"Prediction is very difficult, especially about the future" - Niels Bohr, Danish physicist
"...the function of the margin of safety is, in essence, that of rendering unnecessary an accurate estimate of the future." - Benjamin Graham, value investing "Dean"
Warren Buffett, probably the most successful investor alive, doesn't make earnings forecasts. He doesn't do what every MBA student is taught: build a model that forecasts future earnings over time. That doesn't mean the future isn't important to him. Quite the contrary. He is obsessed about the future!
But, that doesn't mean he makes forecasts. Why? Because forecasting is notoriously difficult. The records of various forecasters, whether historians, economists, political scientists, financiers, social scientists, and, especially, government bureaucrats, are terrible!
My own record here is exhibit #1. I like to forecast political and social outcomes, but my forecasting record is as dreadful as everyone else's.
But, isn't successful investing about forecasting the future? Doesn't one have to know what sector of the economy, which asset class, etc. will do best? No.
In fact, the records of those who try to do the above are as poor as everyone's. Those selling such forecasts want you to believe the future can be forecast, but if they were any good at it, they'd be making a fortune doing it instead of selling forecasts.
I can guarantee you, knowing the future would make you rich. But, that makes the rather huge assumption that you can do it successfully. I've never met or read about anyone who can. Like ESP, tons of people seem to think it's possible, but when submitted to scientific testing, proves lacking.
So what does Warren Buffett do? He studies the historic record intensely so that he understands a company, its industry, its competition, its competitive advantages and threats, its management, etc., then he pays a cheap price relative to that historic record.
He doesn't forecast earnings growth explicitly, but he does buy businesses with a record of growth and with all the expectations of future growth behind them. Its a qualitative rather than quantitative assessment.
Most importantly, he doesn't pay for future growth. The price he pays has a margin of safety, rendering an accurate forecast of the future unnecessary. If he pays a low enough price today, he'll get an acceptable return no matter what. If growth continues, and he spends gobs of time focusing on this qualitative aspect, his return will be better--perhaps much better.
That's it. No magic flutes, no crystal balls, no whirling dervishes. Just understand intimately a particular business (and no one understands what makes businesses tick like Buffett), pay a fair price for it, and let the qualitative tailwinds blow you on to wealth.
This is very contrary to what most investors, both professional and individual, do. Most investors spend the vast majority of their time trying to figure out what the future holds instead of studying the past and present with the same intensity. They make elaborate models with spreadsheets to forecast all the potential variables to the fourth decimal place.
The result isn't just that they don't understand the important variables of the past, the result is forecasts that are notoriously bad.
The average Wall Street analyst over-estimates business growth by 50% (businesses they study with great intensity and with unique access to industry insiders).
The average economist considers himself a hero if he gets the DIRECTION (not magnitude) of economic variables correct, and almost always miss major turning points (they have models of such mathematical complexity that physicists are intimidated by them).
I could go on, but you get the point. Forecasting is a dead end.
Contrary to all investing lore and conventional wisdom, this does not suggest broad diversification. Don't get me wrong, diversification is the right way to ride economic growth at minimum cost. But, if you want to do better than that, you need to concentrate on the very few things you can understand better than others.
As you may have guessed, that's an understanding of the past and present, not a brilliant forecast of the future.
If you study every cell phone company in great detail from quarter to quarter, and understand each of their technological, managerial, competitive, economic aspects, and you realize that one stands head and shoulders above the others, yet is selling at a very reasonable price, you may have a good investment. If, on the other hand, you recognize that the technological or competitive dynamics are such that you can't figure out who is and will stay on top, then you should move on to an industry where you can.
A tremendous amount of study and intellectual honesty is required to do this, but so few put in the effort that thar's gold in them thar hills.
Don't forecast. Study intensively the past and present, and pay a low price.
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.
Friday, May 13, 2011
Friday, May 06, 2011
The Fallacy of Too Big To Fail
I've tried to stay away from the Too Big to Fail discussion, but after doing research on the banking sector recently, I decided to put in my two cents.
First off, "too big" assumes some standard. It assumes that something of a certain size is "good," but when that size becomes "too" much, it becomes "bad." (What, like too much health, too much peace, too much prosperity, too much happiness, too much virtue?) By what standard? For what goal? By whose judgment? No data or references are provided by most of those who make this argument, which makes me suspicious right-off.
Lately, this argument has been made with respect to banks. "XYZ Bancorp is so large that it can take down the whole financial system" seems to be the implicit line of reasoning behind the Too Big to Fail discussion. Does that mean breaking XYZ into 10 or 100 or 1000 small banks that all fail at once is better simply because they are each small? Are lots of small failures good and one large failure bad? Is smallness somehow an implicit good? No.
I guarantee that if you break XYZ into lots of pieces that all have the same debt to equity ratios and loan exposures as XYZ as a whole, they will all fail at the same time. And, you'll end up in an even worse situation than if an integrated XYZ bank had failed. Too big or small isn't the issue, the real issue is leverage and loan exposure.
The Too Big to Fail argument assumes that somehow lots of smaller banks will not fail at the same time but one large one will. Oh, like lots of small banks did so much better than large banks because the housing market can't possibly crash nationally (note: I'm being sarcastic). Oops, that argument didn't float.
The housing sector crashed nationally and that almost took down our financial sector and the rest of the economy for reasons other than large banks. The banks were a symptom, not a cause.
If banks weren't back-stopped by the FDIC and Federal Reserve and driven to hold low equity to capital, they wouldn't have crashed due to too much leverage.
If home ownership weren't explicitly supported by Congress, the Executive branch, tax policy, FHA, GNMA, Fannie Mae and Freddie Mac (government supported enterprises), etc., then all kinds of mortgage derivative instruments would never have been created and crashed.
If the government hadn't driven the creation of rating agencies and given three of them exclusive control of debt ratings that banks, insurance companies, etc. must use in the purchasing of securities, then risky securities would never have had a huge, captive markets in the first place.
If the Federal Reserve weren't encouraging speculation with interest rates below free market equilibrium, there never would have been massive mis-allocation of capital to the housing sector all at once.
The only thing that seems too big here is government intervention in banking, housing, debt ratings, and interest rates.
Back when banking was more free (it's always had lots of government interference), banks carried 40% equity against 60% in liabilities. With government back-stopping and lots of regulation, that ratio is now 10% equity to 90% liabilities (it was 7%/93% right before the financial crisis). Perhaps things were safer when banking was more free.
The history of bank failures in the U.S. has smallness written all over it. Our regulatory structure has long encouraged lots of small banks. But, a small bank in Iowa is very likely to crash and depositors to be wiped out when an inevitable bad corn crop occurs. In contrast, a large bank with loans to corn farmers in Iowa, gold miners in Nevada, cotton growers in Mississippi, steel manufacturers in Indiana, orange growers in Florida, cheese producers in Wisconsin, etc. is unlikely to have all loans default at the same time, thus protecting depositors and borrowers.
Unless, of course, speculation is encouraged on a national level, or large banks are driven to hold 10% equity to 90% in liabilities. That doesn't happen, though, without national coordination--in other words: without a national regulatory structure that lines up the dominoes to fall at the same time and in the same direction.
If leverage and loan exposures were the problem, wouldn't greater regulation of those issues fix the problem? No. Not all banks are the same, and so no regulatory body can foresee all the potential business mix issues that might come up (only someone omniscient could). JPMorgan, with international operations, investment banking services, and proprietary trading operations, has very different risk exposures than U.S. Bancorp's community banks. You can't come up with one-size-fits all prescriptions for either debt ratios or loan exposures.
In addition, any attempt to prevent problems is more likely to create systemic risk, because a bunch of banks marching to the same music are much more likely to fall together than several separate banks marching to their own drummer (each might fall on their own, but not together systemically). This is the same reason why periodic recessions and small fires that burn the underbrush prevent catastrophic problems.
The road to hell is literally paved with good intentions--which frequently take the form of national (or international) regulation.
I can't help but point out one other blatant inconsistency of the Too Big to Fail argument. If bigness is inherently bad, then why have a BIG, super-governmental body to oversee, break-up, regulate and control banks or any other sector of the economy? Wouldn't its bigness be an inherent threat?
Please keep in mind, too, that no markets in the world are as highly regulated as housing and banking, the epi-center of our latest financial crisis. Big regulation didn't help there. In fact, I strongly argue it created the problem.
When looking at bigness, it's useful to recognize that the regulatory bodies are already much bigger and more powerful than the regulated. The Federal Reserve made $80.9 billion in "profits" last year (by trashing our currency and punishing savers, no less) compared to the two most profitable non-governmental businesses: Nestle's $37 billion and ExxonMobil's $30 billion. At least Nestle and ExxonMobil produced things people wanted to buy! I won't even mention the ridiculous spending power of other federal government branches.
If bigness is the problem, then banks or any other non-governmental businesses are the wrong target for concern. But, even there, the concern is not size, per se, but what an organization does.
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.
First off, "too big" assumes some standard. It assumes that something of a certain size is "good," but when that size becomes "too" much, it becomes "bad." (What, like too much health, too much peace, too much prosperity, too much happiness, too much virtue?) By what standard? For what goal? By whose judgment? No data or references are provided by most of those who make this argument, which makes me suspicious right-off.
Lately, this argument has been made with respect to banks. "XYZ Bancorp is so large that it can take down the whole financial system" seems to be the implicit line of reasoning behind the Too Big to Fail discussion. Does that mean breaking XYZ into 10 or 100 or 1000 small banks that all fail at once is better simply because they are each small? Are lots of small failures good and one large failure bad? Is smallness somehow an implicit good? No.
I guarantee that if you break XYZ into lots of pieces that all have the same debt to equity ratios and loan exposures as XYZ as a whole, they will all fail at the same time. And, you'll end up in an even worse situation than if an integrated XYZ bank had failed. Too big or small isn't the issue, the real issue is leverage and loan exposure.
The Too Big to Fail argument assumes that somehow lots of smaller banks will not fail at the same time but one large one will. Oh, like lots of small banks did so much better than large banks because the housing market can't possibly crash nationally (note: I'm being sarcastic). Oops, that argument didn't float.
The housing sector crashed nationally and that almost took down our financial sector and the rest of the economy for reasons other than large banks. The banks were a symptom, not a cause.
If banks weren't back-stopped by the FDIC and Federal Reserve and driven to hold low equity to capital, they wouldn't have crashed due to too much leverage.
If home ownership weren't explicitly supported by Congress, the Executive branch, tax policy, FHA, GNMA, Fannie Mae and Freddie Mac (government supported enterprises), etc., then all kinds of mortgage derivative instruments would never have been created and crashed.
If the government hadn't driven the creation of rating agencies and given three of them exclusive control of debt ratings that banks, insurance companies, etc. must use in the purchasing of securities, then risky securities would never have had a huge, captive markets in the first place.
If the Federal Reserve weren't encouraging speculation with interest rates below free market equilibrium, there never would have been massive mis-allocation of capital to the housing sector all at once.
The only thing that seems too big here is government intervention in banking, housing, debt ratings, and interest rates.
Back when banking was more free (it's always had lots of government interference), banks carried 40% equity against 60% in liabilities. With government back-stopping and lots of regulation, that ratio is now 10% equity to 90% liabilities (it was 7%/93% right before the financial crisis). Perhaps things were safer when banking was more free.
The history of bank failures in the U.S. has smallness written all over it. Our regulatory structure has long encouraged lots of small banks. But, a small bank in Iowa is very likely to crash and depositors to be wiped out when an inevitable bad corn crop occurs. In contrast, a large bank with loans to corn farmers in Iowa, gold miners in Nevada, cotton growers in Mississippi, steel manufacturers in Indiana, orange growers in Florida, cheese producers in Wisconsin, etc. is unlikely to have all loans default at the same time, thus protecting depositors and borrowers.
Unless, of course, speculation is encouraged on a national level, or large banks are driven to hold 10% equity to 90% in liabilities. That doesn't happen, though, without national coordination--in other words: without a national regulatory structure that lines up the dominoes to fall at the same time and in the same direction.
If leverage and loan exposures were the problem, wouldn't greater regulation of those issues fix the problem? No. Not all banks are the same, and so no regulatory body can foresee all the potential business mix issues that might come up (only someone omniscient could). JPMorgan, with international operations, investment banking services, and proprietary trading operations, has very different risk exposures than U.S. Bancorp's community banks. You can't come up with one-size-fits all prescriptions for either debt ratios or loan exposures.
In addition, any attempt to prevent problems is more likely to create systemic risk, because a bunch of banks marching to the same music are much more likely to fall together than several separate banks marching to their own drummer (each might fall on their own, but not together systemically). This is the same reason why periodic recessions and small fires that burn the underbrush prevent catastrophic problems.
The road to hell is literally paved with good intentions--which frequently take the form of national (or international) regulation.
I can't help but point out one other blatant inconsistency of the Too Big to Fail argument. If bigness is inherently bad, then why have a BIG, super-governmental body to oversee, break-up, regulate and control banks or any other sector of the economy? Wouldn't its bigness be an inherent threat?
Please keep in mind, too, that no markets in the world are as highly regulated as housing and banking, the epi-center of our latest financial crisis. Big regulation didn't help there. In fact, I strongly argue it created the problem.
When looking at bigness, it's useful to recognize that the regulatory bodies are already much bigger and more powerful than the regulated. The Federal Reserve made $80.9 billion in "profits" last year (by trashing our currency and punishing savers, no less) compared to the two most profitable non-governmental businesses: Nestle's $37 billion and ExxonMobil's $30 billion. At least Nestle and ExxonMobil produced things people wanted to buy! I won't even mention the ridiculous spending power of other federal government branches.
If bigness is the problem, then banks or any other non-governmental businesses are the wrong target for concern. But, even there, the concern is not size, per se, but what an organization does.
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.
Friday, April 29, 2011
Growing potential energy
They say patience is a virtue. That doesn't mean it's a whole lot of fun.
Sometimes, I feel like Bill Murray in Groundhog Day, waking up to the same day each and every day and wishing the cycle would end. Each day, I research individual companies with a focus on businesses with competitive advantages and good management selling at low prices. On rare days, when prices deviate enough from fundamentals to merit action, I do some buying and selling. And yet, the cheap companies keep getting cheaper and the expensive ones just get more expensive. I'm waiting patiently for this cycle to end, but it's not much fun.
Unlike Bill in the movie, I'm not trying anything radical to break out of the cycle. As Bill eventually discovers, the cycle ends not from bold or wild action, but from doing the right things. The cycle of the cheap getting cheaper and expensive getting more expensive will end, too. I just need to stay true to my purpose.
So, what allows me to maintain patience? Just like I know virtue leads to happiness and diet and exercise lead to weight loss, I know that buying cheap and selling expensive works over time. Added to this, I understand the concept of growing potential energy.
Potential energy is the result of a force acting on an object over time. When a spring is compressed, it has a lot of potential energy. That potential energy is eventually turned into kinetic energy when the spring is released.
The force, in this case, is crowd momentum causing the expensive to get more expensive. That force, applied over time, is compressing a metaphorical spring, conversely making the cheap become cheaper. That very process, though, leads to its own resolution. Because the system is not in equilibrium, the longer and further the spring is compressed, the more dramatic the eventual release of kinetic energy when the spring's potential energy is transformed.
I have to be patient because no one knows how long crowd momentum will compress the spring (6 years and running, so far). But, knowing that the spring is just getting more and more compressed, creating a growing reserve of potential energy, makes it easier to be patient. I know that the longer the spring is compressed, the greater the reward--the release of kinetic energy--once momentum runs its course.
Or, as 17th century philosopher Spinoza put it, all things excellent are as difficult as they are rare. I'm feeling keenly the difficult and rare part, in time I will gain the excellence as well.
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.
Sometimes, I feel like Bill Murray in Groundhog Day, waking up to the same day each and every day and wishing the cycle would end. Each day, I research individual companies with a focus on businesses with competitive advantages and good management selling at low prices. On rare days, when prices deviate enough from fundamentals to merit action, I do some buying and selling. And yet, the cheap companies keep getting cheaper and the expensive ones just get more expensive. I'm waiting patiently for this cycle to end, but it's not much fun.
Unlike Bill in the movie, I'm not trying anything radical to break out of the cycle. As Bill eventually discovers, the cycle ends not from bold or wild action, but from doing the right things. The cycle of the cheap getting cheaper and expensive getting more expensive will end, too. I just need to stay true to my purpose.
So, what allows me to maintain patience? Just like I know virtue leads to happiness and diet and exercise lead to weight loss, I know that buying cheap and selling expensive works over time. Added to this, I understand the concept of growing potential energy.
Potential energy is the result of a force acting on an object over time. When a spring is compressed, it has a lot of potential energy. That potential energy is eventually turned into kinetic energy when the spring is released.
The force, in this case, is crowd momentum causing the expensive to get more expensive. That force, applied over time, is compressing a metaphorical spring, conversely making the cheap become cheaper. That very process, though, leads to its own resolution. Because the system is not in equilibrium, the longer and further the spring is compressed, the more dramatic the eventual release of kinetic energy when the spring's potential energy is transformed.
I have to be patient because no one knows how long crowd momentum will compress the spring (6 years and running, so far). But, knowing that the spring is just getting more and more compressed, creating a growing reserve of potential energy, makes it easier to be patient. I know that the longer the spring is compressed, the greater the reward--the release of kinetic energy--once momentum runs its course.
Or, as 17th century philosopher Spinoza put it, all things excellent are as difficult as they are rare. I'm feeling keenly the difficult and rare part, in time I will gain the excellence as well.
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.
Friday, April 22, 2011
There's no free lunch
One of the most succinct propositions in economics is that there's no such thing as a free lunch. Put more plainly, when you think you're getting something for nothing, you'd best check your premises.
Take free Internet search. Is that really free? No, it's paid for by advertising. Free news from over-the-air broadcasters ABC, NBC and CBS? Advertising. Free advice from financial planners? Commissions on mutual fund sales. Free roads? Check out the taxes you pay on fuel. Free lunch from an insurance salesperson? Commissions, too (an insurance salesperson once bragged to me that he only needed 1 out of 20 people to buy insurance at those events--so you should know right away the "product" is a rip-off!).
There's no such thing as a free lunch.
In no case should this be more obvious than government support of the economy. Hey, if all it really took were the Federal Reserve printing money to promote prosperity, then Wiemar Germany and Zimbabwe would have been the most thriving economies in history. They weren't/aren't (both disasters on scales that make earthquakes and hurricanes economically boring in comparison).
And so, when the Fed ends it's quantitative easing program this summer, we should all be on the lookout for economic tremors. We ate the lunch, now the bill's coming due.
I'm actually quite surprised market participants have been short-sighted on this issue. I naively thought the quantitative easing program hinted at last summer would be seen for what it was--quite costly. Instead, the market started partying like it was 1999.
This attitude will, however, prove short-sighted. Unfortunately, John Q. Public has joined the stampede. As usual, he waited until the herd reached full speed, long after the lead steers saw the Fed's policy as a license to speculate. My guess is that he'll leap off the cliff only to look back and see the lead steers observing the slaughter from the sidelines.
So was it ever.
Perhaps we'll get a third round of quantitative easing and the day of reckoning will be put off. If so, that lunch will be no more free than the last several.
It will be interesting to observe how the lead steers react, and how long it takes for John Q. Public to learn that there are no free lunches.
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.
Take free Internet search. Is that really free? No, it's paid for by advertising. Free news from over-the-air broadcasters ABC, NBC and CBS? Advertising. Free advice from financial planners? Commissions on mutual fund sales. Free roads? Check out the taxes you pay on fuel. Free lunch from an insurance salesperson? Commissions, too (an insurance salesperson once bragged to me that he only needed 1 out of 20 people to buy insurance at those events--so you should know right away the "product" is a rip-off!).
There's no such thing as a free lunch.
In no case should this be more obvious than government support of the economy. Hey, if all it really took were the Federal Reserve printing money to promote prosperity, then Wiemar Germany and Zimbabwe would have been the most thriving economies in history. They weren't/aren't (both disasters on scales that make earthquakes and hurricanes economically boring in comparison).
And so, when the Fed ends it's quantitative easing program this summer, we should all be on the lookout for economic tremors. We ate the lunch, now the bill's coming due.
I'm actually quite surprised market participants have been short-sighted on this issue. I naively thought the quantitative easing program hinted at last summer would be seen for what it was--quite costly. Instead, the market started partying like it was 1999.
This attitude will, however, prove short-sighted. Unfortunately, John Q. Public has joined the stampede. As usual, he waited until the herd reached full speed, long after the lead steers saw the Fed's policy as a license to speculate. My guess is that he'll leap off the cliff only to look back and see the lead steers observing the slaughter from the sidelines.
So was it ever.
Perhaps we'll get a third round of quantitative easing and the day of reckoning will be put off. If so, that lunch will be no more free than the last several.
It will be interesting to observe how the lead steers react, and how long it takes for John Q. Public to learn that there are no free lunches.
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.
Wednesday, April 13, 2011
Creating instability
I don't envy the Federal Reserve. They have an impossible job. Can you imagine trying to set the price of t-shirts for the whole economy, much less the clearing price between suppliers and demanders of funds in capital markets?
No matter how hard you try, you'd always set interest rates too high or too low, or supply too much or too little money. This would lead to the inevitable shortages or surpluses that any Economics 101 course teaches to new students. If you don't believe me, please see the terrible record of any centrally planned economy.
And yet, the Federal Reserve still tries to make the economic system more stable through its control of the money supply and interest rates. You'd think they'd learn.
Their failure can be seen, most recently, in the swing of commodity prices and interest rates. Increasing the money supply to bring down interest rates has led to un-intended, but inevitable, consequences, like surging commodity prices and civil disorder in the third world.
The Fed keeps insisting that inflation is low by reference to a) the corrupt Consumer Price Index (CPI) and b) the spread between bonds with and without inflation protection.
The circular reasoning required for b) above just boggles the mind: 1) The economy is inherently unstable, so we need a Federal Reserve to prevent that instability from hurting people (they claim), 2) The Federal Reserve refers to free market interest rates (on the premise that market players aren't just reacting to Federal Reserve talk and action) to decide whether they need to intervene, 3) So, if the Federal Reserve is supposed to prevent an inherently unstable system from becoming unstable, why is it using supposedly unstable misinformation from that unstable system to validate its need to act or not?
It sounds like a recipe for creating an even more unstable system. And, so it has.
Below are three graphs. A) shows a stable system where equilibrium is restored with damped oscillations over time. B) shows a stable system where oscillations aren't damped, but the system returns to equilibrium periodically and doesn't fall apart. C) shows an unstable system where the oscillations become greater and greater until things blow up or whatever is causing the divergent oscillations is removed.
The claim is made that we need a Federal Reserve because the systems is inherently like B) or C) and the Fed will make things look like A). But, look at the graph below of S&P 500 profit margins. Does it look like the Federal Reserve is making A) happen, or C)? Looks a lot like C) to me!
It is my contention that the economic system is inherently like A) above, not B) or C), and that Fed intervention is turning the economy into first B) and then C) above.
This is by no means a proof or validation, but it should raise a question in your mind that perhaps markets should be setting interest rates and money supply just like it sets the price of t-shirt, TVs, computers and millions of other products. Every experience with price controls in history has led to surpluses and shortages, and yet we have a Federal Reserve trying to set the most important price in the economy--the price of money.
Maybe it's time to dampen our oscillations by removing the thing that's making our system unstable: the Federal Reserve.
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.
No matter how hard you try, you'd always set interest rates too high or too low, or supply too much or too little money. This would lead to the inevitable shortages or surpluses that any Economics 101 course teaches to new students. If you don't believe me, please see the terrible record of any centrally planned economy.
And yet, the Federal Reserve still tries to make the economic system more stable through its control of the money supply and interest rates. You'd think they'd learn.
Their failure can be seen, most recently, in the swing of commodity prices and interest rates. Increasing the money supply to bring down interest rates has led to un-intended, but inevitable, consequences, like surging commodity prices and civil disorder in the third world.
The Fed keeps insisting that inflation is low by reference to a) the corrupt Consumer Price Index (CPI) and b) the spread between bonds with and without inflation protection.
The circular reasoning required for b) above just boggles the mind: 1) The economy is inherently unstable, so we need a Federal Reserve to prevent that instability from hurting people (they claim), 2) The Federal Reserve refers to free market interest rates (on the premise that market players aren't just reacting to Federal Reserve talk and action) to decide whether they need to intervene, 3) So, if the Federal Reserve is supposed to prevent an inherently unstable system from becoming unstable, why is it using supposedly unstable misinformation from that unstable system to validate its need to act or not?
It sounds like a recipe for creating an even more unstable system. And, so it has.
Below are three graphs. A) shows a stable system where equilibrium is restored with damped oscillations over time. B) shows a stable system where oscillations aren't damped, but the system returns to equilibrium periodically and doesn't fall apart. C) shows an unstable system where the oscillations become greater and greater until things blow up or whatever is causing the divergent oscillations is removed.
The claim is made that we need a Federal Reserve because the systems is inherently like B) or C) and the Fed will make things look like A). But, look at the graph below of S&P 500 profit margins. Does it look like the Federal Reserve is making A) happen, or C)? Looks a lot like C) to me!
It is my contention that the economic system is inherently like A) above, not B) or C), and that Fed intervention is turning the economy into first B) and then C) above.
This is by no means a proof or validation, but it should raise a question in your mind that perhaps markets should be setting interest rates and money supply just like it sets the price of t-shirt, TVs, computers and millions of other products. Every experience with price controls in history has led to surpluses and shortages, and yet we have a Federal Reserve trying to set the most important price in the economy--the price of money.
Maybe it's time to dampen our oscillations by removing the thing that's making our system unstable: the Federal Reserve.
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.
Friday, April 08, 2011
Don't just do something, stand there!
We're a can-do people. From a young age, we're taught that effort leads to results. But, when it comes to investing, activity is not the same as effort. In other words, it is frequently better--as an investor--to stand there instead of doing something.
This is tough for can-do people to swallow. They want to trade and switch and act to achieve success. This may work well in many fields, but investing is not one of them. This is as true for professional as non-professional investors.
This point is well made in Michael Mauboussin's latest article, "The Coffee Can Approach."
Mauboussin's article refers to a professional investor's experience with a client. The client had copied some of the professional's initial investment choices in their own separate portfolio and then just forgotten about it for years. Over time, the forgotten portfolio had greatly out-performed the professional's own record. Some investments had done poorly, but others had done so well it was best to leave them alone. Instead of doing something, the professional investor--and his clients--would have been better off doing nothing after the initial allocation.
The difficulty is that this method takes great patience and many years to work out. If you examine your portfolio too frequently, you'll make changes that tend to yield sub-optimal results. Just as a watched pot doesn't boil, an over-examined portfolio doesn't grow.
This framework is born out by research from the investment field.
John Bogle found that exchange-trade fund (ETF) investors were on average under-performing the reported returns of the ETFs they invested in--by a whopping 4.5% a year! Why? Investors were buying things that had gone up and selling things that had gone down. They would have gotten significantly better returns if they had patiently stayed where they were.
Professional investors don't do much better. Institutional plan sponsors--usually investment committees of professionals--consistently fire managers that have recently done poorly and hire managers that have recently done well. The result: the fired managers subsequently out-perform the hired managers by a wide margin. Plan participants would have been significantly better off if plan sponsors had left things alone.
People, both professionals and non-professionals, tend to evaluate investment managers over three year periods. And yet, research indicates that you need a period of a decade or more to confidently conclude a manager has skill.
In fact, some research suggests that only 35% of skilled managers show up in the top 10% over 1 year periods, and only 50% of skilled managers show up in the top 10%--even with a 10 year evaluation period!
When it comes to investing, picking good investments or good managers should focus much more on the initial decision, and then being patient with that choice over time. Without a doubt, this is hard for can-do people to embrace.
The evidence, however, is clear: recent out-performance is no guarantee of future out-performance, and recent under-performance is no proof of poor future performance. With investing--once an good initial decision is made--it's better to stand there than do something.
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.
This is tough for can-do people to swallow. They want to trade and switch and act to achieve success. This may work well in many fields, but investing is not one of them. This is as true for professional as non-professional investors.
This point is well made in Michael Mauboussin's latest article, "The Coffee Can Approach."
Mauboussin's article refers to a professional investor's experience with a client. The client had copied some of the professional's initial investment choices in their own separate portfolio and then just forgotten about it for years. Over time, the forgotten portfolio had greatly out-performed the professional's own record. Some investments had done poorly, but others had done so well it was best to leave them alone. Instead of doing something, the professional investor--and his clients--would have been better off doing nothing after the initial allocation.
The difficulty is that this method takes great patience and many years to work out. If you examine your portfolio too frequently, you'll make changes that tend to yield sub-optimal results. Just as a watched pot doesn't boil, an over-examined portfolio doesn't grow.
This framework is born out by research from the investment field.
John Bogle found that exchange-trade fund (ETF) investors were on average under-performing the reported returns of the ETFs they invested in--by a whopping 4.5% a year! Why? Investors were buying things that had gone up and selling things that had gone down. They would have gotten significantly better returns if they had patiently stayed where they were.
Professional investors don't do much better. Institutional plan sponsors--usually investment committees of professionals--consistently fire managers that have recently done poorly and hire managers that have recently done well. The result: the fired managers subsequently out-perform the hired managers by a wide margin. Plan participants would have been significantly better off if plan sponsors had left things alone.
People, both professionals and non-professionals, tend to evaluate investment managers over three year periods. And yet, research indicates that you need a period of a decade or more to confidently conclude a manager has skill.
In fact, some research suggests that only 35% of skilled managers show up in the top 10% over 1 year periods, and only 50% of skilled managers show up in the top 10%--even with a 10 year evaluation period!
When it comes to investing, picking good investments or good managers should focus much more on the initial decision, and then being patient with that choice over time. Without a doubt, this is hard for can-do people to embrace.
The evidence, however, is clear: recent out-performance is no guarantee of future out-performance, and recent under-performance is no proof of poor future performance. With investing--once an good initial decision is made--it's better to stand there than do something.
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.
Thursday, March 31, 2011
Market history...simplified
Though I disagree with George Santayana's pragmatist philosophy, I couldn't agree more with his remark that "Those who cannot remember the past are condemned to repeat it." I have thus endeavored to become a student of stock market history to avoid the condemned thing.
Market history is boring and frustrating to think about for most, but I will try here to simplify it for you. Tell me how I do.
Stocks are priced, over time, relative to the earnings of underlying companies. Sometimes market participants are optimistic and willing to pay a lot for underlying earnings, sometimes they are pessimistic and willing to pay little, and most of the time they are somewhere in between.
Briefly, in March 2009, investors were pessimistic enough to demand 16% returns. At present, they are happily accepting less than 4% returns.
With that very brief and simplified market history, let me be bold now and predict the future. Please wait a second while I gaze into my crystal ball...
...I see people getting less than 4% returns in the future, I see them getting very pessimistic at times, very optimistic at others, and spending the majority of the time in between.
Okay, I don't really have a crystal ball, but that's what will happen if you invest in the market today. The past will repeat and those who haven't learned will being doing the condemned thing.
Oh, and by the way, you don't have to invest in the market. Instead, you can--right now--buy pessimistically priced companies and sell optimistically priced ones. That's another lesson of market history, but it's not as simple.
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.
Market history is boring and frustrating to think about for most, but I will try here to simplify it for you. Tell me how I do.
Stocks are priced, over time, relative to the earnings of underlying companies. Sometimes market participants are optimistic and willing to pay a lot for underlying earnings, sometimes they are pessimistic and willing to pay little, and most of the time they are somewhere in between.
- 20% of the time they are optimistic: happily accepting less than 4% annualized returns to buy stocks
- 15% of the time they are pessimistic: demanding 16% or greater returns to buy stocks
- 65% of the time they are in between: expecting something between 4% and 16% returns from stocks
Briefly, in March 2009, investors were pessimistic enough to demand 16% returns. At present, they are happily accepting less than 4% returns.
With that very brief and simplified market history, let me be bold now and predict the future. Please wait a second while I gaze into my crystal ball...
...I see people getting less than 4% returns in the future, I see them getting very pessimistic at times, very optimistic at others, and spending the majority of the time in between.
Okay, I don't really have a crystal ball, but that's what will happen if you invest in the market today. The past will repeat and those who haven't learned will being doing the condemned thing.
Oh, and by the way, you don't have to invest in the market. Instead, you can--right now--buy pessimistically priced companies and sell optimistically priced ones. That's another lesson of market history, but it's not as simple.
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.
Friday, March 25, 2011
Invert, always invert
I'm very proud of my investing record over the last 6 years as a professional (beating roughly 80% of my competitors) and the last 15 years as an individual (beating the S&P 500 by over 4.5% annualized), but it could always use improvement. For, as Goethe put it, "he who moves not forward, goes backward."
With that in mind, I've spent a lot of the last few months reviewing my investment process and looking for ways to improve. One of the most important lessons I have derived is the importance of not investing in things that go down a lot.
Now, this may seem perfectly obvious to you, but it's hard when one is busy with day to day research and portfolio management to focus on the downside instead of the upside.
In fact, I'd go so far as to say that most people focus too much on the upside--myself included. Most people seem to believe that hitting the ball out of the park is the way to win baseball games, when in fact it has more to do with not striking out and getting base hits.
So it is with investing. I'm a devoted fan of Warren Buffett, so this thinking should be more implicit in what I do. Buffett describes his two investing rules quite simply:
I was struck recently with how little I've devoted to this side of the process. How do you not lose money? Don't invest in things that go down a lot. If you avoid blow-ups, then the upside will take care of itself.
Charlie Munger, Buffett's business partner, likes to quote famed German mathematician, Carl Gustav Jacob Jacobi, on this issue. Jacobi told his students to "invert, always invert" (the quote on Wikipedia is "man muss immer umkehren," which I translate as "one must always invert"). What Jacobi meant was that many problems can be solved backwards by inverting the problem.
For example, do you want to know how to be happy? Instead of trying to figure out how to be happy by examining happiness or looking at what happy people do, look for what you absolutely know will make you unhappy and then don't do that. See the subtle difference?
If I study business successes, I may find out what common characteristics business successes possess, but that's not the whole picture. I must also look to see if business failures share those same characteristics to avoid hasty generalization. Perhaps 5 businesses were successful by selling widgets and 95 were failures, so looking only at the 5 successes may lead me to falsely conclude that selling widgets is the way to success. I must also study the failures to see the full truth.
With that in mind, I can invert the problem as Jacobi suggests. What causes businesses to fail? If I know the answer well, and that business successes don't do it, then I can avoid blow-ups by avoiding businesses with failure characteristics. Invert, always invert, indeed.
So, not surprisingly, I've decided to become a student on what makes businesses fail. By inverting the problem to avoid failures, I will ensure greater success in my investing results.
Thank you Buffett, Munger and Jacobi.
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.
With that in mind, I've spent a lot of the last few months reviewing my investment process and looking for ways to improve. One of the most important lessons I have derived is the importance of not investing in things that go down a lot.
Now, this may seem perfectly obvious to you, but it's hard when one is busy with day to day research and portfolio management to focus on the downside instead of the upside.
In fact, I'd go so far as to say that most people focus too much on the upside--myself included. Most people seem to believe that hitting the ball out of the park is the way to win baseball games, when in fact it has more to do with not striking out and getting base hits.
So it is with investing. I'm a devoted fan of Warren Buffett, so this thinking should be more implicit in what I do. Buffett describes his two investing rules quite simply:
- Rule #1: don't lose money
- Rule #2: don't forget rule #1
I was struck recently with how little I've devoted to this side of the process. How do you not lose money? Don't invest in things that go down a lot. If you avoid blow-ups, then the upside will take care of itself.
Charlie Munger, Buffett's business partner, likes to quote famed German mathematician, Carl Gustav Jacob Jacobi, on this issue. Jacobi told his students to "invert, always invert" (the quote on Wikipedia is "man muss immer umkehren," which I translate as "one must always invert"). What Jacobi meant was that many problems can be solved backwards by inverting the problem.
For example, do you want to know how to be happy? Instead of trying to figure out how to be happy by examining happiness or looking at what happy people do, look for what you absolutely know will make you unhappy and then don't do that. See the subtle difference?
If I study business successes, I may find out what common characteristics business successes possess, but that's not the whole picture. I must also look to see if business failures share those same characteristics to avoid hasty generalization. Perhaps 5 businesses were successful by selling widgets and 95 were failures, so looking only at the 5 successes may lead me to falsely conclude that selling widgets is the way to success. I must also study the failures to see the full truth.
With that in mind, I can invert the problem as Jacobi suggests. What causes businesses to fail? If I know the answer well, and that business successes don't do it, then I can avoid blow-ups by avoiding businesses with failure characteristics. Invert, always invert, indeed.
So, not surprisingly, I've decided to become a student on what makes businesses fail. By inverting the problem to avoid failures, I will ensure greater success in my investing results.
Thank you Buffett, Munger and Jacobi.
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.
Wednesday, March 16, 2011
China Rising?
So much ink has been spilled--especially over the last several years--about the rise of China that I wanted to devote a blog to the subject.
I won't bury the lead: I believe China is more likely another Japan than another United States on the rise. My goal is not so much to tell the future--I don't know what will happen--as much as it is to cast doubt on the overwhelming consensus of China's inevitable rise to supremacy.
What consensus you might ask? That China's economy will inevitably surpass the U.S.'s in the next 10, 20, or 30 years; that China will surpass the U.S. in technological superiority; that China will surpass the U.S. militarily; that China will surpass the U.S. in every way possible, it seems.
All of these things very well may come to pass. But, it is not written in the stars, and the consensus view is almost entirely built on an extrapolation of current trends--a technique of forecasting which is almost never accurate.
As an interesting illustration of forecasting difficulty, I'd like exhibit #1 to be Paul Kennedy's excellent book, The Rise and Fall of the Great Powers. Now, granted, this book came out in 1987, when Japan's ascendancy was widely accepted as given, but it's a wonderful example of how someone extremely knowledgeable in a specific field can suffer from the biases of extrapolation.
In his book, he speaks of the 5 centers of power at the time: the U.S., the U.S.S.R., Japan, China and the European Economic Community. He spells out how clearly Japan is surpassing or going to surpass the U.S. in computers, robotics, telecommunications, automobiles, trucks, ships, biotechnology and aerospace.
Please understand, he was writing in 1987, when Japan Inc. was thought to be unbeatable, buying up property all over the world, technologically unstoppable. He didn't know Japan would fall into an economic funk a mere two years later where Japan's economy wouldn't grow for the next 22 years (nor did he see the fall of the U.S.S.R. coming, and even seems to poo-poo the idea). So much for Japan Inc. and extrapolation of the past.
But, really, how could anyone really think that Japan would surpass the U.S. in computers and software? Or biotechnology and aerospace? Yes, Japan has definitely done better in robotics, automobiles and ships, but to provide such a long and overwhelming list as a historian? A bit naive, I think.
The consensus view on China reminds me in many ways of the view 20 years ago of Japan. Don't get me wrong, Japan and China are very different stories, but people's perception seems to be similar.
Just as China's centrally planned economy and "state capitalism" (an oxymoron if there ever was one) is seen as the wave of the future and a better way to govern, so Japan's Ministry for International Trade and Industry (MITI) and it's coordination of economic activity was seen as a huge advantage over the U.S.'s capitalism.
Just as China's production of engineers and scientists is seen as an unstoppable force, so was Japan's. Just as China's high research and development budget is seen as superior, so was Japan's.
Just as China's high national savings rate is seen as an advantage over the U.S.'s consumption, so was Japan's. Just as China's superiority in aptitude tests is seen as intellectually over-powering the U.S.'s poor scores, so was Japan's.
I believe people make these extrapolations because they don't really understand the sources of growth. They simply expect the recent past to keep going, but it almost never does.
Just as Japan's extraordinary growth came from adopting western technology and industry and having huge western markets to sell to, so does China's. If either Japan or China had had to create these industries from scratch, as the U.K. and U.S. had done, the growth would never have materialized. And, just as Japan's economy has demonstrated over the last 20 years, if China ever has to rely on it's own consumers and businessmen for innovation and growth, you'll see growth fall off a cliff.
Neither Japan nor China invented the Bessemer process, or assembly lines, or transistors, or binary computer logic, or almost any of the other major innovations which allowed them to grow. They got it all from the west.
And, this brings me back to my blog of two weeks ago, where I said that return on capital is the most important concept in finance. You see, neither Japan nor China view return on capital as a primary concept. Japanese businessmen are frequently on record saying that the U.S.'s focus on shareholder returns is ridiculous. China is a communist state that sees returns on investment as a mere means to other ends.
The U.S. and U.K., at least during periods of innovation, let returns on capital as determined by individuals allocate resources, instead of some central planning bureaucracy. The U.S. and U.K., thanks to intellectual greats like Adam Smith (a moral philosopher, not economist), recognized that human potential was unlocked when individuals were able to pursue their self-interest, as long as there was a rule of law and, specifically, protection of property rights.
Good luck finding that intellectual framework in Japan or China.
In forecasting the future, this return on capital concept is vital to accuracy.
If the U.S. abandons its focus on return on capital (as the U.K. has in most ways done), good-bye growth and innovation, good-bye technological and military superiority, good-bye world leadership.
If Japan adopts a focus on return on capital at the individual level, which I believe is possible over time (perhaps in the next decade) welcome back growth and innovation.
If China adopts a focus on return on capital at the level of the individual--an unlikely route, in my opinion--it can become a leading state. Without that focus, growth will eventually crash and burn as it did in Japan (China is witnessing a boom in real estate, just as Japan did before its crash--coincidence?).
Forecasting China or U.S. over the next 30 years seems a bit silly without a focus on return on capital, but the consensus opinion is that it's a done deal--China will be supreme.
I beg to differ because I don't believe large population, numbers of engineers, test scores or central planning are the lifeblood of growth, but the innovation of individuals who produce high returns on capital for their own 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.
I won't bury the lead: I believe China is more likely another Japan than another United States on the rise. My goal is not so much to tell the future--I don't know what will happen--as much as it is to cast doubt on the overwhelming consensus of China's inevitable rise to supremacy.
What consensus you might ask? That China's economy will inevitably surpass the U.S.'s in the next 10, 20, or 30 years; that China will surpass the U.S. in technological superiority; that China will surpass the U.S. militarily; that China will surpass the U.S. in every way possible, it seems.
All of these things very well may come to pass. But, it is not written in the stars, and the consensus view is almost entirely built on an extrapolation of current trends--a technique of forecasting which is almost never accurate.
As an interesting illustration of forecasting difficulty, I'd like exhibit #1 to be Paul Kennedy's excellent book, The Rise and Fall of the Great Powers. Now, granted, this book came out in 1987, when Japan's ascendancy was widely accepted as given, but it's a wonderful example of how someone extremely knowledgeable in a specific field can suffer from the biases of extrapolation.
In his book, he speaks of the 5 centers of power at the time: the U.S., the U.S.S.R., Japan, China and the European Economic Community. He spells out how clearly Japan is surpassing or going to surpass the U.S. in computers, robotics, telecommunications, automobiles, trucks, ships, biotechnology and aerospace.
Please understand, he was writing in 1987, when Japan Inc. was thought to be unbeatable, buying up property all over the world, technologically unstoppable. He didn't know Japan would fall into an economic funk a mere two years later where Japan's economy wouldn't grow for the next 22 years (nor did he see the fall of the U.S.S.R. coming, and even seems to poo-poo the idea). So much for Japan Inc. and extrapolation of the past.
But, really, how could anyone really think that Japan would surpass the U.S. in computers and software? Or biotechnology and aerospace? Yes, Japan has definitely done better in robotics, automobiles and ships, but to provide such a long and overwhelming list as a historian? A bit naive, I think.
The consensus view on China reminds me in many ways of the view 20 years ago of Japan. Don't get me wrong, Japan and China are very different stories, but people's perception seems to be similar.
Just as China's centrally planned economy and "state capitalism" (an oxymoron if there ever was one) is seen as the wave of the future and a better way to govern, so Japan's Ministry for International Trade and Industry (MITI) and it's coordination of economic activity was seen as a huge advantage over the U.S.'s capitalism.
Just as China's production of engineers and scientists is seen as an unstoppable force, so was Japan's. Just as China's high research and development budget is seen as superior, so was Japan's.
Just as China's high national savings rate is seen as an advantage over the U.S.'s consumption, so was Japan's. Just as China's superiority in aptitude tests is seen as intellectually over-powering the U.S.'s poor scores, so was Japan's.
I believe people make these extrapolations because they don't really understand the sources of growth. They simply expect the recent past to keep going, but it almost never does.
Just as Japan's extraordinary growth came from adopting western technology and industry and having huge western markets to sell to, so does China's. If either Japan or China had had to create these industries from scratch, as the U.K. and U.S. had done, the growth would never have materialized. And, just as Japan's economy has demonstrated over the last 20 years, if China ever has to rely on it's own consumers and businessmen for innovation and growth, you'll see growth fall off a cliff.
Neither Japan nor China invented the Bessemer process, or assembly lines, or transistors, or binary computer logic, or almost any of the other major innovations which allowed them to grow. They got it all from the west.
And, this brings me back to my blog of two weeks ago, where I said that return on capital is the most important concept in finance. You see, neither Japan nor China view return on capital as a primary concept. Japanese businessmen are frequently on record saying that the U.S.'s focus on shareholder returns is ridiculous. China is a communist state that sees returns on investment as a mere means to other ends.
The U.S. and U.K., at least during periods of innovation, let returns on capital as determined by individuals allocate resources, instead of some central planning bureaucracy. The U.S. and U.K., thanks to intellectual greats like Adam Smith (a moral philosopher, not economist), recognized that human potential was unlocked when individuals were able to pursue their self-interest, as long as there was a rule of law and, specifically, protection of property rights.
Good luck finding that intellectual framework in Japan or China.
In forecasting the future, this return on capital concept is vital to accuracy.
If the U.S. abandons its focus on return on capital (as the U.K. has in most ways done), good-bye growth and innovation, good-bye technological and military superiority, good-bye world leadership.
If Japan adopts a focus on return on capital at the individual level, which I believe is possible over time (perhaps in the next decade) welcome back growth and innovation.
If China adopts a focus on return on capital at the level of the individual--an unlikely route, in my opinion--it can become a leading state. Without that focus, growth will eventually crash and burn as it did in Japan (China is witnessing a boom in real estate, just as Japan did before its crash--coincidence?).
Forecasting China or U.S. over the next 30 years seems a bit silly without a focus on return on capital, but the consensus opinion is that it's a done deal--China will be supreme.
I beg to differ because I don't believe large population, numbers of engineers, test scores or central planning are the lifeblood of growth, but the innovation of individuals who produce high returns on capital for their own 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.
Friday, March 11, 2011
An investment advisor's most important job
Before deciding to have a child, my wife and I did a tremendous amount of research on how best to parent. It occurred to us both, early on, that one of our jobs would be to comfort her when she was cast down, and challenge her when she was feeling too self-satisfied.
This reminds me, in a lot of ways, of what an investment advisor must do for clients.
Too many investment advisors are eager to give clients what they want, not what they need (we all know how that parenting style works). In such a relationship, the advisor benefits at the expense of clients. Not good.
Most investors get overly excited about market prospects after investments have made big gains, then become overly despondent when investments tank. This is not some great sin on the part of investors--it's a well tested and documented human tendency.
Investors who don't exhibit this tendency, and there are quite a few, don't really need an investment advisor. If they tend to zig when others are zagging, their investment results are likely to be very good without the help and expertise of an advisor.
Investors who exhibit the all-too-human tendency referenced above, however, do need the help of an adivsor. In fact, I would argue it's the advisor's most important job to prevent clients from buying at market tops and selling at market bottoms.
I've made this focus the centerpiece of client communications. When markets look frothy, I write client letters and blogs that express concern and cautious action. When markets look abandoned, I express enthusiasm and a need for bold action.
This is vitally important, because most investors won't get anywhere close to meeting their retirement goals if they buy at tops and sell at bottoms. If you need concrete examples, please see any of the multitude of studies showing how unprepared baby boomers are for retirement.
So, it was with great distress that I read an article in SmartMoney today highlighting that 1/3 of advisors moved client dollars out of the stock market and into conservative investments (cash and bonds, mostly) in 2009 and early 2010.
In other words, those advisors were doing just the opposite of their most important job. Instead of talking clients off the ledge, they were facilitating their jump.
Even if you could argue that those clients needed to get out of the market for psychological reasons (can't sleep at night), I would further suggest they didn't belong in the market to begin with, and that their advisor should have been the one to figure that out before the market tanked.
Any advisor worth their salt should have been able to see that in early March 2009, the stock market looked likely to provide 20% annualized returns in the future (10% earnings yield, plus 6% economic growth, plus 4% dividend yield). This is not rocket science, but many investment advisors panicked just like their clients.
It's like a pilot running up and down the isles of an airplane with an engine fire instead of soberly resolving the problem. Such a pilot is clearly not doing their job, and neither is such a panicky investment advisor.
Can you imagine if 1/3 of pilots panicked like passengers when problems occurred? No one would be willing to fly on an airplane!
And, yet, investors have and will continue to pick investment advisors based on their community involvement and winning personality, instead of their sober-minded expertise and an ability to deal successfully with psychological stress.
Perhaps investors will learn their lesson this time, and turn to advisors who give them what they need, not what they want.
After all, isn't that a parent's job, 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.
This reminds me, in a lot of ways, of what an investment advisor must do for clients.
Too many investment advisors are eager to give clients what they want, not what they need (we all know how that parenting style works). In such a relationship, the advisor benefits at the expense of clients. Not good.
Most investors get overly excited about market prospects after investments have made big gains, then become overly despondent when investments tank. This is not some great sin on the part of investors--it's a well tested and documented human tendency.
Investors who don't exhibit this tendency, and there are quite a few, don't really need an investment advisor. If they tend to zig when others are zagging, their investment results are likely to be very good without the help and expertise of an advisor.
Investors who exhibit the all-too-human tendency referenced above, however, do need the help of an adivsor. In fact, I would argue it's the advisor's most important job to prevent clients from buying at market tops and selling at market bottoms.
I've made this focus the centerpiece of client communications. When markets look frothy, I write client letters and blogs that express concern and cautious action. When markets look abandoned, I express enthusiasm and a need for bold action.
This is vitally important, because most investors won't get anywhere close to meeting their retirement goals if they buy at tops and sell at bottoms. If you need concrete examples, please see any of the multitude of studies showing how unprepared baby boomers are for retirement.
So, it was with great distress that I read an article in SmartMoney today highlighting that 1/3 of advisors moved client dollars out of the stock market and into conservative investments (cash and bonds, mostly) in 2009 and early 2010.
In other words, those advisors were doing just the opposite of their most important job. Instead of talking clients off the ledge, they were facilitating their jump.
Even if you could argue that those clients needed to get out of the market for psychological reasons (can't sleep at night), I would further suggest they didn't belong in the market to begin with, and that their advisor should have been the one to figure that out before the market tanked.
Any advisor worth their salt should have been able to see that in early March 2009, the stock market looked likely to provide 20% annualized returns in the future (10% earnings yield, plus 6% economic growth, plus 4% dividend yield). This is not rocket science, but many investment advisors panicked just like their clients.
It's like a pilot running up and down the isles of an airplane with an engine fire instead of soberly resolving the problem. Such a pilot is clearly not doing their job, and neither is such a panicky investment advisor.
Can you imagine if 1/3 of pilots panicked like passengers when problems occurred? No one would be willing to fly on an airplane!
And, yet, investors have and will continue to pick investment advisors based on their community involvement and winning personality, instead of their sober-minded expertise and an ability to deal successfully with psychological stress.
Perhaps investors will learn their lesson this time, and turn to advisors who give them what they need, not what they want.
After all, isn't that a parent's job, 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.
Friday, March 04, 2011
The most important concept in finance
I was going to write a blog about why I think China looks more like developing Japan (with the same dreadful destination) than developing America, but realized I just couldn't get there without an intermediate step.
That intervening step may seem like a minor point, but I believe it's the most important concept in finance and one of the most important in economics: return on capital.
Okay, of the 10 people reading this blog, I just lost 80% with that last sentence, so thanks for sticking around remaining 2!
Return on capital probably seems like either a very mundane or overly abstract concept. Everyone knows that for any financing to work, the financier must get his capital back and then some. Otherwise, why bother, right?
But, it seems like people frequently drop this context when they discuss broader issues.
Take college loans for example. If you lend someone more money than they could possibly repay to go to college, it's not economic. But, you've got to do the math to really grasp this concept.
If you lend someone $100,000 to go to college, and they earn a degree that pays $20,000 a year, then it would take 20% of their pay ($4,000) for the rest of their life just to service a 4% interest rate--and that's without paying any of the principal!
No intelligent financier would ever make such a loan, yet most people think the financier is being mean. What they should recognize is that such a loan is bad for the borrower and society just as much as for the financier--such a loan saddles the borrower for life and reduces the productive capacity and standard of living for the whole economy. It's not mean, it's just a plain stupid.
In 2006, I would have been laughed at for suggesting that many home loans were being done under the same uneconomic conditions. I hope that 2007-2009 has convinced most people of the soundness of this logic. If you can't get a positive return on capital, it screws up the whole economy and wrecks the lives of those involved. If you can't get a positive return on capital, it's not financial or economic, it's charity.
Society does not grow and prosper by charity, it requires a positive return on capital. For those who wish we were ants or that reality was other than it is, this may be a real downer, but that's the way it is.
In order to meet our current and growing needs, we need to produce more this year than last, and the only way to do that is to get a positive return on capital.
What, exactly, does that term mean, anyway? It means if you borrow $10 from someone, you need to be able to pay them back the $10 plus whatever makes it worth their time. Or, more importantly, it means that you need to do something with that $10 that will generate $10 plus interest.
Or, more fundamentally, it means that if you buy 10 pieces of wood for $10, you better be able to turn those 10 pieces of wood into something worth more than $10, or you're wasting your time and someone else's money.
Or, even more fundamentally, if you don't produce something worth more than $10, then you've reduced the productive capital available and thus lowered everyone's standard of living (please see Peter Schiff's How an Economy Grows and Why It Crashes for an excellent, very readable, and more thorough illustration).
This is not a minor point, I hope you can see. If you lend someone $10 and they can only pay back $9, it's not just bad for you, it's bad for them and for the rest of society. Those 10 dollars were earned by your time, effort and resources, which you can never get back. That $1 is done, gone, kaput!
Perhaps dollars is an inadequately concrete way to describe this point. Suppose you had 10 pieces of wood and you destroyed one by fire without producing any product or service. Nothing you can do will bring that piece of wood back. That wood can't be used for fuel, or be turned into furniture, or anything else ever again. Time and effort would have to be expended to gain a new piece of wood--time and effort could have been used productively instead of simply bringing things back to the way they were before.
Return on capital isn't just nice to have, it is a very concrete description of what is necessary to maintain and grow our standard of living. We must use our resources wisely such that they produce more and more each year.
It's the bedrock upon which our world is built, and if taken too lightly, our foundation and prosperity will suffer.
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.
That intervening step may seem like a minor point, but I believe it's the most important concept in finance and one of the most important in economics: return on capital.
Okay, of the 10 people reading this blog, I just lost 80% with that last sentence, so thanks for sticking around remaining 2!
Return on capital probably seems like either a very mundane or overly abstract concept. Everyone knows that for any financing to work, the financier must get his capital back and then some. Otherwise, why bother, right?
But, it seems like people frequently drop this context when they discuss broader issues.
Take college loans for example. If you lend someone more money than they could possibly repay to go to college, it's not economic. But, you've got to do the math to really grasp this concept.
If you lend someone $100,000 to go to college, and they earn a degree that pays $20,000 a year, then it would take 20% of their pay ($4,000) for the rest of their life just to service a 4% interest rate--and that's without paying any of the principal!
No intelligent financier would ever make such a loan, yet most people think the financier is being mean. What they should recognize is that such a loan is bad for the borrower and society just as much as for the financier--such a loan saddles the borrower for life and reduces the productive capacity and standard of living for the whole economy. It's not mean, it's just a plain stupid.
In 2006, I would have been laughed at for suggesting that many home loans were being done under the same uneconomic conditions. I hope that 2007-2009 has convinced most people of the soundness of this logic. If you can't get a positive return on capital, it screws up the whole economy and wrecks the lives of those involved. If you can't get a positive return on capital, it's not financial or economic, it's charity.
Society does not grow and prosper by charity, it requires a positive return on capital. For those who wish we were ants or that reality was other than it is, this may be a real downer, but that's the way it is.
In order to meet our current and growing needs, we need to produce more this year than last, and the only way to do that is to get a positive return on capital.
What, exactly, does that term mean, anyway? It means if you borrow $10 from someone, you need to be able to pay them back the $10 plus whatever makes it worth their time. Or, more importantly, it means that you need to do something with that $10 that will generate $10 plus interest.
Or, more fundamentally, it means that if you buy 10 pieces of wood for $10, you better be able to turn those 10 pieces of wood into something worth more than $10, or you're wasting your time and someone else's money.
Or, even more fundamentally, if you don't produce something worth more than $10, then you've reduced the productive capital available and thus lowered everyone's standard of living (please see Peter Schiff's How an Economy Grows and Why It Crashes for an excellent, very readable, and more thorough illustration).
This is not a minor point, I hope you can see. If you lend someone $10 and they can only pay back $9, it's not just bad for you, it's bad for them and for the rest of society. Those 10 dollars were earned by your time, effort and resources, which you can never get back. That $1 is done, gone, kaput!
Perhaps dollars is an inadequately concrete way to describe this point. Suppose you had 10 pieces of wood and you destroyed one by fire without producing any product or service. Nothing you can do will bring that piece of wood back. That wood can't be used for fuel, or be turned into furniture, or anything else ever again. Time and effort would have to be expended to gain a new piece of wood--time and effort could have been used productively instead of simply bringing things back to the way they were before.
Return on capital isn't just nice to have, it is a very concrete description of what is necessary to maintain and grow our standard of living. We must use our resources wisely such that they produce more and more each year.
It's the bedrock upon which our world is built, and if taken too lightly, our foundation and prosperity will suffer.
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.
Friday, February 25, 2011
Investing records and political handicapping
The investors with the best records over the last decade have proven themselves more adept than others at navigating the shifting investment landscape.
Is it because they're better at valuing businesses, digging into financial statements, analyzing competitive advantages, assessing the ability of management, forecasting economic outcomes? No.
Great investing records over the last 10 years have been generated by correctly assessing how, when and where the government will intervene.
Betting on AIG, Citigroup, Bank of America, General Motors, General Electric, and so on, before or shortly after the government bailed them out has made fortunes for a handful of hedge and mutual fund managers. AIG, et al., should have gone bankrupt, and their share prices properly reflected that reality. But, when Uncle Sam intervened, lumps of useless coal were transformed into valuable diamonds. No one investing more prudently could beat such out-size returns.
Investors who have correctly forecast the Federal Reserve's frequent and haphazard interventions have rung up major dollars, too. If they had been wrong, they would have lost their fortunes. But, they were right.
I'm not drawing attention to conspiracy, here, because I don't believe a conspiracy exists. Those investors with the best records have simply better realized that the investing landscape has changed, and that correctly guessing Uncle Sam's intervention is the new way to make big dollars.
Am I envious of such results? In a way, yes. I wish I had been more perceptive that the game had changed. But, in another way, I'm not at all envious.
First, guessing Uncle Sam's next move may win for a while, but it will eventually fail. Even Uncle Sam's pockets aren't infinitely full of economic stimulus.
Second, correctly guessing Uncle Sam's next move is as much a matter of luck as skill. Just because someone wins the lottery or makes $10,000 in Vegas doesn't mean that's the way to plan for retirement. Lady Luck will eventually come to collect the bill.
No, I'm quite satisfied to invest prudently, if unspectacularly, and slowly build wealth over time. Just because the new game is popular and seems more profitable (remember the dot-com craze of 1999 or flipping houses in 2005?) doesn't mean the old rules no longer apply. They do.
Eisenhower warned of the military-industrial complex in his 1961 Presidential farewell address. Did he know it would become the military-real estate-banking-automobile-pharmaceutical-tobacco-airline-firefighter-teacher-investment banking-college funding-steel manufacturing-etc.-industrial complex?
If he had, I think he, too, would have looked at Roman and British history and said such complexes are nothing new, and always end 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.
Is it because they're better at valuing businesses, digging into financial statements, analyzing competitive advantages, assessing the ability of management, forecasting economic outcomes? No.
Great investing records over the last 10 years have been generated by correctly assessing how, when and where the government will intervene.
Betting on AIG, Citigroup, Bank of America, General Motors, General Electric, and so on, before or shortly after the government bailed them out has made fortunes for a handful of hedge and mutual fund managers. AIG, et al., should have gone bankrupt, and their share prices properly reflected that reality. But, when Uncle Sam intervened, lumps of useless coal were transformed into valuable diamonds. No one investing more prudently could beat such out-size returns.
Investors who have correctly forecast the Federal Reserve's frequent and haphazard interventions have rung up major dollars, too. If they had been wrong, they would have lost their fortunes. But, they were right.
I'm not drawing attention to conspiracy, here, because I don't believe a conspiracy exists. Those investors with the best records have simply better realized that the investing landscape has changed, and that correctly guessing Uncle Sam's intervention is the new way to make big dollars.
Am I envious of such results? In a way, yes. I wish I had been more perceptive that the game had changed. But, in another way, I'm not at all envious.
First, guessing Uncle Sam's next move may win for a while, but it will eventually fail. Even Uncle Sam's pockets aren't infinitely full of economic stimulus.
Second, correctly guessing Uncle Sam's next move is as much a matter of luck as skill. Just because someone wins the lottery or makes $10,000 in Vegas doesn't mean that's the way to plan for retirement. Lady Luck will eventually come to collect the bill.
No, I'm quite satisfied to invest prudently, if unspectacularly, and slowly build wealth over time. Just because the new game is popular and seems more profitable (remember the dot-com craze of 1999 or flipping houses in 2005?) doesn't mean the old rules no longer apply. They do.
Eisenhower warned of the military-industrial complex in his 1961 Presidential farewell address. Did he know it would become the military-real estate-banking-automobile-pharmaceutical-tobacco-airline-firefighter-teacher-investment banking-college funding-steel manufacturing-etc.-industrial complex?
If he had, I think he, too, would have looked at Roman and British history and said such complexes are nothing new, and always end 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.
Friday, February 18, 2011
You say you want a revolution?
We in the United States of America romanticize revolution. After all, our revolution ended in the greatest country in the world, so it must be good for others, right?
Well, not always.
Take, for example, the French Revolution of 1789. It occurred 13 years after our Declaration of Independence, but ended in the Reign of Terror and Napoleon steamrolling Europe and Russia. France is now on their 5th Republic and still trying to get it right. You say you want a revolution?
Or, take the Russian Revolution of 1917. It was supposed to free the oppressed people of Russia from the yoke of the Czar (isn't it mind-boggling that we now use this term to denote our government figures: Auto Czar, Drug Czar, Energy Czar, etc.?). Instead of a worker's paradise, they got Stalin, purges, millions dead by murder and famine, and Nazi slaughter.
Or, for instance, the Chinese Revolution of 1949. Chairman Mao, millions dead of murder and famine, Cultural Revolution (there's that word again!), etc. You say you want a revolution? Okay this story is, currently, going better than France and Russia, but that came about without a revolution.
For those who think potential revolutions in the Middle East are necessarily a good thing, it's time to review the history of revolutions. They don't all end happily.
The western press was quick to assume the 1979 Iranian Revolution was a good thing, too. It wasn't (unless you're one of the goons in charge, I suppose). The press thought the English speaking people they interviewed represented the revolution, but Islamic clerics were pulling the strings and ended up in charge. You say you want a revolution?
I'm not saying all revolutions end badly, but enough of them do that they shouldn't all be greeted gladly. Things in the Middle East may get better through revolution, but don't count on it.
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.
Well, not always.
Take, for example, the French Revolution of 1789. It occurred 13 years after our Declaration of Independence, but ended in the Reign of Terror and Napoleon steamrolling Europe and Russia. France is now on their 5th Republic and still trying to get it right. You say you want a revolution?
Or, take the Russian Revolution of 1917. It was supposed to free the oppressed people of Russia from the yoke of the Czar (isn't it mind-boggling that we now use this term to denote our government figures: Auto Czar, Drug Czar, Energy Czar, etc.?). Instead of a worker's paradise, they got Stalin, purges, millions dead by murder and famine, and Nazi slaughter.
Or, for instance, the Chinese Revolution of 1949. Chairman Mao, millions dead of murder and famine, Cultural Revolution (there's that word again!), etc. You say you want a revolution? Okay this story is, currently, going better than France and Russia, but that came about without a revolution.
For those who think potential revolutions in the Middle East are necessarily a good thing, it's time to review the history of revolutions. They don't all end happily.
The western press was quick to assume the 1979 Iranian Revolution was a good thing, too. It wasn't (unless you're one of the goons in charge, I suppose). The press thought the English speaking people they interviewed represented the revolution, but Islamic clerics were pulling the strings and ended up in charge. You say you want a revolution?
I'm not saying all revolutions end badly, but enough of them do that they shouldn't all be greeted gladly. Things in the Middle East may get better through revolution, but don't count on it.
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.
Friday, February 11, 2011
In praise of recessions
Parenting is simple, but not easy.
What I mean by that statement is that it's not hard to figure out what to do as a parent (simple), but it's frequently difficult to implement in practice (not easy).
Little Vivian wants a glass of apple juice, but it's an hour and a half before dinner and she'd prefer to drink apple juice 24/7 rather than eat any solid food--ever!
I have a choice: I can give her the apple juice she so much desires and worry she won't eat the food she needs, or I can give her some non-apple-juice options to make sure she'll be hungry for dinner.
It's easy to give her the apple juice, right? But, will it result in the long run outcome I want? Probably not. So, I offer her water and tell her she doesn't want to ruin her appetite for dinner.
The first several times I provide this option, Vivian--like any self-respecting 3-year-old-- breaks down in tears. Not being entirely hard-hearted, I feel sympathy at the cutest screaming fit you've ever seen (not easy).
I know the right option (simple), but I dread the implementation (not easy).
After 3 iterations of this process, though, Vivian no longer breaks down and cries. She expects this outcome and goes about her life quite happily knowing she can't have what she wants whenever she wants it.
And so it is with the economy, too. Knowing human nature, it's easy to see that people take things to excesses at times. Whether keg parties, American Idol, Nuremberg rallies, or investment fads, people tend to herd in ways that aren't necessarily best for their long term well-being.
Every once in a while, economic excesses need to be purged, too, and that is what I think recessions do. Investors, consumers, regulators, etc. get caught up in herd behavior, periodically, and recessions allow mis-allocated resources get re-allocated back to productive (positive return on capital) uses.
It's easy to understand this process is necessary, assuming you understand human tendencies (simple), but it's unpleasant (not easy) to watch the resulting pain inflicted.
I'm not hard-hearted enough to enjoy watching people become unemployed any more than I like watching my daughter collapse in tears. But, I must consider the alternative.
If we try to prevent recessions, is the long term outcome better or worse? Giving my daughter the apple juice prevents short term pain (for both her and me), but creates long term problems. And, so it is with recessions.
Preventing recessions leads to a build-up of bigger and bigger problems. Periodic purges prevent major disastrous purges. If you don't believe me, consider the Great Recession of 2008-2009, the Great Depression, and Japan's lost decade.
In each case, political intervention was intended to keep the economy on stable footing. The hope was to prevent short-term pain, but with little regard for long term consequences.
I think an analogy to nature here is useful. A catastrophic fire occurred in Yellowstone National Park in 1988 that burned several orders of magnitude more acres of forest than had been experienced in the past (please see Mark Buchanan's Ubiquity for more information).
At first, experts were bewildered at the damage and what could have caused it. Over time, though, they began to recognize that not letting forest fires occur occasionally had led to a super-critical state where a catastrophic fire was inevitable.
In other words, the attempt to prevent small periodic fires had caused a major forest fire that wouldn't have even been possible without preventing small fires.
I believe the same thing is at work in the economy. Small periodic recessions are good for purging the under-growth of our economic forest. Without such small recessions, a super-critical state is created. The attempt to prevent small recessions is the cause of large, disastrous ones.
And so, I praise small periodic recessions as the necessary prevention for big, terrible ones. It's time to take some short term pain that is necessary, but not easy, rather than face the long term calamities that are simply not necessary.
It's time for the parents to say no to the kids who want something that's bad for their long term well-being.
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 I mean by that statement is that it's not hard to figure out what to do as a parent (simple), but it's frequently difficult to implement in practice (not easy).
Little Vivian wants a glass of apple juice, but it's an hour and a half before dinner and she'd prefer to drink apple juice 24/7 rather than eat any solid food--ever!
I have a choice: I can give her the apple juice she so much desires and worry she won't eat the food she needs, or I can give her some non-apple-juice options to make sure she'll be hungry for dinner.
It's easy to give her the apple juice, right? But, will it result in the long run outcome I want? Probably not. So, I offer her water and tell her she doesn't want to ruin her appetite for dinner.
The first several times I provide this option, Vivian--like any self-respecting 3-year-old-- breaks down in tears. Not being entirely hard-hearted, I feel sympathy at the cutest screaming fit you've ever seen (not easy).
I know the right option (simple), but I dread the implementation (not easy).
After 3 iterations of this process, though, Vivian no longer breaks down and cries. She expects this outcome and goes about her life quite happily knowing she can't have what she wants whenever she wants it.
And so it is with the economy, too. Knowing human nature, it's easy to see that people take things to excesses at times. Whether keg parties, American Idol, Nuremberg rallies, or investment fads, people tend to herd in ways that aren't necessarily best for their long term well-being.
Every once in a while, economic excesses need to be purged, too, and that is what I think recessions do. Investors, consumers, regulators, etc. get caught up in herd behavior, periodically, and recessions allow mis-allocated resources get re-allocated back to productive (positive return on capital) uses.
It's easy to understand this process is necessary, assuming you understand human tendencies (simple), but it's unpleasant (not easy) to watch the resulting pain inflicted.
I'm not hard-hearted enough to enjoy watching people become unemployed any more than I like watching my daughter collapse in tears. But, I must consider the alternative.
If we try to prevent recessions, is the long term outcome better or worse? Giving my daughter the apple juice prevents short term pain (for both her and me), but creates long term problems. And, so it is with recessions.
Preventing recessions leads to a build-up of bigger and bigger problems. Periodic purges prevent major disastrous purges. If you don't believe me, consider the Great Recession of 2008-2009, the Great Depression, and Japan's lost decade.
In each case, political intervention was intended to keep the economy on stable footing. The hope was to prevent short-term pain, but with little regard for long term consequences.
I think an analogy to nature here is useful. A catastrophic fire occurred in Yellowstone National Park in 1988 that burned several orders of magnitude more acres of forest than had been experienced in the past (please see Mark Buchanan's Ubiquity for more information).
At first, experts were bewildered at the damage and what could have caused it. Over time, though, they began to recognize that not letting forest fires occur occasionally had led to a super-critical state where a catastrophic fire was inevitable.
In other words, the attempt to prevent small periodic fires had caused a major forest fire that wouldn't have even been possible without preventing small fires.
I believe the same thing is at work in the economy. Small periodic recessions are good for purging the under-growth of our economic forest. Without such small recessions, a super-critical state is created. The attempt to prevent small recessions is the cause of large, disastrous ones.
And so, I praise small periodic recessions as the necessary prevention for big, terrible ones. It's time to take some short term pain that is necessary, but not easy, rather than face the long term calamities that are simply not necessary.
It's time for the parents to say no to the kids who want something that's bad for their long term well-being.
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.
Friday, February 04, 2011
All returns are not created equal
In my last two blogs, I wrote about 1) measuring what matters most: after-fee, after-tax returns and 2) capital preservation: maintaining purchasing power as the prime directive of investing.
Now, I want to bring those two thoughts together with a third: all returns are not created equal.
Just as investors place undo emphasis on 1) tax avoidance and low fees instead of actual returns, and 2) volatility and "safe" securities instead of the risk of permanent loss and after-inflation purchasing power, I believe investors also commit a third sin: 3) undo emphasis on returns earned over some arbitrary period instead of the process by which those returns were generated.
A quick example here should illustrate my point.
Suppose you were given the choice to invest for the next 10 years with two money managers: Firm C or Firm M. Suppose, too, that you were presented with their 5 year investing records: Firm C: -6% loss over 5 years; Firm M: +6% gain over 5 years.
For most people (and for me in the past), this is an easy choice. Over 5 years Firm M has earned a positive 6% return and Firm C has lost 6%, so go with Firm M, right?
But, wait! How were those returns achieved? Let's examine each firm's annual returns over the last 5 years:
As a thought experiment, I put these two investing firms against each other. Each year, one bets $1,000 that a 6-sided die will land on 1 and get paid $4,500, and the other takes that bet (hoping the die lands on 2 through 6). In my example, Firm M is making the bet and Firm C is taking the bet.
Now, perhaps, you're not so sure you want to invest with Firm M! Sounds more like gambling than investing? Yes, precisely.
Each year, Firm M has a 1-in-6 chance of gaining $4,500 and a 5-in-6 chance of losing $1,000. Although Firm M's investing record looked pretty good over the last 5 years (because the way the die just happened to roll those 5 times), you may not feel too comfortable now that you know how the return was generated.
In fact, the next 10 years have a very high likelihood of Firm M losing 4.2% a year and Firm C gaining 4.2% a year. That's where the firm names came from: M is for Madoff and C is for Casino. The odds were on the casino's side all along, even though the record looked bad over those five years, and the odds were always against Madoff.
And, that's the point I'd like to make. Most investors look at an investing record and believe past is prologue. But, the past is rarely the best judge of the future. Instead, the right way to judge returns is by examining the method used.
Two investing firms can have the exact same investing record, but one can generate returns by taking bad bets (and getting lucky) and the other by taking good bets. You need to figure out which firm is taking good bets to generate satisfactory returns in the future.
This is particularly the case today. Some firms have deceivingly weak records over the last several years because they've taken smart bets and the die has rolled against them. Other firms have brilliant-looking records although they've taken bad bets and the die has rolled in their favor.
Only by looking behind the curtain will you see if there is a real wizard or a blathering fake. It may seem trivial or time-consuming, but understanding how returns are generated is much more important than the return record itself--future returns will depend on it (as Madoff so ably illustrated).
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.
Now, I want to bring those two thoughts together with a third: all returns are not created equal.
Just as investors place undo emphasis on 1) tax avoidance and low fees instead of actual returns, and 2) volatility and "safe" securities instead of the risk of permanent loss and after-inflation purchasing power, I believe investors also commit a third sin: 3) undo emphasis on returns earned over some arbitrary period instead of the process by which those returns were generated.
A quick example here should illustrate my point.
Suppose you were given the choice to invest for the next 10 years with two money managers: Firm C or Firm M. Suppose, too, that you were presented with their 5 year investing records: Firm C: -6% loss over 5 years; Firm M: +6% gain over 5 years.
For most people (and for me in the past), this is an easy choice. Over 5 years Firm M has earned a positive 6% return and Firm C has lost 6%, so go with Firm M, right?
But, wait! How were those returns achieved? Let's examine each firm's annual returns over the last 5 years:
- $100,000 invest with Firm C
- Year 1: -4.5%, $95,500
- Year 2: +1.0%, $96,500
- Year 3: +1.0%, $97,500
- Year 4: +1.0%, $98,500
- Year 5: -4.6%, $94,000
- $100,000 invested in Firm M
- Year 1: +4.5%, $104,500
- Year 2: -1.0%, $103,500
- Year 3: -1.0%, $102,500
- Year 4: -1.0%, $101,500
- Year 5: +4.4%, 106,000
As a thought experiment, I put these two investing firms against each other. Each year, one bets $1,000 that a 6-sided die will land on 1 and get paid $4,500, and the other takes that bet (hoping the die lands on 2 through 6). In my example, Firm M is making the bet and Firm C is taking the bet.
Now, perhaps, you're not so sure you want to invest with Firm M! Sounds more like gambling than investing? Yes, precisely.
Each year, Firm M has a 1-in-6 chance of gaining $4,500 and a 5-in-6 chance of losing $1,000. Although Firm M's investing record looked pretty good over the last 5 years (because the way the die just happened to roll those 5 times), you may not feel too comfortable now that you know how the return was generated.
In fact, the next 10 years have a very high likelihood of Firm M losing 4.2% a year and Firm C gaining 4.2% a year. That's where the firm names came from: M is for Madoff and C is for Casino. The odds were on the casino's side all along, even though the record looked bad over those five years, and the odds were always against Madoff.
And, that's the point I'd like to make. Most investors look at an investing record and believe past is prologue. But, the past is rarely the best judge of the future. Instead, the right way to judge returns is by examining the method used.
Two investing firms can have the exact same investing record, but one can generate returns by taking bad bets (and getting lucky) and the other by taking good bets. You need to figure out which firm is taking good bets to generate satisfactory returns in the future.
This is particularly the case today. Some firms have deceivingly weak records over the last several years because they've taken smart bets and the die has rolled against them. Other firms have brilliant-looking records although they've taken bad bets and the die has rolled in their favor.
Only by looking behind the curtain will you see if there is a real wizard or a blathering fake. It may seem trivial or time-consuming, but understanding how returns are generated is much more important than the return record itself--future returns will depend on it (as Madoff so ably illustrated).
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.
Friday, January 28, 2011
Capital preservation
Investing is not as complex as most in the field like to make it out to be. Economists, financial planners, market strategists, professors of finance and economics, etc. like to make the field seem more difficult to grasp than it is. Not surprisingly, this serves their interests.
In the Middle Ages, when hardly anyone could read or understand Latin, men of the church had a stranglehold on religious doctrine. If you wanted to understand or get guidance on the most important issues of the time, you had to go through the men of the church. This served the church's interests well.
And, so it is now with investing. Today's clergymen of finance work hard to cloak the simplicity of investing in higher math, floating abstractions, mindless charts, confusing terms. Their efforts are not to clarify, but to obfuscate; for, if you're completely confused, then you'll need their help!
(As an amusing aside: a former investing boss of mine, in criticizing my writing ability, complained that I wasn't writing in a sufficiently high-minded way. He told me that magazines and newspapers were written at an 8th grade level, and so was my writing, but he wanted it at an 11th or 12th grade level. When I commented that it might make the writing unintelligible to many of his clients, he said that was okay because his clients would prefer someone who sounded smart over actually understanding!)
So, why do I claim that investing is simple? I read a description of investing 16 years ago that made perfect sense and was simple, and I've used it ever since. This description, from Benjamin Graham and David Dodd's Security Analysis, 1934:
No mention of alpha, beta, standard deviation, diversification, macro-economic forecasting, the efficient frontier, small cap blend, negative correlation, optimized portfolios. You're investing if you 1) do thorough analysis, and 2) invest in securities that promise a) safety of principal and b) a satisfactory return.
If you don't do thorough analysis or hire someone who doesn't, it's not investing, it's speculation. No stock tips, no hunches, no astrology, no gut feel, no "I just know...", no buying lots of everything--just thorough analysis.
If you invest in securities that don't promise--first--safety of principal and--second--a satisfactory return, then you're not investing, you're speculating. A lot of investors focus on that second part, the satisfactory return part, but few put the emphasis necessary on the first part (which Graham and Dodd correctly made primary).
Many financial planners and investment advisors give lip service to safety of principal, or capital preservation, but few give it the attention it needs. This lip service to capital preservation is frequently waved away with the magic of diversification. If you put your eggs in many baskets, they say, then there's no way all your eggs will break at once.
2008, or any other financial crisis in history for that matter, should put that notion to rest. Unfortunately, it hasn't. Putting your eggs in poorly built baskets, no matter how many of them, is unwise.
Capital preservation is also framed in terms of volatility. If the basket goes up and down a lot, they say, you'll get scared. Fear is a relevant issue, but it's not the same as capital preservation. Capital preservation is whether the eggs break or remain whole, not whether they are jostled or swung about.
Capital preservation means you get back what you put in. Not volatility, not fear, but whether you get back what you put in. The price of an investment may go up and down and all over, but it's still capital preservation if you get back what you put in.
Risk, as Graham defined it, is the permanent loss of capital. Not the temporary loss of capital, not the fear of the loss of capital, but the permanent loss of capital. Not eggs jostled or raised and lowered, but eggs BROKEN.
If your investment returns the capital you put in, then capital has been preserved. If not, or if the safety of that capital, upon thorough analysis, is suspect, then it's not investing.
This raises an important issue which many overlook: capital preservation is preservation of the spending power of the capital. Not the capital quoted in dollars, drachma, cows, or shells, but the real, sustainable purchasing power of that capital. If you put in 6 large eggs and get back 6 small ones, or if even 1 is missing, then it's not capital preservation.
Many incorrectly think of cash or bonds as being the soundest means of capital preservation. In most cases it is, but not if inflation occurs. If inflation is a real threat over the time-frame that capital must be used, then capital preservation must necessarily include inflation protection. Cash and bonds, by themselves, don't cut it.
Most investing experts focus too much on secondary, tertiary, etc., issues. They focus on diversification, statistical "guarantees," unexamined impressions, recent history. But, investing just isn't that complex.
You need to do thorough analysis (examine that basket in-depth), you need to preserve capital primarily (will I get back the same number of actual eggs I put in the basket, unbroken), and you'd like to get a satisfactory return secondarily (given that the number and size of eggs is safe, can I get back more eggs than I put in).
It's not rocket science or brain surgery--it's quite simple.
But, as Warren Buffett put it, investing is simple, but not easy. Which means: knowing how to invest is not complex, but doing it well is difficult. Losing weight requires you to consumer more calories than you put in--that's simple. But doing it isn't easy--it's very difficult (especially around Christmas!).
Perhaps Buffett's investment success should lead investors to focus on his methodology (including very little of what financial clergymen sell), which starts with: capital preservation.
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.
In the Middle Ages, when hardly anyone could read or understand Latin, men of the church had a stranglehold on religious doctrine. If you wanted to understand or get guidance on the most important issues of the time, you had to go through the men of the church. This served the church's interests well.
And, so it is now with investing. Today's clergymen of finance work hard to cloak the simplicity of investing in higher math, floating abstractions, mindless charts, confusing terms. Their efforts are not to clarify, but to obfuscate; for, if you're completely confused, then you'll need their help!
(As an amusing aside: a former investing boss of mine, in criticizing my writing ability, complained that I wasn't writing in a sufficiently high-minded way. He told me that magazines and newspapers were written at an 8th grade level, and so was my writing, but he wanted it at an 11th or 12th grade level. When I commented that it might make the writing unintelligible to many of his clients, he said that was okay because his clients would prefer someone who sounded smart over actually understanding!)
So, why do I claim that investing is simple? I read a description of investing 16 years ago that made perfect sense and was simple, and I've used it ever since. This description, from Benjamin Graham and David Dodd's Security Analysis, 1934:
"An investment operation is one which, upon thorough analysis, promises safety of principal and a satisfactory return. Operations not meeting these requirements are speculative."
If you don't do thorough analysis or hire someone who doesn't, it's not investing, it's speculation. No stock tips, no hunches, no astrology, no gut feel, no "I just know...", no buying lots of everything--just thorough analysis.
If you invest in securities that don't promise--first--safety of principal and--second--a satisfactory return, then you're not investing, you're speculating. A lot of investors focus on that second part, the satisfactory return part, but few put the emphasis necessary on the first part (which Graham and Dodd correctly made primary).
Many financial planners and investment advisors give lip service to safety of principal, or capital preservation, but few give it the attention it needs. This lip service to capital preservation is frequently waved away with the magic of diversification. If you put your eggs in many baskets, they say, then there's no way all your eggs will break at once.
2008, or any other financial crisis in history for that matter, should put that notion to rest. Unfortunately, it hasn't. Putting your eggs in poorly built baskets, no matter how many of them, is unwise.
Capital preservation is also framed in terms of volatility. If the basket goes up and down a lot, they say, you'll get scared. Fear is a relevant issue, but it's not the same as capital preservation. Capital preservation is whether the eggs break or remain whole, not whether they are jostled or swung about.
Capital preservation means you get back what you put in. Not volatility, not fear, but whether you get back what you put in. The price of an investment may go up and down and all over, but it's still capital preservation if you get back what you put in.
Risk, as Graham defined it, is the permanent loss of capital. Not the temporary loss of capital, not the fear of the loss of capital, but the permanent loss of capital. Not eggs jostled or raised and lowered, but eggs BROKEN.
If your investment returns the capital you put in, then capital has been preserved. If not, or if the safety of that capital, upon thorough analysis, is suspect, then it's not investing.
This raises an important issue which many overlook: capital preservation is preservation of the spending power of the capital. Not the capital quoted in dollars, drachma, cows, or shells, but the real, sustainable purchasing power of that capital. If you put in 6 large eggs and get back 6 small ones, or if even 1 is missing, then it's not capital preservation.
Many incorrectly think of cash or bonds as being the soundest means of capital preservation. In most cases it is, but not if inflation occurs. If inflation is a real threat over the time-frame that capital must be used, then capital preservation must necessarily include inflation protection. Cash and bonds, by themselves, don't cut it.
Most investing experts focus too much on secondary, tertiary, etc., issues. They focus on diversification, statistical "guarantees," unexamined impressions, recent history. But, investing just isn't that complex.
You need to do thorough analysis (examine that basket in-depth), you need to preserve capital primarily (will I get back the same number of actual eggs I put in the basket, unbroken), and you'd like to get a satisfactory return secondarily (given that the number and size of eggs is safe, can I get back more eggs than I put in).
It's not rocket science or brain surgery--it's quite simple.
But, as Warren Buffett put it, investing is simple, but not easy. Which means: knowing how to invest is not complex, but doing it well is difficult. Losing weight requires you to consumer more calories than you put in--that's simple. But doing it isn't easy--it's very difficult (especially around Christmas!).
Perhaps Buffett's investment success should lead investors to focus on his methodology (including very little of what financial clergymen sell), which starts with: capital preservation.
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.
Friday, January 21, 2011
Measure what matters
Measuring what matters is one of the hardest things to do in life.
Take happiness. Everyone wants it, but few get it. Why? Because most pursue short term pleasures, becoming hedonists, and chase their tail instead of becoming happy. You have to think long term, and focus on virtue to become happy. Short term pleasure is the wrong thing to measure; long term virtue is the right thing to measure.
Or, take weight loss. Almost everyone wishes they weighed less. But, most fail to lose weight because they try some crash diet they couldn't possibly stay on over the long term. The result: they lose a little weight, but put it all back on again because they focused on the wrong measurement--short term scale measurements. To keep the weight off, you need a long term change of lifestyle--usually less food and more exercise. You need to measure less food and more exercise over the long term.
But, it's not easy to measure what matters most. It's hard to do and doesn't give instant results. C'est la vie!
I run into this all the time with investing. People want to build long-term wealth, but they try a quick fix instead of measuring what matters most.
Take, for example. investing in fads. Many think investing in the latest thing or making a big lottery-style bet is the way to build wealth. It isn't, so the vast majority of those who try this approach don't build wealth.
Or, take index investing. People hear or read that you can't beat the market, that low fees matter most, so they jump on the index investing bandwagon (usually after several years where it has worked--too bad we can't drive by looking in the rear view mirror). But, paying low fees doesn't do you any good if the index goes no where for a decade.
Which brings me to the measure that matter most for investing: after-tax, after-fee returns.
There's no benefit to avoiding taxes if you get lousy returns, can invest very limited amounts of money, and pay all kinds of extra fees. Many 401k and 529 plans exhibit this "benefit."
Avoiding taxes is not the measure that matters most. If you can get 10% returns in a tax deferred plan and 10.91% returns in a taxable plan (assuming 33% turnover and 25% marginal tax rate), you end up with the same after-tax money. That's right, just find someone who can beat the market by 0.91% over the long run and you might as well save in a taxable account.
This matters because most 401k and 529 plans stove-pipe investors into a few limited options--options that are heavily marketed to make sure lousy money managers can get lots of assets under management. And that's before we even get into all the wonderful fees and restrictions that come with such plans.
There's no benefit to paying low fees if you get lousy returns, either. Many investors over-focus on fees. If you are looking at two options that will generate the same returns, then fees are what matter. But, that's a big IF--IF THEY WILL GENERATE THE SAME RETURNS!
If manager A beats the market by 0.5% after fees and index B only charges you 0.25%, you should go with manager A, because your after fee returns are 0.75% better.
The measure that matters most in investing is after-tax, after-fee returns, not fees by themselves, not tax deferral, not anything else. Anyone who tries to convince you otherwise is probably selling you something.
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.
Take happiness. Everyone wants it, but few get it. Why? Because most pursue short term pleasures, becoming hedonists, and chase their tail instead of becoming happy. You have to think long term, and focus on virtue to become happy. Short term pleasure is the wrong thing to measure; long term virtue is the right thing to measure.
Or, take weight loss. Almost everyone wishes they weighed less. But, most fail to lose weight because they try some crash diet they couldn't possibly stay on over the long term. The result: they lose a little weight, but put it all back on again because they focused on the wrong measurement--short term scale measurements. To keep the weight off, you need a long term change of lifestyle--usually less food and more exercise. You need to measure less food and more exercise over the long term.
But, it's not easy to measure what matters most. It's hard to do and doesn't give instant results. C'est la vie!
I run into this all the time with investing. People want to build long-term wealth, but they try a quick fix instead of measuring what matters most.
Take, for example. investing in fads. Many think investing in the latest thing or making a big lottery-style bet is the way to build wealth. It isn't, so the vast majority of those who try this approach don't build wealth.
Or, take index investing. People hear or read that you can't beat the market, that low fees matter most, so they jump on the index investing bandwagon (usually after several years where it has worked--too bad we can't drive by looking in the rear view mirror). But, paying low fees doesn't do you any good if the index goes no where for a decade.
Which brings me to the measure that matter most for investing: after-tax, after-fee returns.
There's no benefit to avoiding taxes if you get lousy returns, can invest very limited amounts of money, and pay all kinds of extra fees. Many 401k and 529 plans exhibit this "benefit."
Avoiding taxes is not the measure that matters most. If you can get 10% returns in a tax deferred plan and 10.91% returns in a taxable plan (assuming 33% turnover and 25% marginal tax rate), you end up with the same after-tax money. That's right, just find someone who can beat the market by 0.91% over the long run and you might as well save in a taxable account.
This matters because most 401k and 529 plans stove-pipe investors into a few limited options--options that are heavily marketed to make sure lousy money managers can get lots of assets under management. And that's before we even get into all the wonderful fees and restrictions that come with such plans.
There's no benefit to paying low fees if you get lousy returns, either. Many investors over-focus on fees. If you are looking at two options that will generate the same returns, then fees are what matter. But, that's a big IF--IF THEY WILL GENERATE THE SAME RETURNS!
If manager A beats the market by 0.5% after fees and index B only charges you 0.25%, you should go with manager A, because your after fee returns are 0.75% better.
The measure that matters most in investing is after-tax, after-fee returns, not fees by themselves, not tax deferral, not anything else. Anyone who tries to convince you otherwise is probably selling you something.
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.
Thursday, January 13, 2011
Not so great expectations
If I've said it once, I've said it a million times: for most investors long term returns are what count most--not what the stock market will do this year or next.
And yet, most investors over-focus on short term prospects. That's probably why they get lousy investment results over the long run and brilliantly high (and then low) returns over the short.
It's not the returns you could have gotten that count, it's the returns you actually get.
But, long term prospects don't look that great right now. By my reckoning, the S&P 500 is set to deliver slightly more than 3% annualized returns over the next 5 years. With inflation of 1-2%, that's a real return of only 1-2%.
Do investors have great expectation when they should have realistic expectations? I believe so, and they very much want to believe the market commentators who promise 10% returns this year.
Don't get me wrong, we may see 10% - 20% returns over the next couple of years. It's not just possible, it may even be likely!
But, those returns will be given right back over time. The market will regress to the mean, as it always does, and investors will once again be right back where they started, or lower.
The way off this treadmill-to-nowhere is to start with realistic expectations and then pick investments that can solidly beat them. But, this takes time and effort, so most investors prefer the strategy of hope.
Hope, let me be clear, is NOT a strategy (a mantra I learned to repeat from my time in the Air Force).
Can you find investments right now that will beat 1-2% inflation-adjusted returns? Yes. Will bonds that yield 3% do it? Most likely not. Will stocks of companies with solid franchises, strong balance sheets, reliable cash flow, meaningful dividends, selling at low prices to fundamentals do it? Most likely.
Will such investments beat the market every month, quarter, or year? Almost certainly not. That's why most people don't own them! But, after the market goes up and then down, or down and then up, or sideways for years, or whatever else could happen, such investments will almost certainly win.
Just look for investments in companies that have pricing power--the ability to raise prices with inflation. That will take care of that nasty 1-2% (or likely more) inflation.
Then look for businesses that grow with the economy--they sell products or services that people can't do without. That will likely give you 3% real returns.
Then look for businesses that aren't financed with tons of debt--they are the ones that could go bankrupt in tough times.
Then, look for businesses that can and do pay out a portion of their earnings in dividends, and make sure they can continue to pay even if business conditions become poor--they are the one's whose dividends are covered easily by earnings in good times and bad. That should give you a 2-4% return while you wait for the market to regress to the mean.
Then, make sure you don't pay too much. If you pay a high price to fundamentals, you're doing the same thing as buying the S&P 500 and locking in 1-2% real returns. If you pay a low price to fundamentals, you're protected against the downside and likely to benefit from the 1-2% inflation, 3% underlying growth, and 3% dividend specified above.
If you do all that, you should lock in 6% real returns instead of 1-2%. That may not blow your hair back, but it's a lot better than riding the roller coaster up and then down again for the 3rd time in 15 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.
And yet, most investors over-focus on short term prospects. That's probably why they get lousy investment results over the long run and brilliantly high (and then low) returns over the short.
It's not the returns you could have gotten that count, it's the returns you actually get.
But, long term prospects don't look that great right now. By my reckoning, the S&P 500 is set to deliver slightly more than 3% annualized returns over the next 5 years. With inflation of 1-2%, that's a real return of only 1-2%.
Do investors have great expectation when they should have realistic expectations? I believe so, and they very much want to believe the market commentators who promise 10% returns this year.
Don't get me wrong, we may see 10% - 20% returns over the next couple of years. It's not just possible, it may even be likely!
But, those returns will be given right back over time. The market will regress to the mean, as it always does, and investors will once again be right back where they started, or lower.
The way off this treadmill-to-nowhere is to start with realistic expectations and then pick investments that can solidly beat them. But, this takes time and effort, so most investors prefer the strategy of hope.
Hope, let me be clear, is NOT a strategy (a mantra I learned to repeat from my time in the Air Force).
Can you find investments right now that will beat 1-2% inflation-adjusted returns? Yes. Will bonds that yield 3% do it? Most likely not. Will stocks of companies with solid franchises, strong balance sheets, reliable cash flow, meaningful dividends, selling at low prices to fundamentals do it? Most likely.
Will such investments beat the market every month, quarter, or year? Almost certainly not. That's why most people don't own them! But, after the market goes up and then down, or down and then up, or sideways for years, or whatever else could happen, such investments will almost certainly win.
Just look for investments in companies that have pricing power--the ability to raise prices with inflation. That will take care of that nasty 1-2% (or likely more) inflation.
Then look for businesses that grow with the economy--they sell products or services that people can't do without. That will likely give you 3% real returns.
Then look for businesses that aren't financed with tons of debt--they are the ones that could go bankrupt in tough times.
Then, look for businesses that can and do pay out a portion of their earnings in dividends, and make sure they can continue to pay even if business conditions become poor--they are the one's whose dividends are covered easily by earnings in good times and bad. That should give you a 2-4% return while you wait for the market to regress to the mean.
Then, make sure you don't pay too much. If you pay a high price to fundamentals, you're doing the same thing as buying the S&P 500 and locking in 1-2% real returns. If you pay a low price to fundamentals, you're protected against the downside and likely to benefit from the 1-2% inflation, 3% underlying growth, and 3% dividend specified above.
If you do all that, you should lock in 6% real returns instead of 1-2%. That may not blow your hair back, but it's a lot better than riding the roller coaster up and then down again for the 3rd time in 15 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.
Friday, January 07, 2011
Shifting tides
The stock market is frequently looked at as one amorphous whole. It's not.
Underneath the calm surface of aggregate stock market statistics are rip-tides of out- and under-performance. Small companies beating large, value beating growth, foreign beating domestic, bonds beating stocks, commodities beating bonds, etc.
What seems to surprise investors is how long these trends can last--years, not months. Looking at 3 or 5 year performance, investors conclude that because foreign has beaten domestic for that long, it must continue. Just the opposite is the case.
Mean reversion--the tendency of a prices to move back to average--is one of the most powerful forces in finance. That which has performed best is likely to reverse over the long run. Just when investors think the tide has gone out, it comes back in.
I believe this is especially the case today. Specifically, small companies have trounced large over the last five years, bonds have crushed stocks, foreign has crushed U.S., and commodities have crushed...well...almost everything. But, that which can't go on forever, won't.
In particular, I've been surprised at how well small has done versus large. From April 1999 until December 2010, The Russell 2000 (representing small) has beaten the S&P 500 (large) by over 6% a year! If that doesn't sound like much, let me rephrase: it's the difference between no return over 12 years and doubling your money!
Let me clarify: small usually beats large. Small companies can grow faster and are more nimble, so it's normal for small to beat large over the long run. But, the margin is usually a little over 1% a year, not more than 6%. It's the difference between having 12% extra money and having over 100% extra.
Now, this can not last. And, it won't. Regression to the mean will cause large to out-perform small for several years until historical relationships are restored. I can't guarantee that, but it's as close to a sure thing as you can get with investing.
When will the tide come back in? I don't know. I was heavily invested in small companies from 2000 until 2004, so I enjoyed riding the tide out. From 2004 until now, I've been shifting more and more from small to large in anticipation of the sea change. What has surprised me is that I expected the tide to come in sooner (as it has historically).
Just because the tide seems to be going out more than I thought doesn't mean I should try to ride it to the last. Quite the opposite. The smart thing to do is switch when it becomes prudent and wait for the inevitable. I'm patiently waiting, and expect to be riding back in to shore soon enough.
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.
Underneath the calm surface of aggregate stock market statistics are rip-tides of out- and under-performance. Small companies beating large, value beating growth, foreign beating domestic, bonds beating stocks, commodities beating bonds, etc.
What seems to surprise investors is how long these trends can last--years, not months. Looking at 3 or 5 year performance, investors conclude that because foreign has beaten domestic for that long, it must continue. Just the opposite is the case.
Mean reversion--the tendency of a prices to move back to average--is one of the most powerful forces in finance. That which has performed best is likely to reverse over the long run. Just when investors think the tide has gone out, it comes back in.
I believe this is especially the case today. Specifically, small companies have trounced large over the last five years, bonds have crushed stocks, foreign has crushed U.S., and commodities have crushed...well...almost everything. But, that which can't go on forever, won't.
In particular, I've been surprised at how well small has done versus large. From April 1999 until December 2010, The Russell 2000 (representing small) has beaten the S&P 500 (large) by over 6% a year! If that doesn't sound like much, let me rephrase: it's the difference between no return over 12 years and doubling your money!
Let me clarify: small usually beats large. Small companies can grow faster and are more nimble, so it's normal for small to beat large over the long run. But, the margin is usually a little over 1% a year, not more than 6%. It's the difference between having 12% extra money and having over 100% extra.
Now, this can not last. And, it won't. Regression to the mean will cause large to out-perform small for several years until historical relationships are restored. I can't guarantee that, but it's as close to a sure thing as you can get with investing.
When will the tide come back in? I don't know. I was heavily invested in small companies from 2000 until 2004, so I enjoyed riding the tide out. From 2004 until now, I've been shifting more and more from small to large in anticipation of the sea change. What has surprised me is that I expected the tide to come in sooner (as it has historically).
Just because the tide seems to be going out more than I thought doesn't mean I should try to ride it to the last. Quite the opposite. The smart thing to do is switch when it becomes prudent and wait for the inevitable. I'm patiently waiting, and expect to be riding back in to shore soon enough.
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.
Subscribe to:
Posts (Atom)