rational. Some of the intellectual underpinning goes back to Adam Smith, some to Hayek's "Use of Knowledge in Society": prices are signals. That logic was imported into financial markets, implication that you couldn't outguess the market. In the case of financial markets, two ideas get confused. One: as individual investor, what do you think about when someone comes to you saying "GM's a great buy now at $.40, I think it's worth $10." Economist would say that the information is already embedded in the price and you are probably not going to make a lot of money; index mutual funds best long-term strategy. That lesson still pretty intact. Hayek's insight important and basically true. You have to have a really good argument as to why that information is not already embedded in the price, especially as an outside observer. For market as a whole, success of value investing, indicates there are exceptions, if you stick with it you can do better. Argument for index funds: on the whole investors will have performance equal to the market--investment minus costs. Whatever you are paying, that's the thing you have to catch up from. With index funds you are keeping the costs down and you have a nicely diversified portfolio. You might be able to do better, but in the process of paying someone to put together that better portfolio, you will wipe out any advantage you've gained. John Bogle podcast. Lots of low-lying fruit. Bogle's research--the one reliable predictor is cost.
7:25More interesting question is the strong form--the overall market level, not just relative prices that matter, which was Hayek's insight, is what matters for financial market investors. Strongest form is that that overall level of market is the result of fundamentals, both at individual stocks and the market as a whole; and that has been challenged due to recent events, going back 20 years or so. Why harder to argue? Had never really been demonstrated with any empirical evidence. What happened: Miller-Modigliani papers, 1958 and early 1960s: we know bubbles happen, but for the purposes of what we are doing here, figuring out corporate financial model, we think it's fine to assume markets are always rational. They weren't saying that they always believed this, but just that to proceed, let's assume that. Discipline of finance went in this direction, useful starting point, but it led people to ignore some important aspects of how financial markets really behave. Most of the time it works really well, but every once in a while not true. Nassim Taleb podcast. Rare events, though rare, impact is not small. Interesting challenge for finance. Have heard: All we ever meant with the efficient market hypothesis is that on average the markets are right; never really said over what period you take the average. But if you say on average over a one-month period prices will fluctuate around the correct price, that's vastly different from saying on average over a thirty year period prices will fluctuate around the correct price. Like saying a small child, two feet high, can swim safely as long as the average depth of the water is less than two feet--the average is not what matters; that's how you drown; care about the deepest part. Economics will always have this: crisis, focus on the extreme outcomes; then when things are calm again, return to focusing on the average.
12:15Raises question, skeptical of use of sophisticated statistical models in economics, but finance exception to that skepticism. Challenge: have we made progress? Fanciest tools of all time, gone from running calculations on primitive computers to sophisticated models. Not an economist, as an outsider, like economists; on average they play a useful role about the economy. Taleb, over-the-top, world would be better off without economists; Myron Scholes should go home and play Sudoku; impolite, and just don't know. At their best, the models force people--Samuelson's argument about using mathematics in economics based on his dissertation, Foundations of Economic Analysis, 1947--a lot of economic arguments are by nature logical. Clearer discussion if you put things in models. Diminishing returns. Up to a point, forced economists to agree on a common ground even if they had different political views; increased respectability and influence for economics as a discipline. As you keep moving in that direction, gets problematic. People who have to actually make decisions in this recent economic crisis have backtracked 50 years and are using this really simple Keynesian and other models to try to explain what's going on, whereas most of the academic work at top universities insists on everything having micro-foundations and start from individual behavior. None of those people have given us any idea what's going on or to do next. May be in a time of a paradigm shift in financial and macro economics. Overview and survey: how often tractability became the centerpiece. The normal distribution is what we're good at. Isn't it better to be agnostic and say you don't know? Some like that, and some want answers. Economists who actually gave answers got listened to. Detroit: 33 times saying "I don't know," as opposed to Jeremy Siegel. Probably a way to find middle ground, "no perfect answers, but here are some thoughts." Bad joke: How do you know macroeconomists have a sense of humor? A: Because they use decimal points. Statement about precision that isn't deserved.
18:55Warren Buffett, example of a skilled coin flipper. At any point in time there are going to be people, because of survivor bias, who are going to look like they are successful, wise, geniuses, but really just a long string. Some people think Buffett might really be the exception, and onto something. Structured to give himself greatest possibility of success. Mutual funds: pretty bad setup for beating the market--managers are paid for gathering assets, not for performance. Once you reach a certain size, having more assets makes it harder to beat the market; people can put money in or pull money out at any time. Instead, for Buffett, it's all up to him; his cash is not from people who buy shares in Berkshire Hathaway but from the cash flow of enterprises at Berkshire Hathaway. Looked at agency problems, attention after 1990s. Better setup. General mode of investing has been value investing--trying to discern what the fundamental value of a company is and then deciding whether it's worth buying or not. Not only he that that has worked well for; even less sophisticated strategy of buying stocks with low price to earnings ratios would outperform a market index. Also, Buffett is really smart. Underlying these kinds of claims is the idea of arbitrage. Joke: There's a $20 bill on the street; if it's really there somebody would have picked it up already. There can be a first person who picks it up; can it be the same person repeatedly? Have to make some kind of argument that Buffett is unique, special; hard to justify. One out of 6 billion is rare. If there were no link between skill and reward in investing, then there is no way that markets could be efficient; has to be some link, have to be some people out there succeeding for a reason. Investors as a group can't beat the market; professional money managers as a group, since they pretty much drive markets, can't beat it either. On average, absolutely true, and a lot who seem to beat the market are either taking stupid risks or it's just random luck. But there is a group that is larger than one and less than 6 billion getting returns commensurate with their skill or the work they've done in digging up information. It's two--Buffett and his partner. Studies in the early 1970s by Fischer Black about Value Line: service giving recommendations based on fundamentals. If you look at those recommendations the second they came out, it was a market-beating strategy; but the problem was no one could act on them the second they came out--they came in the mail. No way for an outside person to take advantage of it; but if someone at Value Line had taken advantage of it, it would have beaten the market.
25:24Market-beating strategies can exist; leap of logic; information moves quickly so typically there is no arbitrage opportunity. But it doesn't move infinitely quickly, so there has to be some possibility of arbitrage. Paradox: this works really well, but once everybody knows it doesn't work in the same way. Example: disappearance of beta--riskiness of an individual stock relative to the overall market, Treynor, Sharpe. Turned out to be great predictor of what happened to mutual funds in the 1960s, performance obsession, Fidelity stars. Conclusion of study was that the reason they were outperforming the market was that they were loading up on high beta stocks, riskier, and prediction was that as soon as the market declined they would do worse than the overall market. Exactly what happened. So, beta performed brilliantly as an explanation in the 1960s. In early 1990s, new tests of beta were made and it started failing. Story: part of it was the success of finance professors in preaching beta and efficient markets was behind people's buying index funds and S&P500 index funds; skewed the returns those funds upward. Question: If no one is buying index funds and is buying individual stocks or managed funds, then buying index funds will do very well; but if every single investor buys index funds, the underlying logic doesn't work any more. Is that correct? There would be nobody doing the arbitrage. Hasn't happened. Portfolio insurance, Berkeley professors, 1970s, launched in the 1980s, Hayne Leland: the moment he devised it--strategy for selling stocks quickly as the market falls--he knew that if everybody did this it would be a disaster, causing market prices to fall even faster. How long would it take? It took seven years, 1987 crash; lots of explanations, anecdotal to blame it on portfolio insurance. Grasping at straws trying to find things to explain a 30% drop. Dogmatic approach helps organize thoughts.
31:29Trip to business school at U. of Chicago. Template for intellectual debates; visiting Eugene Fama on one floor, Richard Thaler on another. What do they represent and what did they say? Fama is author of efficient market hypothesis, in book seen as heroic figure. Authored hypothesis, suggested how to test it; did initial test in 1970s, seemed to be accepted; then revisited it in late 1980s and early 1990s and said no, it failed the test. Interviewed for Fortune article previous to book; Fama still pretty strident about defending efficient worldview at the time. Letter on desk about allowing the word "bubble" to creep into an article. Said: as soon as you move away from the efficient market, the whole model we've built in finance falls apart; can't talk about the cost of capital, etc. Then downstairs to Thaler, less feisty, brings Fama into his class once a year and tells students that everything Fama says about advice for individual investors is completely right; but also said but there's this more interesting intellectual question of how rational, reliable is the market? To Fama's point that about you take away the efficient market hypothesis, Thaler agreed: "Absolutely. It's going to be a big mess." Postscript: then said he was having lunch at a seminar, students presenting research; discussion of Shanghai apartment market, couching explanations in psychological terms. Back up: Thaler trained at the U. of Rochester, "even more Chicago school than Chicago in the 1970s," orthodox training; became fascinated with psychology and interested in work of Daniel Kahneman who right around that time shared the Nobel prize with Vernon Smith. Thaler interesting mix: orthodox training but thought cognitive psychology offered some appeals. So, grad student trying to explain the Shanghai housing market based on the ideas of Kahneman-Tversky ; and Thaler remarks, "Well, maybe that's just the result of supply and demand." Half-full, half-empty debate. People aren't fully rational and to assume they are can be productive way to look at the world; but things can go wrong.
37:00One of challenges with financial markets is temptation to say it's all irrational, all flawed because of people's emotional role, role of bubbles. People are trying to figure out how to construct the securitization market, credit cards. The market if left alone wouldn't solve that problem because it probably shouldn't get solved; market would lead people to say this is a dangerous complex thing we didn't understand; I'm going to stay away from it for a while. Market sometimes makes those corrections on its own. George Cooper book, criticizing efficient market theory, broader definition than Fama ever meant. Makes point that you can't combine that belief with the belief that it's the job of the government or a central bank to stop financial crises without creating a situation where you just create more financial crises. Idea that you should be hands off while markets are going up but hands on when they are going down asymmetrical and flawed. Austrian, libertarian approach: let cycles happen and you'll have fewer of these big busts. More politically likely: we need to do more to constrain bubbles--e.g., restricting leverage, though financial people very good at gaming leverage rules. Deepest intellectual question looking from the outside: feedback loops that are destabilizing. Do individual players in the market and the market as a whole figure out ways to reduce that instability? For some reason we've decided to never give it a chance.
43:28Long-Term Capital Management (LTCM), example of hubris run amok. Why successful for a while and why did they fail? They were an arbitrage operation, finding tiny pricing discrepancies between, say, Treasury bills that had just been auctioned and the previous years; buy one, sell other short, make money. Pioneers and efficient about it, but as more and more people got into that, only way to keep delivering those same returns was to keep levering up. Margins shrinking, but if you borrow enough return can be decent. Flip side: more you borrow the greater the risk you are taking. Scholes's argument; does admit they understood their individual risk but not the market risk if something happened to drive everything in the wrong direction for an extended period of time. All the theories of financial economics starting with Markowitz's portfolio theory in the early 1950s all based on idea that you are a price taker--markets set the price. Flaw with portfolio theory in 1987, flaw again with LTMC. Idea: If you are the only guy doing probably okay but if everybody doing it, it spirals in unstable way. What happened? The Russian debt default; suddenly caused spreads between risky assets and assets perceived as safe to balloon all over world. LTCM's business assumed that any long-term spreads would go away. Started having trouble in summer of 1998, hit big when default came at end of summer. Initial calculations had foreseen that something like that could happen; might lose 30% but would still be able to go forward. Didn't get that since they survived on borrowed money and that other companies were doing the same and making the exact same trade that it didn't end there. Lenders called in loans, prices dropped further. William McDonough, NY Fed, called everyone into a room and said to fix it. Bear Sterns, Merrill Lynch story: Not idiots, but what was not understood was that if everybody made the same bet and tried to unravel it at the same time, price consequence would be extremely unpleasant, reverberates through capital markets, lending rates to you go up; suddenly you're dead. You're not stupid, you know that could happen; but after a while surely you realize that everyone's going to try to unravel it at once. You are not the only customer of AIG and they might not a going concern. Why unanticipated? They were paid well not to. Gillian Tett's Fool's Gold, story of J.P. Morgan Chase, one of the few to not get caught in vortex; they were innovators in some of the derivative products, but their people said they didn't understand how you could make the risk-reward work so they stayed out of it. Every six months Diamond would look around and consider getting into it, but accepted staff's recommendation that it was too risky. Underperforming banking industry for a couple of years, got flack for it. Less secure leader might have found it hard to resist. How much of it was hubris versus how much were people counting on being bailed out? After earlier experiences, might have come to conclusion that the Fed would figure a way out.
48:58Behavioral finance; if you say you don't know you don't get airtime or time on TV. Product differentiation. Arnold Kling, articulating George Mason, view: "The U. of Chicago people say markets work well, so you should use the market. At MIT and other bastions of mainstream economics, they say markets fail; use government. At George Mason we say markets fail; use markets." People are imperfect, people mess up, maybe even are bubbles; but governments and leaders are also imperfect, better to have decentralization. What would proponents of behavioral paradigm say? Don't even deal with markets as a whole. David Brooks in the NYTimes: markets irrational but so are the bureaucrats. In 19th century, less government involvement, no central bank; had bubbles and recessions of harsh severity. Torn. Last couple of years has been scary. Compare to policy of 1893-1894. Length of time of Great Depression is debated, and also whether the policies helped, hurt, or did nothing. Where is finance headed on the academic side? Parts in dead end; don't know where it is going. Visiting Duke U., finance faculty members, half, behavioral finance liked idea of writing book on the fall of the efficient market hypothesis and half said, "What fall?" Behavioral finance guys doing interesting stuff; other side don't really believe in perfect rationality but think it's a good starting point. Finance not dealing with this crisis, in sense the economics profession trying to do. All will have to come to grips with it. No obvious new direction. Hard to admit. May not be a soluble problem. Fama, phone call, laughed and said that's why I don't teach corporate finance any more. Underpinning of our prosperity if we have smaller, less transparent capital markets.

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COMMENTS (15 to date)
Jake Russ writes:

I liked the guest's subtle critique of the mainstream attitude toward market regulation. The idea that we're supposed to be hands off when markets are going up, but then hands on when markets start to fall. This flaw is one that proponents of new regulation and government intervention have to square before proceeding further.

Floccina writes:

About the too big to fail comments, I do not think that anyone says, ah well if it gets bad enough the feds will bail us out so lefts take the risk but I do think in a meeting someone might say look what happened to LTCM and everyone would know what he meant and the implications.

Russ Roberts writes:

Fioccina,

Since doing the interview, I've been thinking about the too big to fail argument some more and I think I've been thinking about it in the wrong way. It's not like the execs said, hey, let's take too much risk, we'll get bailed out. Instead, it's the possibility of bailout rationally encourages more risk-taking than would otherwise take place. The real question is whether the magnitudes of risk make sense. Hope to have more to say and learn on this in an upcoming podcast.

Nethy writes:

Can someone tell me why the following is not reasonable:

Executives can never have their interests completely aligned with owners without being owners. If a company succeeds for 9 years and fails on the 10th, it does not matter how badly it fails past a certain point. They cannot be penalised past a certain point. Theoretically, they could lose all 10 years bonuses (have a bonus at the end of 10 years), but this is unlikely. In any case, they cannot lose more then that, but companies can. Companies can be worse off at the end of ten years.

Execs can be limitlessly be incentivized to succeed via bonuses. They cannot be incentivized not to fail to the same degree. This is a weakness in a structure that separates ownership from decision making.

If the above reasoning is correct, isn't encouraging more risk-taking irrelevant? Are execs significantly better off as a consequence of the bailout?

tw writes:

Russ,

I enjoyed the podcast, particularly the brief discussion of Warren Buffett. Next time I'm at Border's, I'm going to look for Mr. Fox's book and skim his chapter on Buffett (aren't we all a free rider from time to time?).

I liked his point about how Buffett has set up his company and his incentives well, and that Buffett is incredibly smart. But I think his success rate is caused by more than that. Because Berkshire Hathaway is so big, they can acquire whole companies, or at least controlling interest in a company, and can therefore exert much more influence over their investments than can a mutual fund. I'm not sure how best to describe it, but it's like he operates more like a venture capitalist investing in mature companies.

In any event, Buffett would be a fascinating guest for an upcoming podcast. CNBC seems to be on good terms with him, so perhaps if you have any contacts there, you could try to reach him. It would be interesting to hear him talk about economics and economic theory, as well as how he runs his business.

Adam writes:

My understanding of the moral hazard argument was not that it involved anyone thinking "well, if worse comes to worse we'll get bailed out." Rather, I think it occurs more institutionally; in an unfettered market those companies that encourage behavior that leads to long-run losses will be weeded out. The companies that have lower returns in the short-run but more stable strategies for the long-run will be rewarded once the less stable competitors go bust, and they can buy up a lot of their assets.

When the Fed comes in and bails all the big players out, the companies with myopic strategies are not forced to adapt or go bust; they remain institutionally preserved. Even if they want to reform, they don't have the information because the market signals can't get through. So the Fed makes them whole again, and they end up going and taking the same sorts of risks, such that they are even bigger by the next time they need to be bailed out.

It's like breeding. If you only breed the dogs that go blind, eventually all you're going to end up with is blind dogs. If you continue to reward and preserve unstable banks, eventually all you'll be left with are unstable banks.

This is much the same argument that Taleb makes, I think.

Jonathan writes:

Floccina/Russ,
individuals within the market certainly do take risks with the explicit expectation that the central bank/governments will act so as to eliminate or manage extreme tail risk on a systemic level.
This is rational self interest although as an Austrian I would disagree they are correct in having such faith in the State and its agents.
Regards,
Jonathan.

Ward writes:

In the early '90s I heard a speech by President of a Bank that had come through terrible difficulties because of reckless real estate loans. He said everyone had a study that said this shopping ctr will work on this corner but nobody knew there were 3more going up on the other corners. Over simple right but think about it in terms of Tyler Cowen's FAJ article http://www.cfapubs.org/doi/pdf/10.2469/faj.v65.n3.3?cookieSet=1
The problem is that bailouts remove some of the payoff for risk aversion so it makes risk taking more likely at the margin. Everybody thinks the crocodile will eat him last as Churchill said.

[Cookie-free link at Cowen's blog entry, http://www.marginalrevolution.com/marginalrevolution/2009/06/a-simple-theory-of-the-financial-crisis-or-why-fischer-black-still-matters.html -- Econlib Ed.]

PK writes:

I don't understand how recent events (large price corrections) can be used to disprove EMH. If I understand the argument correctly, it goes like this: "If the market price for an asset changes by a large amount in a short period of time, the market is not efficient."

I don't think that conclusion can be drawn. Imagine a hypothetical asset with two equilibrium prices:
1) ($100 value) upside scenario where financial institutions operate smoothly with no counterparty risk, and
2) ($50 value) downside scenario where some "trigger event" causes a cascading breakdown of normal interactions between financial institutions

If trigger events happen very infrequently, it's not unreasonable for the value to be close to $100. After a trigger event it's not unreasonable for the price to drop to $50. Why does that make the market inefficient? "Efficient" doesn't mean "can't change".

Engineers deal with solving for multiple equilibria all the type in control systems analyses. (and they don't accuse the shock absorbers of being irrational) Why isn't it assumed that markets have multiple equilibria too, where prices can end up stabilizing at very different values depending on events? In industries like banking where there are feedback loops (changes in prices cause changes in prices), we should expect quick shifts to lower equilibria occasionally along with an associated change in asset values.

Ray Gardner writes:

He seemed to miss the very obvious fact that recessions/depressions may have been more frequent and sharp under a more free market, but their overall impact was much less. As opposed to what we have under the heavier regulation.

The flaws get covered up instead of purged, while the tinkering minds of finance think up more and more ways to go around the regulations, and things blow less often, but they blow up as never before in a freer market.

(Hello Mr. Taleb, your office is calling.)

Think of it in terms of manufacturing. The old school Detroit way was to make huge batches at a time to utilize the economies of scale. But when they'd finally find a quality problem, a million parts were already made with that same flaw so the quality problem and associated cost were huge.

In Lean manufacturing (properly applied of course) that flaw is caught much sooner - and thus more often - but the cost is smaller, and the impact much lighter.

MM writes:

@tw,
I agree that now Buffet takes more of a "management" role than your typical mutual fund manager, and that definitely contributes to his success, but how do we explain Buffet's success 30 years ago, when he was just starting out and not able to purchase controlling stakes in companies?

I, too, would love to hear a podcast with Buffet as the guest.

kebko writes:

I don't understand the way financial markets are treated as a special case, where every success is lionized & every failure is a drama. Why is it any different than any other industry? We don't have podcasts where we beat our chests about how Circuit City or Montgomery Ward could fail. In any of these cases, an organization found a way to earn excess returns, and over time through inertia, continued innovation, or some kind of unquantifiable competence, they continued earning those returns for some time, until despite all their work, they found themselves on the wrong side of the competitive landscape & returns dried up. There are entrepreneurs in industries throughout the economy who will try & fail, and there are many others who will parlay their efforts into sustained, outsized financial success. When we think about this universal activity when applied to the financial world, why do we revert to this black & white notion of efficient markets?

Michael M writes:

I just want to drop in to remind anyone who listened to Justin's bit about depressions in the 19th century that WE didn't have a central bank, but Britain, the number one source of investment capital in 19th century America, DID. In fact, the Bank of England spent the second half of the 19th century inventing central banking as we know it* today. Things have changed somewhat(we target interest rates instead of the discount rate these days), but sudden, jerking changes in the flow of investment had the same effect then as it does today: Recessions and the business cycle.

(*Also want to take a moment to draw a distinction between a national bank and a central bank: A national bank, like the Bank of the United States or the Bank of England before 1860ish, is a bank which handles the finances of the national government, monetizing and investing its debt and acting as a repository for its funds; a central bank, like the Federal Reserve System or the Bank of England today, is one which actively attempts to use its size and influence to direct the overall flow of capital in a country and manage the entire economy)

AHBRitton writes:

One of Fox's arguments reminded me of Russ's discussion of pragmatism in an earlier podcast, the title of which I cannot specifically remember. As this is from memory, it is paraphrasing at best. The point seemed to be that institutions most likely arise for a reason so the onus lies with the person trying to argue against the tradition.

While I am skeptical of this argument and what I see as a somewhat dubious and unnecessary juxtaposition of tradition and progress. In this instance I think Fox's argument does have some validity. Those in favor of unfettered markets, here most recently stated by Ray Gardner, have what seems to be a deep romanticism for the past. These arguments seem to say that some time in the past (most often prior to 1913) the markets were much freer, and in this freer market things were much better. Sure there may have been more frequent and more severe recessions but it was preferable to todays system.

There is one form of this argument with which I can't really argue. That it was preferable on purely moral grounds, that a free market is intrisically good regardless of outcomes. As for the argument that there were better outcomes I am sympathetic to such a review of the past but also skeptical. I'm interested in what evidence (I'm guessing not very much do to the lack of accurate data) that economies were somehow better and more industrious then. One reason for my skepticism is partly contained in the argument by Ray. Recessions were more often and more severe but better?

Twotenths writes:

According to Buffett, he does not exert meaningful managerial control over his holdings. Rather, he buys companies that are cheap, not those which need reform. Also, his holding period is "forever." Many in the market talk a good game about having a long-term investment outlook, but W.B. appears to be one of the very few who truly acts accordingly. Another important difference to mutual fund managers is that many of his holdings are not marked-to-market, so his success is measured in a very different way. And as was touched on in the interview, he has permanent capital: unlike for a mutual fund manager, W.B.'s investors can't require him to liquidate his holdings on short notice.

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