4 Crucial Lessons From “The Big Short”

The Big Short is an Oscar-winning movie based on Michael Lewis’s book of the same name. The book and movie both explore the real story of a group of investors who bet against the US housing market before the Great Recession. In an environment in which everyone else believed the market was not just stable but growing, the movie’s protagonists dared to bet a collapse was imminent.

The story follows Michael Burry, founder of the hedge fund Scion Capital. As early as 2005, Burry suspected the flourishing US housing market was an asset bubble inflated by high-risk subprime mortgages (loans given to borrowers with poor credit). Relying on his own calculations, Burry made creative use of the credit default swap to sell positions based on the expectation of housing price declines – a method of shorting the housing market.

Jared Vennett, a banking executive (based on Greg Lippmann of Deutsche Bank), became aware of the credit default swaps and began selling them. Meanwhile, Mark Baum, one of Vennett's clients and another hedge fund manager (based on Steve Eisman of FrontPoint Partners) discovered that poorly structured, high-risk packages of loan securities, known as collateralized debt obligations (CDOs), were being given AAA ratings by credit agencies without proper evaluation. This led to a bubble of overpriced, precarious assets.

It ain't what you don't know that gets you into trouble. It's what you know for sure that just ain't so.
— Mark Twain’s quote that begins the movie The Big Short

The movie’s opening quote, credited perhaps erroneously to Mark Twain, aptly captures the predicament of the main characters. Their profits came at the cost of a market collapse. Moreover, while investment banks and credit rating agencies obscured the risks and inflated prices, the middle class bore the brunt of the consequences. The Big Short is a multifaceted expose of the global financial system, offering a range of invaluable lessons for investors.

1. When Opportunity Strikes, Grab It Quickly

The eccentric Michael Burry wasted no time in purchasing credit default swaps. The bankers were perplexed by someone betting against the seemingly stable housing market, so they readily accepted his offers. However, Jared Vennett learned about his analysis and saw a different opportunity. He entered the market to convince firms to buy swaps.

Neither the hedge fund manager nor the banker orchestrated the situation. Yet they did take advantage of a corrupt system, benefiting themselves and their clients. It exemplified a harsh yet efficient rule of capitalism: Opportunity exists within the system – even when flawed – but one must be quick to recognize it and act upon it.

Each narrative thread was affected by the ripple effect caused by the hedge fund manager's discovery. All were united by the notion that an opportunity means nothing without prompt and decisive action.

The CDO was, in effect, a credit laundering service for the residents of Lower Middle Class America. For Wall Street, it was a machine that turned lead into gold.
— Michael Lewis in his book The Big Short: Inside the Doomsday Machine

2. Question the Herd Mentality

Herd mentality is a phenomenon in which a person bases their own behavior and beliefs on the behaviors and beliefs of the group they are in. It can affect everything from what a person wears to how they vote. When applied to stock markets and other financial situations, a person might assume that people in their larger group are making decisions based on research that they have not done, or on knowledge they don’t have.

However, very often this isn’t the case, and collective behavior can lead to the formation of asset bubbles or market crashes through panic buying and panic selling. This is the antithesis of due diligence.

To counter herd mentality, think independently to identify any potential issues. Mark Baum looked into CDOs and took his entire team across the country, physically visiting homes for sale and talking with retail bankers. This gave his team a firsthand perspective of the industry’s happenings. In one scene, while conversing with retail bankers, Baum interrupts the discussion, pulling his team aside:

Mark Baum: I don’t get it. Why are they confessing?
Danny Moses: That’s not confessing.
Porter Collins: They’re bragging.
— dialogue between Mark Baum, Danny Moses, and Porter Collins, workers of the fictional trading company in the movie The Big Short

The bankers were essentially bragging about approving subprime mortgage loans for borrowers with poor credit, no assets, and no income. This served as a troubling indication of the banking sector’s disregard for the safeguards intended to protect the housing market.

Scenes like this underscored how easy it could have been to understand the situation better. Although it demands more time and effort, conducting research, consulting experts, scrutinizing financial statements, and gathering all available information are crucial steps to avoid the herd mentality.

3. Be Aware of Conflicts of Interest

Another key lesson that can be taken from The Big Short is understanding how conflicts of interest can affect the reliability of the information provided by financial institutions. Charlie Munger, former vice chairman of Berkshire Hathaway, once said, “Show me the incentive and I will show you the outcome.”

A central issue that contributed to the Great Recession was the incorrect incentives for lenders. Mortgage brokers and rating agencies failed to accurately assess risk or fairly rate loans due to the financial incentives of issuing subprime mortgages with adjustable rates. In other words, they approved adjustable-rate subprime loans because of the monetary bonuses they received, thus creating a conflict of interest.

Ultimately, this harmed buyers when homeowners defaulted on loans they could no longer afford. Investors were also affected because of the inaccurate ratings assigned to mortgage bonds that were riskier than warranted. The ripple effect didn’t stop there, though; it hit the entire economy.

What are the odds that people will make smart decisions about money if they don’t need to make smart decisions – if they can get rich making dumb decisions? The incentives on Wall Street were all wrong; they’re still all wrong.
— Michael Lewis in his book The Big Short: Inside the Doomsday Machine

4. Hedge Your Bets Against the Worst

Another pivotal concept explored in The Big Short is the hot hand fallacy, a term originating from basketball. It’s the mistaken belief that if someone has successfully made a series of shots, they are more likely to continue scoring. The fallacy lies in assuming that success in a random event increases the likelihood of future success.

In basketball, it's called the hot hand fallacy. A player makes a bunch of shots in a row. People are sure they're going to make the next one. People think whatever's happening now is going to continue to happen into the future. During the real estate boom, the markets were going up and up and people thought they would never go down.
— Nobel laureate Richard Thaler in the movie The Big Short

The Big Short vividly portrays how housing prices continued to rise, leading everyone to believe that the market of mortgage-backed securities was experiencing a hot streak. It was the perfect combination of the herd mentality and the hot hand fallacy. 

When Michael Burry investigated mortgage-backed securities, he saw the faulty foundations that led to the crash. Housing prices plummeted by an average of 20%, shocking both investors and homeowners. This should remind investors that hedging against risk can help prepare for unforeseen circumstances, such as a lockdown or a market crash.

The Final Lesson: Learn From the Mistakes of Others

The Big Short is an entertaining movie featuring a star-studded cast and an engaging storyline. However, scenes like Margot Robbie explaining the stock market while sipping champagne in a bathtub, or Selena Gomez demonstrating the hot hand fallacy in a poker game, should not divert your attention from the film’s core messages. In the end, it's not just about enjoying a good movie; it's about learning from history to mitigate the impact of similar catastrophes in the future.