Photo Credit: Dana || They charge more for "Arrest me red" too!

Photo Credit: Dana || They charge more for “Arrest me red” too!

This should be a relatively quick note on personal lines insurance. I’m writing this after reading the piece in this month’s Consumer Reports on Auto Insurance.  I agree with most of it.  For those that are short on time, my basic advice is this: bid out your auto, home, umbrella and other personal lines property & casualty insurance policies once every three years, or after every significant event that changes your premium significantly.

Here are a few simple facts to consider:

  • Personal lines insurance — auto, home, umbrella, rental, etc. is a very competitive business, and the companies that offer it all want an underwriting formula that would give them the best estimate of expected losses from each person insured.
  • After that, they want to know how much “wiggle room” that they would have to build in some profit.  Where might the second place bid be?  How likely are consumers to shop around?
  • Most insurers use a mix of credit scores and claim history to calculate rates.  Together, they are effective at forecasting loss costs — more effective than either one separately.
  • Read my piece On Credit Scores.  They are very important, because they measure moral tendency.  People with low scores tend to have more claims than those with high scores on average.  People with high scores tend to be more careful in life.  This is a forward-looking aspect of a person’s underwriting profile.
  • It’s fair to use “credit scores” because they are positively and significantly correlated with loss costs.  The actuaries have tested this.  Note that it is legal in almost all states to use credit scores, or something like them, but not all of them.
  • As the Consumer Reports article points out, many insurance companies take advantage of insureds that stick with them year by year, because they don’t shop around.  Easy cure: bid out your policy every three years at minimum.  If enough people do this, the insurance companies that overcharge loyal customers will stop doing it.  (Note: when I was a buy side analyst analyzing insurance stocks, one company implicitly admitted to doing this, and I was insured by them.  Guess what I did next?  It was not to sell the stock, though eventually I did when I saw that their premium increases were no longer increasing profits.)
  • Also be willing to unbundle your home and auto policies — there may be a discount, or there may not as the Consumer Reports article states.  I’ve worked it both ways, and am unbundled at present.
  • If they have that much money for amusing advertising, it implies that the market isn’t that rational.  Bid it out.
  • But — it is important to realize that insurers don’t all have the same formulas for underwriting, and those formulas are not static over time.  Bidding out your insurance makes sure you benefit from changes that positively affect you.
  • Insurers tend to get more competitive as the surplus they have to deploy gets bigger, and vice-versa when it shrinks after a large disaster.  If your premium goes up after a disaster, bid the policies out.  If it drifts up slowly when there have been no significant disasters, or claims on your part, they are taking advantage of you.  Bid it out.

Bid it out.  Bid it out.  Bid it out.  What do you have to lose?  If loyalty means something to the insurer, they will likely win the bid.  If it doesn’t, they will likely lose.  Either way you will win.  If you have an agent, they will note that you are price-sensitive.  The agent will become more of an ally, even if it doesn’t seem that way.

I went through this several times.  Most people who have read me for a while know that I have a large family — I am going to start teaching number seven to drive now.  I bid it out when kids came onto my policy.  It produced a change.  When two of my kids had accidents in short succession, my premiums rose a lot.  They would not underwrite one kid.  I got most of it back when I bid it out.  Since that time, the two have been claim-free for 2.5 years.  Guess what I am going to do next March, when I am close to the renewal where premiums would shift?  You got it; I will bid it out.

There is one more reason to bid it out: it forces you to review your insurance needs.  You may need more or less coverage than you currently have. You might realize that you need an umbrella policy for additional protection.  You may decide to self-insure more by raising your deductibles.  The exercise is a good one.

You don’t need transparency, or more regulation.  You don’t get transparency in the pricing of many items.  You do need to bid out your business every now and then.  You are your own best defender in matters like this.  Take your opportunity and bid out your policies.

Make sure that you:

  • Choose a range of insurers — Large companies, smaller local companies, stock/mutual, and any that favor a group you belong to, if the group is known to be filled with good risks.
  • Give them a standardized request for insurance, giving all of the parameters for your coverage, and data on those insured.
  • Tell them they get one shot, so submit their best bid now… there will be no second looks.
  • Some companies argue more about paying claims.  (AIG once had a reputation that way.)  Limit your bidders to those with a reputation for fairness.  State insurance departments often keep lists of complaints for companies.  Take a look in your home state.  Talk with friends.  Google the company name with a few choice words (cheated, claim denied, etc.) to see complaints, realizing that complainers aren’t always right.
  • Limit yourself to the incumbent carrier and 4-6 others.  Seven is more than enough, given the work involved.

So, what are you waiting for?  Bid out your personal insurance business.

Full disclosure: long AIZ, ALL, BRK/B, TRV for myself and clients (I know the industry well)

Photo credit: jonesylife || Oh look, a dozen doves flying at the FOMC!

Photo credit: jonesylife || Oh look, a dozen doves flying at the FOMC!

June 2015July 2015Comments
Information received since the Federal Open Market Committee met in April suggests that economic activity has been expanding moderately after having changed little during the first quarter.Information received since the Federal Open Market Committee met in June indicates that economic activity has been expanding moderately in recent months.No real change.
Growth in household spending has been moderate and the housing sector has shown some improvement; however, business fixed investment and net exports stayed soft.Growth in household spending has been moderate and the housing sector has shown additional improvement; however, business fixed investment and net exports stayed soft.No real change. Swapped places with the following sentence.
The pace of job gains picked up while the unemployment rate remained steady. On balance, a range of labor market indicators suggests that underutilization of labor resources diminished somewhat.The labor market continued to improve, with solid job gains and declining unemployment. On balance, a range of labor market indicators suggests that underutilization of labor resources has diminished since early this year.No real change. Swapped places with the previous sentence.
Inflation continued to run below the Committee’s longer-run objective, partly reflecting earlier declines in energy prices and decreasing prices of non-energy imports; energy prices appear to have stabilized.Inflation continued to run below the Committee’s longer-run objective, partly reflecting earlier declines in energy prices and decreasing prices of non-energy imports.No real change.
Market-based measures of inflation compensation remain low; survey-based measures of longer-term inflation expectations have remained stable.Market-based measures of inflation compensation remain low; survey‑based measures of longer-term inflation expectations have remained stable.No change.  TIPS are showing higher inflation expectations since the last meeting. 5y forward 5y inflation implied from TIPS is near 2.10%, up 0.07% from April.
Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability.Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability.No change. Any time they mention the “statutory mandate,” it is to excuse bad policy.
The Committee expects that, with appropriate policy accommodation, economic activity will expand at a moderate pace, with labor market indicators continuing to move toward levels the Committee judges consistent with its dual mandate.The Committee expects that, with appropriate policy accommodation, economic activity will expand at a moderate pace, with labor market indicators continuing to move toward levels the Committee judges consistent with its dual mandateNo real change.
The Committee continues to see the risks to the outlook for economic activity and the labor market as nearly balanced. Inflation is anticipated to remain near its recent low level in the near term, but the Committee expects inflation to rise gradually toward 2 percent over the medium term as the labor market improves further and the transitory effects of earlier declines in energy and import prices dissipate. The Committee continues to monitor inflation developments closely.The Committee continues to see the risks to the outlook for economic activity and the labor market as nearly balanced. Inflation is anticipated to remain near its recent low level in the near term, but the Committee expects inflation to rise gradually toward 2 percent over the medium term as the labor market improves further and the transitory effects of earlier declines in energy and import prices dissipate. The Committee continues to monitor inflation developments closely.CPI is at +0.2% now, yoy.  No change in language.
To support continued progress toward maximum employment and price stability, the Committee today reaffirmed its view that the current 0 to 1/4 percent target range for the federal funds rate remains appropriate. In determining how long to maintain this target range, the Committee will assess progress–both realized and expected–toward its objectives of maximum employment and 2 percent inflation. This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial and international developments.To support continued progress toward maximum employment and price stability, the Committee today reaffirmed its view that the current 0 to 1/4 percent target range for the federal funds rate remains appropriate. In determining how long to maintain this target range, the Committee will assess progress–both realized and expected–toward its objectives of maximum employment and 2 percent inflation. This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial and international developments.No change.
The Committee anticipates that it will be appropriate to raise the target range for the federal funds rate when it has seen further improvement in the labor market and is reasonably confident that inflation will move back to its 2 percent objective over the medium term.The Committee anticipates that it will be appropriate to raise the target range for the federal funds rate when it has seen some further improvement in the labor market and is reasonably confident that inflation will move back to its 2 percent objective over the medium term.No real change.

No rules, just guesswork from academics and bureaucrats with bad theories on economics.

The Committee is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and of rolling over maturing Treasury securities at auction. This policy, by keeping the Committee’s holdings of longer-term securities at sizable levels, should help maintain accommodative financial conditions.The Committee is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and of rolling over maturing Treasury securities at auction. This policy, by keeping the Committee’s holdings of longer-term securities at sizable levels, should help maintain accommodative financial conditions.No change.  Changing that would be a cheap way to effect a tightening.
When the Committee decides to begin to remove policy accommodation, it will take a balanced approach consistent with its longer-run goals of maximum employment and inflation of 2 percent. The Committee currently anticipates that, even after employment and inflation are near mandate-consistent levels, economic conditions may, for some time, warrant keeping the target federal funds rate below levels the Committee views as normal in the longer run.When the Committee decides to begin to remove policy accommodation, it will take a balanced approach consistent with its longer-run goals of maximum employment and inflation of 2 percent. The Committee currently anticipates that, even after employment and inflation are near mandate-consistent levels, economic conditions may, for some time, warrant keeping the target federal funds rate below levels the Committee views as normal in the longer run.No Change.

“Balanced” means they don’t know what they will do, and want flexibility.

Voting for the FOMC monetary policy action were: Janet L. Yellen, Chair; William C. Dudley, Vice Chairman; Lael Brainard; Charles L. Evans; Stanley Fischer; Jeffrey M. Lacker; Dennis P. Lockhart; Jerome H. Powell; Daniel K. Tarullo; and John C. Williams.Voting for the FOMC monetary policy action were: Janet L. Yellen, Chair; William C. Dudley, Vice Chairman; Lael Brainard; Charles L. Evans; Stanley Fischer; Jeffrey M. Lacker; Dennis P. Lockhart; Jerome H. Powell; Daniel K. Tarullo; and John C. Williams.No change, sadly.

We need some people in the Fed and in the government who realize that balance sheets matter – for households, corporations, governments, and central banks.  Remove anyone who is a neoclassical economist – they missed the last crisis; they will miss the next one.

Comments

  • This FOMC statement was another great big nothing. No significant changes.
  • Don’t expect tightening in September. People should conclude that the FOMC has no idea of when the FOMC will tighten policy, if ever.  This is the sort of statement they issue when things are “steady as you go.”  There is no hint of imminent policy change.
  • Despite lower unemployment levels, labor market conditions are still pretty punk. Much of the unemployment rate improvement comes more from discouraged workers, and part-time workers.  Wage growth is weak also.
  • Equities and long bonds rise. Commodity prices and the dollar are flat.
  • The FOMC says that any future change to policy is contingent on almost everything.
  • Don’t know they keep an optimistic view of GDP growth, especially amid falling monetary velocity.
  • The key variables on Fed Policy are capacity utilization, labor market indicators, inflation trends, and inflation expectations. As a result, the FOMC ain’t moving rates up, absent improvement in labor market indicators, much higher inflation, or a US Dollar crisis.
  • We have a congress of doves for 2015 on the FOMC. Things will continue to be boring as far as dissents go.  We need some people in the Fed and in the government who realize that balance sheets matter – for households, corporations, governments, and central banks.  Remove anyone who is a neoclassical economist – they missed the last crisis; they will miss the next one.

I’m not going to argue for any particular strategy here. My main point is this: every valid strategy is going to have some periods of underperformance.  Don’t give up on your strategy because of that; you are likely to give up near the point of maximum pain, and miss the great returns in the bull phase of the strategy.

Here are three simple bits of advice that I hand out to average people regarding asset allocation:

  1. Figure out what the maximum loss is that you are willing to take in a year, and then size your allocation to risky assets such that the likelihood of exceeding that loss level is remote.
  2. If you have any doubts on bit of advice #1, reduce the amount of risky assets a bit more.  You’d be surprised how little you give up in performance from doing so.  The loss from not allocating to risky assets that return better on average is partly mitigated by a bigger payoff from rebalancing from risky assets to safe, and back again.
  3. Use additional money slated for investing to rebalance the portfolio.  Feed your losers.

The first rule is most important, because the most important thing here is avoiding panic, leading to selling risky assets when prices are depressed.  That is the number one cause of underperformance for average investors.  The second rule is important, because it is better to earn less and be able to avoid panic than to risk losing your nerve.  Rule three just makes it easier to maintain your portfolio; it may not be applicable if you follow a momentum strategy.

Now, about momentum strategies — if you’re going to pursue strategies where you are always buying the assets that are presently behaving strong, well, keep doing it.  Don’t give up during the periods where it doesn’t seem to work, or when it occasionally blows up.  The best time for any strategy typically come after a lot of marginal players give up because losses exceed their pain point.

That brings me back to rule #1 above — even for a momentum strategy, maybe it would be nice to have some safe assets on the side to turn down the total level of risk.  It would also give you some money to toss into the strategy after the bad times.

If you want to try a new strategy, consider doing it when your present strategy has been doing well for a while, and you see new players entering the strategy who think it is magic.  No strategy is magic; none work all the time.  But if you “harvest” your strategy when it is mature, that would be the time to do it.  It would be similar to a bond manager reducing exposure to risky bonds when the additional yield over safe bonds is thin, and waiting for a better opportunity to take risk.

But if you do things like that, be disciplined in how you do it.  I’ve seen people violate their strategies, and reinvest in the hot asset when the bull phase lasts too long, just in time for the cycle to turn.  Greed got the better of them.

Markets are perverse.  They deliver surprises to all, and you can be prepared to react to volatility by having some safe assets to tone things down, or, you can roll with the volatility fully invested and hopefully not panic.  When too many unprepared people are fully invested in risky assets, there’s a nasty tendency for the market to have a significant decline.  Similarly, when people swear off investing in risky assets, markets tend to perform really well.

It all looks like a conspiracy, and so you get a variety of wags in comment streams alleging that the markets are rigged.  The markets aren’t rigged.  If you are a soldier heading off for war, you have to mentally prepare for it.  The same applies to investors, because investing isn’t perfectly easy, but a lot of players say that it is easy.

We can make investing easier by restricting the choices that you have to make to a few key ones.  Index funds.  Allocation funds that use index funds that give people a single fund to buy that are continually rebalanced.  But you would still have to exercise discipline to avoid fear and greed — and thus my three example rules above.

If you need more confirmation on this, re-read my articles on dollar-weighted returns versus time-weighted returns.  Most trading that average people do loses money versus buying and holding.  As a result, the best thing to do with any strategy is to structure it so that you never take actions out of a sense of regret for past performance.

That’s easy to say, but hard to do.  I’m subject to the same difficulties that everyone else is, but I worked to create rules to limit my behavior during times of investment pain.

Your personality, your strategy may differ from mine, but the successful meta-strategy is that you should be disciplined in your investing, and not give into greed or panic.  Pursue that, whether you invest like me or not.

This morning, I looked at the fall in the Chinese stock market, and I said to myself, “It’s been a long journey since the last crash.” After that, I wrote a brief piece at RealMoney, and another at what was then the new Aleph Blog, which was republished and promoted at Seeking Alpha, and got featured at a few news outlets.  It gave my blog an early jolt of prominence. I was surprised at all of the early attention. That said, it encouraged me to keep going, and eventually led me away from RealMoney, and into my present work of managing money for upper middle class individuals and small institutions.

I try to write material that will last, even though this is only blogging.  Looking at the piece on the last China crash made me think… what pieces of the past (pre-2015) still get readers?  So, I stumbled across a way to answer that at wordpress.com, and thought that the array of articles still getting readers was interesting.  The tail is very long on my blog, with 2725 articles so far, with an average word length of around 800.  Anyway, have a look at the top 20 articles written before 2015 that are still getting read now:

20. Got Cash?

Though I write about personal finance, it’s not my strongest suit.  Nonetheless, when I wanted to write some articles about personal finance for average people, I realized I needed to limit myself mostly to cash management.  A few of the articles in the new series “The School of Money,” should be good in that regard.

19. Book Review: Best Practices for Equity Research Analysts

I write a lot of book reviews.  I have some coming up.  I was surprised that on this specialized got so many hits after four years.

18. On the Structure of Berkshire Hathaway, Part 2, the Harney Investment Trust

This is a controversial piece on the most secretive aspects of what Buffett does in investing.  I have tried to get people from the media to pick up this story, but no one wants to touch it.  I think I am one of the few admirers of Buffett willing to be critical… but so what?  Hasn’t worked on this story.

17. Learning from the Past, Part 1

This short series goes through my worst investing mistakes.  It’s almost finished.  I have one or two more articles to write on the topic.  This one covers my early days, where I made a lot of rookie errors.

16. On Trading Illiquid Stocks

I describe some of my trading techniques that I use to fight back against the high frequency traders.

15. De Minimus Laws

Here I do a post aiding all of my competitors, giving the relevant references to the de minimus laws for registered investment advisers in all 50 states, plus DC and Puerto Rico.  Note that I got my home state of Maryland wrong, and I corrected it later.

14. The Good ETF, Part 2 (sort of)

Reprises an article of mine explaining what makes for exchange-traded products that are good for investors.

13. On Bond Risks in the Short-Run

A piece giving advice on institutional bond management.  Kinda surprised this one still gets read…

12. Should Jim Cramer Sell TheStreet or Quit CNBC?

Cramer generates controversy, and thus pageviews as well.  As an aside, TheStreet.com is down another 20% since I wrote that.  Still, the piece had my insights from brief discussions that I had with Cramer, way back when.

11. An Internship at a Hedge Fund

Basic advice to a young man starting a new job at a hedge fund.

10. Q&A with Guy Spier of Aquamarine Capital

I have always enjoyed the times where I have had the opportunity to interact with the authors of the books that I have gotten to review.  Guy Spier was a particularly interesting and nice guy to interact with.

9. The Good ETF

This is the predecessor piece to the one rated #14 on this list.  Brief, but gets the points across on what the best exchange traded products are like.  It was written in 2009.

8. We Eat Dollar Weighted Returns — III

I’ve been banging this drum for some time, and the last one in this series was quite popular also.  This article highlighted how much average investors lose relative to buy-and-hold investors in the S&P 500 Spider [SPY].  Really kinda sad, underperforming by ~7%/year.

7. Portfolio Rule Seven

Now, why does my rebalancing trade rule get more play than any of my other rules?  I don’t know.

6. The US is not Japan, but there are some Similarities

I had forgotten that I had written this one in 2011.  Why does it still get hits?  In it I argue that the US will get out of its difficulties more easily than Japan.  (Maybe this gets read in Japan?)

5. Actuaries Versus Quants

My contention is that Actuaries are underrated relative to Quantitative Analysts, and have a lot to offer the financial markets, should the Actuaries ever get their act together.

4. Can the “Permanent Portfolio” Work Today?

Does it still make sense to split your portfolio into equal proportions of stocks, long Treasuries, T-bills, and gold?!  Maybe.

3. The Venn Diagram Method for Greatest Common Factors and Least Common Multiples

I was shocked at this one, written in 2008.  This post explains a math concept in simple visual terms for teachers to explain greatest common factors and least common multiples.

And now for the last three:

2. On Berkshire Hathaway and Asbestos

1. On the Structure of Berkshire Hathaway

0. Understanding Insurance Float (oops, miscounted when I started… so much for being good at math 😉 )

Should it be any surprise that the last three, the most popular, are on Buffett, Berkshire Hathaway and Insurance?  People go nuts over Buffett!

The one novel thing I bring to table here is my understanding of the insurance aspects of BRK.  Each of the three deal with that topic in a detailed way.  Aleph Blog is pretty unique on that topic; who else has written in detail about the insurance company-driven holding company structure?  Aside from that, many don’t get how critical BRK is to covering asbestos claims, and don’t get the economics of insurance float.  Many think float is magic, when it can lead to an amplification of losses, as well as an intensification of gains.

These last three pieces got really popular in March, around the time that BRK released its 2015 earnings, even though they were one year old.

Anyway, I hope you found this interesting… I was surprised at what gets read after time goes by.  One final note: for every time the most popular pre-2015 article was read, articles that would have been rated #22 and beyond got read 10 times… and thus the long tail.  It’s nice to write for the long term. :)

Full disclosure: long BRK/B for myself and clients

This post is an experiment, and not meant to be definitive. If you have any comments to improve it, leave a comment, or email me.  Thanks.

The School of Money

Most books dealing with money tend to be too advanced for average people.  If you’ve read me long enough, you know that I am pretty conservative with my finances.  That conservatism has generally worked well for me, my family, and the church that I help lead.  It’s possible this post could lead to a series of posts; let me know what you think.

First Grade — Preparing to Work

It could be our culture.  It could be the way that public schools are organized.  My guess is that parents don’t talk about it much, and think that it will happen easily.  The transition of children learning to eventually applying their learning to work is a difficult thing in a world where there are many things to do, and not enough practicality involved in education.

Part of the problem is not having or developing an attitude of service.  There is no shame in helping others.  In one sense, compensation derives from how many people you help, times how valuable your contribution to that good or service is.

So, rather than “following your bliss,” the best work comes from enabling the bliss of others.  It is rare that anyone will pay you for doing what you enjoy, and only that.  Most work involves some things that are disagreeable.  It’s important to look for the good that you can do in the midst of difficulty.  Sometimes that greatest value comes from finding a new way to deal with difficulties, and making processes more productive as a result.

Somewhere around age 15, young people need to see what areas in the economy need talent, and what sort of skills are needed.  In addition to specific skills, remember that in much of life mathematical reasoning, verbal skills, and genuine curiosity for solving problems will apply to a wide number of situations.  Remember, the economy will be different 20 years from now in ways that we do not presently fathom.  Being able to think creatively and critically, and being able to express it well in oral and written ways will never go out of fashion. (As an aside, that is one of the criticisms I hear in the local money management community.  Young people come out of college, but cannot express themselves well in writing.)

Informational interviewing at younger ages could be useful.  Even at older ages, when you get the chance to ask business owners or managers questions, ask them what are the biggest problems that they face, what keep them up at night, etc.  If nothing else, you’ll get a better perspective on what it is like to be in charge, and the headaches thereof.

Software may eliminate many jobs where analytical processes can be easily replicated by code.  Analyze any career for the threat posed by software, or, employ the software yourself to enable you to do more and better work.

You’ll need to consider whether you want to take more risk and run your own business, or less risk and work at a set of skills for someone else.  That said, you can never eliminate risk.  Most of the firms that I once worked for are out of business today, or doing business in such a way that I might not be employed by them now.  There are advantages to trying to control your own destiny, even if you fail a few times in the process.  The skills you will might come in useful if you do choose to work for someone else later.  But if you succeed, you could end up with a valuable business that helps many people — customers, employees, vendors, and of course you.  High rewards go to those who lead and structure the work of others successfully.

College is needed for many high level jobs, and sometimes a master degree or a doctorate.  In other cases, additional training at a special school or a junior college may be enough.  Even after graduation, a plethora of certification situations may present themselves.  Before entering any education situation, try to analyze whether it will genuinely pay off for you or not.  Remember, even nonprofit colleges and universities rely on students to come and pay tuition so that the schools can survive.  This is why it pays to have a range of ideas in mind of what you might like to do before going for higher education.  There is nothing worse than taking on a load of debt that is not dischargeable in bankruptcy, and having no good way to pay it off.  (Note: consider income-based repayment plans if debt is high, and income low.)

Also note that you may not find what you want to do on the first try, in addition to job obsolescence.  Sometimes the path may involve retraining.  If so, count the opportunity cost of the time and money spent.  Sometimes the best path may be indirect — get a lesser job at a firm that you might want to work for and then try to interact with those in the area that is your greater interest.  In this day and age, many employers don’t advertise positions — the only way to find out about them within a firm, or by word of mouth.  If you can show a degree of talent and diligence, greater opportunities may open up for you.

In the end, remember that your work is a means to an end of helping others, while personally benefiting in the process.  Look to the needs of others, and find a way to serve well.  In most cases, the rewards should follow.

Critical Questions

  • What human needs are not getting met?
  • Do you have an idea for a business that meets those needs?
  • Have I talked with enough different people, or read enough, to get a view of what is in demand, growing, etc.
  • What jobs pay well that don’t require college?
  • What sorts of jobs and people getting work visas for at present?
  • What education or skills do I need?  How might that change?
  • Do I have good basic reasoning skills in math, science, reading, writing, general reasoning and logic, etc?

From a friend who is a client:

Here are a couple of things I have been pondering.

  • Market capitalization is pretty fictitious. It assumes that all the shares of a company are worth the price at which the last block sold. However, if you tried to sell all of the shares of a large company (hypothetically), the price would drop to almost zero.
  • It seems to me the primary reason the stock market goes up over time is because the money supply increases. To put it another way, if the money supply did not increase the stock market could only increase in value by increasing the % percentage of the money supply spent on stocks, which is obviously limited.

My views here might be somewhat naive. Comments/criticism/feedback welcome.

Dear Friend,

Ben Graham used to talk about the stock market being a cross between a voting machine and a weighing machine.  On any given day, economic actors vote by buying and selling shares, and in the short run, the trades happen at the levels dictated by whether the buyers or sellers are more aggressive.  That is the voting machine of the market.  In the short run, values can be pretty senseless if one side or the other decides to be aggressive in their buying or selling.

What arrests the behavior of the voting machine is the weighing machine.  The price of a stock can’t get too low, or it will get taken over by a competitor, a private equity firm, a conglomerate, etc.  The price of a stock can’t get too high, or valuation-sensitive investors will sell to buy cheaper shares of firms with better prospects.  Also, corporate management will begin thinking of how they could buy up other firms, using their stock as a currency.

I’ve written more on this topic at the article The Stock Price Matters, Regardless.  Within a certain range, the market capitalization of a company is arbitrary.  Outside the range of reasonableness, financial forces take over to push the valuation to be more in line with the fundamentals of the company.

Macro Stock Market Measures

Every now and then, someone comes along and suggests a new way to value the stock market as a whole.  I’ve run across the idea that the stock market is driven by the money supply before.  The last time I saw someone propose that was in the late 1980s.  I think people were dissuaded from the idea because money supply changes in the short run did not correlate that well with the movements in stock indexes over the next 25 years.

Now, in the long run, most sufficiently broad macroeconomic variables will correlate with levels of the stock market.  Buffett likes to cite GDP as his favorite measure.  It’s hard to imagine how over the long haul the stock market wouldn’t be correlated with GDP growth.  (Why do I hear someone invoking Kalecki in the background?  Begone! 😉 )

There are other popular measures that get trotted out as well, like the Q-ratio, which compares the stock market to its replacement cost, or the Shiller Cyclically Adjusted P/E ratio [CAPE]. All of these have their merits, but none of them really capture what drives the markets perfectly.  After all:, various market players note that the market varies considerably with respect to each measure, and they try to use them to time the market.

The best measure I have run into is a little more complicated, but boils down to estimating the amount that Americans have invested in the stock market as a fraction of their total net worth.  You can find more on it here. (Credit @Jesse_Livermore)  Even that can be used to try to time the market, and it is very good, but not perfect.

But in short, the reason why any of the macro measures of the market don’t move in lockstep with the market is that market economies are dynamic.  For short periods of time, our attention can fixate on one item or group of items.  In my lifetime, I can think of periods where we focused on:

  • Monetary aggregates
  • Inflation
  • Unemployment
  • Housing prices
  • Commercial Mortgage defaults
  • Japan
  • China
  • High interest rates
  • Low interest rates
  • Bank solvency

Profit margins rise and fall.  Credit spreads rise and fall.  Interest rates rise and fall.  Sectors of the economy go in and out of favor.  The boom/bust cycle never gets repealed, and economists that think they can do so eventually get embarrassed.

That’s what keeps this game interesting on a macro level.  You can’t tell what the true limits are for market valuation.  We can have guesses, but they are subject to considerable error.  It is best to be conservative in our judgments here, in order to maintain a margin of safety, realizing that we will look a little foolish when the market runs too hot, and when we seem to be catching a falling knife in the bear phase of the market.  Take that as my best advice on what is otherwise a cloudy topic, and thanks for asking — you made me think.

One of the constants in investing is that average investors show up late to the party or to the crisis.  Unlike many gatherings where it may be cool to be fashionably late, in investing it tends to mean you earn less and lose more, which is definitely not cool.

One reason why this happens is that information gets distributed in lumps.  We don’t notice things in real time, partly because we’re not paying attention to the small changes that are happening.  But after enough time passes, a few people notice a trend.  After a while longer, still more people notice the trend, and it might get mentioned in some special purpose publications, blogs, etc.  More time elapses and it becomes a topic of conversation, and articles make it into the broad financial press.  The final phase is when general interest magazines put it onto the cover, and get rich quick articles and books point at how great fortunes have been made, and you can do it too!

That slow dissemination and gathering of information is paralleled by a similar flow of money, and just as the audience gets wider, the flow of money gets bigger.  As the flow of money in or out gets bigger, prices tend to overshoot fair value, leaving those who arrived last with subpar returns.

There is another aspect to this, and that stems from the way that people commonly evaluate managers.  We use past returns as a prologue to what is assumed to be still greater returns in the future.  This not only applies to retail investors but also many institutional investors.  Somme institutional investors will balk at this conclusion, but my experience in talking with institutional investors has been that though they look at many of the right forward looking indicators of manager quality, almost none of them will hire a manager that has the right people, process, etc., and has below average returns relative to peers or indexes.  (This also happens with hedge funds… there is nothing special in fund analysis there.)

For the retail crowd it is worse, because most investors look at past returns when evaluating managers.  Much as Morningstar is trying to do the right thing, and have forward looking analyst ratings (gold, silver, bronze, neutral and negative), yet much of the investing public will not touch a fund unless it has four or five stars from Morningstar, which is a backward looking rating.  This not only applies to individuals, but also committees that choose funds for defined contribution plans.  If they don’t choose the funds with four or five stars, they get complaints, or participants don’t use the funds.

Another Exercise in Dollar-Weighted Returns

One of the ways this investing shortfall gets expressed is looking at the difference between time-weighted (buy-and-hold) and dollar-weighted (weighted geometric average/IRR) returns.  The first reveals what an investor who bought and held from the beginning earned, versus what the average dollar invested earned.  Since money tends to come after good returns have been achieved, and money tends to leave after bad returns have been realized, the time-weighted returns are typically higher then the dollar-weighted returns.  Generally, the more volatile the performance of the investment vehicle the larger the difference between time- and dollar-weighted returns gets.  The greed and fear cycle is bigger when there is more volatility, and people buy and sell at the wrong times to a greater degree.

(An aside: much as some pooh-pooh buy-and-hold investing, it generally beats those who trade.  There may be intelligent ways to trade, but they are always a minority among market actors.)

HSGFX Dollar Weighted Returns

HSGFX Dollar and Time Weighted Returns

That brings me to tonight’s fund for analysis: Hussman Strategic Growth [HSGFX]. John Hussman, a very bright guy, has been trying to do something very difficult — time the markets.  The results started out promising, attracting assets in the process, and then didn’t do so well, and assets have slowly left.  For my calculation this evening, I run the calculation on his fund with the longest track record from inception to 30 June 2014.  The fund’s fiscal years end on June 30th, and so I assume cash flows occur at mid-year as a simplifying assumption.  At the end of the scenario, 30 June 2014, I assume that all of the funds remaining get paid out.

To run this calculation, I do what I have always done, gone to the SEC EDGAR website and look at the annual reports, particularly the section called “Statements of Changes in Net Assets.”  The cash flow for each fiscal year is equal to the net increase in net assets from capital share transactions plus the net decrease in net assets from distributions to shareholders.  Once I have the amount of money moving in or out of the fund in each fiscal year, I can then run an internal rate of return calculation to get the dollar-weighted rate of return.

In my table, the cash flows into/(out of) the fund are in millions of dollars, and the column titled Accumulated PV is the accumulated present value calculated at an annualized rate of -2.56% per year, which is the dollar-weighted rate of return.  The zero figure at the top shows that a discount rate -2.56% makes the cash inflows and outflows net to zero.

From the beginning of the Annual Report for the fiscal year ended in June 2014, they helpfully provide the buy-and-hold return since inception, which was +3.68%.  That gives a difference of 6.24% of how much average investors earned less than the buy-and-hold investors.  This is not meant to be a criticism of Hussman’s performance or methods, but simply a demonstration that a lot of people invested money after the fund’s good years, and then removed money after years of underperformance.  They timed their investment in a market-timing fund poorly.

Now, Hussman’s fund may do better when the boom/bust cycle turns if his system makes the right move somewhere near the bottom of the cycle.  That didn’t happen in 2009, and thus the present state of affairs.  I am reluctant to criticize, though, because I tried running a strategy like this for some of my own clients and did not do well at it.  But when I realized that I did not have the personal ability/willingness to buy when valuations were high even though the model said to do so because of momentum, rather than compound an error, I shut down the product, and refunded some fees.

One thing I can say with reasonable confidence, though: the low returns of the past by themselves are not a reason to not invest in Mr. Hussman’s funds.  Past returns by themselves tell you almost nothing about future returns.  The hard questions with a fund like this are: when will the cycle turn from bullish to bearish?  (So that you can decide how long you are willing to sit on the sidelines), and when the cycle turns from bearish to bullish, will Mr. Hussman make the right decision then?

Those questions are impossible to answer with any precision, but at least those are the right questions to ask.  What, you’d rather have the answer to a simple question like how did it return in the past, that has no bearing on how the fund will do in the future?  Sadly, that is the answer that propels more investment decisions than any other, and it is what leads to bad overall investment returns on average.

PS — In future articles in this irregular series, I will apply this to the Financial Sector Spider [XLF], and perhaps some fund of Kenneth Heebner’s.  Till then.

It is difficult to make predictions, especially about the future.

Attributed to many people

Susan Weiner has an interesting piece as her blog on Investment Writing called Are financial predictions too risky for investment commentary writers?  I would say the answer is:

  • Yes, and
  • No, because you can’t avoid them if you are writing about investing

Why You Should Avoid Making Predictions

My leading reason for avoiding making predictions is that when you are wrong, and someone loses a lot of money, he gets really annoyed.  I can’t say that I blame them much.

Now, I might do it more if I got praise equal to the amount of annoyance.  But my experience from my RealMoney days was for every bit of praise that I would get from a correct prediction, I would get 10 bits of criticism for one that I got wrong.  That’s not much different in a way from reviews you read on the web for restaurants, hotels, service companies, etc., because people get greater motivation to write when bad service is delivered rather than good.

Why You Can’t Avoid Making Predictions

We can talk about the past, present, and the future.  We know the past reasonably well.  The present is fuzzy. We know the future not at all — we can only make guesses.  Those guesses might be educated guesses, but they are still guesses.

You could spend all your time writing about the past, but readers would ask how that can benefit them now.  Logically, they could ask “If this past situation had the result you mentioned, can I expect the same thing in this current situation that seems a lot like it?”  It’s a fair question, and if you don’t answer it, you might find that your readers go elsewhere.  They’d rather risk being burned than not get an opinion on some issue that they care about.

You could just report on the present.  Some of that is useful, like hearing color commentary at a sports game.  The same set of questions could come to you, like: “The market has been hitting new highs.  Does that mean it will hit higher highs, or is it time to take some risk assets off of the table?”  Another fair question, and readers would like an opinion.

As an aside, when I began studying nonlinear modeling, it was noted by many that nonlinear models don’t predict well.  One academic decided to take the bull by the horns, and wrote a paper that was entitled something like, “If Nonlinear Models Can’t Predict Well, Why Should We Bother With Them?”  One possible answer would be that most models don’t predict well, but that’s too discouraging for most readers.

The thing is, readers have their concerns about the future, and they want advice.  Many would rather have a false certainty than a nuanced set of possibilities.  We can’t do anything for them — they are fodder for the charlatans.

My answer for my writing is to try to be humble about the possibilities, and write things that explain thought processes rather than conclusions.

“Give a man a fish and he eats for a day.  Teach a man to fish and he eats for a lifetime.”

— Old Proverb

The trouble is, we can’t even give people easy investment ideas that will always work.  We can try to explain how to think about the question, and the possible scenarios that could result, and how likely they are.  Giving people the building blocks of investment knowledge is more valuable than handing out tips.  The building blocks have been tested, and work most of the time, but they take work to deploy.  Tips are uncertain, but neophytes love them, partly because they take almost no effort to implement.

Finally, be happy about whatever audience you get.  Largely, you will get the audience you deserve, and the criticism that goes along with it.  Just be careful, and take a page from Hippocrates that resembles the concept of margin of safety:

First do no harm.

Here are some simple propositions on liquidity:

  1. Liquidity is positively influenced by the quality of an asset
  2. Liquidity is positively influenced by the simplicity of an asset
  3. Liquidity is negatively influenced by the price momentum of an asset
  4. Liquidity is negatively influenced by the level of fear (or overall market price volatility)
  5. Liquidity is negatively influenced by the length of an asset’s cash flow stream
  6. Liquidity is negatively influenced by concentration of the holders of an asset
  7. Liquidity is negatively influenced by the length of the time horizon of the holders of an asset
  8. Liquidity is positively influenced by the amount of information available about an asset, but negatively affected by changes in the information about an asset
  9. Liquidity is negatively influenced by the level of indebtedness of owners and potential buyers of an asset
  10. Liquidity is negatively influenced by similarity of trading strategies of owners and potential buyers of an asset

Presently, we have a lot of commentary about how the bond market is supposedly illiquid.  One particular example is the so-called flash crash in the Treasury market that took place on October 15th, 2014.  Question: does a moment of illiquidity imply that the US Treasury market is somehow illiquid?  My answer is no.  Treasuries are high quality assets that are simple.  So why did the market become illiquid for a few minutes?

One reason is that the base of holders and buyers is more concentrated.  Part of this is the Fed holding large amounts of virtually every issue of US Treasury debt from their QE strategy.  Another part is increasing concentration on the buyside.  Concentration among banks, asset managers, and insurance companies has risen over the last decade.  Exchange-traded products have further added to concentration.

Other factors include that ten-year Treasuries are long assets.  The option of holding to maturity means you will have to wait longer than most can wait, and most institutional investors don’t even have an average 10-year holding period.  Also, presumably, at least for a short period of time, investors had similar strategies for trading ten-year Treasuries.

So, when the market had a large influx of buyers, aided by computer algorithms, the prices of the bonds rose rapidly.  When prices do move rapidly, those that make their money off of brokering trades take some quick losses, and back away.  They may still technically be willing to buy or sell, but the transaction sizes drop and the bid/ask spread widens.  This is true regardless of the market that is panicking.  It takes a while for market players to catch up with a fast market.  Who wants to catch a falling (or rising) knife?  Given the interconnectedness of many fixed income markets who could be certain who was driving the move, and when the buyers would be sated?

For the crisis to end, real money sellers had to show up and sell ten-year Treasuries, and sit on cash.  Stuff the buyers full until they can’t bear to buy any more.  The real money sellers had to have a longer time horizon, and say “We know that over the next ten years, we will be easily able to beat a sub-2% return, and we can live with the mark-to-market risk.”  So, though they sold, they were likely expressing a long term view that interest rates have some logical minimum level.

Once the market started moving the other way, it moved back quickly.  If anything, traders learning there was no significant new information were willing to sell all the way to levels near the market opening levels.  Post-crisis, things returned to “normal.”

My Conclusion

I wouldn’t make all that much out of this incident.  Complex markets can occasionally burp.  That is another aspect of a normal market, because it teaches investors not to be complacent.

Don’t leave the computer untended.

Don’t use market orders, particularly on large trades.

Be sure you will be happy getting executed on your limit order, even if the market blows far past that.

Graspy regulators and politicians see incidents like this as an opportunity for more regulations.   That’s not needed.  It wasn’t needed in October 1987, nor in May 2009.  It is not needed now.

Losses from errors are a great teacher.  I’ve suffered my own losses on misplaced market orders and learned from them.  Instability in markets is a good thing, even if a lot of price movement is just due to “noise traders.”

As for the Treasury market — the yield on the securities will always serve as an aid to mean-reversion, and if there is no fundamental change, it will happen quickly.  There was no liquidity problem on October 15th.  There was a problem of a few players mistrading a fast market with no significant news.  By its nature, for a brief amount of time, that will look illiquid.  But it is proper for those conditions, and gave way to a normal market, with normal liquidity rapidly.

That’s market resilience in the face of some foolish market players.  That the foolish players took losses was a good thing.  Fundamentals always take over, and businesslike investors profit then.  What could be better?

One final aside: other articles in this irregular series can be found here.

I’ve been on both sides of the fence.  I’ve been a bond manager, with a large, complex (and illiquid) portfolio, and I have been a selector of managers.  Thus the current squabble between Jeffrey Gundlach and Morningstar isn’t too surprising to me, and genuinely, I could side with either one.

Let me take Gundlach’s side first.  If you are a bond manager, you have to be fairly bright.  You need to understand the understand the compound interest math, and also how to interpret complex securities that come in far more flavors than common stocks.  This is particularly true today when many top managers are throwing a lot of derivative instruments into their portfolios, whether to earn returns, or shed risks.  Aspects of the lending markets that used to be the sole province of the banks and other lenders are now available for bond managers to buy in a securitized form.  Go ahead, take a look at any of the annual reports from Pimco or DoubleLine and get a sense of the complexity involved in running these funds.  It’s pretty astounding.

So when the fund analyst comes along, whether for a buy-side firm, an institutional fund analyst, or retail fund analyst who does more than just a little number crunching, you realize that the fund analyst likely knows less about what you do than one of your junior analysts.

One of the issues that Morningstar had  was with DoubleLine’s holdings of nonagency residential mortgage-backed securities [NRMBS].  These securities lost a lot of value 2007-2009 during the financial crisis.  Let me describe what it was like in a chronological list:

  1. 2003 and prior: NRMBS is a small part of the overall mortgage bond market, with relatively few players willing to take credit risk instead of buying mortgage bonds guaranteed by Fannie, Freddie and Ginnie.  Much of the paper is in the hands of specialists and some life insurance companies.
  2. 2004-2006 as more subprime lending goes on amid a boom in housing prices, credit quality standards fall and life insurance buyers slowly stop purchasing the securities.  A new yield-hungry group of buyers take their place, with not much focus on what could go wrong.
  3. Parallel to this, a market in credit derivatives grows up around the NRMBS market with more notional exposure than the underlying market.  Two sets of players: yield hogs that need to squeeze more income out of their portfolios, and hedge funds seeing the opportunity for a big score when the housing bubble pops.  At last, a way to short housing!
  4. 2007: Pre-crisis, the market for NRMBS starts to sag, but nothing much happens.  A few originators get into trouble, and a bit of risk differentiation comes into a previously complacent market.
  5. 2008-2009: the crisis hits, and it is a melee.  Defaults spike, credit metrics deteriorate, and housing prices fall.  Many parties sell their bonds merely to get rid of the taint in their portfolios.  The credit derivatives exacerbate a bad situation.  Prices on many NRMBS fall way below rational levels, because there are few traditional buyers willing to hold them.  The regulators of financial companies and rating agencies are watching mortgage default risk carefully, so most regulated financial companies can’t hold the securities without a lot of fuss.
  6. 2010+ Nontraditional buyers like flexible hedge funds develop expertise and buy the NRMBS, as do some flexible bond managers who have the expertise in staff skilled in analyzing the creditworthiness of bunches of securitized mortgages.

Now, after a disaster in a section of the bond market, the recovery follows a pattern like triage.  Bonds get sorted into three buckets: those likely to yield a positive return on current prices, those likely to yield a negative return on current prices, and those where you can’t tell.  As time goes along, the last two buckets shrink.  Market players revise prices down for the second bucket, and securities in the third bucket typically join one of the other two buckets.

Typically, though, lightning doesn’t strike twice.  You don’t get another crisis event that causes that class of securities to become disordered again, at least, not for a while.  We’re always fighting the last war, so if credit deterioration is happening, it is in a new place.

And thus the problem in talking to the fund analyst.  The securities were highly risky at one point, so aren’t they risky now?  You would like to say, “No such thing as a bad asset, only a bad price,” but the answer might sound too facile.

Only a few managers devoted the time and effort to analyzing these securities after the crisis.  As such, the story doesn’t travel so well.  Gundlach already has a lot of money to manage, and more money is flowing in, so he doesn’t have to care whether Morningstar truly understands what DoubleLine does or not.  He can be happy with a slower pace of asset growth, and the lack of accolades which might otherwise go to him…

But, one of the signs of being truly an expert is being able to explain it to lesser mortals.  It’s like this story of the famous physicist Richard Feynman:

Feynman was a truly great teacher. He prided himself on being able to devise ways to explain even the most profound ideas to beginning students. Once, I said to him, “Dick, explain to me, so that I can understand it, why spin one-half particles obey Fermi-Dirac statistics.” Sizing up his audience perfectly, Feynman said, “I’ll prepare a freshman lecture on it.” But he came back a few days later to say, “I couldn’t do it. I couldn’t reduce it to the freshman level. That means we don’t really understand it.”

Like it or not, the Morningstar folks have a job to do, and they will do it whether DoubleLine cooperates or not.  As in other situations in the business world, you have a choice.  You could task smart subordinates to spend adequate time teaching the Morningstar analyst your thought processes, or, live with the results of someone who fundamentally does not understand what you do.  (This applies to bosses as well.)

In the end, this may not matter to DoubleLine.  They have enough assets to manage, and then some.  But in the end, this could matter to Morningstar.  It says a lot if you can’t analyze one of the best funds out there.  That would mean you really don’t understand well the fixed income business as it is presently configured.  As such, I would say that it is incumbent on Morningstar to take the initiative, apologize to DoubleLine, and try to re-establish good communications.  If they don’t, the loss is Morningstar’s, and that of their subscribers.