MF Global and Jon Corzine's Beginner Mistake
by Justin Dove, Investment U Research
Wednesday, November 2, 2011
By now you've heard or read about the collapse of MF Global and its beleaguered CEO Jon Corzine.
But just in case you've been under a rock...
Corzine heavily bet his clients' and firm's money on relatively high-risk, high-return European debt. He avoided Greek debt, but felt that other European debt, such as Spain and Italy's, wasn't as risky as it was made out to be.
Everything worked out fine... except for the fact that Italy and Spain's debt were weaker than previously thought and recently forced a margin call. Because of such high leverage, the margin call essentially bankrupted Corzine and MF Global's heavy bets on the risky debt.
Should Have Known Better
The worst part of the whole mess is that Corzine should have known better. In fact, he was co-head of Goldman Sachs (NYSE: GS) in the 1990s when it profited heavily on Long-Term Capital Management's margin-call problems.
And even then, Corzine was known to have some "reckless trading instincts."
Corzine essentially put all his eggs into the debt basket - MF Global was said to hold five times the amount of debt to equity.
And even though Corzine could end up being right in the long run with his bet on Italian and Spanish debt, the margin call was ruinous to MF Global due to such high leverage.
Even the most inexperienced investors learn that diversification is the key to de-risking a portfolio. Corzine had to understand the risk he was taking, but he did it anyway.
The Male Disadvantage
Could Corzine's gender have been his greatest disadvantage? Well, there's certainly some evidence that women are more successful investors simply because they're less apt to take on risk.
A 2001 study by University of California at Davis found the following:
"Psychological research has established that men are more prone to overconfidence than women. Rational investors trade only if the expected gains exceed transactions costs.
"Overconfident investors overestimate the precision of their information and thereby the expected gains of trading. They may even trade when the true expected net gains are negative.
"Models of investor overconfidence predict that, since men are more overconfident than women, men will trade more and perform worse than women. Our empirical tests provide strong support for the behavioral finance model. Men trade more than women and thereby reduce their returns more so than do women."
The fact is that men are more prone to take risks. And that's something that holds many male investors back.
How to Learn From MF Global
Corzine was certainly making nice income from the high-priced debt in Europe, but that income came with a large risk. While a more diversified portfolio may have held back MF Global's earnings in the short run, it would have saved them from the huge collapse that the margin calls generated in its highly leveraged portfolio.
In hindsight, Corzine should have employed a strategy such as the one Jason Jenkins recommended last month of reducing risk with dividend-paying stocks. When you reduce risk in shaky markets, you can ride the highs when things recover. When you lose everything in a bear market, you don't have the capital to take the ride back up.
Hopefully this situation teaches investors a valuable lesson in risk-taking.