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Costas Kaplanis, another alumnus of the Liar’s Poker training class, headed arbitrage trading for Salomon Brothers in London and became the head of Global Arbitrage Trading for Citigroup, after it acquired Salomon. Costas complained to me how an “arbitrage” ruined one of his summer trips with his wife, Evi. He was trying to enjoy an al fresco dinner, but he anguished over an interest rate spread trade he had put on. Positions of $1 billion were not unusual if the volatility was “controlled.” The problem with volatility is that it doesn’t care whether or not you think it is controlled, and the trade had moved against him. He couldn’t eat, he couldn’t sleep, and he couldn’t think.

If you lose sleep worrying about losing money, it is not an arbitrage.

At its Third World Conference of the Bachelier Finance Society in Chicago in 2004, Phelim Boyle, a visiting professor at the London School of Economics, presented work on stochastic volatility models and made an analogy: “Pricing is like falling in love, but a hedge is like getting married.” It sounded catchy and got a laugh. Never one to leave a bad analogy unchallenged, I countered:“A hedge is just a date. If I am going to marry for money, I’ll marry an arbitrage, but I’ll dump a hedge in a heartbeat.”

A genuine arbitrage is a very rare occurrence and technology inefficiencies can be a cause. Lee Argush, the managing partner at Concord Equity Group Advisors, ran a fund that took advantage of a rare information arbitrage opportunity in the new-born Russian currency market exchanges. In the early 1990s, the ruble traded at 200 rubles to the dollar in Moscow, but in St. Petersburg, it traded at 250 rubles to the dollar.The Russian phone system was poor. Even a bandwidth sharing arrangement using excess Soviet military communication lines resulted in numerous communication breaks. (Imagine if there was a real need during the Cold War!) Argush installed Sprint and traded the currency arbitrage.

Since a true arbitrage is so hard to find, I focus on value investing for my personal portfolio in the Benjamin Graham and Warren Buffett tradition.

While Warren Buffett continues to look for value opportunities, all over the globe new money gushes into hedge funds and leveraged investments. We do not care if rich people want to speculate knowing they may lose their money. Unfortunately, many public pension funds and other “safe” investors allocate some of their money to hedge funds.

In 1990 there were a few hundred hedge funds with less than $50 billion in total assets under management. By the summer of 2008, there were around 8,000 hedge funds (depending on who was counting) with $1.87 trillion in assets under management.8 Since hedge funds can only be sold to wealthy investors, they are mostly unregulated based on the flimsy theory that rich investors are sophisticated investors.

Only accredited investors are allowed to invest in hedge funds, but they are pretty easy to find. Regulation D of the Securities Act of 1933 defines an accredited investor as anyone with a net worth—including the value of real estate—in excess of $1 million. If your net worth is not that high, but you have income greater than $200,000 for the past two years—make that $300,000 if you are married—and expected the same this year, you qualify as an accredited investor.

A mere million dollars makes you a high-net-worth individual, but that may not be enough to get you access to the elite hedge funds. Some require a minimum investment of $5 million. Others court the “carriage trade” (old money) and the “caviar crowd” (new money), seeking out ultra-high-net-worth investors worth more than $30 million. In the estimated $1.87 trillion global hedge fund business, fewer than 10 percent of the funds control more than 85 percent of the money.

Banks, savings and loans, and most investment companies qualify as accredited investors. Most trusts with more than $5 million in assets and partnerships also qualify. Many retirement plans, including Employee Benefit Plans, Keogh Plans, and IRAs meet the test. Now