The myth of the rational investor

One aspect of my job I love best is reading to broaden my horizons. I recently finished a book by Dan Arielly called Predictably Irrational: The Hidden Forces That Shape Our Decisions. It was an eye-opening look into how real humans make decisions and what traps to avoid.

This may sound like heady stuff, but it's quite useful to a professional investor like me. You see, I happen to be human, and knowing the errors that humans frequently make can help me avoid mistakes and become a more successful investor over time. Quite practical, really.

Arielly highlights that most economic theory, up until the pioneering research done by behavioral economists, tended to assume that humans make fully rational decisions, especially when it comes to spending money. On the contrary, research has shown that we humans make all kinds of silly mistakes.

For example, we tend to over-value what we own. Before we buy a car, say a VW bug, we want to pay as little as possible for it. But, once we've bought it, we suddenly value it much more than we did before ownership. We won't sell it unless we can get top-dollar, even though we didn't think it was worth top-dollar when we bought it. And, the longer we own it, the more attached we can become, especially if we put a lot of work into ownership. I'll think about that the next time I go to sell a stock. I may want a price no one's willing to pay simply because once I've owned it for a while. Using objective value measures like price to earnings or price to book value give me an objective reference point to avoid this trap.

Another problem for humans is we want to keep our options open. Keeping options open makes sense in many contexts, but not when economic costs outweigh benefits. Arielly and crew showed how people generally over-weigh the benefit of keeping options open, literally to the degree of putting a higher price on keeping options open than the benefit derived. By trying to keep our options open, we frequently get distracted from the true objective. I'll remember this the next time I go to make an investment decision. When considering investment options, I know that wanting to keep my options open may distract me from making a good decision. Instead, I'll make the best decision given the facts and move on.

We humans are also greatly impacted by our expectations, and we may never change our minds even when confronted with contrary evidence. Arielly and his colleagues demonstrated through several experiments how people's pre-conceived notions literally impact their experiences. This is easy to find with investing, too. Once we buy an investment with the vision of great wealth pouring down on us, we hold on to that vision long after the facts have shown the vision to be faulty. This is a great thing to keep in mind when making investment decisions. Am I ignoring evidence? Am I looking for opinions different than my own? Can I dig for dis-confirming evidence instead of just looking for proof that backs my pre-conceived notion?

Being human has many wonderful benefits, but being rational decision makers, in the economic sense, is not one of them. This doesn't mean we should throw in the towel, it just means we have to be very objective when making investment decisions. This book helps me ask myself: 1) am I over-valuing something simply because I own it? 2) am I losing economic benefits because I want to keep options open? 3) am I looking for dis-confirming evidence to contradict my pre-conceived notions? Such questions lead to better decision making and better investment results.

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

The long road back

The stock market has rallied strongly since March, and this has a lot of investors feeling optimistic again.

A lot of the numbers touted by the press (with Wall Street's careful nudging) foster this cycle of optimism. For example, the S&P 500, on a price-only basis, is up 56% from its ominous intra-day bottom of $666.79 (March 6, 2009). 56% sounds very impressive, indeed!

But, the context of that 56% number is important. If you bought a company for $100 a share and it fell to $1 (99% decline), and then rallied to $1.56 (up 56% from the bottom, but down 98% from purchase price), you'd have a 56% "gain." Not as impressive when put that way.

The same context should be included in any analysis of the S&P's meteoric 56% increase.

The S&P 500 peaked on 10/9/2007 at $1,565.15. That means, on a price-only basis, the S&P 500 is down 34% even after it's 56% increase. It's not very impressive to have gained 56% when 1/3 of your wealth is still missing in action.

This is where most investors get confused because percentage changes aren't intuitively obvious (why, oh why, do teachers spend so much time on trigonometry and calculus and so little on the math of compounding!?). Percentage changes must be put in context and looked at over longer time periods, otherwise they can give an incomplete impression and perhaps even deceive.

Let me illustrate. My clients' growth accounts were down 24% from the end of October 2007 (the month when the market last peaked) through the end of August 2009 (including fees and dividends, consult my notes on performance for full disclosure). Down 24% sounds bad, but not when you compare it to the S&P 500 total return (includes dividends): down 31%.

Down 24% may not sound much more impressive than down 31% because they are both down a lot. But, when you're down 24%, it takes a 32% gain to get back to breakeven; when you're down 31%, it takes a 45% gain to get back to breakeven. It will likely take less time to climb 32% than 45%.

Stretching these number out over time illustrates why a broader context and longer time periods are important.

My clients' growth accounts are up 5.76% since inception (4/30/05) versus down 3.30% for the S&P 500. If "big-whoople-dee-doo" is your response, I don't blame you--it might not sound impressive at first glance.

But, from a broader context, that means my clients were 9% ahead of the S&P 500 after 4 years and 4 months, and that's worth a lot over the long run where even small out-performance adds up. 2% out-performance (which I am by no means promising) means 50% more wealth over a 20 year period. That can really make a difference.

Even with its recent climb, the market still has a long road back.

Another factor in thinking about the 56% climb is valuation--what is the market likely to do going forward? If the market were dramatically under-valued, then that 56% climb may keep going. But, what if that 56% climb started from fair value or over-valuation? Then expecting the dramatic rise to continue wouldn't make sense.

By my calculations, the S&P 500 is very close to fair value right now. Assuming underlying growth of 3%, inflation of 3%, and a 3% dividend yield, the expected return going forward is around 9% a year. At 9% a year, it would take the market another 5+ years to climb another 56%. Just because the market has risen a lot doesn't mean it will continue to do so.

I'm not making a market prediction. I'm just trying to illustrate that the market's recent rise must be kept in context, must be looked at over a broader time span, and must be looked at with respect to underlying fundamentals.

Given that, the market could rise, fall or remain flat. I have no idea what it'll do. But, it would not be reasonable to take the 56% rise and extrapolate that performance going forward.

It's a long road back, and it'll likely take some time to cover the distance.

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.

"Good" company versus good stock investment

One of the most difficult concepts to grasp in all investing is the difference between a "good" company and a good stock investment.

The intuitive take most people have is that a "good" company is a good stock investment. Seems to make sense, doesn't it?

But, this is rarely the case. Why? Because a company's stock price reflects how people in general think of it.

If everyone loves a company and buys its stock, then its stock price will rise to meet that growing demand. Popular stocks have high prices relative to their underlying value.

"Good" companies, as recognized by the vast majority of people, tend to be over-priced.

The opposite is true for "bad" companies. When the vast majority of people think a company is garbage, its stock price reflects that lack of demand. Unpopular companies tend to have low prices relative to fundamentals.

"Bad" companies, as recognized by most people, tend to be under-priced.

This is very counter-intuitive for most people and a bit hard to handle. It doesn't seem to make sense to buy something everyone hates and sell something everyone loves. After all, can the majority be consistently wrong?

Yes. The proof of the pudding is in the eating, and when you buy "bad" companies and sell "good" companies, you get better returns than if you sell "bad" companies and buy "good" companies. The statistical studies on this are too numerous to detail here, but the solid weight of statistical and anecdotal study is that "bad" companies' stocks out-perform "good" companies' stocks.

You can implement this strategy in a non-concentrated way by simply buying the hated and selling the loved. I recommend high diversification for this approach because some of those "bad" companies will actually turn out to be bad and some of those "good" companies will turn out to be good investments. You need the benefit of a large number of investments to get everything to average out and get good results.

Another approach, that I believe generates better results, is to work hard to figure out which companies are good and perceived "bad."

As you may have noticed, I've been using quotation marks around "good" and "bad" to indicate good or bad as seen by the majority. But, the majority isn't always right. Sometimes a "bad" company is a very good investment because it is actually good and everyone perceives it to be bad. Then, not only do you have the long run tailwind of a good company's underlying fundamentals that time will make clear, but you also get to buy it at a "bad" company discount to underlying value. Then, you can get some truly phenomenal long term investing results.

This is the approach that I use. I buy companies everyone seems to hate where I believe the crowd is wrong.

It's tough to implement this approach, though, because when you tell people what you're buying, they look at you like you're crazy (frequently a sure sign of good investment). It's hard to be on the extreme minority side of opinion, and with investments people can be very passionate about their views (people like to tell you how stupid you are and all the things you aren't paying attention to). Sometimes, the majority turns out to be right and you end up looking and feeling like a fool. That's the price you pay to get outstanding results, though, and it's well worth it.

Remember, a "good" company isn't necessarily a good investment. Knowing the difference can mean the difference between good and bad investing results.

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

The economy's white knight

There's been a lot of talk about what will pull the world economy out of the funk it entered a year ago.

Most of the focus has been on the U.S. consumer and what they can do to pull us out of our economic malaise. After all, consumer spending is usually 60%-70% of the economy.

Others, instead, focus on the governments of the world, whether U.S., Chinese or European. To this way of thinking, the economies of the world have come off the tracks, and only government can get them back on the again and moving forward.

But, I think this misses the most likely source of future economic growth: businesses.

Consumers are tapped out, they have to pay off debt and build up savings. Most governments are tapped out, too, they are simply borrowing from others in hopes that spending now will produce growth sooner rather than later. The financial sector, which can usually spur growth with lending and investment, is even more highly in debt than consumers or governments, so they don't seem likely to be the impetus for growth.

Businesses, on the other hand, are in relatively good shape. Businesses faced a very tough recession in 2000-2002, and they have since lowered their debt and learned to react quickly and decisively to tougher economic times. They tend to be leaner and more flexible than they were a decade ago, and many have large cash hordes they can put to work.

In my opinion, this is where growth will come from sooner than any other place. In fact, I believe it's already happening.

Now that demand seems to be stabilizing, businesses will start hiring again. The U.S. economy needs to shift from a consumption to a production focus. China needs to shift from a production to a consumption focus. Businesses will lead the way in this shift because they will see the most profitable ways to benefit from the new landscape. The smart businesses, the lean and flexible ones who see the future first, will expand production and meet business demand first. They will then have the profits to hire and expand more. And, thus, the upward cycle will grow and expand.

This will not happen quickly. Production won't go from 30% of the U.S. economy to 50% overnight. And, 30% of the economy will not make up for the 70% of consumption all at once. It will be a slow, steady growth that will build a more stable, more production focused economy.

This will be a good thing. For, as Jean-Baptiste Say said almost 200 years ago, supply creates its own demand. Production, after all, must precede consumption--you can't consume what hasn't been produced. Having an economy more focused on production than consumption will grow more steadily and resiliently.

The economy's white knight is riding to the rescue, and below the radar of almost everyone. Businesses will lead the way.

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.

Focused investing

There are as many different ways to invest as there are stars in the sky.

And, this is why most investors are dumb-founded when trying to pick investments--the choices are limitless.

One of the key problems is that most investment managers are not terribly honest about what they do. They say they do in-depth research, they say they don't just invest in the market, they promise the moon and stars...

The reality is that the average mutual fund owns 172 stocks. That means their average position size is 0.6%. Even if a 0.6% position doubles, you won't feel the benefit much.

Added to this, with 172 positions, how on earth does an investment manager do in-depth research on individual companies? Just keeping track of quarterly announcements would utterly over-whelm them. They can't possibly follow 172 companies in-depth!

The average mutual fund charges their customers around 1% a year to manage money. But, with 172 holdings, it's almost impossible for them to beat the market after fees. Why not just buy an index fund and get charged 0.2%?

The alternative is to invest with a manager who focuses on only a few investments, let's say less than 25. Such investors at least have the possibility of beating the market, unlike someone who owns 172 stocks.

If you look at the records of managers who have strongly out-performed the market over the long term, you will almost certainly have found a focused investment manager.

There aren't that many managers who focus on fewer than 25 investments. Why? Because most invest managers lack the courage of their conviction. As Warren Buffett put it, "wide diversification is only required when investors do not understand what they are doing."

Added to this, being focused on only 25 investments frequently means higher short-term volatility and requires a lot of patience because short-term under-performance is inevitable.

But, the benefits can be huge. Focused investing can lead to out-performance that can have a huge impact on your long term wealth.

It may take time, it may take patience, it may take a stomach that can handle nerve-wracking ups and downs, but for some investors, it's well worth the effort.

Besides, what would you rather do with your time? 1) spend several hours picking a manager who knows what they're doing, or 2) spend the rest of your life diversifying, rebalancing your portfolio, and getting mediocre results anyway?

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.

One clunker of an idea

I usually try to stay away from political commentary, but the "cash for clunkers" idea needs to be addressed from an economic standpoint.

If you haven't heard about it, the "cash for clunkers" program gives cash to people who trade in their low mile per gallon vehicles to purchase newer, higher mile per gallon vehicles. From the way I understand it, you get $3,500 to $4,500 (depending on the mileage of the vehicle you purchase) for "cashing in" your "clunker."

Now, let's trace this idea from beginning to end and understand what's going on. The government is paying people cash to throw away functioning cars. Where does the cash they are giving away come from? It comes from issuing government debt.

That means the government is raising money from someplace (China, Japan, Middle East, U.S. investors) that would otherwise have been invested in some other way, and using it to pay people to throw away functioning cars. Why?

(I'm sure it has nothing to do with the fact that the U.S. government has become a huge investor in Chrysler and GM. Note: I'm being sarcastic).

One reason is that most economists look at economic growth in terms of new things being sold instead of return on investment. Gross Domestic Product (GDP), which is the figure most economists and government employees watch, will show an increase because of the cash for clunkers program. GDP increases whenever things are sold, the government spends money, or we export more than we import.

Using this magical math, the economy grows any time consumers or the government spends, whether or not that's positive return on investment spending.

But, let's think further about this issue. Say you buy a car because of the cash for clunkers program. Because you are now making payments on a new car, and those payments are almost certainly higher than the payments on your clunker, then you have less money to spend on other things. In other words, spending has simply been taken from one place and put in another. GDP will show a spike because you spent a lot money today on a new car, but then you'll have payments plus interest in the future which you can't spend. Is that positive return on investment growth? Not likely.

Plus, the government has incurred debt to finance this spending. That won't show up in GDP figures, so everything seems peachy. But, borrowed money needs to be paid back, with interest, and where will that money come from? It's simply been borrowed from the future!

When I make an investment, the issue isn't just: does growth occur? I must get a return on investment more than what was put into it.

Suppose I bought a company for $100,000 and had to put $10,000 into it in the first year. Suppose I only netted $5,000 in earnings. No one would consider that a wise investment. Suppose I put $15,000 into the business the next year and made $7,500. That would be growth, right, from $5,000 to $7,500, but I don't think anyone would rejoice in putting in $25,000 and getting $$12,500 back over 2 years.

So, why would someone consider it a good investment to borrow money to pay people to buy something they don't need? I don't get it.

By such reasoning, it would make sense to burn down all the houses in my neighborhood so we could spend money to build new homes. If that's considered economic growth by someone, then cash for clunkers makes sense.

But, to me, it doesn't.

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.

Process versus results

Every few months, I seem to return to this subject because it's so important to successful investing--there is a world of different between investment process and investment results, especially in the short term!

Results are what you get, process is how you get it. Confusing the two leads to all kinds of investment mistakes. Why?

The reason why, to over-simplify, is randomness. The world is so complex that you can't possibly know all the variables that can impact a particular result. You may have a bad results, but a good process. Or, you may have a bad process, but get good results in the short term.

If you have the right process, but watch short term results too closely, you may give up before the big payday comes. If you have the wrong process, but get lucky and have a good result, you may continue to implement the wrong process leading to terrible long term results.

Let me give a concrete example because the subject probably seems way too abstract so far.

Suppose I make you an offer: would you pay me $200 for a one in six change of winning $1,000? I'll roll a die, if it comes up 1 I'll pay you $1,000, if it comes up 2-6, I keep the $200 you pay me to play. Sound like a good offer?

No, it's not. You have a 1 in 6 chance of getting $1,000, so you have a 16.67% chance of winning. Multiply the probability, 16.67% times the payout, $1,000, and you come up with the expected value: $166.67. Because you have to pay $200 to play and the expected value is less, you shouldn't play.

Let's suppose you haven't done the math above, and you decide to play. Suppose you win. Winning will be psychologically exhilarating, releasing all kinds of feel-good endorphins in your brain. This "high" feeling will encourage you to play again. But, the more you play, the more likely you are to lose. The odds and payout are against you.

The good result, winning luckily the first time, may encourage you to continue using a bad process, playing a game with a negative expected value.

Let's suppose I tell you it costs $100, instead of $200, to play the game. Would you play now? Because the expected value is more than the price to play, you should play.

Let's suppose you decide to play, but you lose the first time. Let's suppose you play again, and lose again. The more you play and lose, the more you feel like you should quit the game. The price of playing over and over again and losing takes it's toll on you, you begin to get angry, frustrated, and want to quit. Should you?

No. The odds and payout are in your favor, so you should keep playing. Just because the outcomes look bad over the short term, doesn't mean they are bad over the long run. In the long run, you'll win if you keep playing, but that takes a lot of discipline.

I think about process and results all the time. Sometimes I make a good process investment and it doesn't do well. I beat myself up for being so stupid, but that doesn't mean my process is bad or that my long run results will be poor. If the odds and payout are in my favor, I'll win if I keep implementing the right process. Sometimes I make a bad process investment and it does well. This encourages me to repeat the process, especially if I don't examine whether I was lucky or good. But, implementing the bad process will eventually catch up with me, the odds always do, and I'll lose in the long run.

Focusing on process is vitally important in any situation where randomness plays a part. If you focus too much on short term results instead of the process, you'll make costly and repeated mistakes.

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

The stock market is all about expectations

The stock market has rallied strongly since March. Why has the market rebounded in the face of weak economic data? The reason: because the market is all about expectations.

The stock market is a reflection of investor expectations about future economic profits. When investors expect economic conditions to improve and companies to make growing profits, the stock market tends to go up.

Recent economic reports do not show a growing economy, but they do show that the economy is declining less quickly. Why is that a good thing? Think about an airplane in a nosedive. Before it starts to climb again, it's rate of descent needs to slow. Then it levels off before it climbs. The rate of descent must get less bad before leveling or climbing can occur. Same with the economy.

The market has rallied since March not because economic data or profits have grown, but because things are getting bad less quickly. If it turns out that profits level off at a low level, keep declining slowly, or climb at a slower rate than people expect, the market will decline. In other words, the market will decline if economic growth and company profits don't meet or exceed investors' current expectations.

How likely is it that economic growth and company profits will miss, meet or exceed expectations? I have no idea, but in the short run that's the $64,000 question. If you invest long term, pick good investments, and pay the right price, you don't need to guess this outcome.

But, it's an interesting question to ask. Do you expect strong economic growth over the next year? Do you think consumers are ready to start spending again despite 10%+ unemployment? Do you think recent government efforts to spur economic growth will work? Do you think company profitability will rebound by around 50% like the market is expecting?

After listening to conference calls over the last 3 weeks, I have to admit to having an opinion (for what that's worth). Almost every company I've listened to has beat profit expectations by cutting costs and missed expectations in terms of sales. In other words, they are missing expectations for selling products, but meeting profit expectations by firing people and not spending for future growth. That doesn't sound sustainable to me.

The market seems to be basking in the glow of potential, not actual growth. If that growth turns out to be ephemeral, look out below!

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

China's precarious position

One of the major reasons for the market's continued rally is China.

China has been buying up commodities, especially copper, and that has caused a resurgence in the price of copper. Because copper is such a fundamental unit in overall economic demand, many are taking the surge in copper prices as a sign that underlying economic demand is rebounding and set to run for quite some time.

But, is the demand from China fundamental, or is it due solely to economic stimulus from China's government? Even if it is due to government stimulus, does that mean such demand will or will not continue? These questions are not easy to answer.

China's banking system is not very sound because so many loans are given out as political favors. On the other hand, the Chinese save a huge percentage of their income, some say 20-40%, which is three to seven times higher than here in the U.S. (and that's the highest U.S. saving rate of around 6% since the 1990's). Savings become investment over time, and investment can make up for a lot of bad loans.

China is also experiencing political unrest. China's highly centralized government is fighting to balance the interests of 600 million people living on the east coast (who benefit from free trade) with the interests of 700 million people living in China's interior (who are mostly dirt-poor farmers). This is a delicate balancing act, and, without high economic growth, likely to get much more difficult.

China's economy is very dependent on exporting products. Because worldwide demand is down so much, China has little to export. They are trying to shift their economy more from exporting to internal demand, but this will take a lot of time and effort, and success is by no means assured.

If China succeeds in their efforts to keep growth going, then expect higher commodity prices and increasing growth for the world economy. If China can't keep the growth engine going, then expect commodity prices to tank and for the world economy to muddle along.

China is likely to be the main driver of short to intermediate economic growth for some time.

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.

How to invest with deflation/inflation

Last week, I talked about why I thought we'd be experiencing deflation over the short term and inflation over the long run. This week, I'll discuss how to invest in both scenarios.

A deflationary environment is the harder of the two.

The thing that does best is U.S. government bills, notes and bonds. This was clear late last year as U.S. Treasuries were the best performing asset class. Cash and gold did okay as well, but U.S. Treasuries were the all-star.

Not much else does well in deflation. Some people think other bonds like corporates or municipals or mortgage backed do well, but I beg to differ. The problem is that deflation usually leads corporations to collect less revenue, thus increasing default and bankruptcy risk. Municipalities suffer from less tax revenue and, unlike the Federal government, can't print money or run huge budget deficits. Mortgage backed bonds do poorly for the same reason as corporations--people default on their loans under deflation.

Gold tends to hold its value, but it doesn't produce any cash flow and it is very expensive to store, insure, etc. Cash is a great thing to have, especially if you can deploy that cash as deflation is bottoming and before inflation has taken off.

Stocks tend to get clobbered during deflation. Some companies do better than other, though. High quality companies do better than low quality companies. Companies with pricing power--that can raise and lower their prices easily--tend to do well. Companies with low or no debt do well.

Another problem with investing during deflation is timing. If deflation increases or decreases, it can dramatically impact returns. If you are sitting in U.S. Treasuries when deflation bottoms, you can get clobbered (and many have since January). Nobody can time the market, so trying to go to Treasuries and jump back into stocks or other risky assets is very tough. I don't know anyone who can consistently do it.

Inflation is an easier environment to invest in.

Most people instantly think of gold, but I don't believe gold is the best investment in inflation. Once again, gold is expensive to invest in and it doesn't throw off cash. It will maintain its value over the long run, and that's important, but other investments do better.

Commodities do well under inflation. Resource and mining companies tend to do even better. Land and real estate--as long as it's not bought with debt--can hold up well in an inflationary environment. The things that do well in inflation tend to be tangible.

Stocks tend to do poorly in the initial stages of inflation, but then do outstandingly when inflation is brought under control. Once again, companies with pricing power do better. Companies with debt can do well as long as their debt isn't floating (variable rate).

The problem, like with deflation, is getting the timing right. It's not easy or even possible to do.

For that reason, I have a different approach than most to investing in a deflationary and then inflationary environment, especially because I know I can't get the timing right on when deflation will turn into inflation.

First, I am buying high qualities companies with pricing power. They should fall less during deflation and should recover more quickly when inflation kicks in.

Second, I am buying companies with resource exposure as the market goes down. I can lock in better and better prices on the way down, and then really do well as inflation kicks in.

Third, I'm investing in foreign companies. When the dollar goes down for U.S. macro-economic reasons, that doesn't mean other country's currency will go down, too. High quality companies with pricing power in countries with more solid economics than the U.S. fit the bill here.

Finally, I'm caring more cash than usual going into this deflationary scenario. I will have cash as the market goes down and will be able to buy great companies, resource companies and foreign companies on the way down. It's hard to buy low if you don't have cash because you have to pick something that will probably have gone down a lot to buy something else cheap.

Deflationary and inflationary environments are tough to invest in, but there are smart options. Timing things perfectly can't be done, so don't try it. Investing to benefit from such an environment, however, can allow you to build tremendous wealth over the long run, and having a disciplined plan in place helps. Happy investing!

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.

Inflation or deflation?

One of the big arguments raging in markets is whether we face inflation or deflation going forward. This is an extremely complex subject, and I don't believe anyone really knows, with certainty, which will happen. I certainly don't. My educated guess is that we'll experience deflation in the short run and then inflation in the long run.

I believe this issue is clouded because the terms "inflation" and "deflation" are used to refer to two entirely different, but related, things in reality.

One is what I'll refer to as monetary inflation and deflation. Monetary inflation and deflation is caused when the supply of money grows faster or slower than the economy. When money is created faster than the economy grows, all things equal, then inflation results. When money is created slower than the economy grows, all things equal, then deflation results.

The second kind is what I'll refer to as credit based inflation and deflation. Credit based inflation or deflation is caused by the creation or retraction of credit. This is very similar to monetary inflation in that banks can create money equivalents when they advance credit to borrowers using the money they gather from demand depositors (that's your checking account--it's lent out to borrowers). When credit money is created faster than the economy grows, you get credit based inflation, and when credit money is destroyed through bad loans or banking regulation, you get credit based deflation.

Credit inflation and deflation require more explanation, so stick with me for a little bit. Credit inflation creates an artificial demand that flows into whatever sector is popular--housing in the mid 2000's. Credit deflation occurs when the credit expansion collapses because asset prices collapse without an ever-increasing supply of more credit--welcome to the 2007 and 2008 residential real estate bust. Credit deflation is very ugly because using borrowed money to buy a product and then finding out you can't pay back what you borrowed creates a real decline in growth. Borrowing $100 and paying back $90, when done in the aggregate, leads to negative economic growth. No fun.

If you're lost at this point, you're not alone. Like I said before, this subject is complex and it doesn't seem like anyone has a firm grasp on this overly abstract subject.

I don't think you'll find any conventional economists or investors using the terms I've used above. It's my nomenclature and it's based on my extensive reading and experience on the subject.

Things get very difficult to grasp because when the Fed creates money in the monetary inflation sense, it also causes banks to create credit based inflation as well. This was easy to see in the Dot Com bubble of the late 1990's and the housing bubble of the early and mid 2000's. In both cases, inflation didn't show up in the conventional measures (like the consumer price index), but it was easy to see in assets prices--technology stocks in the first case and residential real estate in the second.

With that framework in mind, let me explain where I think we are now and where I think things will go. I think the monetary inflation that was unleashed to fight the Dot Com collapse created a credit inflation that went, predominantly, into residential real estate in the early and mid 2000's. Because these loans went bad, meaning people in aggregate borrowed $100 only to find out they invested in something that was worth less than $100, we are experiencing credit based deflation.

The Federal Reserve is trying to fight that credit based deflation by using monetary inflation. This keeps prices from spiraling down, in theory, but it doesn't make the original credit based borrowing justified. What you see, in the short term, is a credit based deflation in relative equilibrium with monetary inflation, keeping prices, as a whole, from falling.

The problem is that printing money--monetary inflation--doesn't really solve the problem. When someone invests money and doesn't get all their money back, then you have insolvency instead of a lack of liquidity (a lack of money to lend or spend). What needs to happen is people need to spend less than they make to replenish the capital that was lost in bad investments made with credit based money. That takes time.

When that capital is replenished and growth continues, the Fed will have to use monetary deflation--taking money out of the system--to prevent inflation. I'm not sure if you can see where this is going, but the Fed has an almost impossible task. It has to print just the right amount of money to make up for credit based deflation--and no one knows exactly what that number is--and then they have to take the exact right amount of money back out of the system when the credit based deflation ends and becomes inflation again. I think that's a super-human task that no mere mortal can perform (not even Ben "Helicopter" Bernanke).

Perhaps a simpler way of putting it is this: the banks made a bunch of bad loans at the behest of politicians trying to bring prosperity through collusion, and then those loans went bad. Now the Fed is printing money to make up for the bad loans, but the banks aren't lending that money out, yet, because they need to rebuild their money to make up for loan losses. When those losses are made up for and the banks start lending again, the Fed has to bring all that printed money back out of the system.

In the short run, I think the Fed isn't printing enough money to make up for loan losses because it's under-estimating how many bad loans were made. That's why I think we will be experiencing deflation over the short term.

Eventually, though, due to higher saving rates (consumers have gone from saving less than 0% of their income 2 years ago to saving almost 6% of their income now), capital will be rebuilt and banks will start lending. This will not be entirely clear at the time, and the Fed (facing a lot of political pressure from the President and Congress) will not want to pull money from the system until they are sure the economy is going again. The Fed will almost certainly wait too long and not pull the money out fast enough, which will lead to inflation.

In my opinion, this will be the highest inflation we will have seen since the 1970's. The Fed will get on the ball, eventually (like it did in the early 1980's), and that will probably cause another nasty recession (like it did in the early 1980's).

The result, in my humble opinion, will be deflation over the next few years and then high inflation.

Next week, I'll address how to invest under these scenarios and why this could be an unbelievably good time to make money when everyone else is losing theirs.

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 could go wrong?

The economy seems to be getting back on its feet. New unemployment claims seem to be turning the corner. Manufacturing seems to be turning up. The housing market even seems to be stabilizing.

There are very good reasons to believe the U.S. economy may be growing again before year end.

That's the good news.

But, what could go wrong? When things look rosy, I begin to wonder what would happen if most people are wrong. There are good reasons to worry.

This is not a normal post World War II recession. This is a credit induced recession, and credit induced recessions take longer to work out. It's possible we are out of the woods, but I don't think it's likely.

For starters, the thing that got us into this recession, a credit induced binge to buy real estate, doesn't seem to have worked its way out, yet. Housing may be stabilizing, but option ARM, jumbo, Alt A and prime loans will be reseting to higher rates over the next couple of years. That could put us right back into a 2007-2008 scenario.

On the other hand, the governments of the world have done everything they can, both monetary and fiscal stimulus, to get the world economy going again. There's no such thing as a free lunch, so such stimulus will have consequences. Those consequences could include much higher inflation and perhaps even a dollar crisis.

More credit defaults would be deflationary. If the economy improves, then government stimulus will be highly inflationary. We are stuck between a rock and a hard place. If everything happens perfectly, then we'll be okay and we won't experience inflation or deflation. But, that doesn't seem to be the odds-on bet.

More likely than not, investors will want to be prepared for both contingencies. If deflation happens, then you'll want to be in solid companies with strong balance sheets and earnings power. If inflation happens, you'll want to be invested in companies that benefit disproportionally from inflation, like resource companies or companies with strong pricing power.

It's possible for us to reach a Goldilocks economy again with low inflation and good growth, but it doesn't seem likely considering the dynamics currently at play.

Be prepared for either inflation or deflation. Keep some dry powder in case great opportunities come up. Don't invest in marginal or junky companies--this is not the time to gamble.

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.

Investing in the unloved

The highest returning investments are also the most unloved.

This may sound counter-intuitive at first, but it makes sense when you stand back and think about it.

Great companies, like Google and Apple, that are firing on all cylinders, almost always have share prices that reflects that fact. The very obviousness that such companies are doing well causes investors to flock to those stocks, and hence bid up their shares to very high prices relative to underlying fundamentals. As Warren Buffett puts it, you pay a high price for a cheery consensus. Once everyone loves a stock and has bought it, who is left to buy more?

The companies that are seemingly on the ropes, like Microsoft and Dell (full disclosure: my clients and I both own shares of Microsoft and Dell), on the other hand, have share prices that reflect their tough competitive landscape. Everyone knows that Google is going to crush Microsoft and that Apple is going to crush Dell, so Microsoft and Dell have low share prices relative to their fundamentals. Once everyone who hates a stock has sold it, who is left to sell more?

But, what if what everyone knows to be true isn't true? What if Microsoft and Dell aren't completely doomed? What if they do even slightly better than everyone thinks? Then their share prices may perform better than consensus. Actually, once everyone who is going to sell Microsoft and Dell to buy Google and Apple have done so, then there is only one direction share prices can go, and its the opposite of what most people expect.

In my experience, the more hated the company, the more potential for great upside. This isn't always the case (think: Worldcom, Enron, AIG, Citigroup), but it happens much more frequently than most think.

In fact, I tend to get excited when the consensus comes to such a conclusion. When I tell people I own Comcast (full disclosure: my clients and I own Comcast) and their reaction is, "they are toast, everyone will be watching TV and movies for free over the Internet!", I just smile and nod. I know that Comcast's share price reflects this consensus opinion, and that it's price probably has a lot of upside.

Investing in what is hated is tough. No one will pat you on the back at cocktail parties. But, what would you rather have? Pats on the back, or long run market out-performance? Not everyone agrees with me on this, but it's an easy choice for me (and I think my clients are happy that I take on that burden for them).

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

Don't invest with your heart, invest with your head

Emotions make us lousy investors. People, as humans, tend to act in emotional ways during tough or exciting times. When people give in to emotions--investing with their hearts instead of their heads--they get lousy results.

If you've refused to sell a losing investment, bought because everyone else was, sold because a stock's price went down, picked investments because they seemed safe, or sold because the economy looked dreadful, then you've invested with your emotions. Don't feel bad, everyone fights and succumbs to this at some point.

The field of behavioral finance has clearly shown that we humans suffer from several biases that lead us to make unwise investment decisions.

For example, there's anchoring bias. If you hold an investment waiting for it to get back to the price you paid, you're suffering from anchoring bias. If you wait to buy an investment until it declines back to the price you could have bought it at (and regret not having done so), that's anchoring bias again.

Another bias is called recency bias. This is the tendency to think that recent events are more likely than they are (and that distant events are less likely). Someone who buys hurricane insurance because a bunch of hurricanes seem to have hit recently is suffering from recency bias. Someone who drops earthquake coverage because an earthquake hasn't happened in a while has been hit with recency bias.

Loss aversion is one of the most common biases. It happens when people refuse to sell an investment because they don't want to "book the loss." People feel losses more keenly than gains, and they usually need twice the gain to make up for a given loss. This can lead people to make bad investment decisions by holding on to something they should sell.

Then, there's the endowment or halo effect. This happens when one particular good attribute overwhelms all other attributes. Many people still see GM as a great company because it was in the past, even though there's a lot of evidence it isn't anymore. It can also happen the other way around, when one particular bad attribute overwhelms all good attributes. Many assume a company whose stock has gone down a lot must be bad, even though it may have many excellent characteristics. The price drop seems to overwhelm everything else.

Finally, there's overconfidence. When asked, we all claim to be above average drivers, kissers, and investors, but this isn't Lake Wobegon and everyone can't be above average. It's hard for us view ourselves objectively, and so we make unwise investments when we feel more confident than the facts suggest.

The way to fight these biases is simple, but not easy: discipline. If you use strict criteria to buy and sell investments and act on that criteria, you can fight these emotional biases and win. This will greatly improve your results. Even better, If you'd prefer to let someone else be disciplined for you (I'm not unbiased on this suggestion), then unemotionally select an advisor that can act with discipline on your behalf.

Invest with your head instead of your heart, and you'll get dramatically better investment results over the long term.

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.

Can investors trust their money managers?

A recent article in the Wall Street Journal, "Taking Control," by Jennifer Levitz highlights how investors feel they can no longer trust money managers. Multi-billion dollar Ponzi schemes by the likes of Bernie Madoff, prominent financial companies being accused of cheating clients, and terrible recent performance have all conspired to make investors feel shell-shocked.

This is quiet understandable. After being re-assured that regulators were looking out for their interests and by money managers who have conflicts of interest, no wonder people feel scared.

The article goes on to spell out some of the things investors can do to take back control, so they don't feel as scared.

1) Do your homework when picking a financial advisor. Every investment advisor must provide a Form ADV Part II to prospective clients. This form spells out an adviser's structure, methodology, criminal record, compensation, etc. If you advisor won't disclose this basic information, then don't consider them. I gladly provide this form to all my prospective clients.

2) Ask tough questions to identify potential conflicts of interest. Some advisers are salespeople in disguise. They are compensated by commissions and they only have to judge a potential investment as "suitable" for clients. A tougher standard, which all registered investment advisers must meet, is a "fiduciary" standard. A fiduciary must put the client's interests first. A commission-based broker only has to ensure an investment is "suitable," which has a lot of wiggle room. Make sure your advisor holds themselves out to the fiduciary standard. I do.

3) Find out how an advisor is compensated. If they are compensated by commission, then your interests and theirs are not aligned. Their commissioned-based structure may not be obvious to you, so ask a lot of questions. If an advisor gives you a financial plan for $500, and they recommend you put $100,000 with a mutual fund they get a 5% commission ($5,000) for recommending, they have 10 times the reason to get you to buy their fund than to provide you with an objective financial plan. If they work for a flat fee and don't receive kick-backs for recommending investments, then their interests and yours are aligned. If they work for a fee based on assets under management, then their interests are aligned with yours except when you ask them how much of your money they should manage. Find out how your advisor is compensated and you'll find out if their interests are aligned with yours. I'm compensated by a fee based on assets under management, so my interests are aligned with clients, and I disclose my conflict of interest when they ask me how much money they should stick with me.

4) Ask tough questions about risk factors. Most advisers try to paper over risk factors. They stick clients with a hundred page prospectus (feeling certain no one except accountants and engineers will read it), or they try to understate risk considerations. Make sure your advisor can clearly articulate the risk factors of their particular approach. I have a brutally honest web page that explains the risk factors of equity investing (which is what I do), and I tend to over-emphasize risk to my clients. My first client letter, in the summer of 2005, said the market was over-valued and that clients should lower their return expectations. Fortune favors the prepared mind.

5) Don't expect a free lunch. When someone gives you a free steak dinner, you have to question their motivation and objectivity. When someone says something is "cash-like," doubt their statement. Cash is cash-like; structured products, bonds, even CDs all carry risks that are distinctly not cash-like. I invest in equities, and they are not cash-like. Don't be fooled by someone trying to pitch a product that anything other than cash is truly cash-like.

6) Does a manger invest his own money the same way he's recommending you invest your money? Does he or she eat their own cooking? If your advisor doesn't or won't invest where he is recommending you invest, be very worried. If they earn $100,000 a year selling variable annuities and have $20,000 of their own money in a variable annuities, be very worried (they make so much more from selling annuities that they'll never care about the mere $20,000 they might lose). If an advisor believes in what they do, then they'll have all, or almost all, of their money invested there. I have over 90% of my money invested in the same securities I recommend for clients. My other 10% is in a bank account in case an emergency happens.

7) Does your adviser's firm have interests aligned with yours? Firms make more money when they advise more people. But, the more people they advise, the less time they have for you. Such is the conflict of interest of money management. Added to this, large firms cannot move as quickly as small firms to exploit market opportunities, nor can they deploy their money in smaller situations like small firms can. The benefit of large firms is the possibility of lower costs. With Vanguard, that's the case. Most firms that are 100x my size still charge more than I do, when all costs are considered. Many large firms charge their clients to help them market to new clients, that's what 12b-1 fees are at mutual funds. What a rip-off. My firm is small and nimble, allowing me to provide excellent, personalized customer service to a limited number of unique clients.

Yes, Virginia, some money managers can be trusted, but you have to do your homework to find that out. Get full disclosure, ask about advisor conflicts of interest, find out how they're compensated, get clear information about risk, don't expect a free lunch, ask lots of questions and expect understandable answers. It's hard work, but very much worth the effort.

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.

Higher saving rates are a GOOD thing!

The U.S. saving rate recently hit 5.7%, and all types of commentators have been saying this is bad for the economy. I think this is a load of hooey!

One of the most famous economists of the last century, John Maynard Keynes, made this fallacy main stream with his "Paradox of Thrift."

I'll spare you the details, but the gist is that savings aren't spent in the economy, and therefore prevent growth, employment, all good things.

This fallacy has all kinds of people, including economists and commentators with IQs that are much higher than mine, saying that more savings will crush the economy.

But, I think they are full of baloney. Saving stuffed under a mattress, as they were during Keynes time, aren't spent in the economy. But who puts their savings under a mattress nowadays?

No, most people put their saving into the bank, bonds or stocks.

If savings go to the bank, they are lent out again and used for consumption or investment in productive capacity. I call that spending.

If the money goes into bonds, then whoever sold the bond will either spend the money, which is consumption, or invest the money elsewhere, which will turn into an investment in productive capacity.

If the money goes into stocks, you get the same thing as with bonds.

If people save their money (and don't stick it under the mattress), it gets invested. Investment is where higher productivity, new jobs, and growth come from.

We shouldn't be encouraging people to spend, we should be encouraging them to save and invest. Consumption, especially consumption paid for with debt, is what got us into this economic mess to begin with!

What we need is more, not less savings. That will create new jobs, higher productivity and higher growth. This will not prevent growth, but is the necessary precursor to growth.

Okay, I'll get off my soap-box now...

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.