Even as the financial system collapsed last year and millions of investors lost billions of dollars, one unlikely investor was racking up historic profits: John Paulson, a hedge fund manager in New York.
His company made $20 billion between 2007 and early 2009 by betting against the housing market and big financial companies. Paulson's personal cut would amount to nearly $4 billion, or more than $10 million a day. That was more than the 2007 earnings of J.K. Rowling, Oprah Winfrey and Tiger Woods combined.
How did he do it? Believing that a collapse in the housing market was coming, Paulson spent more than $1 billion in 2006 to buy insurance on what he then saw as risky mortgage investments. When the housing market cracked and the mortgages tumbled, the value of Paulson's insurance soared. One of his funds rose more than 500% that year.
Then in 2008, he shorted financial shares, or wagered that they would fall in price, profiting again when those companies collapsed.
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Are there any investing skills that average investors can learn from his success? Yes. There are no guarantees, of course, but the success of Paulson and a few other underdog investors lends encouragement to individuals trying to compete with Wall Street's pros.
Here are eight investing lessons of Paulson's $20 billion gamble, the greatest trade in financial history:
1. Don't rely on the experts
Many investors lost big in 2007 and 2008 as housing crumbled and the stock market tumbled. But no one lost more than commercial and investment banks caught with toxic mortgage-related securities. Those bankers were the same ones who had created the bad investments, and Wall Street's top analysts had vouched for their safety, even as Paulson and other investors bet against the investments.Lesson: When Wall Street is wheeling out its latest can't-miss product, be skeptical.
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2. Bubble trouble
Some academics argue that financial markets have become more efficient. But a rash of financial bubbles in recent years, including those in housing, energy, technology and Asian currencies, suggests that markets are becoming harder to navigate and are more prone to overshooting.Today, investors of all sizes read the same articles, watch the same business television programs and chase the same hot tips. They invariably head for the exits at the same time.
Lesson: Have an exit strategy -- and cash to cushion any tumble.
3. Focus on debt markets
Most investors track the ups and downs of the stock market but have only a vague sense of moves in debt markets. That's a mistake.Early signs of trouble were seen in sophisticated markets that don't get much limelight, like the subprime-mortgage bond market. Those problems eventually felled the housing and stock markets -- and the overall economy -- like a set of falling dominoes that Paulson and his team correctly had anticipated.
Lesson: Debt markets can do a better job of predicting problems than stock markets.
4. Master new investments
Paulson scored huge profits by buying credit default swaps, derivative investments that serve as insurance on debt. When risky mortgage bonds tumbled in value, Paulson's insurance soared. But many experts were flummoxed by CDS contracts or shied away from educating themselves about those relatively new investments.Paulson and his team had no experience with CDS contracts, but they put the time into learning about them.
Lesson: Educate yourself about the range of exchange-traded funds being introduced, some of which can play a valuable role in a portfolio.
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5. Insurance pays
A number of investors worried about a bursting of the housing market, but few did much about it, even though insurance, such as CDS contracts, at the time were selling dirt-cheap. Out-of-the-money put contracts -- options that pay off only if the market tumbles -- also were trading at reasonable levels. As cheap as this insurance was, many pros ignored it.Lesson: Don't underestimate the value of a safety net, such as put options.
6. Experience counts
Some of the biggest winners in the meltdown were middle-aged investors dismissed by some observers as past their prime. But they had experienced previous market downturns, while some of the bankers and analysts caught flat-footed had known only good times.Lesson: A historical perspective can be a valuable tool.
7. Don't fall in love with an investment
In early 2009, Paulson became more bullish about the banks and financial companies that he had wagered against in 2008, after determining that the companies had improved their balance sheets. The moves resulted in profits this year.Lesson: Even the greatest trade doesn't last forever.
8. Luck helps
In early 2006, Paulson determined that housing was in trouble and set out to profit from the impending fall. But some housing experts had already determined that real estate was overpriced. Others had wagered against housing but could no longer stomach their losses. Just months after Paulson placed his historic trade, U.S. housing prices began to fall.Lesson: Don't risk too much in any one trade, even one that seems like a sure thing.
This article was adapted from "The Greatest Trade Ever: The Behind-the-Scenes Story of How John Paulson Defied Wall Street and Made Financial History" by Gregory Zuckerman.
