When do we reach our financial decision making peak?

Financial sophistication peaks in our early 50's. Younger adults and older adults borrow at higher interest rates and pay more fees than middle-aged adults.

These conclusions come from a fascinating paper I read recently.

The authors hypothesized that financial sophistication would depend on a combination of analytic ability and experiential knowledge.

Their research on cognitive aging implied that analytic ability follows a declining concave trajectory after age 20. Our brains function as well as they will in our early 20's, then degrade from there.

The authors also hypothesized that experiential knowledge follows an increasing concave trajectory due to diminishing returns. The older we get, the more experience we have. The more experience we have, the better decisions we can make. But, each unit of experience does not provide the same benefit as the unit before. Hence the diminishing returns. Our experience helps us make better decisions, but each bit of experience benefits us less and less over time.

When adding together the effect of cognitive decline and experience with diminishing returns, we end up reaching our peak at some point and then our abilities decline over time.

The same thing can be seen in other pursuits. Baseball players peak in their late 20's. Mathematicians, theoretical physicists and lyric poets peak around age 30. Chess players peak in their mid 30's. Autocratic rulers peak in their early 40's. Authors peak around 50.

The authors validated their hypothesis by showing that younger and older financial decision makers pay too much in interest and fees. Sure enough, those in their early 50's pay the least in interest in fees, seemingly validating the cognitive decline/experience with diminishing returns thesis.

Here's an interesting question: what age person should you want to work with to help you make financial and investing decisions? Would you want to chose someone in their mid 50's, whose cognitive abilities are declining and whose experience doesn't make up for this decline? I don't think so.

You'd probably want someone on the upswing, someone whose cognitive abilities may be declining, but who has enough experience to make up for that decline. Perhaps you'd want to pick someone who would reach their sweet spot of optimal decision making in the future, who still had the best benefits of aging and experience ahead of them.

Okay, this is a shameless, self-promoting plug. I'm in my late 30's and will become a better investor over the next 15 years. Doesn't that sound like the right target, instead of someone with so much experience they're in decline? If you're going to work with someone for 30 years to reach your goals, wouldn't you prefer someone on the upswing instead of the downswing. I sure would.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Social influence plays a big part in outcomes

The success or failure of a venture can be greatly influenced by the early reactions of people.

This statement may seem obvious to you, but a recent academic study recently showed just how important initial reactions can be on success or failure.

I read about the study in Michael Mauboussin's recent Legg Mason article. Three Columbia University sociology researchers set up a website where people could download music. 20% of the people who went to the website were provided with no information about what others had downloaded. Another 8 groups (10% each) were formed which could see download rankings.

The study showed that top songs tended to finish in the top, and bottom songs tended to finish at the bottom regardless of whether download rankings were available. But, the vast majority of songs in the middle were ranked very differently depending on whether people could see download frequency.

In fact, the study showed that once 1/3 of the participants had downloaded songs, the next 2/3 of people followed their lead. This lead to very different outcomes between the 8 groups who could see download frequency.

In other words, the intrinsic quality of songs was trumped by the cumulative advantage of social influence for the vast majority of songs. Songs downloaded frequently by a group were then downloaded more frequently by others, creating cumulative advantage.

This may seem obvious when you think about Betamax versus VHS digital video tapes, or Apple versus Microsoft Windows, or, more recently, iPod versus any other MP3 player.

The same is undoubtedly true for picking investments. In the short term, people pile into the same investments that everyone else is talking about, regardless of the intrinsic value of the underlying business.

Luckily, the market has the benefit of quarterly and annual earnings reports, which force stock prices to track with underlying value over the fullness of time.

This doesn't mean that stock prices are always right--quite the opposite.

Don't judge an investment by what it's stock does over the short term if you're a long term investor. Otherwise, you may suffer from the social influence of following the crowd.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

401k investing

Many investors are just plain baffled about how to invest their money. They don't know where or how to invest to reach a comfortable retirement.

One of the best investment vehicles out there, if it's available through your employer, is the 401k plan.

Traditional 401k plans allow for pre-tax contributions that grow tax-deferred until retirement (when withdrawals are taxed as ordinary income). Roth 401k plans allow for after-tax contributions that grow tax-deferred and are not taxed on withdrawal (they also provide more flexible withdrawals and better estate planning options).

Many employers match employee contributions. This is like getting a raise in salary, yet less than 66% of all employees eligible participate in such plans.

If a 401k plan is available to you, you should almost certainly be contributing to it.

The earlier you start saving, the sooner you don't have to work for other people or the bigger your retirement will be. Start saving NOW!

Before you invest, you should learn a few things about the plan available from your employer. You'll want to know your employer's policy on matching contributions, the vesting schedule for contributing, and the plan's maximum contributions.

The hardest part about investing in a 401k--after clearly understanding you should--is picking the right investment(s). Most plans offer anywhere from 25 to 900 choices. Almost all investors are overwhelmed by such choices.

Unlike most advisors, I don't necessarily believe that investors should go crazy diversifying their money to the 4 corners of the investment world. There are better and worse investing opportunities, and any good investment advisor will know the difference between the two.

Don't necessarily go for target date funds, either. Their allure seems wonderful because someone else does the thinking for you, but their high fees and necessarily mediocre performance may not meet your personal desires or your investment needs.

Finally, I would advise you not to invest in your company's stock through such a plan. Your pay check is already dependent on the company, so you probably don't want your retirement nest-egg to be in the same spot. The folks at Enron, Worldcom and Arthur Anderson found out the hard way what a big mistake that can be.

If you need any help making these decisions, I'd be happy to help. Just give me a call at 719-761-3148.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Your returns depend on the CEOs you invest with

Not surprisingly, what's happening in a CEO's life impacts the performance of their company and it's stock price. A September 5th article in the Wall Street Journal by Mark Maremont highlighted this fact, recently.

Several studies have shown that a death in a CEO's family negatively impact the company's stock price. The death of a child resulted in an average loss of 20%. The death of a spouse led to a 15% slip in price. Amusingly enough, the death of a mother-in-law led to a 7% rise in stock price.

Other studies showed that the stocks of companies run by CEOs who buy or build megamansions sharply under-performed the market. This hardly seems surprising to me, but it's good to see the statistical backing.

Another study showed that narcissistic executives, those who tended to take all the credit for what their companies accomplished, tended to take greater risks that led to bigger swings in company profitability.

Although I've never done a statistical study of these issues, I've always looked hard at the leaders of the companies I invest in. Not only does this result in better investment results, on average, but it also allows me, and my clients, to sleep better.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Bad reasons not to save

Jonathan Clements, who writes for the Wall Street Journal, had a somwhat amusing article on September 9th.

His title was, "Six Bad Reasons Not to Save for Retirement." I couldn't agree more.

Bad reason #1: I still have plenty of time.

Say you start saving for retirement as a diligent 25 year old. Your goal is to have $1 million by retirement, which you plan to start at 65 years old. You'd need to save around $846 a month for 40 years.

If you wait until 35, you'd have to save 70% more a month, or $1,441 per month for 30 years. If you wait until you're 45, you'd have to save 322% more a month, or $2,726 per month for 20 years. If you wait until 55, you'd have to save 803% more a month, or $6,791 per month for 10 years.

It pays to start as early as possible. The longer you wait, the more painful reaching retirement will be.

If you think you'll earn more money as you age and have more money to save later, you're right on the first issue but wrong on the second, because I almost guarantee you're expenses will go up faster than your income as you age.

Start saving as soon as you can, as much as you can, and you'll reach a bigger retirement with a lot less stress and strain.

Bad reason #2: My house is worth a bundle.

See my previous post on this subject. Counting your home as a retirement asset usually doesn't work out.

Bad reason #3: My investments are doing great.

They may be doing well, now, but what matters is how they do over the full length of your retirement years.

For those who retired in the late 1990's with enough money, the sell-off during 2000-2003 slammed them right back into working again. It's not enough to have a lot of money at the peak.

A retirement plan should be set up with a margin of safety, not merely "enough money to get by as long as everything goes well."

The best way to get there is to save continuously into your retirement plan (which should be based on reasonable assumptions).

Bad reason #4: I'll receive a fat inheritance.

Very few people, after inheritance taxes, will receive enough money to retire on, perhaps 1.6% as Clements suggests.

If you are part of that 1.6%, congratulations.

If not, get to saving.

Bad reason #5: I have a pension.

41% of households currently have a defined-benefit pension plan, whereas 62% of workers expect to receive a pension.

If you actually have a pension and are not part of the 21% of "land-of-fantasy" types who expect a magical pension to appear in the future, be sure it will cover your actual expenses in retirement.

Also, keep in mind that, because of recent accounting pronouncements and the expense of defined-benefit plans for companies, many defined pension plans are going the way of the dodo.

If you don't have a pension or are part of the 21% who are clicking your heels for the future-fantasy-pension, get to saving.

Bad reason #6: I'll work in retirement.

This is actually not a bad idea.

I love my job and don't plan to stop working until I'm unable to work, so I can sympathise with this argument.

But, many people don't want to or can't work into their 70's and 80's.

Planning to work into your 60's makes sense, but assuming you'll be capable of working into your 70's and 80's is gambling where the odds are against you.

Plan to work if you can and want to, but have enough money saved in case you just plain can't.

Saving for retirement is like paying for insurance. You may never make a claim or need as much money as you've saved, but that doesn't mean you don't want to make regular payments so you are safe and secure in your old age.

Save for retirement as soon as you can, as much as you can, and as regularly as you can. You'll sleep better and have greater peace of mind.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Is the Fed cutting interest rates really a good thing?

It seems like market participants have been wishing, hoping and praying that the Fed will cut interest rates for over a year now. Unfortunately, this may not be a good sign for the market, but a clear signal of worse things to come.

You see, the Fed cuts interest rates not because things are going great, but because they are seeing clear signals the economy is headed for rough waters.

In fact, the stock market has historically dropped around 40% during an average recession, so the Fed cutting interest rates may not be a signal market participants should be cheering about.

Two weeks ago, John Hussman had a brief section on this subject in his weekly Market Comment. He posted a couple of graphs showing how the S&P 500 did during Fed rates cuts that led up to the 2000-2001 and 1981-1982 recessions.

From 2000-2001, the Fed cut interest rates from 6.5% to 1.25%, and yet the S&P 500 tanked around 41.1% over that same period.

From 1981-1982, the Fed cut rates from 20% down to 11%, and yet the S&P 500 tanked around 21.5%.

The Fed cutting interest rates is not a cure-all that makes the market go up. The market does sometime do well because of rate cuts, but not every time.

So, if you've been betting on the Fed cutting interest rates in hopes of making a killing in the stock market, you may want to consider buying short term bonds instead--they will much more likely benefit.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

If a shoe falls in the woods, and no one is around to hear it, does it make a sound?

In an earlier post, I brought up what could knock down credit markets. One issue was the availability of credit, which has been the subject of much pain and anguish, recently. The other two issues were interest rates and employment.

In the news today, the employment report for the month of August looked dreadful. For the first time in 4 years (when we were stumbling out of the last recession), payrolls tracked by the Labor Department shrank instead of climbing.

Could this be the result of financial service firms laying off workers in an attempt to adapt to current credit conditions? Could these laid off workers then have trouble making their home payments, thus promoting the negative spiral of home price declines, credit defaults, financial market troubles, and more layoffs?

I certainly think so. In fact, I believe this is the beginning of the other shoe dropping. I also believe the Fed will react as it always does, by lowering interest rates in an attempt to "jump-start" the economy.

This will, in time, lead to higher interest rates on longer dated bonds as foreigners demand higher rates to compensate for the dropping dollar. The dollar will drop further as more and more market participants realize the Fed will lower interest rates by printing more dollars (in other words, creating inflation).

How bad will this get? I don't know, but lower employment and higher interest rates will make current housing problems look tame by comparison.

It's a good time to avoid companies with lots of debt. It's a good time to avoid investments related to the housing market or its financing (although a bit late).

More importantly, it's a good time to be invested in securities that will benefit from this fallout. It's a good time to have some cash that can be invested as the market goes down.

If inflation is a concern, it's a good time to consider investing in tangible things (other than real estate) that are hedges against inflation. It's not a bad time to consider foreign investments that may be hedges against inflation, too.

It's also a great time to consider those companies that will fair best as we emerge from our credit market problems and into another growth up cycle.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Do you include the value of your home as a retirement asset?

An excellent article in the Wall Street Journal on September 2nd, by Glenn Ruffenach, echoed what I've been telling people for years: you may not want to count your house as a retirement asset.

As the article states, many people have been thinking of their home as an investment asset they can cash in when they retire. The thinking goes like this, "If my budget gets tight in retirement, the equity in my home will serve as a safety net."

In fact, a study by Bell Investment Advisors in California "found that 68% of surveyed 60-year-olds count their personal residence as a retirement asset. And of that 68%, one in four say their home represents half or more of their retirement savings."

The problem is that home prices are falling nationwide, the decline is accelerating, and it's particularly bad in the same places where real estate prices climbed the most, like California, Florida, Nevada, and Washington, D.C.

As the article states, "If the value of your home falls...there's less equity to help finance your retirement."

There are two problems with thinking of your home as an investment asset.

The first is that most people are unwilling to give up their lifestyle to cash out their home and move into a smaller place.

The second problem is that higher interest rates, which are not unlikely in the future, could make house prices fall even further and dramatically decrease the payout of doing a reverse mortgage (having the bank provide you with monthly payments as they acquire the equity in a home).

Counting your home as a retirement asset may not be prudent. It turns out that few people can turn the value of their home into cash flows during retirement.

If you count your home in your net worth or as a retirement asset, you may want to reconsider.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

"The typical small investor has no idea what his or her performance has been"

This distressing quote comes from an article I read in the September edition of Financial Advisor magazine.

A study by Markus Glaser and Martin Weber of the University of Mannheim came to this conclusion after surveying 215 retail investors to find out what they thought about their investment results versus how they had actually done.

Their study showed that investors with bad results thought they were doing just fine, and that there was almost no relationship between how investors actually performed and how they believed they had done. They also discovered most investors weren't as successful as they thought.

Although the authors focused on cognitive biases that caused this result, my mind turned, instead, to other questions.

If investors don't know how they're doing, is that their fault, or the fault of their advisors?

If investors think they are doing okay when they're not, how would they know they should switch advisors?

If investors work with advisors who aren't serving their best interests, do they know they can get better results by working with an advisor with fiduciary responsibility?

It's troubling that so few have saved enough for retirement. It's more troubling to realize they may not know this. To me, it's most troubling that the people who should be helping investors reach their goals are frequently using an investor's ignorance to keep them in the dark.

After all, who gets an education in the math of investing such that they understand investing results? Who gets an education in the costs of investing and the compensation schemes of financial service providers? How can people make good decisions if their financial advisors benefit at their expense?

Many investors are getting bad advice because they work with salespeople who are likeable. Such salespeople are trained to be likeable because financial service firms know most people can't judge performance and tend to choose based on gut feel.

I believe this is the real cause of the problem Glaser and Weber discovered. The solution is to work with professionals. Professionals are experts in their field based on extensive education, training and experience. They tend to have ethical guidelines and join associations that enforce those ethical standards.

If you want a great doctor, pick a doctor with great education, training and experience. If you want a great accountant or lawyer, look for the same thing.

If you want to pick a great investment advisor, look for education, training and experience--not likeability.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Moral Hazard

Today, the Federal Reserve and President of the United States offered a life raft to the mortgage market.

It sounds like this will come in the form of additional liquidity for lenders from the Federal Reserve, and loan guarantees and loan restructuring for borrowers through various government departments.

Although this may seem like much needed help for "victims" of the market, to me it looks like a dangerous incentive to take more risk--also known as moral hazard.

You see, borrowers who shouldn't have gotten money were lent money. Many were speculators hoping home prices would keep going up. Others were ignorant of the loans they signed because they didn't bother to read the paperwork.

Should borrowers be bailed out who shouldn't have borrowed? Suppose I go out and buy a large screen TV with my credit card. Suppose I can't make the payments because I didn't realize the interest rate I would pay. Should taxpayers bail me out because I'm ignorant of the contract I signed? If they do, what would I learn? Not to take the risk?

Even worse, lenders knew about their borrower's credit histories and ability to pay. Lenders also knew they would pass such loans off to Wall Street investment banks who would sell such bad loans to ignorant investors.

Should the mortgage originators, Wall Street banks and lazy investors be bailed out for making bad loans? Suppose I lend someone money at a 20% rate because they can't get a loan elsewhere. Suppose they can't make payments at some point. Should the taxpayer bail me out for making a bad loan? What would I learn? Not to make loans to people who can't pay?

The Fed and President are offering to bail out borrowers and lenders with other people's money. Those other people are U.S. taxpayers. You will pay in the form of inflation due to the Fed printing money and higher tax rates or higher government debt due to the executive branch bailing out "victims" of bad lending.

The real problem with this scheme, as any study of history will tell you, is moral hazard. If someone learns they can take risk at another's expense, then they're incentivized to take that risk over and over again.

If you let a teenager borrow your car and they get in an accident, what do they learn if you prevent them from living with the consequences? Why would that be any different with adult borrowers and lenders in the U.S. economy?

Just look at the people rebuilding their huge houses in Alabama that were wiped out by hurricane Katrina. They know they don't have to pay for insurance because the government will bail them out, so they are quite happy to rebuild because they know they won't bear the expense of the risk they're taking.

So, when you see spiking inflation over the next several years and higher tax rates or increased federal debt to pay for all the bailouts the government is offering, keep in mind that you're getting to bail out speculators in real estate, people with bad credit histories, banks who pass their loans off to Wall Street, Wall Street investment banks that don't need the help, and investors who don't bother researching what exactly they are buying.

And, when such teenagers take this risk over and over again, and you get to bail them out each time, remember that there is a name for this phenomenon--moral hazard.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

My evolving investment approach

It's interesting to note how my investment research process has changed over the years.

From the time I first read about value investing in 1995 up until 1998, my focus was almost exclusively on the numbers. Basically, I picked investments based on my assessment of the value of each business with a much lower emphasis on other factors (management, economics, product life cycles, etc.). I crunched the numbers and bought if something looked remarkably cheap.

From 1998 until 2001, my focus began to include a more thorough analysis of business economics. Here, my aim was to gain an in-depth understanding of the competitive advantages of each business and to what degree they were sustainable. This effort was much more qualitative than quantitative.

In 2001, I started to include a much more thorough analysis of management, too. For this, I looked at management's tenure, their competence in the field, their compensation structure, their ownership of the business, the way that they talked to shareholders, etc. This, too, was a more qualitative effort.

What I've found is that you can never stop learning in this field (or in any other for that matter). Every year, I bring new elements into my analysis. Every year, I read books or articles that lead me to dig deeper into certain aspects of each business.

Although my general approach has remained the same--I look to buy underlying businesses, not stocks, and I try to buy them significantly below their assessed value--I continue to add more and more layers of analysis and experience on top.

I keep very good records of the investments I've looked at over time, both the ones I invest in and the ones I don't. This has allowed me to review my past decisions and prevent sins of both omission (not investing) and commission (investing when I shouldn't have) going forward.

I love my job, and I love learning more and more each year such that I can improve my expertise and, more importantly, my results going forward. And, as Charlie Munger and Warren Buffett have amply demonstrated, that's a great way to build wealth and enjoy life.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

On becoming a father

Last Wednesday, I became a dad. My daughter, Vivian Lacy Rivers, was born at 8:55 am. She was 8 pounds 11.6 ounces and 21 inches long. I have a new found respect for my wife (and I respected the heck out of her before).

Now that's a life changing event.

I feel a tremendous sense of responsibility to help this little being. My wife and I have been reading about child rearing and preparing for it for well over a year and a half.

My wife was trained as a chemist and I was trained as an engineer, and we're both avid schedule makers and precise planners. You can guess what the first week has looked and felt like to us. Pure chaos.

We're adjusting, though, and we both feel more purpose and humility than ever before. I can't wait to be a guide for her discovering life, and I'm sure I'll be growing right with her because I have so much to learn, too.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Monday's articles

I read several enjoyable articles today that put the market's current situation in context.

The first is by John Hussman of Hussman funds. In it, he takes the Fed Model to task. The Fed Model says that the stock market's earning yield can be compared to the yield on 10 year US Treasury bonds. As he clearly shows, this model looks great from 1980 to 1998, but would have given terrible investing advice from 1948 to 1980 and from 1998 until now. Does that sound like a good guide to investing--a method that worked during only 30.5% of post WWII stock market history?

He also takes to task the current practice of saying the stock market is reasonably priced by looking at forward price to earnings ratios and comparing that to historical trailing price to earnings ratios. Not only is this comparing apples and oranges by comparing projections and history, but it also ignores that profit margins are at all time highs and will almost certainly come down over time. As usual, his analysis brings a broader historical context to the situation.

The second is by Edward Chancellor (author of Devil Take the Hindmost: A History of Financial Speculation) and appeared in the Washington Post. His title is, "Look out. This crunch is serious." In it, he argues that comparing current market problems to the short term problems of 1987 and 1998 may not be valid. His warning is that credit splurges have turned into major market problems in the past, and this one may look more like 1929 when everything is said and done.

The third article, in the Financial Times, is by Gillian Tett. In it, Tett argues that bond insurers, like MBIA and Ambac, may be in for serious trouble because they've insured so many structured financial products that contained bad credits. As he suggests, it's very hard to know what these bond insurers have backed, so holding on to them as investments may prove foolhardy if it turns out they must actually support the insurance they've underwritten.

The last is by Bill Gross, of PIMCO, and appeared in Fortune. Gross compares current market turmoil to playing Where's Waldo. Everyone seems to know a lot of bad credits are "out there," but no one seems sure who is exposed to such fallout and by how much. Problems keep turning up in unexpected places, like German and French bank's books. These problems were created by financial wizards on Wall Street who believed they could turn lead into gold, and, unbelievably, some people actually believed them!

In my opinion, it will take a long time to fully understand the severity of the current situation. This may turn out to look like 1987 or 1998, but it could also be much worse. For those who believe that credit excess always ends badly, it's a great time to play defense and bet on those who can benefit from debt implosions.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Warren Buffett's rules for investing

Warren Buffett has amusingly spelled out his two rules for investing many times in the past:
Rule #1: Don't lose money
Rule #2: Don't forget Rule #1

This may seem like a gross oversimplification, but it holds a kernel of truth I believe few grasp.

Those who've made a lot of money investing--whether in real estate, equities, bonds, commodities, whatever--have almost always done so because they didn't lose very often, and when they did it was with small bets.

In my opinion, this stands in stark contrast with the belief that most people hold: that people who make a lot of money investing do it by gambling big and hitting the jackpot. They tend to think that great investors bet the farm on a wild toss of the coin and make out like bandits.

I'm certain some people have gotten rich that way, but they are a very small minority. The vast majority have done it by not losing their shirts on bad gambles.

Not losing money isn't very sexy. It's not like buying Cisco and watching it go up by 10 times. It's the hard work of picking things you're pretty certain will go up and almost 100% certain will not go down.

Instead of trying to catch shooting stars, not losing means finding a few things that, after a whole lot of research and study, look like they will provide good upside and have an extremely low likelihood of going down much, if at all over the long run.

Why is it that trying to catch shooting stars doesn't work and not losing does? Because most attempts to catch a shooting star ends with a large if not total loss. Even if you manage to catch a shooting star once, the next time you play you are more likely to lose than win. Over time, this just doesn't work.

Not losing slowly builds over time into a growing some of money. It doesn't happen fast. It doesn't look very sexy. But it works. If you aren't losing, you just keep building up and up.

That's what Mr. Buffett is trying to tell you.

Don't swing from your heels at a wild pitch and hope you connect and knock it out of the park. Instead, wait for a pitch you are almost positive you can hit, and then get a base hit that allows you to move forward in the game. Over time, this will build into a win.

Swinging for the fences will provide a couple of exciting moments, but will lead to loss after loss over time. And, that's not how to successfully invest.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

What will happen if the credit market's other shoe drops?

Recent bond and stock market turmoil has turned full attention to credit markets. What has surprised me is that conditions for credit markets aren't that bad. Am I mad, you may be thinking?

Here's my line of reasoning. There are three things that can really beat up the consumer credit market: availability of credit, interest rates and employment.

The fireworks seen so far are almost purely due to the availability of credit. Market participants have been scared by recent credit defaults and delinquencies, and so they are refusing to grant such markets more credit.

But, interest rates and employment are just as important, and they are doing great right now. Both look as good as they have since the 1950's and 1960's, with long term interest rates at 4-5% and unemployment down around 4-5%.

What would happen if this were to change, and why doesn't anybody seem to be discussing this?

I guaranty that if interest rates increase and employment starts to fall, you will see many more defaults and delinquencies. In other words, what we are witnessing in credit markets could just be the tip of the iceberg.

With Congress threatening 27.5% tariffs on Chinese goods and China threatening to sell the huge amount of US Government Treasury bonds they hold in response, the threat of higher interest rates is real. With credit market troubles in the US forcing the Fed to intervene and the dollar falling, higher interest rates are even more of a threat.

With the housing market supplying so many jobs since the 2001 recession and the housing market crashing, employment problems could just be surfacing. With recent retail sales so poor, additional employment problems could be rearing their ugly head, too.

I don't know how this will play out, but I'm watching it carefully. If the economy continues to be strong, then interest rates and employment will not be big concerns.

But, if the economy continues to slow, the dollar continues to fall, retails sales continue to look punk, the housing market continues to decline, or protectionist sentiment in Congress gains momentum, look out below!

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Graham and Dodd on guaranteed real-estate mortgages and mortgage bonds

I recently re-read--with pleasure--chapter XVII of the 1934 Edition of Security Analysis by Benjamin Graham and David Dodd. The chapter addresses guaranteed real-estate mortgages and mortgage bonds.

I re-read the section because I think it highlights the problems of mortgage insurance companies and other insurance companies that enter the business of guaranteeing the payment of mortgages and mortgage securities (such as surety businesses like bond insurers).

You see, the real estate boom of the 1920's led to a terrible real estate crash in the 1930's. It basically wiped out the mortgage insurance industry and many of the surety companies that ended up guaranteeing mortgage bonds. The history is illustrative for what can happen and what may be happening today.

I quote liberally from the text below (starting on page 184).

"The idea of underlying real-estate mortgage guarantees is evidently that of insurance."

"It is within the province of sound insurance practice to afford this protection in return for an adequate premium, provided of course, that all phases of the business are prudently handled. Such an arrangement will have the best chance of success if:
1. The mortgage loans are conservatively made in the first instance.
2. The guaranty or surety company is large, well managed, independent of the agency selling the mortgages, and has a diversification of business in fields other than real estate.
3. Economic conditions are not undergoing fluctuations of abnormal intensity.
The collapse in real-estate values after 1929 was so extreme as to contravene the third of these conditions."

"In the first place a striking contrast may be drawn between the way in which the business of guaranteeing mortgages had been conducted prior to about 1924 and the lax methods which developed there-after, during the very time that this part of the financial field was attaining its greatest importance."

"The amount of each mortgage was limited to not more than 60% of the value, carefully determined; large mortgages were avoided; and a fair diversification of risk...was attained." [loan to value ratios run very high today: 80%, 90% and even 95%]

"It is true also that the general practice of guaranteeing mortgages due only three to five years after their issuance contained the possibility, later realized, of a flood of maturing obligations at a most inconvenient time."

"The building boom which developed during the new era was marked by an enormous growth of the real-estate-mortgage business and of the practice of guaranteeing obligations of this kind."

"Great emphasis was laid upon the long record of success in the past, and the public was duly impressed...."

"The weakness of the mortgages themselves applied equally to the guarantees which were frequently attached thereto for an extra consideration."

"The rise of the newer and more aggressive real-estate-bond organizations had a most unfortunate effect upon the policies of the older concerns. By force of competition they were led to relax their standards of making loans."

"...the face amount of the mortgages guaranteed rose to so high a multiple of the capital of the guarantor companies that it should have been obvious that the guaranty would afford only the flimsiest of protection in the event of a general decline in values."

"When the real-estate market broke in 1931, the first consequence was the utter collapse of virtually every one of the newer real-estate-bond companies and their subsidiary guarantor concerns. As the depression continued, the older institutions gave way also."

"During the 1924-1930 period several of the independent surety and fidelity companies extended their operations to include the guaranteeing of real-estate mortgages for a fee or premium."

"...surety companies began the practice of guaranteeing real-estate-mortgage bonds only a short time prior to their debacle...."

"In most cases the resultant losses to the suretor were greater than it could stand; several companies were forced into receivership, and holders of bonds with such guarantees failed to obtain full protection."

Perhaps the real estate boom of the early 2000's was similar to that of the 1920's. If that is the case, and I believe it is to some degree, then Graham and Dodd's historical lesson served as a potent warning for investors in mortgage and bond insurance companies. Maybe that is why they have sold at such seemingly cheap prices over the years....

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

The Fed to the rescue?

The Fed, also known as the Federal Reserve, had to ride to the rescue of financial markets today and yesterday.

The market suffered from a liquidity crunch this week, which means that many investors were unwilling to put their money into markets. This causes a dry up of so-called liquidity, or ready money.

You see, most financial institutions operate on a lot of borrowed money. When they can't borrow money, their operations seize up for a lack of a better term.

The Fed came to the rescue by pumping $24 billion into the market in two transactions yesterday and $38 billion into the market in three transactions today, more than the $50 billion pumped into markets after 9/11. (As an aside, the European Central Bank pumped almost $200 billion into their markets to keep things going)

How does the Fed do this? They lend money to banks at low rates. Not surprisingly, the Fed does not create value from thin air, they must do something for this so-called liquidity to appear.

The long and short is that they "printed" money out of thin air for the banks to borrow. I put printed in quotes because it's almost all done electronically now, so the printing is purely in computer bits.

Does such market aid come at a cost? You betcha! Printing money faster than economic growth causes inflation. As Milton Friedman said, inflation is everywhere and always a monetary phenomenon.

Perhaps that is why the price of gold decoupled from the stock market today. You see, the gold market has been moving in conjunction with the stock market lately, which is very unusual. Today it stopped moving in conjunction with the stock market, though, perhaps indicating that buyers and sellers of gold recognized that the Fed printing money to rescue the financial system is just another way of saying, "Here comes some inflation for ya!"

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

What a roller coaster ride!

Boy have the markets been exciting lately!

After reaching a new intraday high of 14,121.04 on July 19th, the Dow Jones Industrial Average has plunged to an intraday low of 13,041.77 (a negative 7.6% return) on August 1st, and then hit an intraday high of 13,769.63 today (up 5.6%). That's quite a round trip in 20 days!

In the same time, bond yields, too, have plunged and then recovered to some degree. All this volume and price movement must be making some traders and brokers happy...

What does it all mean? I'm not going to act like I know, but I do know that market moves like this represent opportunity.

Sure enough, I took the opportunity to purchase a Real Estate Investment Trust for my income clients on August 1st. It was yielding almost 10% at that point and its price has already recovered 9.6% since I bought.

I don't see this as a chance to brag, because I know very well its price could plunge before I have a chance to publish this post. What I do want to highlight is the golden opportunity found in market volatility.

While some people panic, cooler heads find opportunities. It's not my area of specialty, but I guarantee you that some distressed debt gurus are out there picking up securities on the cheap that will pay them handsomely over time.

Market volatility equals market opportunity. Instead of panicking, go shopping instead.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Buying great businesses

When the market is volatile, like it has been lately, I like to look hard at the underlying businesses I own.

Specifically, I like to focus on the economics of each business (competitive advantages, industry dynamics, industry growth, etc.), each business's management (their long term track record, their business ownership, their pay structure, their focus on shareholder value, etc.) and each business's valuation (some measure each business's long term value relative to current price).

Every time I do this, especially when the market is volatile, I'm most happy with the great businesses I own. Why? Because looking at their fundamentals, I feel comfortable they will do well regardless of how much stock market prices fluctuate.

In fact, the best businesses seem to benefit disproportionately when the market seems most shaky. This is when great businesses buy things on the cheap, take advantage of weaker competitors, plan for the next upswing, etc.

And, looking at such great businesses makes me feel very comfortable with how my clients' and my own money are invested, because I know that when the market eventually recovers, we'll almost always recognize disproportionate benefits. That's a nice feeling to have.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Clampdown on risky mortgages

The Wall Street Journal had an interesting article today by James Hagerty and Ruth Simon titled "Lenders Broaden Clampdown on Risky Mortgages."

In it, they highlighted that "Jittery home-mortgage lenders are cutting off credit or raising interest rates for a growing portion of Americans."

As they say, "This worsening credit crunch threatens to put further pressure on the housing market."

The mortgages being effected aren't just subprime, but also included so-called Alt-A loans, a category in between prime and subprime. This illustrates how the credit crunch impacting the subprime market is spreading to other markets.

The articles quotes Thomas Lawler, a housing economist in Vienna, Va, who said the credit squeeze "will further crimp the effective demand for housing, and will make the late summer home-sales season even worse than the dismal spring season."

Also, American Home Mortgage Investment stopped making loans earlier this week and said late yesterday it would cease most operations and lay off over 6,000 employees. Accredited Home Lenders Holding is almost in as much trouble after auditors said its "financial and operational viability" is uncertain.

In other words, the so-called "contained" credit market squeeze continues to impact more and more markets and businesses. It's my guess that it will take years for this situation to fully work out and that players in the credit markets will see record stress before it's all over.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Beware the Black Swan

I've been babbling for several months now on this blog (and, as my wife can attest, for several years before that) about the risk of low probability, high impact events--what Nassim Taleb refers to as Black Swans--particularly related to the housing market.

It seems that chicken may finally be coming home to roost in the housing market and the markets that rely strongly on the housing industry.

Before I crow too loud about the malaise that is occurring, I must freely admit that I did not place any money-making bets on this decline. Quite the contrary, all I did was try to stay away from such a risk.

In staying away, I missed out on the huge run-up that has occurred in mortgage lenders, mortgage insurers, bond insurers, home builders, etc. This made me look pretty stupid in the short run, but right now I'm quite happy I don't own any companies in these industries.

Will these industries face a total collapse or a financial crisis? I have no idea. The odds are against it. But, like all Black Swans, I want to avoid such negative, low likelihood, high impact events.

I don't have to be able to predict when they will happen or how bad it will get, I simply have to stay away from risks I cannot accurately assess or that do not provide sufficient compensation for their risk.

I will be very interested to see how bad such housing related markets get, but I still don't think I'll be participating there for quite some time. After all, because it seems to be a Black Swan, I don't know how bad it will get, and so I'm staying away until I understand what's going on.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Have corporate profit margins reached a permanently high plateau...doubtful

James Montier of Dresdner Kleinwort has another great article out.

In it, he takes Jeremy Siegel to task for his recent assertion that profit margins will not revert to the mean (go back to their average level of the past or below) and will stay at their current, record highs.

Jeremy Siegel is famous for being a professor at the esteemed University of Pennsylvania Wharton School of Business as well as being the well known author of Stocks for the Long Run.

Siegel's argument is that U.S. based firms are deriving much more of their profits from fast-growing, overseas economies and that including private firms' profits with public firms' profits reduces the profit margins close to average.

Both of these arguments are suspect in Montier (and my) opinion.

As Jeremy Grantham puts it, if profit margins don't mean revert (go back to average), then capitalism is broken. Competition will always drive aggregate profit margins down over time. This is an iron law of free market economics.

As for private plus public firms' profit margins, the current margin of profits to Gross Domestic Product are at a 45 year high of 20%, far above the 16% average. Perhaps Siegel is looking at different numbers than Montier is.

Added to this, market history is littered with brilliant people who believe "it's different this time." As John Templeton put it, those are the four most dangerous words in investing.

A brilliant economist named Irving Fisher is famous for having said that stocks had hit a permanently high plateau in 1929. Unfortunately for Fisher's reputation, the stock market proceeded to crash by over 90% over the following 3 years. Perhaps Siegel is hoping to supplant Fisher...

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Jeremy Grantham "has almost never been this dire"

Jeremy Grantham heads one of the best quantitative, value-oriented firms out there, Grantham Mayo and Van Otterloo (referred to as GMO for short). In his quarterly letter (www.gmo.com, you have to register to read their letters, but it's worth it and I've never received a bit of unsolicited email from them), Grantham puts forward the same message he's been delivering for some time: the market is grossly over-valued.

Grantham has been preaching this for some time, but his record in being right, though almost always early, is excellent. Heeding his words back in the late 1990's would have saved you a lot of heart-ache if you were invested in the tech and telecom bubble.

Grantham's theme in the past focused on a reversion to the mean of corporate profit margins. In this letter, he doesn't spend much time on that subject, but he does take private equity, corporate tax rates, global financial markets, subprime mortgages, etc. to task. He simply sees too much risk taking out there and predicts it will end poorly.

I'll just quote Grantham here because he says it best, "To conclude, I have been trying to come up with a simple statement that would capture how serious the situation is for the overstretched, overleveraged financial system, and this is it: In 5 years I expect that at least one major "bank" (broadly defined) will have failed and that up to half the hedge funds and a substantial percentage of the private equity firms in existence today will have simply ceased to exist."

Wow, that's quite a prediction!

He goes on to say, "I have often been too bearish about the U.S. equity markets in the last 12 years (although bullish on emerging equity markets), but I think it is fair to say that my language has almost never been this dire. The feeling I have today is that of watching a very slow motion train wreck."

He's not mincing words there, either.

What's his suggested solution? In a word, "anti-risk." He doesn't take much time explaining what that means, but I think I can guess. Some investements will do a lot better than others if or when risk becomes a four-letter-word again. That may include shorting the market, buying commodities or gold, buying Treasury securities, or finding business managers who can benefit greatly in a market situation characterized by a lot of risk aversion.

In this last category, I'd put companies like Berkshire Hathaway, Leucadia and Fairfax Financial, companies that have a lot of cash on hand or are short the market and are waiting for a risk averse market to put their money to work. In the interest of full disclosure, I own positions in all three of these companies both personally and for clients.

A more risk averse market like we are facing usually scares people to death. In contrast, I see such situations as golden opportunities to buy when blood is running in the streets. In addition, I've purchased securities that I believe will do well even if the market does fair poorly.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Continued ripple effects

It's been interesting to watch how the fallout in credit markets has rippled across other markets.

The initial indication of credit market stress showed up as subprime problems during late winter and early spring of this year. At the time, many market commentators were saying it was isolated and contained.

Then, as expected, credit tightening continued to ripple across other markets as it became more difficult to raise high yield debt. This, too, was described as a short term and isolated situation.

Now, it sounds like prime home equity loans are having trouble as are auto loans. The ripples keep showing up in more and more places. And, the market commentators continue to declare that it's contained and short term.

Is this unusual? Not at all. This is exactly the type of thing that happens every time credit markets get too loose. As the credit market gets further and further away from its most recent problems, lower quality borrowers are loaned more and more money, or money is lent to borrowers at a rates not high enough to compensate for the risk involved.

At some point in time (forecasting if it will happen is easy, forecasting when is extraordinarily difficult), credit markets tighten again as lenders realize they have made bad loans.

This usually takes several years to unfold and almost always includes a large and "unexpected" crisis such as Long Term Capital Management in 1998, the Saving and Loan Crisis in the late 80's and early 90's, or the corporate credit squeeze in 2002.

I expect greater difficulties for banks (especially mortgage banks) that made bad loans, bond insurers that insured AAA tranches that were much more risky than they assumed, and mortgage insurers who looked only at recent data when pricing their insurance premiums.

At a later point in time, the market will become so disgusted that great buying opportunities will occur. I don't think that time is here, yet, but I also assume that smart investors will start buying long before the bottom is reached. I just may be in that group, too.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Just for fun

If you've ever wondered if you can pick stocks successfully, I've got a website I'd like to recommend to you: www.marketocracy.com

The concept of the site is that there may be many people out there that are good at managing money, but have never had the chance or are simply in a different career field.

Marketocracy allows you to start out with a theoretical portfolio of $1 million. You pick the stocks you think will beat the market, make theoretical buys and sell orders, and then can track your performance over time. The site allows yo to compare your performance to the Dow Jones Industrial Average, the S&P 500, the Nasdaq and the top 100 players on Marketocracy.

It's actually a lot of fun, too. I started a couple of fantasy portfolios there in the fall of 2001, and my picks have done pretty well. See here for yourself: Mike Rivers Mutual Fund and Rivers Capital. They've also let me experiment with some specific methods of applying the value investing philosophy before doing it in my own or my clients' accounts.

If you've ever wondered whether you're good at picking stocks, you may want to give Marketocracy a try. If you're good, you may want to start managing your own money, and if you're really good, perhaps you can become a professional money manager yourself!

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Credit spreads too thin?

John Mauldin's latest Thoughts from the Frontline Weekly Newsletter featured an excellent article by Michael Lewitt of Harch Capital Management.

The subject was the state of credit markets. This may seem like an unimportant subject to many observers, but it impacts the financial markets and global economy in ways most don't grasp.

Specifically, the article talked about how credit spread are still very thin compared to historical average. What are credit spreads? Generally, they are the difference between the yield on a risky credit (corporate debt, mortgage backed securities) compared to a non-risky credit, which is considered to be a government bill, note or bond depending on the maturity of the bond.

When the credit spread is wide, market participants are worried about credit risk and are demanding a large spread over risk-free securities. When the spread is thin, the market is unworried about credit risk and is demanding very little compensation over risk-free securities.

Historically, credit markets go through swings of greater and lesser toleration for credit risk. Typically, the market gets complacent after a long period of low defaults and then gets over-concerned after a short period of high defaults.

Right now, we have just recently come off some of the lowest credit spreads in history. The normal result is a market shake-up that returns low credit spreads to high credit spreads. These can be very disturbing events, as it was in 1998 when Long Term Capital Management collapsed.

Credit markets tend to reflect the market's toleration for bearing risk. When the market is complacent, it signals trouble may be ahead. When the market is worried, it frequently signals a great time to invest. In my opinion, we are on our way from complacent to worried, and that means opportunity lies ahead.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Reading list for investors

James Montier of Dresdner Kleinwort came out with a great letter recently. In it, he provides his recommended reading list as Investing 101.

The list includes classics like Graham and Dodd's 1934 edition of Security Analysis, Chapter 12 of Keynes's General Theory, Kindelberger's Manias, Panics and Crashes, and John Burr William's Theory of investment value. I've read all of these and found them very illuminating.

In the modern category, he includes Greenblatt's Little Book That Beats The Market, Taleb's Fooled by Randomness, and Dreman's Contrarian Investment strategies. Once again, I've read each and really benefited.

In his psychological section, he suggests a bunch of books I haven't read, but am very interested in such as Keith Stanovich's Robot's Rebellion, Tim Wilson's Stranger to Ourselves, and Thomas Gilovich's How we know what isn't so. Gilovich's title is enough to get my brain going.

His final category is hidden gems and also includes several books I haven't read, yet. This includes Phil Rosenzweig's Halo Effect, Robert Haugen's The Inefficient Stock Market, and Jason Zweig's Your Money and Your Brain. Halo Effect is particularly interesting because it covers how people characterize things as good based on a general impression and then mistakenly attribute favorable details based on their general impression. Before reading the book, I already know this is a great description of what goes on in financial markets every day.

His letter goes into much more detail about the books and why Montier recommends them.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Is now a good time to invest in the stock market?

To see a historical take on where we are now, read John Hussman's latest.

Using historical analysis, he shows that today's valuations do not bode well for long term returns on the overall stock market.

Enjoy!

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Why I love the 4th of July

I believe the 4th of July is the most meaningful holiday we have in the United States.

It celebrates not when we defeated the British. It celebrates not when we signed our Articles of Confederation nor our great Constitution. It celebrates not the Boston Tea Party nor the Battle of Lexington.

In other words, the 4th of July does not celebrate the means by which we became independent nor the specific manner by which we decided to govern ourselves, but the principle behind our new government.

You see, the principles are much more important than the means or the manner. Principles are a necessary precursor.

And, that is what we celebrate each July 4th. We celebrate our separation from a tyrannical government through our declaration that a proper government is not tyrannical. The founding fathers, Thomas Jefferson in particular, put into words the proper form of government and our justified reasons for desiring separation.

There may be fireworks, hot dogs, burgers and beer at most people's celebration, but the real reason for this holiday is the principle that we have the right to form our own government, and that our government exists solely to allow individuals to pursue their life, liberty and happiness.

And I think the celebration of profoundly important principles makes the 4th of July a truly unique and wonderful holiday.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

The problem with tax deferred investments

If you've read much about investing or financial planning, you've heard the mantra about investing in tax deferred plans.

These plans come in many different forms (traditional IRAs (Individual Retirement Accounts), Roth IRAs, Simple IRAs, SEP IRAs, 401(k)s, Roth 401(k)s, Thrift Savings Plans, etc.), but they all provide the benefit of tax deferred savings.

For most investors, the problem isn't understanding why tax deferred plans are a good idea, but in selecting what to do with the money they've put into these plans.

Most investors don't even invest in these plans, frequently because they are overwhelmed by the options.

Many leave it in low returning money market accounts or chase the performance of the most recent "winners," both ending up with poor returns, but for different reasons.

When my clients come to me with lists varying from 25 to 900 options, their question is always the same, "where should I put my money?"

I'll admit right off, the answer isn't easy. Because I make my living focusing on investments, I know how to pick good money managers. But there's no reason to expect everyone to know how to do this.

When a plumbing leak occurs in my house, I call a plumber. When my car needs its timing belt changed, I take it to a maintenance professional. But, most people try to make the choice of where to invest their money on their own.

They usually ask a friend or relative, because they can trust such people. The problem is that they may end up with the blind leading the blind. A person can be trustworthy and still not know what they're talking about. I wouldn't ask my dad to change my timing belt unless I thought he knew what the heck he was doing.

The problem is that picking a money manager is notoriously difficult. A whole profession of consultants has sprung up to help people make this choice. Most of them, unfortunately, are paid commissions to sell certain funds. Others are entranced by the mathematical analysis of short term performance, which has the same utility as examining goat entrails.

No, the best way to find a good money manager is to ask a good money manager. Good investment managers tend to watch what other money managers do, and they have to spend a lot of time figuring out who is really good and who is just lucky. Because I'm in the field and follow the best managers closely, I know who's good and who isn't.

The secret is to watch their process. If you just look at their results, you may just be seeing luck. Even 20 year records can be built on sand if their process is flawed. If you had asked the folks in New Orleans about the levy before and then after Katrina, you would have heard two very different opinions. Past performance is no guarantee of future results.

If their process is sound, the results will take care of itself, even if their record doesn't look great in the short term. In the late 1990s, a lot of money managers were dumped because "they didn't get the 'net." Look at their records now and you'll see that process is much more important than a 1, 3 or 5 year records, especially if you're investing for the long run.

To solve the problem with tax deferred investments, people will have to spend more time either learning how to pick managers, or in finding people who can pick managers. I think the best approach is to ask investment managers who are good investors themselves, and to focus on process over results.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

"Reasoning correctly from erroneous premises"

The quote above is from John Locke, but I found it second hand from Nassim Taleb's The Black Swan. Supposedly, it's Locke's definition of a madman.

In my opinion, this quote accurately describes the state of the art in academic finance and economics.

Although it may be hard to believe, the Nobel prize has been given out repeatedly to very smart people who are exemplars of the above quote.

As a result, the field of finance, economics and investing is populated with folks who seem to unquestioningly follow such teachings.

That's why most people are over-diversified and think risk equals volatility. The result is that most investors are under-protected from low probability, high impact, negative events and over-protected from low probability, high impact, positive events.

When a couple of Nobel laureates who exemplify the quote above followed their own advice, they lost almost all of their investors' money and nearly caused a temporary collapse in the world's financial system (if you think I'm exaggerating, read When Genius Failed by Roger Lowenstein).

Despite this paradigm shifting result, most market participants go right on assuming that erroneous premises can be followed with rigorously correct reasoning (and lots of higher math and Greek symbols).

Which reminds me of an apt definition of insanity: "doing the same thing over and over again and expecting different results" (Albert Einstein).

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Bill Gross's Investment Outlook

Bill Gross is a legend in the investing industry. He doesn't work, though, in the more glamorous equity side of investing. Instead, he is a bond market investor, and has one of the best long term records in the business.

Gross also happens to be an outstanding writer. I envy his ability to say a lot with few words, and to explain complex financial concepts with amusing analogies.

For these reasons, his monthly Investment Outlook is a must read for me. As usual, his Investment Outlook for this month didn't disappoint.

Gross takes to task the mortgage market, how it has performed and will perform in the future. His conclusion is that the fallout is not over, and that we're just looking at the tip of the mortgage iceberg.

He believes this is the case because many adjustable rate loans made over the last several years have yet to reset, and when they do, many more homeowners will punt their houses back to the market.

He also indicates that these problems will be felt in the Mortgage Backed Security (MBS) and Collaterlized Debt Obligation (CDO) markets. This, along with legislative action, will tighten credit and limit the number of people who can get new loans.

His conclusion is that the housing market will takes years to work through it's problems (tougher credit, high inventories of homes for sale, anchoring by home sellers), and that the Federal Reserve may soon cut rates in an attempt to limit such problems now that inflation is looking less threatening (according to their narrow metrics).

Am I planning on acting on this advice? I can't say I am. Unlike a bond market guru with institutional clients who demand short term performance, I don't need to forecast interest rates or try to guess what the housing market will do. But, I find his thinking very provocative, and it reinforces my desire to stay far away from companies that deal intimately with the housing or mortgage market.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.