Most investors are happily oblivious of accounting rules. I envy them.
Accounting rules are supposed to standardize how companies report their financial condition. Instead, the rules tend to muddy the waters.
Few realize that accounting rules are set by an accounting body called the Financial Accounting Standards Board (FASB). Although this body is supposed to be independent, when majority rule or special interests don't like its rules, the Congress or Executive branch pressure it to toe the line. This is seldom in the interests of individuals or shareholders.
Accounting rules don't stop shareholders from digging through the data and seeing things clearly. In fact, I'd say such an effort is one of the keys that allows dedicated investors to get better returns than most.
You see, what matters is not the accounting number a company reports, but how much money a business actually makes. What matters is cash: how much cash did the company make after all expenses.
Earnings per share and net income--the accounting fictions companies report--are not the same as cash. Accounting fictions are based on assumptions that can distort or even mislead. Cash doesn't mislead. It's what's left in the the bank account at the end of the day.
Most investors ignore cash because it takes effort to calculate and understand. The accountants don't make it easy to find. But, it's there for those who look.
A business spends cash to buy inventory, pay workers, build factories. After it sells its end product, it receives cash from buyers. Subtract cash received from cash spent, and you have cash earned.
What matters it not accounting profits--which can't pay dividends, repay debt, buy back stock, expand the business--but cash.
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.
Tuesday, July 26, 2011
Thursday, July 21, 2011
Savings, not consumption, grows the economy
It's hard to believe, but in a country where thrift was once a virtue, it's become a vice in the view of many.
The blame lies clearly with economists and politicians who try to reverse cause and effect. Their attempt fails when confronting the facts.
Imagine yourself on an island in the Pacific Ocean without any outside contact. Do you think you could grow your standard of living by eating more, or by storing food?
The answer is obvious. You can't consume what you haven't produced. You can't live in the shelter you haven't built, you can't eat the fish you haven't caught, and you can't escape on the boat you haven't constructed.
To have the time to build the shelter and boat, you'd have to put enough fish aside so you could build instead of fishing. You can't both build and go fishing, and without fish you'd starve. To grow your standard of living, you have to forgo consumption by eating less, which then becomes savings. The savings then allows you to build shelter and a boat. Savings is what leads to growth, not consumption.
And, so it is in the world economy. To get to the point where we have shelter, transportation, clothes, etc., we need to first save up enough food to have the time and resources to devote to building the other things we need.
Here's another example. Assume you want to open a store that sells clothes. To rent the store, purchase inventory and pay employees, you need money. You can't use the sales revenue you haven't gotten yet. You need to use someone else's savings. Once those savings are used to rent the store, buy the inventory and pay employees, you can pay back the person you borrowed from. But, you can't borrow what's been consumed--it must be saved first. The lender has to save instead of consuming in order for the store, the jobs or the clothes to ever exist.
Once again, so it is with the world economy. To create growth, hire new employees, etc., you need savings first. Savings that are invested create growth. Consumption can't do it.
If you spend more than you produce, your standard of living will go down. That's just a fact. You can't spend your way to prosperity. You have to save first. But, to save, you need to spend less than you make.
Sometimes, savings doesn't produce growth. As illustration, suppose you put enough fish aside to build some shelter, but a storm comes along and blows it away. Now, you have to save enough fish up, again, so you have enough to get by as you rebuild a new shelter. Consumption won't fix the problem, only more saving.
Using my second example from above, suppose the clothes store fails--suppose buyers are not interested enough in the clothes to pay as much as the rent, employees and inventory cost? Then you won't have enough to pay back the person you borrowed from. To build back to the point the lender started from, more savings will be required--which means the lender will have to consume less and save more.
Once again, so it is with the world or national economy. Bad loans are solved by more saving, not consumption. Destruction by mother nature requires more saving, not more spending.
More spending than production leads to lower standards of living. The solution, once again, is savings, not consumption.
Don't be fooled by those who say the U.S., or China, or Europe, or Japan, or anyone else can create prosperity or growth by borrowing to consume. Growth comes from savings, not consumption. And borrowing to consume requires even more savings to get back to break even.
Next time you hear someone prattle on about how we need more consumption to get growth "going" (I don't care if they have a Nobel prize in economics--that just means they should know better!), think about an island in the Pacific and that consuming fish doesn't create shelter or boats.
It's time to go back to our country's roots, it's time to tear down the over-worship of consumption and spending and replace it with a reverence for savings and investment.
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 blame lies clearly with economists and politicians who try to reverse cause and effect. Their attempt fails when confronting the facts.
Imagine yourself on an island in the Pacific Ocean without any outside contact. Do you think you could grow your standard of living by eating more, or by storing food?
The answer is obvious. You can't consume what you haven't produced. You can't live in the shelter you haven't built, you can't eat the fish you haven't caught, and you can't escape on the boat you haven't constructed.
To have the time to build the shelter and boat, you'd have to put enough fish aside so you could build instead of fishing. You can't both build and go fishing, and without fish you'd starve. To grow your standard of living, you have to forgo consumption by eating less, which then becomes savings. The savings then allows you to build shelter and a boat. Savings is what leads to growth, not consumption.
And, so it is in the world economy. To get to the point where we have shelter, transportation, clothes, etc., we need to first save up enough food to have the time and resources to devote to building the other things we need.
Here's another example. Assume you want to open a store that sells clothes. To rent the store, purchase inventory and pay employees, you need money. You can't use the sales revenue you haven't gotten yet. You need to use someone else's savings. Once those savings are used to rent the store, buy the inventory and pay employees, you can pay back the person you borrowed from. But, you can't borrow what's been consumed--it must be saved first. The lender has to save instead of consuming in order for the store, the jobs or the clothes to ever exist.
Once again, so it is with the world economy. To create growth, hire new employees, etc., you need savings first. Savings that are invested create growth. Consumption can't do it.
If you spend more than you produce, your standard of living will go down. That's just a fact. You can't spend your way to prosperity. You have to save first. But, to save, you need to spend less than you make.
Sometimes, savings doesn't produce growth. As illustration, suppose you put enough fish aside to build some shelter, but a storm comes along and blows it away. Now, you have to save enough fish up, again, so you have enough to get by as you rebuild a new shelter. Consumption won't fix the problem, only more saving.
Using my second example from above, suppose the clothes store fails--suppose buyers are not interested enough in the clothes to pay as much as the rent, employees and inventory cost? Then you won't have enough to pay back the person you borrowed from. To build back to the point the lender started from, more savings will be required--which means the lender will have to consume less and save more.
Once again, so it is with the world or national economy. Bad loans are solved by more saving, not consumption. Destruction by mother nature requires more saving, not more spending.
More spending than production leads to lower standards of living. The solution, once again, is savings, not consumption.
Don't be fooled by those who say the U.S., or China, or Europe, or Japan, or anyone else can create prosperity or growth by borrowing to consume. Growth comes from savings, not consumption. And borrowing to consume requires even more savings to get back to break even.
Next time you hear someone prattle on about how we need more consumption to get growth "going" (I don't care if they have a Nobel prize in economics--that just means they should know better!), think about an island in the Pacific and that consuming fish doesn't create shelter or boats.
It's time to go back to our country's roots, it's time to tear down the over-worship of consumption and spending and replace it with a reverence for savings and investment.
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, July 13, 2011
Long term optimistic, short term pessimistic
Markets seem to be sitting on the edge of their seats, and for good reason.
On the positive side, there are tremendous innovations in technology, growing and thriving emerging markets, and the possibility (I didn't say likelihood) of real fiscal reform in developed markets.
On the other hand, there are very big fiscal problems in developed markets, increasingly burdensome regulation that's slowing growth/innovation/employment, threats from bad growth and politics in emerging markets, and the ever-present danger of terrorism and natural disasters.
Markets are waiting to see what choices politicians make, because if they screw up--which is extremely likely--then things will get significantly worse before they get better. If politicians straighten out the fiscal messes they've made, and reduce ineffective and burdensome regulations, then individuals and entrepreneurs will be free to innovate and grow everyone's prosperity.
If they don't, then several crises will unfold and we'll likely end up with the same reforms anyway. Herb Stein once said that if something can't go on forever, it won't.
The developed countries of the world have built up too much debt and entitlement programs which can't possibly be paid for. If/when politicians wait too long to deal with those mathematical problems, crises will result that will force change anyway. We'll get change, it just depends on which route we take.
One route will require much more pain and time and the other will require less difficulty and set us on the road to a big recovery.
Having studied history quite a bit, I think politicians and voters will put off the pain until it's too late, but they can't avoid logical consequences any more than the U.S. Congress can legislate gravity out of existence.
Canada in the mid-1990's faced the music and have been booming ever since. They saw that economic reality couldn't be avoided and changed course. They are very much the exception, not the rule.
If the U.S., Europe and Japan face the music, we can all get on with life. If not, then tough days are ahead.
And, that's why I'm long run optimistic and short term pessimistic. I don't think our politicians will face the music because voters don't want to, either. But, like a 3-year-old throwing a fit, that won't change the facts.
If past market cycles are any guide, we'll get down to 10x normalized earnings at some point, which would be 670 on the S&P 500 today, 890 five years from now, or 1200 ten years from now (versus a level of 1320 now, requiring drops of 50%, 33% and 10%, respectively).
It's not inevitable, but it's very likely. Plan accordingly.
After that, we'll probably have another long boom that will take the market back to euphoric peaks. That will be a fun ride, and I'm very optimistic it will happen. But, probably not as soon as I'd like.
Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.
On the positive side, there are tremendous innovations in technology, growing and thriving emerging markets, and the possibility (I didn't say likelihood) of real fiscal reform in developed markets.
On the other hand, there are very big fiscal problems in developed markets, increasingly burdensome regulation that's slowing growth/innovation/employment, threats from bad growth and politics in emerging markets, and the ever-present danger of terrorism and natural disasters.
Markets are waiting to see what choices politicians make, because if they screw up--which is extremely likely--then things will get significantly worse before they get better. If politicians straighten out the fiscal messes they've made, and reduce ineffective and burdensome regulations, then individuals and entrepreneurs will be free to innovate and grow everyone's prosperity.
If they don't, then several crises will unfold and we'll likely end up with the same reforms anyway. Herb Stein once said that if something can't go on forever, it won't.
The developed countries of the world have built up too much debt and entitlement programs which can't possibly be paid for. If/when politicians wait too long to deal with those mathematical problems, crises will result that will force change anyway. We'll get change, it just depends on which route we take.
One route will require much more pain and time and the other will require less difficulty and set us on the road to a big recovery.
Having studied history quite a bit, I think politicians and voters will put off the pain until it's too late, but they can't avoid logical consequences any more than the U.S. Congress can legislate gravity out of existence.
Canada in the mid-1990's faced the music and have been booming ever since. They saw that economic reality couldn't be avoided and changed course. They are very much the exception, not the rule.
If the U.S., Europe and Japan face the music, we can all get on with life. If not, then tough days are ahead.
And, that's why I'm long run optimistic and short term pessimistic. I don't think our politicians will face the music because voters don't want to, either. But, like a 3-year-old throwing a fit, that won't change the facts.
If past market cycles are any guide, we'll get down to 10x normalized earnings at some point, which would be 670 on the S&P 500 today, 890 five years from now, or 1200 ten years from now (versus a level of 1320 now, requiring drops of 50%, 33% and 10%, respectively).
It's not inevitable, but it's very likely. Plan accordingly.
After that, we'll probably have another long boom that will take the market back to euphoric peaks. That will be a fun ride, and I'm very optimistic it will happen. But, probably not as soon as I'd like.
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, July 07, 2011
In-depth research
I must admit, I love doing research. I have an innate curiosity about almost everything, so when I get to dig into a company and its industry, I'm in hog heaven.
Recently, I've been digging into the technology field and it's amazing how many nooks and crannies there are to understand.
Just in computers, you have two major sides: hardware and software. Both of those can be divided into customer sectors: consumer, small and medium business, public, and enterprise.
Just in the enterprise part, you have storage, servers, mainframe/virtualization/cloud software, networking equipment, database software, operating systems software, middleware, and applications.
Some businesses compete across all categories, like IBM, HP and Oracle. Others pick niches that allow them to work with competitors in one market and against them in another.
The hardware side also has a long chain of providers. If you buy a disk drive, the company you buy from probably out-sources assembly and buys parts from others instead of manufacturing itself. In the case of enterprise storage companies like EMC and NetApp, they are more software than hardware companies!
And then there are services. Some businesses are pure consulting with no products to sell, others provide services in one particular niche, like storage, and still others do everything from top to bottom, like HP.
Is it better to be a niche company, or cover the whole field? Which companies have sticky products that are hard to dump, and whose products or services are easy to quit? How is the landscape changing?
Technology seems to be more rapidly changing now than five years ago, and a lot of that is a culmination of widely available and cheap high speed broadband, both wireline and wireless.
Will old businesses that were once dominant be toppled, or can they adapt to the new landscape? Or, will customers be the ones to benefit because stiff competition reduces profitability?
To truly understand all these nuts and bolts, and to be honest enough with yourself to know what you don't know, you need to do a lot of homework. Sometimes that homework pays off in insights that generate better than average returns. Sometimes it's just a dead end.
Either way, in-depth research is the best way to go when it comes to investing. I believe that is one of the reasons it's so hard for part-time investors to generate above average results--they are competing with people who are digging deep in areas and ways that no part-timer can match.
But, it's not enough just to understand the companies, the technologies and the competitive landscape. You also need to understand the financials and be able to value individual securities.
In many ways, I think I'm one lucky duck, because I get to do what I love, what interests me, what I'm good at, and what the market needs all at once.
For me, in-depth research isn't just a means to other ends, it's a very enjoyable end in itself.
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.
Recently, I've been digging into the technology field and it's amazing how many nooks and crannies there are to understand.
Just in computers, you have two major sides: hardware and software. Both of those can be divided into customer sectors: consumer, small and medium business, public, and enterprise.
Just in the enterprise part, you have storage, servers, mainframe/virtualization/cloud software, networking equipment, database software, operating systems software, middleware, and applications.
Some businesses compete across all categories, like IBM, HP and Oracle. Others pick niches that allow them to work with competitors in one market and against them in another.
The hardware side also has a long chain of providers. If you buy a disk drive, the company you buy from probably out-sources assembly and buys parts from others instead of manufacturing itself. In the case of enterprise storage companies like EMC and NetApp, they are more software than hardware companies!
And then there are services. Some businesses are pure consulting with no products to sell, others provide services in one particular niche, like storage, and still others do everything from top to bottom, like HP.
Is it better to be a niche company, or cover the whole field? Which companies have sticky products that are hard to dump, and whose products or services are easy to quit? How is the landscape changing?
Technology seems to be more rapidly changing now than five years ago, and a lot of that is a culmination of widely available and cheap high speed broadband, both wireline and wireless.
Will old businesses that were once dominant be toppled, or can they adapt to the new landscape? Or, will customers be the ones to benefit because stiff competition reduces profitability?
To truly understand all these nuts and bolts, and to be honest enough with yourself to know what you don't know, you need to do a lot of homework. Sometimes that homework pays off in insights that generate better than average returns. Sometimes it's just a dead end.
Either way, in-depth research is the best way to go when it comes to investing. I believe that is one of the reasons it's so hard for part-time investors to generate above average results--they are competing with people who are digging deep in areas and ways that no part-timer can match.
But, it's not enough just to understand the companies, the technologies and the competitive landscape. You also need to understand the financials and be able to value individual securities.
In many ways, I think I'm one lucky duck, because I get to do what I love, what interests me, what I'm good at, and what the market needs all at once.
For me, in-depth research isn't just a means to other ends, it's a very enjoyable end in itself.
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, June 23, 2011
Ahhh...the classics
Just as there are classics to be read and re-read in literature, history, philosophy, psychology, etc., there are classics that should be read and re-read in investing.
The most important, in my opinion, is Graham and Dodd's 1934 classic, Security Analysis. I just finished re-reading it recently, and found many gems to share here:
I could go on (and on and on and on, as my wife can tell you), but you get the idea.
It's amazing how much wisdom can be derived from a book written 77 years ago, and how little can be found in thousands written since....
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 most important, in my opinion, is Graham and Dodd's 1934 classic, Security Analysis. I just finished re-reading it recently, and found many gems to share here:
"A moment's thought will show that there can be no such thing as a scientific prediction of economic events under human control."Free will makes precise economic predictions a fool's errand.
"There are no dependable ways of making money easily and quickly, either in Wall Street or anywhere else."That seminar you and 40,000 other participants paid for and sat through will make the speakers a fortune, not you.
"Investment theory should recognize that the merits of an issue reflect themselves in the market price not by any automatic response or mathematical relationship but through the minds and decisions of buyers and sellers"Take that efficient market clods!
"Perhaps [the intelligent student] would be well advised to devote his attention to the field of undervalued securities--issues, whether bonds or stocks, which are selling well below the levels apparently justified by a careful analysis of the relevant facts."Value investing...careful analysis of the relevant facts...there it is.
"Analysis connotes the careful study of available facts with the attempt to draw conclusions therefrom based on established principles and sound logic."Principles applied logically!
"The value of analysis diminishes as the element of chance increases."No, Virginia, everything is not worthy of analysis.
"The analyst must pay respectful attention to the judgment of the market place and to the enterprises which it strongly favors, but he must retain an independent and critical viewpoint. Nor should he hesitate to condemn the popular and espouse the unpopular when reasons sufficiently weighty and convincing are at hand."Lemmings need not apply.
"Analyzing a security involves an analysis of the business."It's shocking how infrequently this is the case.
"In general, the analyst should refrain from elaborate computations or adjustments which are not needed to arrive at the conclusion he is seeking."Occam's razor for investing!
I could go on (and on and on and on, as my wife can tell you), but you get the idea.
It's amazing how much wisdom can be derived from a book written 77 years ago, and how little can be found in thousands written since....
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, June 17, 2011
Vacillating when the outcome is clear
Sometimes, the outcome is obvious, but people wish it were otherwise.
Whether you look at the fiscal situation in Europe, Japan and the United States, or countless examples in world history, you'll find lots of examples where the proverbial writing is on the wall, but most ignore it.
It's not that they don't grasp it. They do. It's that they don't want to. Like a three-year-old having a good temper tantrum, they drop to the floor, close their eyes, and kick and scream that reality is what it is.
And yet, reality doesn't change. It doesn't care how loud you scream, how much you kick, or how tightly you squeeze your eyes. At least a three-year-old can make an honest argument that they don't really understand.
I was really struck by this recently in watching The Teaching Company's course, "From Yao to Mao: 5000 Years of Chinese History" taught by professor Kenneth Hammond. In it, I learned that China's confrontation with the western world in the 19th century was as clear as could be.
First there were the Opium Wars with Britain, then the defeat in the Sino-French War, and then the crushing blow in the first Sino-Japanese War. In every confrontation of east meets west (for Japan had adopted western ways), east lost--Big Time.
How did China face each of these defeats? Did they realize they were behind the times and needed to change? Nope. Each time, political infighting within China snuffed out any good kind of reform and led to the next defeat.
The writing was clearly on the wall, and yet the political leaders in China just kept clicking their heels like Dorthy in the Wizard of Oz. It didn't work.
Can Greece continue paying public employees huge salaries when not enough taxes are collected? No. And yet they riot.
Can German banks afford the losses on the Greek debt they hold? No. And yet they dither.
Can Japan's economy grow when most of its companies show contempt for shareholder interests? No, sir. Can an aging population that doesn't allow much immigration support that aging population by borrowing? Not really. But they'd really prefer not to change.
Can Wisconsin, Illinois, New Jersey, New York, San Francisco or California afford its pension promises? No, and yet they vacillate.
Can the United States pay its current obligations to Social Security and Medicare. Not at all. But reform hasn't occurred.
Like China confronting the west, the outcome is clear. And yet, they all vacillate.
Wouldn't it be easier to face facts, do some math, and make necessary changes? Without the slightest doubt. But, on the other hand, most people don't want to. I wonder if reality will change for them this 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.
Whether you look at the fiscal situation in Europe, Japan and the United States, or countless examples in world history, you'll find lots of examples where the proverbial writing is on the wall, but most ignore it.
It's not that they don't grasp it. They do. It's that they don't want to. Like a three-year-old having a good temper tantrum, they drop to the floor, close their eyes, and kick and scream that reality is what it is.
And yet, reality doesn't change. It doesn't care how loud you scream, how much you kick, or how tightly you squeeze your eyes. At least a three-year-old can make an honest argument that they don't really understand.
I was really struck by this recently in watching The Teaching Company's course, "From Yao to Mao: 5000 Years of Chinese History" taught by professor Kenneth Hammond. In it, I learned that China's confrontation with the western world in the 19th century was as clear as could be.
First there were the Opium Wars with Britain, then the defeat in the Sino-French War, and then the crushing blow in the first Sino-Japanese War. In every confrontation of east meets west (for Japan had adopted western ways), east lost--Big Time.
How did China face each of these defeats? Did they realize they were behind the times and needed to change? Nope. Each time, political infighting within China snuffed out any good kind of reform and led to the next defeat.
The writing was clearly on the wall, and yet the political leaders in China just kept clicking their heels like Dorthy in the Wizard of Oz. It didn't work.
Can Greece continue paying public employees huge salaries when not enough taxes are collected? No. And yet they riot.
Can German banks afford the losses on the Greek debt they hold? No. And yet they dither.
Can Japan's economy grow when most of its companies show contempt for shareholder interests? No, sir. Can an aging population that doesn't allow much immigration support that aging population by borrowing? Not really. But they'd really prefer not to change.
Can Wisconsin, Illinois, New Jersey, New York, San Francisco or California afford its pension promises? No, and yet they vacillate.
Can the United States pay its current obligations to Social Security and Medicare. Not at all. But reform hasn't occurred.
Like China confronting the west, the outcome is clear. And yet, they all vacillate.
Wouldn't it be easier to face facts, do some math, and make necessary changes? Without the slightest doubt. But, on the other hand, most people don't want to. I wonder if reality will change for them this 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.
Thursday, June 09, 2011
The Virtue of Concentration
If you ask 100 financial planners the most important concept in investing, my guess is 99 of them will say diversification. I agree with that sentiment for most people, but not for everyone.
Most people, after all, don't lead the world. Most are happy to be led, to let someone else take the risks. Most seek first and foremost to stay out of trouble. It works, but it's not a great way to get ahead.
Diversification is protection against ignorance. If you don't know what you are doing, diversification allows you to benefit from some of the upside while primarily focusing on protection from the downside.
If you don't want to take risks, if you don't know what you are doing, if you don't want to stand out, or if you are unsure of yourself, then heavy diversification makes a lot of sense.
If, however, you do want to get ahead, diversification is the wrong way to go.
The facts bear out this contention. Investors with the best records don't diversify heavily, they stay focused in the areas they truly understand and they concentrate their bets there.
In fact, the firms with the best records tend to hold only 5-10 positions per analyst. As any financial planner will tell you, that's not diversification.
It makes sense, too, if you think about it. If an investor works 250 days a year and 10 hour days, he has 2,500 hours a year to work. If he owns 500 stocks, that's a mere 5 hours a year to understand each stock. If he owns 100 stocks, that's 25 hour per stock per year.
How well can an analyst really know a company he studies for 5 to 25 hours a year in a dynamic, rapidly changing economy? Not very well.
Now, suppose his competition only follows 25 or 10 stocks. That's 100 or 250 hours a year to follow each business. Who do you think knows each business better, understands its competition and economics, evaluates management more thoroughly? The guy who spends 5 to 25 hours per year, or the guy who spends 100 to 250 hours per year?
It's really no contest.
And that's why I'm a concentrated investor and consider it a virtue. I'm seeking to lead, to get better than average results, to get ahead.
I know I can't compete with investors who spend 20 to 50 times more hours understanding each business, and I take great comfort knowing most of my competitors are less focused than I am.
Don't get me wrong--concentrated investing is not for everyone. It's almost guaranteed to be more volatile, look more risky, and suffer the criticisms of financial planners.
Those who don't want to stand out, take intelligent risks, or be criticized won't enjoy being concentrated. But, for those who do, the rewards are great.
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.
Most people, after all, don't lead the world. Most are happy to be led, to let someone else take the risks. Most seek first and foremost to stay out of trouble. It works, but it's not a great way to get ahead.
Diversification is protection against ignorance. If you don't know what you are doing, diversification allows you to benefit from some of the upside while primarily focusing on protection from the downside.
If you don't want to take risks, if you don't know what you are doing, if you don't want to stand out, or if you are unsure of yourself, then heavy diversification makes a lot of sense.
If, however, you do want to get ahead, diversification is the wrong way to go.
The facts bear out this contention. Investors with the best records don't diversify heavily, they stay focused in the areas they truly understand and they concentrate their bets there.
In fact, the firms with the best records tend to hold only 5-10 positions per analyst. As any financial planner will tell you, that's not diversification.
It makes sense, too, if you think about it. If an investor works 250 days a year and 10 hour days, he has 2,500 hours a year to work. If he owns 500 stocks, that's a mere 5 hours a year to understand each stock. If he owns 100 stocks, that's 25 hour per stock per year.
How well can an analyst really know a company he studies for 5 to 25 hours a year in a dynamic, rapidly changing economy? Not very well.
Now, suppose his competition only follows 25 or 10 stocks. That's 100 or 250 hours a year to follow each business. Who do you think knows each business better, understands its competition and economics, evaluates management more thoroughly? The guy who spends 5 to 25 hours per year, or the guy who spends 100 to 250 hours per year?
It's really no contest.
And that's why I'm a concentrated investor and consider it a virtue. I'm seeking to lead, to get better than average results, to get ahead.
I know I can't compete with investors who spend 20 to 50 times more hours understanding each business, and I take great comfort knowing most of my competitors are less focused than I am.
Don't get me wrong--concentrated investing is not for everyone. It's almost guaranteed to be more volatile, look more risky, and suffer the criticisms of financial planners.
Those who don't want to stand out, take intelligent risks, or be criticized won't enjoy being concentrated. But, for those who do, the rewards are great.
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, June 03, 2011
Economics rap
(If you'd like to skip my set-up to two amusing and excellent economics rap video's, please zip to the bottom for the links)
After graduating from the Air Force Academy in 1992, I went on a knowledge-gathering binge. I read philosophy, pop science, great quotes and great literature. I was eager to put my 17 years of learning to work, but I realized I still had much more still to learn.
After graduating from pilot training, I got back to work in my knowledge-gathering project, this time filling huge gaps in my knowledge of history, politics and economics. In that journey, I found out about the Austrian economists.
In college, I took Economics 101 and 201, which focused on micro-economics--the economics of supply and demand in individual markets--and macro-economics--economics at the aggregate level (national, regional, world).
Little did I know that an intellectual battle had been fought long ago, and that the Austrian economists had been essentially stricken from the record of academia. In almost any college in the nation, the focus of macro-economics courses was on Keynes and the Monetarists (Milton Friedman being the most prominent of the latter).
My problem, before reading the Austrians, was that Keynes and the Monetarists didn't seem to very well describe reality as I saw it. Keynes, a British economist, saw the government having an active roll in the economy, smoothing out the bumps of free markets. But, my reading of history clearly showed this always ended in tears. The Monetarists, based especially out of Chicago and MIT, constructed complex mathematical models based on assumptions that were clearly false, so they too seemed off the mark.
When I read the Austrian economists, especially Carl Menger, everything seemed to fall into place. I felt like a physicist reading Newton for the first time--this was clearly a better description of reality. So, I was stunned that my college classes never mentioned the Austrians and that they were basically relegated to the back-woods of academia (much like Aristotle during the Dark Ages).
As time went by (I first read the Austrians 16 years ago), I realized the Austrians weren't and wouldn't get a hearing any time soon. The Austrians, including Hayek and Mises, were considered to be cranks and irrelevant (like those who believe in the gold standard--oh wait, that's becoming fashionable again, too!).
The Austrians showed that economics was best left to individuals freely choosing their own economic destiny. Interest rates, prices, quantities produced, etc. set by the free market would fluctuate, but this would be infinitely better than bureaucrats setting them more disastrously.
In particular, they showed that bureaucrats setting interest rates would lead to gross mis-allocation of capital over time, leading to worse booms and busts than occur in free markets.
This discussion may seem academic, but it became clear to me that the Great Depression could be clearly understood in this framework. The Federal Reserve was created in 1913 to prevent financial panics. In the mid 1920's, the Fed held interest rates artificially low so France and Britain could pay back their debts from World War I. This led first to a real estate and then a stock market bubble that crashed (sound familiar?).
The mis-allocation of capital for years before 1929 had caused the Great Depression, not animal spirits (Keynes) or inadequate money supply (the Monetarists). This seemed a more accurate description of reality than anything else I had read.
Not surprisingly, this meant the Austrians clearly saw the dot-com and housing bubbles building and bursting more recently--because they were focused on the mis-allocation of capital due to the Fed fiddling with interest rates! Keynes and the monetarists were oblivious and even responsible for the busts!
Despite all this supporting evidence, I still expected the Austrian economists to remain in the backwoods during my lifetime. I didn't think they'd get their hearing.
I must admit, I was short-sighted and wrong. The Austrian economists are coming back. As proof, here are two links (Keynes and Hayek round 1, Keynes and Hayek round 2) to rap video's featuring none other than Keynes and Hayek (not the real people--they are both dead--but actors playing economist rappers).
Perhaps the Austrians will get their hearing. Perhaps people will start demanding economic policies that conform to the facts of reality and human nature. I must admit, I would be all too happy to be wrong on this.
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.
After graduating from the Air Force Academy in 1992, I went on a knowledge-gathering binge. I read philosophy, pop science, great quotes and great literature. I was eager to put my 17 years of learning to work, but I realized I still had much more still to learn.
After graduating from pilot training, I got back to work in my knowledge-gathering project, this time filling huge gaps in my knowledge of history, politics and economics. In that journey, I found out about the Austrian economists.
In college, I took Economics 101 and 201, which focused on micro-economics--the economics of supply and demand in individual markets--and macro-economics--economics at the aggregate level (national, regional, world).
Little did I know that an intellectual battle had been fought long ago, and that the Austrian economists had been essentially stricken from the record of academia. In almost any college in the nation, the focus of macro-economics courses was on Keynes and the Monetarists (Milton Friedman being the most prominent of the latter).
My problem, before reading the Austrians, was that Keynes and the Monetarists didn't seem to very well describe reality as I saw it. Keynes, a British economist, saw the government having an active roll in the economy, smoothing out the bumps of free markets. But, my reading of history clearly showed this always ended in tears. The Monetarists, based especially out of Chicago and MIT, constructed complex mathematical models based on assumptions that were clearly false, so they too seemed off the mark.
When I read the Austrian economists, especially Carl Menger, everything seemed to fall into place. I felt like a physicist reading Newton for the first time--this was clearly a better description of reality. So, I was stunned that my college classes never mentioned the Austrians and that they were basically relegated to the back-woods of academia (much like Aristotle during the Dark Ages).
As time went by (I first read the Austrians 16 years ago), I realized the Austrians weren't and wouldn't get a hearing any time soon. The Austrians, including Hayek and Mises, were considered to be cranks and irrelevant (like those who believe in the gold standard--oh wait, that's becoming fashionable again, too!).
The Austrians showed that economics was best left to individuals freely choosing their own economic destiny. Interest rates, prices, quantities produced, etc. set by the free market would fluctuate, but this would be infinitely better than bureaucrats setting them more disastrously.
In particular, they showed that bureaucrats setting interest rates would lead to gross mis-allocation of capital over time, leading to worse booms and busts than occur in free markets.
This discussion may seem academic, but it became clear to me that the Great Depression could be clearly understood in this framework. The Federal Reserve was created in 1913 to prevent financial panics. In the mid 1920's, the Fed held interest rates artificially low so France and Britain could pay back their debts from World War I. This led first to a real estate and then a stock market bubble that crashed (sound familiar?).
The mis-allocation of capital for years before 1929 had caused the Great Depression, not animal spirits (Keynes) or inadequate money supply (the Monetarists). This seemed a more accurate description of reality than anything else I had read.
Not surprisingly, this meant the Austrians clearly saw the dot-com and housing bubbles building and bursting more recently--because they were focused on the mis-allocation of capital due to the Fed fiddling with interest rates! Keynes and the monetarists were oblivious and even responsible for the busts!
Despite all this supporting evidence, I still expected the Austrian economists to remain in the backwoods during my lifetime. I didn't think they'd get their hearing.
I must admit, I was short-sighted and wrong. The Austrian economists are coming back. As proof, here are two links (Keynes and Hayek round 1, Keynes and Hayek round 2) to rap video's featuring none other than Keynes and Hayek (not the real people--they are both dead--but actors playing economist rappers).
Perhaps the Austrians will get their hearing. Perhaps people will start demanding economic policies that conform to the facts of reality and human nature. I must admit, I would be all too happy to be wrong on this.
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 27, 2011
Gold is money, but that doesn't make it a sound investment
"Gold is money. Everything else is credit." - John Pierpont Morgan
I must admit, I'm a bit of a gold bug.
After studying economic and financial history for over 16 years, it's quite clear to me that wealth is not pieces of paper, but economic goods. And money--as a store of value or medium of exchange--is not pieces of paper, either, but an objective equivalent of wealth freely chosen by economic participants.
Over thousands of years of human history, economic actors chose first rocks and cattle, then base metals like copper, and finally precious metals like silver and gold as mediums of exchange.
Governments, starting with Croesus in Greece, started minting coins of precious metal not because they arbitrarily decided what money should be, but because market participants were already using it and they grabbed the market for themselves (not for the first or last time, I might add).
After seizing that market, every government has proceeded to debase money by reducing the amount of precious metal in coins, and every time economic participants have adjusted their actions accordingly, revealing the debasement for what it really is--inflation.
Every time, inflation got out of hand and led to price controls that, as always, caused shortages instead of reducing inflation. And each and every time, this led to a slowing and contraction in economic growth that eventually led people to demand money backed by specie--metal or metal-backed currency.
Both the Chinese and French boldly tried paper currency only to find it yielded the same disastrous result as metal coin debasement--but faster. Since the 1930's, U.S. currency has not been redeemable in specie. Since the early 1970's, U.S. currency has not been backed by specie at all. Want to guess why the 1970's witnessed a huge spike in inflation?
Look at a dollar bill some time and you'll see written across the top "Federal Reserve Note." A note, for those of you who don't live on planet economica perpetua (I do!), is a debt instrument--in other words, credit. As Mr. Morgan put it, gold is money and everything else is credit.
With that overlong introduction, you get an idea of why I believe gold is money. But, let me be clear, that doesn't necessarily make it a good investment.
I think Warren Buffett put things clearly when asked a question about inflation protected assets at his most recent annual meeting. He noted that there were three types of assets: 1) assets backed by currency, like dollars, euros, bonds, savings accounts, 2) assets backed by something tangible, like gold, art, antique cars, diamonds, land, and 3) producing assets, like stocks, farm land, rental real estate.
In an inflationary scenario, you can expect the first type to lose value (perhaps badly), you can expect the second to maintain value, and you can expect the third to grow in value.
I place gold firmly in the second category, which makes sense. You expect gold to maintain value regardless of inflation, but you don't expect it to grow in value relative to the value of other things. Gold is money, so it is a store or protector of value, not a grower of value.
You do, however, expect the third category to continue growing regardless of inflation, because it throws off economic value. Instead of being debased, like currency denominated assets, or maintaining value, like tangible assets, you would expect producing assets to continue producing.
A farm continues producing corn, regardless of how corn is priced. Stocks are priced in terms of earnings, where revenues and costs adjust to changing prices over time. Rental real estate rates adjust to underlying currency, whether dollars, dinars, or drachma. You get the idea.
I know gold is money, but that doesn't make it a great investment. Gold may preserve value, it may provide insurance against negative outcomes, but gold is not a producing asset. You may speculate in gold prices, but that's not investing. For my money, I want growth, not standing still or speculation.
Gold is money, no doubt, but that doesn't make it a sound investment.
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 must admit, I'm a bit of a gold bug.
After studying economic and financial history for over 16 years, it's quite clear to me that wealth is not pieces of paper, but economic goods. And money--as a store of value or medium of exchange--is not pieces of paper, either, but an objective equivalent of wealth freely chosen by economic participants.
Over thousands of years of human history, economic actors chose first rocks and cattle, then base metals like copper, and finally precious metals like silver and gold as mediums of exchange.
Governments, starting with Croesus in Greece, started minting coins of precious metal not because they arbitrarily decided what money should be, but because market participants were already using it and they grabbed the market for themselves (not for the first or last time, I might add).
After seizing that market, every government has proceeded to debase money by reducing the amount of precious metal in coins, and every time economic participants have adjusted their actions accordingly, revealing the debasement for what it really is--inflation.
Every time, inflation got out of hand and led to price controls that, as always, caused shortages instead of reducing inflation. And each and every time, this led to a slowing and contraction in economic growth that eventually led people to demand money backed by specie--metal or metal-backed currency.
Both the Chinese and French boldly tried paper currency only to find it yielded the same disastrous result as metal coin debasement--but faster. Since the 1930's, U.S. currency has not been redeemable in specie. Since the early 1970's, U.S. currency has not been backed by specie at all. Want to guess why the 1970's witnessed a huge spike in inflation?
Look at a dollar bill some time and you'll see written across the top "Federal Reserve Note." A note, for those of you who don't live on planet economica perpetua (I do!), is a debt instrument--in other words, credit. As Mr. Morgan put it, gold is money and everything else is credit.
With that overlong introduction, you get an idea of why I believe gold is money. But, let me be clear, that doesn't necessarily make it a good investment.
I think Warren Buffett put things clearly when asked a question about inflation protected assets at his most recent annual meeting. He noted that there were three types of assets: 1) assets backed by currency, like dollars, euros, bonds, savings accounts, 2) assets backed by something tangible, like gold, art, antique cars, diamonds, land, and 3) producing assets, like stocks, farm land, rental real estate.
In an inflationary scenario, you can expect the first type to lose value (perhaps badly), you can expect the second to maintain value, and you can expect the third to grow in value.
I place gold firmly in the second category, which makes sense. You expect gold to maintain value regardless of inflation, but you don't expect it to grow in value relative to the value of other things. Gold is money, so it is a store or protector of value, not a grower of value.
You do, however, expect the third category to continue growing regardless of inflation, because it throws off economic value. Instead of being debased, like currency denominated assets, or maintaining value, like tangible assets, you would expect producing assets to continue producing.
A farm continues producing corn, regardless of how corn is priced. Stocks are priced in terms of earnings, where revenues and costs adjust to changing prices over time. Rental real estate rates adjust to underlying currency, whether dollars, dinars, or drachma. You get the idea.
I know gold is money, but that doesn't make it a great investment. Gold may preserve value, it may provide insurance against negative outcomes, but gold is not a producing asset. You may speculate in gold prices, but that's not investing. For my money, I want growth, not standing still or speculation.
Gold is money, no doubt, but that doesn't make it a sound investment.
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 20, 2011
Is the trend really your friend?
"Many shall be restored that now are fallen and many shall fall that now are in honor."
- Horace, Ars Poetica.
We humans have a tendency to extrapolate recent trends into the distant future. This approach doesn't work in the real world.
Stocks that roared from 1996 to 2000 were expected to keep roaring. They didn't.
The national housing market that hadn't declined since the 1930's was expected never to decline. It did.
Extrapolating recent trends into the distant future is foolhardy. And yet, people do it over and over again.
Once dominant IBM became less so. The same can be said for Apple and Google today, or even Facebook and LinkedIn. But, try telling that to the raving supporters of such companies. You'll be angrily told you don't get it.
China is on the upslope and Japan on the downslope. These trends, too, are unlikely to continue. Such is the nature of things.
Regression to the mean--the tendency of economic series to drift back to average--is a well-founded phenomena. And yet, people expect present trends to continue forever. They won't.
Corporate profit margins are at all-time highs. They won't continue higher for long, or even stay at today's levels.
Commodities have been roaring. That trend will not go in one direction.
Bond yields have been going down since the early 1980's. That cannot continue indefinitely.
The U.S. government has never significantly defaulted on its debt. Just a matter of time.
Small capitalization companies have done exceedingly well over the last 10 years. The future will not look the same.
Emerging markets have been on a decade-long tear. Anyone want to bet that will go on forever?
Trend extrapolation is a dangerous way to invest. And yet, people keep doing it over and over again--and then losing their shirts.
A few trends last long, but they are the exception, not the rule. Those who bet on a regression to the mean always look stupid in the short run, but then rich in the long run.
So, why are so many suggesting, once again, that the trend is your friend?
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.
- Horace, Ars Poetica.
We humans have a tendency to extrapolate recent trends into the distant future. This approach doesn't work in the real world.
Stocks that roared from 1996 to 2000 were expected to keep roaring. They didn't.
The national housing market that hadn't declined since the 1930's was expected never to decline. It did.
Extrapolating recent trends into the distant future is foolhardy. And yet, people do it over and over again.
Once dominant IBM became less so. The same can be said for Apple and Google today, or even Facebook and LinkedIn. But, try telling that to the raving supporters of such companies. You'll be angrily told you don't get it.
China is on the upslope and Japan on the downslope. These trends, too, are unlikely to continue. Such is the nature of things.
Regression to the mean--the tendency of economic series to drift back to average--is a well-founded phenomena. And yet, people expect present trends to continue forever. They won't.
Corporate profit margins are at all-time highs. They won't continue higher for long, or even stay at today's levels.
Commodities have been roaring. That trend will not go in one direction.
Bond yields have been going down since the early 1980's. That cannot continue indefinitely.
The U.S. government has never significantly defaulted on its debt. Just a matter of time.
Small capitalization companies have done exceedingly well over the last 10 years. The future will not look the same.
Emerging markets have been on a decade-long tear. Anyone want to bet that will go on forever?
Trend extrapolation is a dangerous way to invest. And yet, people keep doing it over and over again--and then losing their shirts.
A few trends last long, but they are the exception, not the rule. Those who bet on a regression to the mean always look stupid in the short run, but then rich in the long run.
So, why are so many suggesting, once again, that the trend is your friend?
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
The Foolishness of Forecasting
"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.
"...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 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.
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