Putting Your Money Where Your Mouth Is

Dynamic Markets is a unique course at HBS. Instead of just talking, you are required to put your views into practice. Apply the standard theory, try to think ahead of the class, or toss out the theory and go on gut. Whatever strategy you choose is tested in a real-time, competitive trading environment. You also get a lesson in something that MBAs are typically perceived to be weak in: Execution.

Dynamic Markets differs from the typical HBS case-based class in 3 important ways:

First-hand application of theory by trading in a disguised historical market scenario rather than discussion of a historical event
Real-time, constant feedback on your performance in the form of results from your trading strategy and post-mortem discussions
A formalized system whereby your section-mates express their confidence (or lack thereof) in your ability to apply old lessons and adapt to new complications

First, a quick rundown on how it’s structured. Before each class, students are given a description of the instruments that will be traded, a basic primer on how to value them and additional reading on ways to think about the market. We then decide our trading strategies and build models to implement them. Class starts with everyone logging in and trading in a market where the decisions of each student (and some pre-programmed computer traders) impact market prices and liquidity. At the end of the simulation we review the results and discuss what happened, who did what, what worked, what didn’t, and why. After a few trading sessions, students become “fund managers” and are given “capital” to manage for the rest of the semester. Another interesting feature of the course is that each student has a separate “fund-of-funds” capital pool to invest in their classmates’ funds. Each “fund manager” tries to attract their classmates to invest in them by competing on fees, performance, representations of expertise, etc. Students are graded on class participation, their own fund performance, and their “fund-of-funds” performance.

One great advantage of this format is that the lessons really stick. For example, I could get the general gist of liquidity risk and the consequences of leverage from a classroom discussion. But I began to understand the issue on a whole different level after trading in a market that started to experience those problems and saw my fund blow up along with _ of my classmates due to a liquidity crunch. This happened to me, not Erik Peterson. We don’t get to look at a protagonist and with the benefit of hindsight say, “Oh, I would have done this or that better, and foreseen those consequences”. This time, you are the protagonist. Was your strategy faulty? Were you just unlucky? You can learn a lot with an honest assessment of the situation and how you responded.

This is going to sound nerdy (I’ve learned to embrace my inner nerd), but the simple action of taking a formula and building an Excel model based on it greatly improves retention and depth of understanding. Maybe it’s just me, but I remember nodding along when my FIN2 professor was explaining the Black-Scholes formula in class, then forgetting almost all of it as soon as the end-of-class clapping was over. Being forced to put it down in a model that I would trade on in real-time helped me really get my head around the different variables that go into it and how (and when) they affect value.

The level of transparency in class also leads to interesting lessons. Everyone’s trading performance is public information, and we do a post-mortem discussion after every simulation to “look under the hood” and ask the best (and worst) performing “fund managers” what they were doing, how they approached the problem, etc. In this way, you don’t just hear what your classmates think “should be done.” You get to see what they in fact did, why they did it, and how it turned out. Among other things, I’ve learned that numbers do lie, if misinterpreted. Fund returns numbers by themselves don’t distinguish skill from luck, and Sharpe ratios can be very misleading.

Having a “fund-of-funds” capital pool to invest in your classmates also makes things a lot more interesting. For those of you who might think this a little too cutthroat and competitive, let’s not kid ourselves: We judge the quality of our classmates’ class participation every day. Even if we don’t intend to, we can’t help forming an opinion on someone’s competence if we sit in class with them and regularly hear their views on a given topic. This just formalizes that process. What it does do is give you more of an incentive to listen carefully to what your classmates are saying, and to think about how the differing investment style/risk appetite of each fund managers fits into your “overall portfolio” of funds, including your own.

Having said all that, this is probably the most “technical” course at HBS. If you want an open-ended discussion where you can always show up hung over and talk about “aligning the incentives” or “supply and demand” to get an easy 2, this is not it. However, if you want to figure out how financial markets work and what to do with all that fancy theory you learned in FIN1 and FIN2, this course is great. Also, if you’re interested in pursuing a career in public markets “focused on the long-term fundamental value of companies,” and want to “buy good businesses that will still be around in 20 years.” then I think you almost need to take this course. Take it from a life-long value investor who has been forced to realize that “getting the valuation wrong” isn’t the only risk an investor takes. There are a host of “non-fundamental” market factors that you just can’t afford to ignore.

February 17, 2009
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