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With Investing, Sometimes It Just Comes Down to Trust

Leon Cooperman had a bad feeling for a good reason.

Back in early May, the chairman of Omega Advisors and widely recognized market sage, confided to 1,500 of his hedge-fund colleagues that an ominous cloud was rising over the financial markets.

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"We're heading for a crisis," he said in Las Vegas at the Skybridge Alternative Investment conference. "I just don't know when."

In Cooperman's estimation, the crisis was still a ways away, and he admitted that until whatever it was out there that was coming to doom the markets hit, .

Actually, the crisis was closer than he could have thought.

For as he spoke, the market was in the early days of a selloff that would take the major averages down close to 20 percent and portend what could well lie ahead for investors: A bumpy, nervous market in which wild swings of several hundred points a day would become commonplace.

To guys in Cooperman's business, delivering alpha—or returns that surpass basic benchmarks—had just gotten even tougher.

Cooperman will be among the panelists at Wednesday's CNBC-sponsored Delivering Alpha investor conference in New York, where a wide swath of experts will converge to talk about how to survive and thrive in such a difficult environment.

"People are scared. They don’t know what to do," Cooperman said. "We all know we’re kicking the can down the road. We don’t know when it will hit. (Until then) equities are the best value in a bad neighborhood."

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How well that strategy sticks going forward is a ticklish question, one that revolves around how well hedgies like Cooperman, as well as portfolio managers and market strategists, can convince investors that there's still value to be had at such a difficult time.

"The concept of 'trust' may be a bit squishy for hard-nosed finance types to accept as a bedrock issue for returns in the capital market," notes Nicholas Colas, chief equity strategist at ConvergEx, in research on the concept. "Shift your focus from classical economics to behavioral finance, however, and trust proves to be a critical driver of investment and growth."

Colas cites dynamics involved in what is known in behavioral science as "The Trust Game." In the exercise, a person is given $10 and can keep the money or hand it over to another person with the promise of either getting a positive return or losing everything. The second person in turn is given another $20, which can be shared with the other player in any way.

The point of the game is that the first person, under the rules of classical economics, never should have handed the money over. However, when that person made the decision, he or she was rewarded for taking that risk.

That is how investing, and alpha delivery, is supposed to work—trust leading to risk and reward. But nowadays the person who gets the $10 is becoming far more reluctant to pass it along.

"Put into the context of social trust, I think a lot of the current market turmoil and slow economic growth in developed economies makes considerably more sense," Colas said. "Why do corporations hoard cash and limit hiring? They do not trust policymakers or the underpinnings of the financial system. Why do American citizens have such fractured views on how to fix the nation’s economic model? They either do not trust government or they do not trust the private sector."

Developing that chain reaction that begins in the Trust Game, then, will be the first step for managers like Cooperman to get the alpha cycle going.

"If there is a silver lining to this cloud, it comes from The Trust Game itself," Colas wrote. "Most people do want to trust their fellow man and woman. It takes time and bad decisions to erode that trust, but it is not the natural course most of us want to take.

"Capitalism and democracy, when allowed to operate properly, remove the untrustworthy and replace them with new agents. Markets and government in many developed economies are clearly in the midst of that sea change."

Indeed, there are the political questions on top of everything else that make old-fashioned investing even more difficult.

Banking analyst Meredith Whitney, another "Delivering Alpha" panelist and perpetual Wall Street lightning rod, has rankled many with her candid assessments of how the markets and the financial institutions at their core are operating.

But her assessment of the market during a controversial CNBC interview in August—during which she famously called Tea Party members —served to encapsulate the dilemmas and difficult choices investors face going forward.

The recent downturn has inspired comparisons to the financial crisis days of 2008—another blow to investor confidence, trust in the market and ability to find alpha. But Whitney said the comparison is misplaced.

"It actually reminds me more of the '70s than 2008," Whitney said, referring to the high-inflation low-P/E days before the rebound in the 1980s. "The market's harder now than it was in 2008 because it's a constant beatdown.

She added: "There are structural problems that we face...huge swings in the face of uncertainty. The uncertainty is we have real structural problems in this economy that have to be dealt with on a real long-term pragmatic basis—not on a quick-fix solution basis."