Martial arts & the UFC; Michael Lewis; and why rouge punters predicted the GFC, not the mainstream

Michael Lewis has stated that what inspired his fantastic book The Big Short (subsequently made into a Hollywood movie) was the mystery and intrigue of why a handful of under-resourced, small time mavericks and outsiders such as Michael Burry seem to have been able to see something that almost the entire mainstream could not, and predict the financial crisis (or, I would add, at least identify a significant risk of one occurring).

Bank CEOs; Chairmen of the Federal Reserve; and mainstream academics and economists alike all completely missed it, and subsequently claimed the crisis was “impossible for anyone to predict”. Michael Lewis likes to base his books around interesting characters that shed light on a deeper and more interesting story. He wrote an fantastic book that I highly recommend, but in my view he never really got to the bottom of the mystery he sought to solve.

In my opinion, there is actually a pretty easy explanation for why the apparent underdogs won, and I think invoking a martial arts analogy is the best way to express it.

In martial arts, there are many traditional and beautiful art forms, from Tai Chi and Kung Fu to TKD and Karate (in the past I have dabbled in TKD and Kung Fu, and currently practice Muoy Thai boxing and have recently taken up BJJ). Traditional martial arts practitioners work hard and learn elaborate patterns and deft block-breaking kicks and flips that look (and are) extremely impressive to watch. There is only one problem with their art form. They can’t fight.

Beautifully rendered traditional martial arts patterns and acrobatic kicks look impressive, but throw those martial artists in a ring with a skillful MMA fighter, or even a tough guy from the wrong ally, and they will be tapped or knocked out in less than a minute ten times out of ten.

On the other side of the spectrum are UFC fighters. They may not always have the elegant, and unadulterated beauty of traditional martial arts forms, but these guys are incredibly skillful brawlers that know how to fight. Their livelihood depends on it. They have to get in the ring and submit and knock people out regularly to stay relevant. They are (quite literally) from the school of hard knocks.

There is no place for convention or puffery in the ring. Only what works matters. You must cast tradition aside, adapt your fighting style to your opponents strengths and weaknesses, and importantly, you must innovate. By comparison, traditional martial arts are rigid in nature and adhere strictly to tradition, in classic Confucian style. Centuries-old protocols are rigorously followed, and consequently, most of these traditional disciplines have not evolved over time, and still closely resemble the original art form devised thousands of years ago.

Not so with UFC. Indeed, UFC 1 was the first time an open, multi-disciplinary competition was held which allowed martial artists from all disciplines to compete head-to-head. It promised to finally answer the age-old question of what was the ‘best’ martial art. The answer came relatively quickly. Meek (relatively speaking) looking Brazilian Ju-Jitsu fighter Royce Gracie, who many feared would meet a swift demise vs. more imposing opponents – was quickly taking down and submitting fighters much larger and stronger than him in a matter of minutes. Buff boxers and world-class acrobatic kickers didn't stand a chance. UFC 1 was a sensation. It turned a lot of conventional wisdom on its head. 

However, more importantly, something very interesting then happened: UFC fighters quickly adapted. UFC 1 made it clear to all that if you couldn't grapple on the ground, you couldn't fight, and so fighters all quickly learned BJJ and how to grapple. They incorporated the best parts of multiple martial arts in unique ways. Now, no serious UFC contender does not know how to grapple, and intriguingly, no fighter that knows BJJ alone stands a chance either. Fighters have raised their game and taken the art form to a whole new level. They have innovated.

So how is this relevant?

How is all this relevant to financial markets and predicting the GFC? The connection is simple. Traditional economists, academics, politicans, and central bank governors, are the traditional martial artists in this analogy. They are classically trained with rigid mental models/routines that have not evolved over time. They look and sound good. They know how to say the right things, play politics, and appear credible. The only problem is they don’t know how to fight.

By comparison, investors such as myself, as well as the various mavericks Michael Lewis discussed in his book, do battle in the ‘ring’ of the market every day. We eat what we kill. Real money is on the line. We need to make money and avoid losing money to stay relevant and best out our opponents. And so we need to cast adrift conventions, stay up with the competition, incorporate new ideas, and innovate. In short, we are battle hardened.

Investing successfully, like being a successful UFC ring fighter, is hard (in different ways), because like the UFC, it is a highly competitive arena where it is not enough to be good – you have to be better than your opponents to win. That is not the case for many professions. If you’re a good engineer, that’s enough. If you're a good doctor or lawyer, that is also enough. Good is not enough in markets – you have to be great – because not everyone can win. Consequently, it is not enough to go to the right schools, get the right degrees, and work for the right brand-name institutions. It won’t help you make money in the markets or correctly understand real-world economics any more than learning fancy TKD patterns and kicks will help you win a UFC fight.

Unlike the markets and a UFC ring, however, which are ruthless meritocracies, many areas of the world are not meritocracies, but are instead highly political. You can rise in the academic world; through the management ranks of a corporation; or through the various levels of government, even if you are incompetent and flat wrong about things. In these domains, being wrong is often not punished like it is in the markets; being unpopular is. You don't have to know how to fight - you just have to know how to sound good and appear credible, and know the right people. Brilliant mavericks such as Michael Burry are often not great politicans or self-promotors, and may lack social graces or necessary connections. They get overlooked for establishment jobs as a result. But the beauty of markets, like the UFC, is that you don't need these things to win - if you can knock people out, no one can argue with you. Results are all that matter.

So the next time you hear someone with a seemingly impressive title pontificating about their views on the economy and markets, ask yourself, do they really know how to fight? Or do they just look and sound good? You should listen to guys like George Soros and Warren Buffett who have made several billion dollars in the ‘ring’ of the market, doing battle with it day-after-day, year-after-year. They are by no means always right, but they are always worth listening to.

By comparison, in the realm of markets and economics, you should instinctively distrust academics from prestigious universities (as a general rule - there are many exceptions), or people like Janet Yellen and Ben Bernanke who have politicked their way top, because these folk never learnt how to fight. In addition, to a considerably lesser extent, you should also instinctively distrust investment advice from investment banks, private wealth advisors, and also many 'establishment' fund management organizations (as opposed to small maverick funds), because many of these organizations are also highly political, and hire people based on their pedigree and ability to sound good and sell products, rather than their in-the-ring skills (again, with many exceptions). That is one reason why their returns are so poor. Many of these people are to be found as talking heads on CNBC. They look and sound good, but they can't fight.

In my view, that is why the ‘establishment’ view of economics and markets is often so wrong, and why mavericks rather than the establishment saw the financial crisis coming.