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Our most recent newsletter discusses some takeaways for individual investors from the allegations of SEC v. Goldman Sachs & Co.  You can read the newsletter here.  Here’s an excerpt from the main article:

But this “sophisticated-investor” defense is telling. What it says is that Goldman Sachs, historically one of the most trusted advisors to the world’s largest corporations, treated the European banks as customers, not clients.

Though often used interchangeably, “customer” and “client” have important differences. “Customer” comes from Latin meaning “habitual” or “custom” and has traditionally been applied to arms-length transactions involving commodity goods and services such as the purchase of groceries, gasoline, or a haircut. “Client” can also mean someone who buys goods or services, but is derived from the Latin “cliens,” meaning “one who is dependent on another” and has traditionally referred to people served by professionals such as lawyers and accountants.

Lest there be any confusion, however, it’s not clear to me that Goldman Sachs acted illegally or even unethically in putting together their synthetic CDO trade.  Rather, at this point — without the benefit of any formal fact-finding process, such as a trial — it seems the greatest blame in all of this lies with the European banks who made poor bets at the derivatives race track.  What were they doing at the race track to begin with? They should have been home guarding their customers’ deposits.

To mix metaphors, it’s as if the European banks believed that since they could play a good pick-up game at the YMCA, they were good enough to walk onto the court with Kobe Bryant and LeBron James.  No wonder they lost their shirts.


Watering & Weeding

by Milo on March 24, 2010

My neighbors and I are having trouble with our gardens.  We put out seedlings — chard, beans, artichoke, lettuce — and something swooped down or crawled up during the night and stripped many of the new plants clean.  The garden guy at the nursery said it could be anything — slugs, birds, even rodents.  We’ve put out iron phosphate and pepper tablets and may have to go to netting soon.

My neighbors were a little upset.  After all, we spent some money on the plants.  I should have been more upset, too, but I wasn’t.  My neighbors are new to gardening whereas I’ve got a little experience and know something they don’t:  the biggest danger to my garden isn’t all the insects, birds, or furry little animals in the world.  It’s me.

Perhaps you’ve had this experience, too:  you build your garden box, tack on the chicken wire (to keep out the gophers), and fill the box with dirt and compost.  You drop the seeds in the ground, de-pot the seedlings, and build your bean trellis.  All goes well for a while.  You’re watering, weeding, plants are growing; you take in your first harvest and then another.

And then one day, life takes over.  You get busy, forget to water, much less weed.  Days and weeks go by.  When you return to your garden, the scene is devastating:  drooping, brown leaves, withered vines, vegetables rotting on the ground.  It’s an embarrassing, yes shameful state of affairs.

Investment portfolios aren’t much different than gardens. They require regular tending, too, even when life gets busy.  And the biggest threats aren’t external; they’re the slow accumulation of small acts of neglect year after year that leave the portfolios dry, withered and small compared to what they could have been with proper weeding and watering, month after month, year after year, and across the decades.


Managing Risk With Franken-Products

by Milo on November 1, 2009

Warren Buffett has long stated that successful investing is “simple, but not easy.” To which I like to add, “in the same way that dieting is simple but not easy.” Your mind knows you should avoid reaching for the next cookie, slice of pizza, or scoop of ice cream. But can your trembling hand resist it?

To help dieters resist temptation in an age of food abundance, an entire industry arose several decades ago offering all kinds of special pills and foil-wrapped “franken-food.” The pills and special foods were meant to help manage your appetite for the more straightforward fruits, vegetables, meats and grains that had a long, established track record of sustaining humankind. Unfortunately for many dieters, the special pills and franken-food lightened only their wallets, not their bathroom scales.

Many investors, I’m afraid, will likely experience a similar fate with some of the special products being offered by banks and brokerage firms these days as a way to participate in equity gains, but supposedly without all the risk of equities. As an example, structured notes — a hybrid debt and derivative product — come to mind.

These franken-products often come with a heavy price tag. Sometimes, it’s simply the out-of-pocket costs that make them an unattractive option compared to a more straightforward solution such as simply reducing your overall equity exposure.

But often there are also hidden risks in franken-products. Pricing even simple derivative products such as options and forwards requires a lot of assumptions to be made about future events; many more assumptions must be made with more complicated derivative products. If the assumptions don’t play out as expected, the franken-product can wind up being an expensive “sugar pill” or worse.

With food, a simple truth sits forever before us. We can have everything we want — every single olfactory and gustatory delight — as long we adhere to one simple rule: don’t take too much.

With investment risk and return, it’s pretty much the same, though admittedly figuring out what constitutes “too much” is a little more involved than counting calories. If you can’t be bothered to figure out your capacity for financial risk before shopping for a new portfolio, then at least keep in mind the most important rule for all investments products: there truly is no free lunch.

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WSJ: The Perils of Chasing Yield

by Milo on September 21, 2009

Jason Zweig’s Wall Street Journal column this week, Don’t Trip In Your Search of for Higher Bond Yields, does a nice job of tapping into the investor zeitgeist:

Last month, investors put twice as much money into intermediate-term and junk-bond funds as into short-term bond portfolios. As a result, they have exposed themselves to much greater risk from rising rates or falling credit quality. When interest rates go up, as in 1994, investors in longer-term bonds can get slaughtered.

“People feel they have to choose between the frying pan of zero yields and the fire of risk,” said Crane Data’s president, Peter G. Crane. “And they’re sick of the frying pan, so they’re jumping into the fire.”

I have to say, though:  it’s nice for a change to be talking about the straightforward perils of chasing yield, rather than the almost unimaginable threat of global economic collapse.  Dare we say it:  maybe things are getting back to normal after all.


Harvard Endowment Lessons

by Milo on September 13, 2009

The Harvard endowment reported last week that it dropped 27.3% during its fiscal year ending June 30, 2009, excluding donations and distributions: Harvard Endowment Drops Sharply Amid Recession. A year earlier Harvard’s portfolio was trouncing the U.S. stock market and being touted as a superior investment approach. 

For example, on September 7, 2008 a Wall Street Journal article entitled “Harvard’s Investments Provide a Good Lesson” praised Harvard’s 2008 outperformance of the S&P 500 Index:

How did Harvard do this? The key is diversifcation, and not just by investing in a variety of stocks and bonds. Harvard invests in 11 non-cash asset classes, only one of which is U.S. stocks. Like Yale and other large endowments, it counts on one or more of these to shine even when others are weak, achieving better long-term results than could be attained with fewer asset classes.

In retrospect, articles like the one above were a contrarian indicator that the “endowment model” was about to get a comeuppance. Over the same twelve months that Harvard’s portfolio declined 27%, the plain-vanilla Vanguard Balanced Fund (VBINX), a 60/40 blend of U.S. stocks and bonds, lost less than 14%. In other words, during the worst market crash since the 1930’s, investors who stuck with stodgy stocks and bonds did much better than sophisticated, exotic-hugging endowments.

But the big lesson here is not about what ingredients belong in a portfolio. Some types of investments will always be outperforming others. Rather, it’s that successful investing requires paying attention as much to what’s outside the portfolio — our capacity for financial risk — as to what’s within it.

In Harvard’s case, the endowment has been paying in recent years as much as 40% of the university’s annual operating expenses. Yet, believing its endowment to be the Titanic of institutional portfolios — unsinkable — the university failed to hold aside emergency reserves to cover these expenses.  As a result, what should have been merely a disappointing investing year has turned into dislocating layoffs in departments across the campus.

In the long run, Harvard’s endowment will likely be just fine. With an unlimited life expectancy, time is on its side and some of its illiquid holdings will eventually rebound. In the meantime, the university can lean on alumni for donations to cover shortfalls and replenish the endowment.

Individuals have no such luxury. They are stuck with their own donations and their particular thirty-to-fifty years of investing and whatever the markets deliver within that time frame. For them it’s even more paramount to consider their capacity for financial risk before thinking about anything as luxurious as “risk tolerance.” 

At this point, it looks like endowment investing offers mostly peril for individual investors. But if Harvard’s example can serve as a cautionary tale to protect individuals from a similar fate, it will, indeed, have served as a superior model.

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In yesterday’s WSJ, Santa Clara finance professor Meir Statman provides a pretty good summary of major investing lessons from the work of behavioral finance in The Mistakes We Make — And Why We Make Them.

Things like:  don’t trade on every piece of market news; don’t succumb to hindsight error by thinking something like the Crash of 2008 was obvious; stop worrying about yesterday’s losses; don’t believe all the success stories promoted by the financial-services industry; and don’t get too excited by your gains or losses.

It’s a good article, and I recommend reading it.  But there was one major lesson missing from the list:  before you deploy your hard-earned capital in risky financial assets, understand why you’re investing. 

In my experience, too many investors fail to define their investment goals before setting sail with their investment program.  Rather than specifying the time frames and dollar amounts of the goals they’re trying to accomplish, they put their capital at risk with vague objectives such as to “make money,” “outperform the market,” or “eventually retire.”  It’s the equivalent of setting sail with the aim of “heading toward the horizon.”

This might be okay for a sunset cruise, but not when you’re crossing the ocean.  Failing to know ahead of time what you’re up against and what you can reasonably expect from the markets over time is, to my mind, the biggest investment mistake of them all.


What The Sardines Can Teach Us

by Milo on August 14, 2009

I visited the Monterey Bay Aquarium this week and learned again about the rise and fall of the sardine fishing industry and Cannery Row.  The amount of fish caught and canned in that small geographic area is hard to imagine.  By the mid-1920’s, using a special “hopper” technique, fisherman were able to vacuum up an unbelievable seventy tons of fish an hour.  Then, in the 1950’s, having fed armies fighting around the globe in WWII, the Pacific sardine population and Cannery Row suddenly collapsed.  Poof.  Gone overnight. 

At the time, overfishing was the prime culprit for the sardine collapse.  But the aquarium exhibit had a surprising fact:  recent scientific research indicates that the main cause of collapse had less to do with overfishing than with the natural cycles of the Pacific sardine population, which we now know rises and falls in 50-year cycles.  

The capital markets, too, have their natural cycles, rising and falling over time.  But until a crash such as last year’s comes along, too many investors behave like the Monterey fishing industry in the 1950’s, failing to attune their portfolios with these cycles and putting their portfolios in harm’s way by overloading financial risk.

The good news today for the Pacific sardines is that they’re back.  And wiser fishing management means they’ll likely never be so heavily fished again.

Investors who still have a few decades left ahead of them and can learn from last year’s market lessons may likewise be given a second chance.  If only they can seize it.


Stock Holding Periods Growing Shorter

by Milo on August 9, 2009

The average time that investors own stocks traded on the New York Stock Exchange has dropped from three-to-five years during 1935 to 1980 to about six months today.  


In other words, a NYSE-listed stock purchased today will likely be sold by February next year. Whatever happened to stocks for the long run?

The end of fixed stock commissions in 1975, which lowered trading costs, probably helped increase the velocity of stock trades, as did sophisticated computer trading programs that became prevalent in the 1980’s.  

Still, stock holding periods — a proxy for investor conviction — haven’t been this low since the speculative days of the 1920’s, just before the other Great Crash.  Perhaps short holding periods and the recent crash are just correlation, not causation.  But if we’d read our Yeats, the data might have given us pause:

Things fall apart; the centre cannot hold;
Mere anarchy is loosed upon the world,
The blood-dimmed tide is loosed, and everywhere
The ceremony of innocence is drowned;
The best lack all conviction, while the worst
Are full of passionate intensity.

Surely some revelation is at hand;
Surely the Second Coming is at hand.

Excerpted from The Second Coming, William Butler Yeats.


Conspiracies Against the Laity

by Milo on August 2, 2009

Until anesthesia came along in the nineteenth century, most physicians were deemed to be about as useful as undertakers for most serious ailments.  It was a time of trial and error, individual doctors making up treatments one day and seeing if they worked the next.  Of course, if something worked, they couldn’t be sure if it was due to luck or chance, not until they had tried the technique out on at least a few more hapless patients.

Unfortunately, the world of financial advice appears to have just barely caught up with nineteenth-century medicine right now.  Different business models, with varied financial incentives for the advisers, necessarily mean that investment recommendations often vary as much as the Himalayas do from Hawaii.  

Similarly, when talking to potential clients, I’ve learned not to ask whether they completed a “financial plan” with a previous advisor.  A “plan” these days can mean anything from a simplistic, linear retirement projection with an assumed 8% portfolio gain every year to a 30-page document full of graphs and statistics, but no real insights.  In other words, it’s a term of art so vague that neither of us can possibly know what the other means in casual conversation.

The good news is that, as a result of last year’s market crash, savvy consumers of financial advice have started to catch on and understand, whether they can articulate or not, the old bromide about there being three kinds of investment professionals:

1.  Those who understand they have no clue where the markets are going in the next six months and who acknowledge this lack of foresight in order to build investment strategies that do not depend on it.

2.  Those professionals who haven’t a clue about what they don’t know and who thus build investment strategies upon flimsy illusions.

3.  Those who, in private moments, know that they don’t know the markets’ next moves, but whose professional existence depends upon pretending that they do.

Once the next bull market is sufficiently underway, however, the bromide will likely be forgotten, until the next generational market crash.  So it’s not clear, as we sit here today, whether the financial-advice industry will ever be incentivized to develop true professional standards of care.  

Then again, the old professional stalwarts, medicine and law, haven’t exactly upheld the highest standards of conduct over the past couple of decades.  So perhaps it’s a good time to recall George Bernard Shaw’s observation long ago that every profession is a conspiracy against the laity, and just leave it at that.  At least consumers will know to keep up their guard.


Investing In Private Companies

by Milo on July 17, 2009

A reporter emailed recently to “talk” about investing in private companies.  With the double whammy in the public equity and real estate markets last year, a lot of individual investors apparently think private companies offer some great opportunities.

They do.  But if a company is already an obviously “great private company,” the odds are extremely small that an investor can get in on the deal without a private invitation — meaning an invite from a VC or private equity firm that already owns a controlling share of the company.  Even the founder of a private company typically has little power to invite other investors once the VC guys get involved.
Further, if that much-sought private invitation does come, then Groucho Marx’s advice applies:  beware of any club that will have you as a member.  If a company’s a great prospect, venture capitalists typically want to reserve future funding rounds for themselves and their friends.  By contrast, if a company is having to look beyond the early angel investors and VC funds, there’s a high probability that the investment will turn out to be a lemon.
Actually, the lemon factor is always high with early stage investments.  The conventional Silicon Valley wisdom is that out of 10 investments, you can expect 7 to go bust, 2 to break even, and 1 at most to pay off big time.  In fact, the insiders know and accept that the odds are far worse than that.
Most of the good angel investors I’ve known or heard about typically have a strong non-economic interest in their investment as well as a financial interest.  For them, it’s fun to roll up their sleeves and get actively involved with the company, its people, and the problems the company needs to solve (technical, legal, competitive, etc.) in order to be successful.  In other words, it’s not just an investment; it’s a way of life.