SPECIAL REPORT

Three Pitfalls that Could Sink the Returns of your

Investment Portfolio

Does your investment portfolio include a ticking time bomb?

$1 traveling with Warren Buffett compared to $1 traveling with the US Stockmarket

1,000,000

100,000

10,000

1,000

100

10

Buffett US Stockmarket

By Jean-Claude Khoury, CFA

May 2009

Page 1 of 9 By Jean-Claude Khoury, CFA

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Introduction
Some funds argue that diversification and or relatively small investments would limit the potential for loss.
However, if one does not understand what one is investing in, the investment is nothing other than a
speculation and should not be included in a prudent portfolio. Diversification is not an excuse for lowering
the guard and not doing the appropriate due diligence.

Investors should be aware of principles of social influence that affect their decision making and investment
choices. They should ensure that the reporting is adequate enough to monitor and understand what type of
risks their active managers are taking. Investors should be especially vigilant when investing with
managers that are generating alpha and understand where the alpha is coming from and whether
circumstances are changing that will make it harder/stop the active managers from continuing to generate
alpha.

In December of 2008, the 71st largest foundation out of well over 10,000 in the US collapsed after losing
virtually all its $1 billion in assets to the Madoff scandal. The Picower Foundation which was founded in
1989, was not alone. According to Jeffrey Solomon, president of the Andrea and Charles Bronfman
Philanthropies in New York, the Madoff scandal resulted in the deaths of 51 foundations and left 143
others “seriously injured”.

Here is an excerpt from JEHT Foundation’s website, another victim:

“The JEHT Foundation, a national philanthropic organization, has stopped all grant making effective
immediately and will close its doors at the end of January 2009.
The JEHT Foundation Board deeply regrets that the important work that the Foundation has
undertaken over the years is ending so abruptly. The issues the Foundation addressed received very
limited philanthropic support and the loss of the foundation’s funding and leadership will cause
significant pain and disruption of the work for many dedicated people and organizations.”

Warren Buffet, arguably one of the best investors in history, has two rules when it comes to investing
money:

“Rule #1 of Investing: Don’t lose any money

Rule #2 of Investing: Never forget Rule #1”
Clearly, Warren Buffett’s first and foremost concern when he invests is the safety of his capital. Given the
two rules, his first assessment is of any downside risk to his investment. Interestingly enough, neither rule
addresses the potential return of the investment. The upside potential is not his initial focus. While these
rules are very simple and straightforward, professional investors continue to break these rules at times.

This Special Report addresses three pitfalls that cause investors to break the first rule and place their capital
at risk of loss.

The first pitfall has to do with the psychology of the investor. Three psychological principles affect the
investor’s ability to make wrong choices and put their capital at risk.

The second pitfall addresses the lack of transparency in the industry. Lack of reporting transparency limits
the investor from understanding exactly what risks are being taken. As a consequence, the investor cannot
ensure the safety of the capital that is being invested.

Finally, the third pitfall addresses the issue of alpha, the excess return over a benchmark that an actively
managed fund potentially generates. Alpha is a double edged sword. While many investors seek alpha to
boost the return of their portfolio, they neglect Rule #1. It is vitally important, especially in cases where
alpha exists, to follow Rule #1 and investigate, understand and be comfortable with the source of Alpha.

Page 2 of 9 By Jean-Claude Khoury, CFA

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1. Three Psychological Biases negatively affect Manager

Selection

On December 10th, 2008, Bernie Madoff drove up to his apartment in New

“…,the investor’s York with his two sons and allegedly confessed to them that the $65 billion
chief problem – hedge fund he had been managing for decades had been nothing other than
and even his worst the largest Ponzi scheme in financial history. His victims included
economists, seasoned money managers, highly successful business leaders, as
enemy – is likely well as large banks, large insurance companies, foundations, charities, and
to be himself.” pension funds. 51 foundations and charitable organizations were forced to
Benjamin Graham close and another 143 were left “seriously injured” as a result of the losses
they incurred by investing with Mr. Madoff..

Despite the high level of financial sophistication that many of the victims had, their experience and skill set
did not stop them from choosing a fraudulent Ponzi scheme as an investment.

In order to understand how that was at all possible, we need to refer to a book written by
Professor Cialdini called ‘Influence”. Charlie Munger, upon reading the book, was so
impressed with the book that he immediately sent copies of the book to his children and
gave the professor a share of Berkshire’s stock thanking him for what he has done to the
public by writing the book.

The book explains how seven principles of social influence cause people to make irrational choices that are
detrimental to them. In the case of Madoff, the high profile victims’ rational decision making ability was
overpowered by three of the principles outlined in the book:

Scarcity, Authority, and Social Proof.

The following table is a representative sample of the type of organizations that lost significant amounts of
investments falling prey to the principles discussed below and choosing to invest with Madoff.

Pension Funds Banks Insurance Other Foundations Endowments

Fairfield Connecticut Barclays AXA International Jewish Community New York Law School
Olympic Foundation of LA
Committee
Fire and Police HSBC Swiss Life The Diocese of JEHT Foundation The Maimonides School
Pension Association of Holding St. Thomas
Colorado
United Association Royal Bank of Swiss Congregation Chais Family Bard College
Plumbers & Scotland Reinsurance Kehilath Foundation
Steamfitters Local 267 Jehurun
in Syracuse
Korea Teachers UniCredit Sumitomo Suport The Elie Wiesel SAR Academy
Pension Life Organization Foundation for
Insurance for the Madison Humanity
Cultural Arts
Royal Dutch Shell BNP Paribas Aioi Julian Levitt New York University
Insurance Co Foundation
Nomura Meiji Yasuda Picower Foundation
Life
Insurance Co

These institutions ended up on the list.

Could you end up on such a list, because some of the choices you made were
influenced by these principles?

Page 3 of 9 By Jean-Claude Khoury, CFA

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1.1 Principle of Scarcity

Professor Cialdini explains that studies have shown that people value opportunities more when there are
restrictions. These restrictions could be in terms of amount such as limited availability or in terms of time
such as a very tight window of opportunity or deadline.
“It is difficult to steel
Madoff’s fund was an exclusive fund. Investors could only get in through the
ourselves cognitively
right connections. In addition, it emphasized secrecy. Investors began to
against scarcity
think not in terms of the risk of losing money when investing but in terms of
pressures because they
the risk of not being able to earn the high return if not being accepted into the
have an emotion-
fund. As a result of the illusion of exclusivity that Madoff created, investors
arousing quality that
felt the strong desire to be part of the fund to enjoy the feeling of being part of
makes thinking
an elite group as well as to make sure they were not losing out on great
difficult”
investment returns. This desire was stronger than the rational thought of Robert Cialdini
proper due diligence and potentially losing out on the opportunity.

To defend against this principle, the investor must be aware of its existence. When selecting managers, the
investor should recognize the situation of scarcity in the due diligence process and analyze the opportunity
appropriately and diligently. The investor should then make the decision based on the merits of the
investment.

Does your portfolio include exclusive funds?

Have you invested in funds that were only open for a very short period and your
due diligence time frame was compromised?

If you answered yes to any of the above questions, are you sure you were not
influenced by the scarcity principle?

1.2 Principle of Authority

Professor Cialdini explains that there is a strong pressure to comply with the requests of an authority.
Authority figures usually possess high levels of knowledge, wisdom, and power, deference to authorities
can occur in a mindless fashion as a kind of decision making short cut. However, this could occur in
response to mere symbols of authority rather than true authorities. This principal becomes even stronger in
situations of uncertainty when people look to authorities for guidance and counsel.

Bernie Madoff’s background and credentials gave him the image of a financial authority. He had decades
of successful experience in the financial industry. His start up company developed and pioneered
electronic trading technology that was eventually adopted by NASDAQ. He became the chairman of
Nasdaq. He was reported to be the largest dealer in NYSE listed stocks in the US. In addition, he
established trustworthiness by serving on the board of National Association of Securities Dealers, a self
regulatory securities industry association. Finally, his charitable and philanthropic involvements gave him
an image of being a good person.

Derivative based hedgefunds are inherently uncertain. As a consequence, investors looked to the image of
a credible authority Bernie Madoff instead of spending the time and effort to perform effective due
diligence on the investment opportunity.

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To defend against this effect of authority influence Professor Cialdini proposes that one asks two questions:
Is this authority truly an expert? How trustful can we expect this expert to be? In addition, the investor
should make sure to follow though with a detailed due diligence, no matter what type of true or imaginative
authority is being analyzed.

Have you cut corners in your due diligence of investment opportunities with so
called experts in the field?
Is that authority truly an expert?

1.3 Principle of Social Proof

The third principal of influence that affects investors’ decision making is the “Everyone is doing it.
principal of social proof. Professor Cialdini explains that the principal of From the Abu Dhabi
social proof is very powerful under two conditions: Investment Authority to
Line Capital of Singapore,
1. Uncertainty to Stephen Spielberg and
2. Similarity the Owner of New York
Mets. You look around
As is the case with the principal of authority discussed above, here again, and everybody else is
people seek external information to help them make a choice. The difference investing there. It seems
in this case is that instead of relying on an authority figure, people have a like a reasonable thing to
tendency to look to and follow what people just like them are doing. To them do.”
the correct choice is based on social evidence of what one’s peers and those in Maurice Schweitzer
one’s social network have decided to do. Professor at Wharton

To defend against this principal, the investor needs to step

back and recognize that actions of their peers should not form
the basis of the decision to invest in an opportunity.

Do you compare your portfolio and allocation to your peers? Has this influenced
your decision to invest in an opportunity?

Page 5 of 9 By Jean-Claude Khoury, CFA

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2. Lack of Transparency leads to Lack of Control

One of the big issues currently affecting the investment management industry
especially with regards to hedge funds is the issue of lack of transparency in “I want to be able to
the reporting. This is particularly important with regards to derivatives and explain my mistakes.
leverage. Numerous money managers provide only a moderate level of detail This means, I do only
on the derivative positions, making it difficult for institutional investors to things I completely
determine the amount of leverage being utilized, the type of derivatives understand”
holdings, and their purpose and use.
“Risk comes from not
As a consequence, institutional investors are not able to assess the impact of knowing what you are
these derivatives on the overall portfolio. In addition, the institutional doing”
investor’s ability to control and monitor managers is radically curtailed. Warren Buffet
Investors cannot monitor and ensure that these managers remain within the
investment policy guidelines and are not taking excessive risk to achieve excess return.

One of the main tenets in investing is to understand and know what one is investing in. The following
graph lists some of the largest financial blow ups. Please note that they all were as a result of positions in
derivatives. Please also note the caliber of the institutions where the traders worked.

Largest Financial Blowups

8.00
European
Index Futures

7.00 Gas Futures

The largest financial Interest Rate &

Equity Derivatives
Loss Amount in today's $ billion

6.00 blowups are caused

by derivatives.
LONG TERM CAPITAL MANAGEMENT

5.00

SOCIETE GENERALE
AMARANTH ADVISORS

4.00
Copper Futures

3.00 Interest Rate

Derivatives
SUMITOMO CORP.

Oil Futures
Nikkei Futures
ORANGE COUNTY

2.00
gesellschaft

BARINGS Bk
Metall-

1.00

0.00
1993 1994 1995 1996 1998 2006 2008

Do you currently know what derivatives positions are in your portfolio and what
effect they could have on your overall portfolio?

Are you able to monitor whether the managers you hired are not employing exotic
risks to achieve excess returns?

Page 6 of 9 By Jean-Claude Khoury, CFA

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3. What is lurking behind Alpha?

There has always been the debate between two schools of thought regarding
market efficiency. One school which includes the majority of today’s academia
argues that markets are efficient and that stock prices reflect all the information
that is available on the company and the economy. Therefore, there are no
undervalued securities.

In this world, investors who beat the market are considered lucky. Statistically
speaking, in a large population of investors and money managers, you will always
find a number of them who will beat the market based on pure chance.

The economist Eugene Fama also known as the father of efficient market hypothesis best explains this
position in the following quote:

Question: "When is the market likely to be inefficient or to misprice securities?" Fama: When it’s closed..."
Eugene Fama (2006)

However, there are a select number of investors who have consistently beaten the
market on a long term basis. The amount by which they beat the market is called
“alpha”. These include Warren Buffet, Martin Whittman, Mohnish Pabrai and others.

They represent the second school of thought. To them, the market is generally efficient.
However, there are times, when the market is inefficient and price and value
discrepancies arise. These investors have shown an ability to spot these discrepancies
and take advantage of them resulting in market superior returns and alpha. It is difficult
to argue that these investors beat the market due to chance because they all happen to
follow the Benjamin Graham philosophy of value investing.

Asked why not more investors use the value investing approach taught by Graham, Warren Buffett answers
as follows:

“I can only tell you that the secret has been out for 50 years, ever since Ben Graham and Dave Dodd
wrote Security Analysis […]. There seems to be some perverse human characteristic that likes to make easy
things difficult. The academic world, if anything, has actually backed away from the teaching of value
investing over the last 30 years. [..] Ships will sail around the world but the Flat Earth Society will
flourish. There will continue to be wide discrepancies between price and value in the marketplace, and
those who read their Graham & Dodd will continue to prosper.” Warren Buffet

However, investors should be very cautious and vigilant when investing in opportunities that are expected
to generate significant alpha. The hedge fund Long Term Capital Management that was founded and run
by former vice-chairman and head of bond trading at Salomon Brothers John Meriwether and Nobel
laureates Myron Scholes and Robert Merton generated significant alpha in its first years. These managers
were able to detect market inefficiencies and exploit these very effectively. However, over time, other
managers began to mimic the trading methodology and the market inefficiencies began to disappear. The
following graph shows LTCM’s decline in alpha before the final collapse of the fund.

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Another example of the declining alpha is Warren Buffett. Warren Buffets portfolio has grown so large so
that his ability to consistently generate large alpha has significantly declined. In this regard, Warren Buffet
made the following statement:

“There is no question that returns for Berkshire will be lower than in the past. We operate in a universe of stocks of
companies worth at least $10 billion and more often $50 billion,” Warren Buffett, AGM BHW 2008

Finally, not only could the situations under which alpha was being generated change, alpha itself could be
as a result of fraud, as seen in the case of Madoff.

It is therefore imperative that investors understand and study the reasons why managers are earning excess
returns before committing capital to them. The investors should then determine whether the method of
generating excess return is in compliance with their investment policy statement.

Do you know whether your manager’s alpha is a result of fraud, chance, or true
ability?
If it is true ability, how long will it last?

Summary
Some funds and investment managers will lower their guard and chose to invest in opaque opportunities
justifying the decision by arguing that diversification or relatively small investments would limit the
potential for loss. As seen above, others do not even bother with diversification. However, if an investor
does not understand what he or she is investing in, the investment is nothing other than a speculation and
should not be included in a prudent portfolio. Diversification is not an excuse for lowering the guard and
not doing the appropriate due diligence.

This special report showed several ways for investors to follow Buffet’s rule of not losing any money.
Investors should be aware of the principles of social influence including authority, scarcity, and social
proof that negatively affect their decision making and investment choices. In addition, the reporting should
be adequate enough for investors to monitor and understand what type of risks their active managers are
taking. In situations where managers are generating alpha, investors should be especially vigilant and
understand where the alpha is coming from. They should also analyze whether circumstances are changing
to such an extent that these active managers will not be able to generate alpha any longer.

Page 8 of 9 By Jean-Claude Khoury, CFA

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About the Author

Jean-Claude Khoury has ten years experience in the investment banking and structured finance industry
working for top tier investment banks including Deutsche Bank, Nomura International, and HVB,
Germany’s second largest bank.

He began his career as a foreign exchange trader for two years, acting as a market maker for the major
currencies in both spot and forwards. Since then, he has structured and executed in excess of $15 billion
of structured bonds working on a variety of innovative structured finance transactions. In his most recent
position, as a director at HVB, he originated, structured, and executed the first ever securitization of land
leases in main land Europe.

Jean-Claude graduate magna cum laude with a Bachelor of Sciences degree in International Business and
Finance from the University of Maryland College Park. He holds an MBA from London Business School
and is a CFA charterholder.

Contact Information:

Jean-Claude Khoury
PO BOX 53695
Irvine, CA 92619

Mobile: (949) 892-9431

e-mail: jckhoury@yahoo.com
www.linkedin.com/in/jckhoury

Note: You are welcome to copy and distribute this special report as often as you wish; I only
request that you please include the author’s information page when doing so. Thank you.

Page 9 of 9 By Jean-Claude Khoury, CFA