The Aleph Blog » 2010 » September

Archive for September, 2010

Book Review: Secrets of the Moneylab

Wednesday, September 29th, 2010

Secrets of the Moneylab

Behavioral economics is hot among investors, particularly value investors.  But the real advantage of behavioral economics is probably not to investors, but to businessmen setting their pricing, because men do not look to maximize utility, but rather to do good enough, and get a better deal than peers.  Men don’t think absolutely, but rather relatively.  Homo Oeconomicus does not exist.

People will refuse unfair allocations in a deal, even if it makes them better off on average.  There is a sense of fairness in all that people do, exceeding the need for personal gain, except when times are tough.

Machiavelli said, “It is better to be feared than be loved.”  I have found it is better to be loved than feared.  I have worked in businesses where fear was significant, and I found that treating people with love and fairness created far more value than fear.

This is another case where doing what is good leads to more profits not only in long run, but even in the short run.

Play games with people offering them wages in short-term that are high, and yes, you will get more productivity from them, but businesses exist not just for the moment, but for the long-term.  Motivating people in the long run is a lot more difficult.  The weakness of this book is focusing on short term experiments, and assuming that they apply to the long run challenges of business.

Reputation is important in business and in life.  Unlike other aspects of business, you can’t diversify reputation.  You only get one.  People are far more willing to do business with someone that has a good reputation than one who does not. A related concept is trust.  People are far more willing to take chances with those that they trust.

Beyond that, when businesses have odd promotions, they should not be surprised if someone finds a hole in the rules and takes advantage of it.

There is wisdom in experts, and wisdom in crowds, but when do you take advantage of each group to maximum advantage?

Overall, I enjoyed the book and think that those who have not visited these concepts would benefit.  Those with more of an investing mindset would probably benefit more from the book Priceless.

Quibbles

Most of my troubles with the book are expressed above.  It is great that HP employed people to analyze trading behavior.  The mistake is applying the results to long term business decisions.

Who would benefit from this book:

If you want to understand how pricing decisions can improve your business, this book could help you.  Value investors, I am sorry, no, this is not the book for you. If you are looking for an entertaining book on how economics really works on the micro level, you would like this book.

If you want to, you can buy it here: Secrets of the Moneylab: How Behavioral Economics Can Improve Your Business.

Full disclosure: I was e-mailed a copy of the book without asking for it.

If you enter Amazon through my site, and you buy anything, I get a small commission.  This is my main source of blog revenue.  I prefer this to a “tip jar” because I want you to get something you want, rather than merely giving me a tip.  Book reviews take time, particularly with the reading, which most book reviewers don’t do in full, and I typically do. (When I don’t, I mention that I scanned the book.  Also, I never use the data that the PR flacks send out.)

Most people buying at Amazon do not enter via a referring website.  Thus Amazon builds an extra 1-3% into the prices to all buyers to compensate for the commissions given to the minority that come through referring sites.  Whether you buy at Amazon directly or enter via my site, your prices don’t change.

My Interview with David X. Martin

Monday, September 27th, 2010

I had the pleasure today of interviewing David Martin who wrote the book Risk and the Smart Investor.  Unlike most of my book reviews, I have the fun of doing a voice interview and doing a written Q&A as well.  This piece will go over my voice interview.

Before I start, why did I decide to do so much with this book?  I did this because I have a love of risk management.  As I read through his book, I sensed a kindred soul who really got what is behind risk management.  I will not put out this much effort for an ordinary book.  I really liked this book, and after my voice interview I can say that I really liked David Martin.

My first question to David Martin was to ask you what motivated him to write the book.  He replied to me that as he had gone through life and learned things, his satchel filled up more and more.  The book was a way of emptying his satchel and giving back to average people.

If I might interject, that is my reason for writing this blog.  I’m not in it for the money; I don’t think David Martin is either.  But for some of us, when you have learned a lot, you feel a need to share it with others, not so much for your ego, but that others can benefit.

My second question to him was, “If you could make a few key changes to the way we do risk management at financial firms in the United States, what would they be?”  After a pause, and saying that’s a big question, he gave me the following answer:

1) Risk management must be holistic.  It must look to the strategy being pursued, the risk involved, and then the capital needed to pursue such a strategy.

2) The risk manager must not only have a seat at the table but must have a voice at the table, with an independent channel to the Board of Directors like the internal audit function.  The Directors have to be aware of the risks that the company is taking.

3) Risk control must be grounded in reality.  It’s fine to have a quantitative model, but after his run for a while, do you test to see how it has performed?  (David Merkel: It is similar to what happens good insurance firms.  Good firms take the results of their valuation work and feed it back into their pricing, so that they do not under- or over-price their products.)  Testing is key.  Was the model truly predictive?  Did it really work?  Did you compare the results to half a dozen alternative models?

4) There are two visions on risk management.  Vision one is the huge screen in front of the risk manager, with advanced math and analytics, that takes in all the data, and allows the risk manager to make simple adjustments in real time to the quantitative feedback.  Vision two is having people with good business judgment look at the state of the markets and the positioning of the financial institution and making informed decisions.  Like me, David Martin favors the second vision.  Models will never be so good that a businessman with good judgment will be inferior.  This is one place where John Henry will beat the steam drill.

He added his experience the time that he met Peter Drucker.  He asked Drucker how one could predict the future.  Drucker answered that one could predict the future by attempting to create the future.

Now what Drucker said was not dumb, in my opinion.  And David Martin followed that advice by helping to create principles for risk management for buy side firms and for directors of mutual funds.  After all, why wait for the problems to come to you?  Why not create best practices now, and do better business for your clients, making yourself more immune to future lawsuits?

David Merkel: As Cordwainer Smith said in his short story “Mother Hitton’s Littul Kittons,” “Bad communications deter theft; good communications discourage theft; perfect communications stop theft.”  The idea here is that good business practices are best for the client and the business in question.  Before you get sued, why not put something into place that minimizes your probability of getting sued, by maximizing the probability of doing business right?

My third question was: “Most of my readers are amateur investors.  What would you want to take away from your book?”

He began by talking about process and learning.  There are no magic ideas.  You’ve got to do the dirty blocking and tackling of learning about investments so that you can make intelligent and informed decisions about what you do.  Further, you have to be disciplined about your decision-making.  Don’t be haphazard in making choices.  (As David Merkel has said for a long time: Decision triumphs over conviction.  Discipline yourself to make your investment decisions businesslike.)

He added that all of us need an internal Board of Directors.  Friends who can counsel us when we are stumped.  He himself has such a Board of Directors – trusted advisors will help when he can’t figure the situation out.  If David Martin needs such a group of men, how much more how much more do average investors like you and me need such advice?

My fourth question was, “What potential problems are under followed in the present financial environment?”

He paused and explained to me that his ideas here are tentative.  Many have been asking him this question, but he is less certain about what the right answer is here.  He then talked to me about information risk.  There are risks to financial systems being hacked.  Financial companies need to verify the validity of transactions before executing on them.  He mentioned a parallel about the noise the present environment when you get so much spam relative to legitimate mail.  He himself hired a hacker at one point to see how the financial systems of the firm he was working for could be compromised.  He was surprised on how easy it was to do.

As for financial reform, he expressed some skepticism because most of financial reform is fighting the last war.  They are not looking through the windshield, they are looking through the rear view mirror.  They need to look at what the next set of problems might be.

He then said that we have not learned our lessons from the current crisis.  We have beliefs of our country, for which we have not counted the costs.  “Everyone deserves a house.”  “Everyone deserves quality healthcare.”  But what of the costs?  Can society as a whole bear the costs of what many believe are entitlements?

He closed with the comment that somehow Main Street and Wall Street must have some sort of rapprochement.  If the two don’t work together, life will be tougher for both.

My final question was, “If you were to write a follow-up book, what would you write about?”

To my happy surprise, he is considering writing a follow-up book.  It is a book that would focus on risk management for the individual investor by looking through the windshield.  Keep moving on; embrace risk.  Develop processes that will help you embrace risk.  Spend more time thinking and less time slaving.

After that we had a bit of a discussion about liquidity, and how difficult it is to explain as well as how it can throw monkey wrenches into the best financial plans.  He felt that most problems from liquidity could be solved through business judgment, but that it would often cut across the short term goals of many financial firms.

What I have not captured in my comments here are the number of times that he emphasized how risk control must be a whole firm process, and how senior management must be committed to risk control.

To close this off, I will say that I found the interview refreshing.  David Martin has a very intelligent view of risk.  Risk must be embraced, but only at reasonable costs, and in view of decent returns.

So with that I once again recommend the book Risk and the Smart Investor. If you want to, you can buy it here: Risk and the Smart Investor.

Full disclosure: I was asked if I would review a copy of the book.  It sounded interesting, so I said I would consider it; I was e-mailed an advance copy of the book.

If you enter Amazon through my site, and you buy anything, I get a small commission.  This is my main source of blog revenue.  I prefer this to a “tip jar” because I want you to get something you want, rather than merely giving me a tip.  Book reviews take time, particularly with the reading, which most book reviewers don’t do in full, and I typically do. (When I don’t, I mention that I scanned the book.  Also, I never use the data that the PR flacks send out.)

Most people buying at Amazon do not enter via a referring website.  Thus Amazon builds an extra 1-3% into the prices to all buyers to compensate for the commissions given to the minority that come through referring sites.  Whether you buy at Amazon directly or enter via my site, your prices don’t change.

Portfolio Rule Two

Saturday, September 25th, 2010

For those that have e-mailed me about equity management, I will get back to you soon; I have been tied up in details of getting my assets management business going recently.

=-=-=–==–=-==–==-=-=-=-=-=-=-

If you have read me for a while, you have heard of my eight rules of stock investing.  Recently some people have been e-mailing me regarding my plans to start Aleph Investments, and one asked if I could write a series of pieces to explain how I manage stocks.  I thought it was a good idea, so this is the second of what is likely to be eight episodes.  Here’s portfolio rule two:

Purchase equities that are cheap relative to other names in the industry. Depending on the industry, this can mean low P/E, low P/B, low P/S, low P/CFO, low P/FCF, or low EV/EBITDA.

The first principle of value investing is having an adequate margin of safety.  Make sure that your downside is clipped, if things go wrong.  But that’s not today’s topic, I will cover it later in this series.

The second principle of value investing is buying the investment cheap to its intrinsic value.  That is an easy phrase to utter, but complicated to implement.  There is no one single simple metric that serves as a guideline for evaluating cheapness as a value investor.

Ideally, one would create an integrated free cash flow and cost of capital model, one like Michael Mauboussin did in his book Expectations Investing.  That is the correct general model to use; the only problem is that it is impossible for individuals or even small investment shops to implement.

So, when evaluating companies, rather than using a complex model for free cash flow and cost of capital, it makes more sense given limited time, to look at the most critical partial sensitivities of the true model.  What do I mean there?

I go back to what the best boss I ever had sent me regarding modeling: “80 to 90% of the valuable model can be encapsulated in the top 2-3 factors of the model.” What that implies to me regarding analysis of valuation is that simple ratios do still have punch.  But the challenge is selecting the ratios that are the most appropriate for companies in a given industry.

Here is the most basic thing I have learned so far about what valuation ratios to use: with financial companies use price-to-book, and with all other companies use price-to-sales.  How did I come up with this insight?  I spent a lot of time using one of Bloomberg’s functions [GE] and I found the tightest correlation of price movement to each of those variables.

But the intuition that I have received from that is not the end of the story.  Let’s stop for a moment and think about what various valuation ratios mean.

The classic ratio is the price to earnings multiple.  It makes a lot of intuitive sense because we want to know how much we are earning per dollar spent on the stock.  Earnings, and its cousin operating earnings, are the lowest figures on the income statement.  They are also the most manipulated numbers on the income statement.  But there are other ratios on the income statement, less manipulated, that exist higher up on the income statement, or over on the cash flow statement.

Operating income/earnings is a means of trying to look at the profitability the business before interest, taxes and nonrecurring elements.  Many analysts think that this is a better measure of earnings on a continuing basis than ordinary earnings, because it eliminates a lot of noise.  But you can go higher up on the income statement and move to price to sales.  Particularly in an environment like this where sales growth is so scarce, the price to sales ratio plays a larger role.  Exactly how cheap can a stock get on price to sales ratio basis?  Where would its valuation be stretched?

Away from that, on the cash flow statement, we have EBITDA, cash from operations and free cash flow.  EBITDA is earnings before interest, taxation, depreciation and amortization.  Cash from operations is simple to understand.  How much cash is the business generating?  So long as that does not involve the buildup of additional liabilities, or need for additional capital expenditure, that can be a useful figure for analysis.  The same is true of EBITDA.  Free cash flow goes further and subtracts maintenance capital expenditure.

Operating earnings and free cash flow are proxies for trying to understand what the income generating capacity of the business is on a normalized basis.

But then there are balance sheet measures like price-to-book and price to tangible book.  The idea is to ask how much assets are allocable to the equity investors.  In financial companies, where the cash flow statement is pretty meaningless, attempting to estimate the value of the firm, using book or tangible book has some power.  Why?  Because financial firms are in the business of shepherding scarce capital in order to produce returns.  Since capital is typically a constraint for earnings price-to-book is a useful measure for analyzing the valuation of the financial company.

The same is largely true of sales for industrial companies, sales are relatively hard to fake.  Now don’t get me wrong here, sales have been faked in many companies.  It helps to study revenue recognition policies, and it also helps to consider the buildup in accruals for accounts receivable.  Yes, sales can be faked, but cash from sales is very hard to fake.

One more metric worthy of consideration is enterprise value to EBITDA.  This metric is useful during times when there are a lot of mergers and acquisitions going on.  This metric measures in a crude way the amount of free cash flow that the assets of the business throw off.  It is the way many acquirers would look at a business.

Another way to think of it is, is the business more valuable in the hands of the current management, or the hands of new management?  If it is more valuable in the hands of new management, enterprise value to EBITDA is the better metric.  If the current management makes it more valuable, then price to sales is the better measure.

Now there are two more ideas that must be considered here: cost of capital, and reversion to mean.  In one sense we want to look at earnings, or free cash flow in excess of the cost capital employed.  The way I handled this is not to estimate the cost of capital but to look at the credit ratings, leverage on the balance sheet, volatility of the stock price, and volatility of earnings in order to get a feel for the riskiness of the company.

Mean-reversion is involved in value investing, in the sense that return on equity for firms tends to mean-revert over time.  What that implies is that it makes sense to pay attention to valuation, because firms in bad shape often clean up their act and get better, and firms in exceptionally good shape find their excess earnings competed away by other firms.  And that’s why value investing tends to work: companies with cheap valuations improve, and multiples expand.  Companies with high multiples tend to contract, because it is difficult to maintain superior growth over the long haul.

Book Review: Risk and the Smart Investor

Saturday, September 25th, 2010

Risk and the Smart Investor

Not every book grabs me at first.  “Risk and the Smart Investor” was one such book.  But it grew on me.  Having been through many exercises in risk control inside insurance companies, I can sympathize with the much more complex job that it is to control risk inside investment banks.

I was fascinated with the structure of the book, which I found tedious and hokey at first, but I grew to like the intriguing and novel approach.  The author introduced the topic through his experience, then explained the theory, then showed how neglect of it led to failure, and then gave stories of Max and Rob, two very different men whose lives illustrated risk management, and the lack thereof.

Risk control has to be realistic.  You can’t eliminate all risks.  You shouldn’t even want to eliminate all risks.  Anyone who tries to eliminate all risk will end up killing the profitability the business.  As that great moral philosopher James Tiberius Kirk once said, “Risk is our business.”  (For the jobs were I was explicitly a risk manager, I kept that quote on my wall.)

I am going to touch on the themes of the book as I understand them.  In order to control risk, one must first be able to control himself.  Without self-control, there is no risk control.  That process requires humility.  Almost every action of risk control involves limiting the behavior of those that have the power to commit money for investment or to sell assets to raise cash.

Part of that comes down to understanding what are reasonable goals, and what aren’t.  Nothing grows without limit.  Almost every business has a maximum growth rate, which if exceeded materially raises the probability of insolvency.  This is true for individuals as well.  Peter Drucker once said something like, “Jobs should be big enough to be challenging, but not so big that they require superhuman effort.”  In the same way, efforts to grow your personal assets too quickly will lead to decisions with a high probability of large losses.

For risk control the context of large firm, the critical question is cultural issues.  That involves instilling the idea of risk control in every person if the firm – making it a part of the firm DNA.  It must extend to the very pinnacle of management, and not let it be seen as something that is a tradable issue.  It is similar to the idea of a reputation.  You only get one reputation.  Your reputation is your brand.  If your reputation is harmed or destroyed, rebuilding it is desperately tough.  Granted, America is the land of unlimited second chances, but rebuilding is still tough.

We can diversify lines of business.  We can diversify assets.  We can diversify funding sources.  We can’t diversify our reputation.  We only have one reputation.  It is as one of my favorite bosses of the past said, “I’m willing to take lots of moderate risks, but not willing to take an action that has a material probability of destroying the firm.”  This is just another way to say that there are things that can be diversified and things that can’t.

Corporate culture cannot be diversified; it flows from the top and affects all employees.  Good risk control cultures inculcate checks and balances.  They make sure that no one has too much power, such that the work cannot be checked.  They insist on transparency within the firm and transparency outside to the degree that it facilitates business and satisfies regulators.

Such a corporate culture monitors continuously the factors that affect profitability future risks.  It also learns from mistakes, but keeps the risks small early in the process so that learning from mistakes is not an expensive and surprising endeavor.

The structure of the book contrasts financial risks and life risks through the lives of Rob and Max.  They are two very different people, one of whom is careful about risk, and one of whom ignores risk.  Just as we have seen firms that were careful about risk, during the present crisis, and firms that ignored risks, so we have seen the same in ourselves and our friends.  The stories of Rob and Max on the risks that we go through life and the risk that we go through markets.  In my opinion it richens the book a great deal.

Risk is inherent to life.  And, the ultimate risk is death.  You can’t diversify death.  You can’t pay a certain spread over LIBOR in order to engage to death swap on your own life.  The most you can do is build something that may last for some small to moderate amount of time after your death.  Even the great Warren Buffett is trying to do something like this, as I explained in my piece Moat, Float, Growth.

Quibbles

None.  It’s a really good book; very well-thought out.

Who would benefit from this book:

This book would benefit anybody who deals with the question of risk, whether personally or corporately, and that means all of us.  Not only do you get a lucid perspective on the causes of the financial crisis, but you get to see firsthand how corporations deliberately the word sound risk management principles in order to make money in the short term.

The reader also gains perspective on how to deal with risk in his or her own life.  Will you go the way of Rob, or will you go the way of Max?  Or, as most of us, will you do little of both?

I read lots of books on asset allocation, but relatively few books on risk control, because few accessible books get written on that topic.  This in my opinion was a very good book on risk control.  It has my highest recommendation.

If you want to, you can buy it here: Risk and the Smart Investor.

Full disclosure: I was asked if I would review a copy of the book.  It sounded interesting, so I said I would consider it; I was e-mailed an advance copy of the book.

If you enter Amazon through my site, and you buy anything, I get a small commission.  This is my main source of blog revenue.  I prefer this to a “tip jar” because I want you to get something you want, rather than merely giving me a tip.  Book reviews take time, particularly with the reading, which most book reviewers don’t do in full, and I typically do. (When I don’t, I mention that I scanned the book.  Also, I never use the data that the PR flacks send out.)

Most people buying at Amazon do not enter via a referring website.  Thus Amazon builds an extra 1-3% into the prices to all buyers to compensate for the commissions given to the minority that come through referring sites.  Whether you buy at Amazon directly or enter via my site, your prices don’t change.

Twenty Answers from the Author of Risk and the Smart Investor

Saturday, September 25th, 2010

A little bit ago, I published Twenty Questions for the Author of Risk and the Smart Investor.  Well, David X. Martin got back to me, and here are his thoughtful answers.  I will have more commentary on this as I write the book review, which I am doing immediately after posting this.

1. Q: Imagine you are talking to a bright 12-year old girl.  How would you explain to her why and how the financial crisis happened?

A: Think of what happens when you blow up a balloon. First it expands, but eventually, if you continue to add more and more air, it bursts. The air going into the balloon in the years leading up to the recent financial crisis was either ‘borrowed’ air, that is air that was bought on credit, or air that was highly leveraged. In other words, only a small part of the air was paid for, and the rest was borrowed. And when the balloon burst most of those that had borrowed air, or had lent air to others, were left with nothing.

2. Q: I was fascinated with the structure of your book, which I found tedious and hokey at first, but I grew to like it.  The way I see it, you introduce the topic through your experience, then explain the theory, then show neglect of it led to failure, and then you give us the stories of Max and Rob.  How did you hit upon this intriguing and novel way to write your book?

A: I first thought about the decision process, and described the continuous process of risk management in relatively simple steps—i.e., assessment (know where you are and what you do not know); rules of the game (know your risk appetite, transparency, diversification, checks and balances); decision-making (alternatives, responsibilities, reputation and time frame); and finally, reevaluation (monitor and learn from your mistakes ). My goal was not to write a “how to book” but rather to help readers build frameworks to make good decisions, and it seemed it would be helpful, and entertaining, I hoped, to see the process in action through the fictional risk story.

3. Q: Why do you suppose so few people in risk management, and senior management at major financial firms, were unwilling to consider alternative views of the sustainability of the risks being taken as the risks got larger and larger relative to the equity of individual companies, the industry as a whole, and the economy as a whole?

A: People get lulled into seeing the world from a particular viewpoint, particularly if they have never been through the worse case scenario. I’ve been through many of them.

4. Q: As a risk manager, bosses would sometimes get frustrated with me when they wanted a simple answer to a complex question that had significant riskiness. They did not like answers like, “I don’t know, it could have six significant effects on our company.”  How can we convey the limits of our knowledge in a way that management can get the true uncertainty and riskiness of the environment that we work in?  How can we get management to consider scenarios that are reasonable, and could harm the company, but few others in similar situations are testing for?

A: Scenarios are a great way of thinking about the future in terms of the realm of possible outcomes. Thinking now about what you can/should be doing about those possible outcomes, is an excellent way to communicate risk potential to management. and engage their interest.

5. Q: In your experience, how good are the managements of financial companies at establishing their risk tolerances?  Better, how good are they at enforcing those limits, such that they are never exceeded?

A: Not very good. Businesses have strategies, strategies entail risks, and risks require capital. Very few companies take a holistic view of risk, capital, and strategy.

6. Q: How do you create a transparent risk culture in a firm?  How do you get resisters to go along, even if it is management that does not see the full importance of the concept?

A: Cultures do not change rapidly, they migrate. Transparency starts at the top and it will never spread through a company if management doesn’t recognize its importance, and communicate its importance to everyone in the firm.

7. Q: Are most cases where a person or a company fails to diversify intentional or unintentional?  Do we put too many eggs in one basket more out of ignorance or greed?

A: Diversification is a strategy that requires discipline. Take the case where you start with a diversified portfolio, and then one position takes off and acquires a disproportionate weight in your portfolio. Regardless whether the cause is ignorance (you did not monitor your portfolio’s balance) or greed (you rode the stock up ), the root problem is a lack of discipline.

8. Q: Why do you suppose that checks and balances for risk management are not built into the cultures of many financial companies?

A: When does a problem exist? Even if it has always been there, it comes into existence only when you recognize that it is a problem. Many times checks and balances do not exist because no one recognizes the risk/problem and therefore no one evaluates the checks, and balances, and controls needed to manage it.

9. Q: I have a friend Pat Lewis who developed a risk management system for Bear that could have prevented the failure of the firm, but it was ignored because it got in the way of profit center manager goals.  Was it the same for you at Citigroup when your “Windows on Risk” got tossed out the window?

A: See pages 124-5 in my book. You never have to ask a portfolio manager what he or she thinks, just look at their portfolio. When I found out Citibank was no longer using Windows on Risk I sold my entire position that day. I recall it was at $51.75.

10. Q: Can culture and personal judgment work in risk management ever?  Take Berkshire Hathaway – risk control is embedded in the characters of a few people, notably Warren Buffett and Charlie Munger. If the culture is really, really good, and it comes from the top, can risk management work when it is seemingly informal?  (Remember, you don’t want to disappoint Warren.)

A: Risk management is all about culture and personal judgment. I remember pondering the question, “How high is up” at a Windows on Risk meeting at Citibank. The most senior management were sitting around the table. We came to our answer by asking the following question: What was the amount of loss we would be embarrassed to read about in the WSJ? That number, it turned out, was not very high, at least in the judgment of the people sitting around that table. News of that decision got around and had an impact on the company culture.

11. Q: How can you teach younger people in risk management intuition about risk that helps them have a healthy skepticism for the results of impressive complex modeling?

A: I co-wrote an article with Mike Powers from the London School of Economics titled “The End of Enterprise Risk Management.” Models are just one input; they are not a substitute for good judgment.

12. Q: Is it possible to do effective risk management in a financial firm if management is less than wholeheartedly committed to the goal?

A: I forgot where I first heard the expression, but it explains my feelings. “A fish starts to stink from its head first.”

13. Q: Aside from AIG, and other financial insurers, the insurance industry came through the crisis better than the banks because they focused on longer-term stress tests, and not on short-term measures like VAR.  Should the banking industry imitate the insurance industry, and focus on longer-term measures of risk, or continue to rely on VAR?

A: VaR is one measure. It has deficiencies. For example, the loss amounts predicted in the tails (that is, the extreme cases) are the best case scenarios, not the worse case. Institutionalizing this one measure, or relying on the measurement of “risk based capital,” has not worked.

14. Q: Seemingly the big complex banks did not analyze their liquidity risk, particularly with repo lines.  Why did they miss such an obvious area of risk management?

A: Liquidity is a very difficult concept. If you decide to sell your house in the suburbs at 2AM in the morning and put a “for sale” sign on your lawn at that hour, how quickly do you think it will sell. Liquidity, therefore, has to be thought of in terms of time. If, for instance, you see high average daily volume in a stock what is your real liquidity if the volume is the result of a nano second of high speed trading?.

15. Q: How much can risk management be shaped in financial firms by the compensation incentives that employees and managers receive?

I saw Walter Wriston six months before he died. He asked me how things were going. I said, nothing wrong with risk as long as you manage it. He smiled at me from ear to ear because those were his words, from his book Risk and other Four Letter Words. I think it is all about matching responsibility and authority, having the right culture, learning from errors, and promoting ethics. Incentives are on the list, but not at the top.

16. Q: I have often turned down shady deals in business, saying that you only get one reputation in this world.  How do you encourage an attitude like this in financial firms among staff?

A: If you go to sleep in s–t, you will most likely wake up covered with flies. I would start with an ethics committee, and make sure the most important people in the firm were on it.

17. Q: A lot of portfolio management and risk management is juggling different time frames.  Is there a good structure for balancing the demands of the short-, intermediate-, and long-terms?

A: A poor investment decision is still the same poor investment decision irrespective of the time frame. If you always try to do the right thing, time frames become less important.

I am not saying to forget about the timeframe, just that you shouldn’t let it lead you to a poor decision.

18. Q: Most developed country economic players assume that wars will have no impact on their portfolios.  Same for famine, plague, or environmental degradation.  What can you do to get investors to think about the broader risks that could materially harm their well-being?

A: Great question, but this one is outside my realm of expertise.

19. Q: Are Rob’s more common in the world than Max’s? That’s my experience; what do you think?

A: I purposely made Rob and Max pretty different in order to illustrate the principles in the book. I think we are all human and have a little bit of each.

20. Q: At the end of your book, one of your friends dies.  Did you mean to teach us that even if we manage our risks right, we still can’t overcome problems beyond our scope, or were you trying to say something else, like creating a system or family that can perform well after you die?

A: My first draft of the book began with what is now the concluding chapter—the one in which I discuss the courage necessary to face death. The developmental editor at McGraw-Hill, of course, didn’t like it up front, so I moved it to the end, where I wrote: “It is at that moment, when death is imminent, and there is no possibility of escape, that courage comes into the picture.”

My view is that this mindset can be useful long before we consider our mortality, by helping us understand that there are realities that must be faced and not avoided. In investing as in life, long term success results from thoughtful, timely preparation. Or in other words, the best decisions are made before we are forced to make them. The best decisions are made before certain inevitabilities, so long on the horizon, appear unexpectedly in front of us, and we no longer have the time to consider the alternatives; when we can still calmly and intelligently assess our circumstances, consider alternatives, and make informed decisions, monitoring the results as we go.

This is what I refer to as “de-risking,” and although the principles set out here are drawn from my experience as a risk manager at a number of leading investment firms, they apply not only to financial matters, but to almost every decision you’ll make over the course of your life.

So to my way of thinking,  when lightning strikes–the processes that you have put in place make courage less necessary. Put another way, if you embrace risk by following an orderly process you will have constructed a framework that will help you make the right decisions

Book Review: Outperform

Friday, September 24th, 2010

Outperform

There are some books, when I read them, that strike me wrong at first, but end up being satisfying in the end.  This book was one of those.  What I expected was a book that would give novel insights to individual investors, showing them how they could do better in the markets by imitating endowments.

This book came to the bold conclusion that there wasn’t much that individual investors could learn from endowments.  I appreciate such honesty, even though that will lead to fewer book sales.  Why is this true?

  • We all look for simple formulas that can improve our investment returns.
  • Endowments have balance sheets that allow them to invest longer-term.  Retail investors have a greater need for short-term liquidity, or, at least have a greater tendency to panic.
  • Retail investors are not large enough to invest in sophisticated asset classes.  Alternative investments have higher minimum dollar amounts.
  • Most endowments have invested in staff that are capable of analyzing complex investment opportunities.  Here would be my challenge for an average retail investor: hand them a copy of an asset backed securities prospectus, and see if they can make heads or tails out of it.
  • Endowments that have large staffs are also capable of analyzing third-party managers, without being slaves to the common theories that dominate the minds of most consultants.

The book begins with a basic explanation of endowments, moves through historical performance of endowments and asset allocation, and then explains the various strategies that endowments use.  After that, it interviews a large number of chief investment officers from public and private universities.  I appreciated the fact they chose lesser-known chief investment officers.  It gave me a better feel for the mindset of the average chief investment officer of university endowments.  Some were very smart, some were not so smart, most were in-between.

After that the book interviewed advisors and managers that would aid the chief investment officers of university endowments.  I felt that this was a weaker part of the book.  I came to that conclusion because they are consultants.  Does that make money in the short run, regardless of what the best results are, tend to be less reliable in their opinions than those that have their necks on the line.

One of the topics that was hot in the book was the question of liquidity.  As I have written about in a number of my blog posts, when the bull market in risk assets was running hot, many endowments and pension funds neglected the value of liquidity.  Some of the chief investment officers were prepared, and some were less prepared.  Regardless, most of them learned their lessons.  It’s similar to what happened after LTCM.  When you see bright investors get skinned as a result of neglecting the value of liquidity, you take notice.  All of a sudden, arbitrage does not seem so easy.  In the same way here, imitating Harvard and Yale is not a road to easy riches.

Another theme in the book as I see it, is that alternative asset classes are not as rewarding as they seem.  Many of them involve leverage.  Many of them are limited in terms of their capacity.  There are large variations in manager quality.  Late imitation is a recipe for disaster, as it is with almost all investment strategies.

This is a very good book, but for the average investor, it will not be useful.  Yes, it is useful to understand that endowment strategies are not useful for retail investors.  But you don’t need to buy a book to know that; you have read that here.

Quibbles

If I had been the authors of the book I would’ve spent more time with the introduction.  That said, they make up for it by having good conclusion.  I also would have eliminated most of the advisors and managers, and instead, interviewed still more chief investment officers.  They have valuable opinions; their necks are on the line for the decisions that they make.

Who would benefit from these books:

This book would be valuable for people who think that there are some great secret about investing, and think that the big guys have all the advantages.  It’s not true.  The big guys have the advantage of having balance sheets.  Retail investors have the advantage of being flexible.  This book is valuable in my opinion for investment professionals that want to get into the mind of the chief investment officers of endowments.

If you want to, you can buy it here: Outperform: Inside the Investment Strategy of Billion Dollar Endowments.

Full disclosure: Without asking, I was mailed a copy of the book.

If you enter Amazon through my site, and you buy anything, I get a small commission.  This is my main source of blog revenue.  I prefer this to a “tip jar” because I want you to get something you want, rather than merely giving me a tip.  Book reviews take time, particularly with the reading, which most book reviewers don’t do in full, and I typically do. (When I don’t, I mention that I scanned the book.  Also, I never use the data that the PR flacks send out.)

Most people buying at Amazon do not enter via a referring website.  Thus Amazon builds an extra 1-3% into the prices to all buyers to compensate for the commissions given to the minority that come through referring sites.  Whether you buy at Amazon directly or enter via my site, your prices don’t change.

Of Investment Earnings Assumptions and Century Bonds

Thursday, September 23rd, 2010

Recently I got an e-mail from my friend Kid Dynamite.  He asked me an interesting question about pensions and long-duration bonds:

“back to the concept of century bonds.  I’m not sure if you read my recent pension post (http://fridayinvegas.blogspot.com/2010/09/problem-with-pensions.html) , but I’m having trouble with the concept of pensions investing in 100 year bonds at 6% while using an 8% portfolio return assumption. Does not compute…(and you can even pretend that pensions have 100 year obligations)

I just don’t get the concept of locking in long duration returns below your long term bogey. That just means that you have to do even better on the balance of your portfolio…which is nice to pretend about, but in reality, if you can do better on the balance, why bother with the 6% fixed income??”

It’s a great question and one that deserves more thought.  To do that, we have to separate the accounting from the economics.

When I was a young actuary, I was preparing to take the old Society of Actuaries test eight, which was the Investments exam.  An older British actuary made a comment in one of the study notes that I had to think about several times before I understood it: “Risk premiums must be taken as earned, and never capitalized.”

Sadly, the pension profession never got the memo on that idea.  The setting of investment assumptions accepts as a rule that risk margins will be earned without fail.  Therefore, when looking at a portfolio of common stocks in a pension trust, the actuary will assume that the equity premium will be earned over the long haul and build that into his discount rate assumptions and earned rate assumptions.  The same is true of bonds in the pension trust.  They may haircut the yield for potential default losses, but they will assume that much of the spread over Treasuries will be earned without fail and thus they capitalize the excess returns.

Let’s pretend that the 6% century bond that Kid Dynamite told me about is risk free.  Also, let’s pretend that the pension actually needs bonds as long as a century bond.  Defined benefit pension plans, if trying to match cash flows, need bonds longer than 30 years, but probably don’t need bonds longer than 75 years.  That said, given the lack of bonds that are longer than 30 years, a century bond will still prove useful in trying to immunize the tail cash flows of the defined benefit pension plan.

What that 6% century bond tells us is that the investment return assumption on an economic basis is too high.  And, given that the yields on safe debt shorter than a century is much less than 6%, it probably means that the investment earnings assumption rate is way too high at 8%, and should definitely be lower than 6%.

I know that’s not what GAAP accounting requires.  GAAP accounting allows you to choose whatever investment earnings rate you can justify using statistics.  That’s not the way GAAP accounting should work though.  GAAP accounting should work with discount rates derived from low risk fixed income securities, and use those to develop the investment earnings assumption.

If you earn more than the risk free investment earnings assumption, good.  Those excess earnings will reduce the pension plan deficit or increase its surplus.

Okay, then suppose we reset the investment earnings assumption at 4%, because that’s closer to where it should be economically.  My, what large pension deficits we see.  But now, all of a sudden, that 6% century bond looks pretty good, because it brings the cash flows of the plan into better balance, and earns a decent return in excess of the earnings assumption.

So, the problem isn’t with the century bond, it’s with the earnings assumption.  Now why does that earnings assumption exist?

  • The US government wanted to encourage the creation of defined benefit pension plans, and so informally encouraged loose standards with respect to the earnings assumption.
  • For years, it worked well, while we had bull markets going on, and interest rates were high, which decreased the value of the pension liabilities.
  • The IRS took actions to prevent defined benefit plans from building up large surpluses, because it decreased their tax take.  Had companies been allowed to build up large surpluses, we wouldn’t be in the mess that we’re in today.
  • There is the lazy acceptance of long-term historical figures in setting earnings assumptions, instead of building them from the ground up using a low risk yield curve, and conservative assumptions on how much risky assets can earn over the low risk yield curve.

So in an environment like this, where interest rates are low, and surpluses could not be built up in the past, pension funds are hurting.  The truth is, they are worse off than their stated deficits imply.  For economic and political reasons, the likely outcome resembles the riddle of how one eats an elephant: one bite at a time.

So we will see investment earnings assumptions and discount rates fall slowly, far too slowly to be the economic truth, but slowly recognizing funding gaps as corporations eat the loss one bite at a time, as they can afford to.

The investing implication is this: for any stock you own that sponsors the defined benefit pension plan, take a look at the earnings assumption and raise the value of the liabilities.  Also recognize that earnings will be lower than expected if the deficit is large and they need to make cash contributions in order to fund the pension plan.  That said, they could terminate the plan, and I suspect many current defined benefit plan sponsors will do so.

And given that, there is one more implication: if you are employed by, or are a beneficiary of a defined benefit pension plan, take a look at the form 5500, or at the company’s financial statements and look at the size of the deficit.  Take a look at what the PBGC will guarantee for you, and adjust your plans so that you are not relying on the continued well-being of the defined benefit pension plan.

I wish I could be the bearer of better news than this, but it is better to be aware of problems, then to learn that what you don’t know can hurt you.

Book Review: The Elements of Investing

Tuesday, September 21st, 2010

The Elements of Investing

This is a basic book.  A very, very basic book.  Did I mention this is a basic book?  Well, it is a basic book.

Sorry about that.  When you read a lot of sophisticated stuff on investing regularly, and then read The Elements of Investing, you know that you have to take a step back and re-think investing for everyone.

Written by Burton G. Malkiel & Charles D. Ellis, two notable investment writers favoring low cost indexing, and with a forward from David Swensen, you know that it will be a traditional buy-and-hold analysis.  (Though there is something funny here.  The authors criticize using the complex asset classes that Swensen uses, and Swensen criticizes buying individual stocks, which the authors use in small measure.)

The book has five sections:

  • Saving
  • Indexing
  • Diversify
  • Avoid Blunders
  • Keep it Simple

The section on saving is excellent, and offers many ways that people can cut their spending without ruining their lives.

The indexing section is fine, though it overstates the inability of investors to beat the indexes.  Yes, the market can’t beat the market as a whole, but dedicated investors following value and momentum can beat the market, until too many copy those unpopular strategies.

Diversification is wise.  But there are limits.  If one is going to be active, be active, and ignore the index.  Otherwise, be passive and index.  What’s that, you say: “If I miss by too much, I will lose a lot of assets.”  Sorry, but that is the price of being an active manager.  If you are going to do it make the most of it; don’t hug the index.  But the wag will say, “just avoid being in the bottom quartile.  You only get fired in the bottom quartile, so hug the index.”  The behaviors that benefit managers are not the same ones that benefit clients.

They recommend rebalancing, which I do as well.  They also recommend value investing in moderation.

I am totally in agreement with the chapter on avoiding blunders.  You win by not losing, and compound it over time to really build value.

The section on keeping it simple focuses on asset allocation, tailoring investment returns to individual situations, and is pretty basic.  I found little objectionable here, but I would spend some time analyzing when asset classes are cheap or dear.

They have an appendix on saving on taxes which is valuable, but if I had been in their shoes, I would have described additional strategies to lower tax liabilities off of both capital gains and losses.

Quibbles

They treat international investing as a free lunch, which it is not due to confiscation, currency risks, war, plague, famine, financial failure, etc.  The last forty years have been special, because of peace in developed economies.  That may not be true in the future.  I invest internationally, but only 25% of assets at most, and only in places where I trust the rule of law.

Who would benefit from these books:

This is the perfect book for your dumb brother-in-law (or similar) who has excess cash flow, and always seems to lose money on his investments.  Given the section on saving, it could also be valuable for your spendthrift brother who is constantly complaining about being in debt.

This is a very basic book.  Give it to the clueless; it cetainly won’t hurt them, and it might help them a lot.

If you want to, you can buy it here: The Elements of Investing.

Full disclosure: Without asking, I was e-mailed a copy of the book.  Personally, if I were the publisher, I would send a physical copy.  Not that I am going to post it for free use, but I know that many will.

If you enter Amazon through my site, and you buy anything, I get a small commission.  This is my main source of blog revenue.  I prefer this to a “tip jar” because I want you to get something you want, rather than merely giving me a tip.  Book reviews take time, particularly with the reading, which most book reviewers don’t do in full, and I typically do. (When I don’t, I mention that I scanned the book.  Also, I never use the data that the PR flacks send out.)

Most people buying at Amazon do not enter via a referring website.  Thus Amazon builds an extra 1-3% into the prices to all buyers to compensate for the commissions given to the minority that come through referring sites.  Whether you buy at Amazon directly or enter via my site, your prices don’t change.

Redacted Version of the September 2010 FOMC Statement

Tuesday, September 21st, 2010
August 2010September 2010Comments
Information received since the Federal Open Market Committee met in June indicates that the pace of recovery in output and employment has slowed in recent months.Information received since the Federal Open Market Committee met in August indicates that the pace of recovery in output and employment has slowed in recent months.No real change.
Household spending is increasing gradually, but remains constrained by high unemployment, modest income growth, lower housing wealth, and tight credit.Household spending is increasing gradually, but remains constrained by high unemployment, modest income growth, lower housing wealth, and tight credit.No change.
Business spending on equipment and software is rising; however, investment in nonresidential structures continues to be weak and employers remain reluctant to add to payrolls.Business spending on equipment and software is rising, though less rapidly than earlier in the year, while investment in nonresidential structures continues to be weak. Employers remain reluctant to add to payrolls.Shades its view down on business spending.
Housing starts remain at a depressed level.Housing starts are at a depressed level.No change.
Bank lending has continued to contract.Bank lending has continued to contract, but at a reduced rate in recent months.Shades up bank lending a little.
Nonetheless, the Committee anticipates a gradual return to higher levels of resource utilization in a context of price stability, although the pace of economic recovery is likely to be more modest in the near term than had been anticipated.The Committee anticipates a gradual return to higher levels of resource utilization in a context of price stability, although the pace of economic recovery is likely to be modest in the near term.No real change.
Measures of underlying inflation have trended lower in recent quarters and, with substantial resource slack continuing to restrain cost pressures and longer-term inflation expectations stable, inflation is likely to be subdued for some time.Measures of underlying inflation are currently at levels somewhat below those the Committee judges most consistent, over the longer run, with its mandate to promote maximum employment and price stability. With substantial resource slack continuing to restrain cost pressures and longer-term inflation expectations stable, inflation is likely to remain subdued for some time before rising to levels the Committee considers consistent with its mandate.The FOMC will try to inflate, and let it into the goods and services markets, rather than merely using it to prop up the prices of assets backed by debt.
The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and continues to anticipate that economic conditions, including low rates of resource utilization, subdued inflation trends, and stable inflation expectations, are likely to warrant exceptionally low levels of the federal funds rate for an extended period.The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and continues to anticipate that economic conditions, including low rates of resource utilization, subdued inflation trends, and stable inflation expectations, are likely to warrant exceptionally low levels for the federal funds rate for an extended period.No change.
To help support the economic recovery in a context of price stability, the Committee will keep constant the Federal Reserve’s holdings of securities at their current level by reinvesting principal payments from agency debt and agency mortgage-backed securities in longer-term Treasury securities.1 The Committee will continue to roll over the Federal Reserve’s holdings of Treasury securities as they mature.The Committee also will maintain its existing policy of reinvesting principal payments from its securities holdings.No real change.
The Committee will continue to monitor the economic outlook and financial developments and will employ its policy tools as necessary to promote economic recovery and price stability.The Committee will continue to monitor the economic outlook and financial developments and is prepared to provide additional accommodation if needed to support the economic recovery and to return inflation, over time, to levels consistent with its mandate.The change is from price stability, to returning inflation to levels consistent with its mandate, which means they will try to inflate, and let it into the goods and services markets, rather than merely using it to prop up the prices of assets backed by debt.
Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; William C. Dudley, Vice Chairman; James Bullard; Elizabeth A. Duke; Donald L. Kohn; Sandra Pianalto; Eric S. Rosengren; Daniel K. Tarullo; and Kevin M. Warsh.Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; William C. Dudley, Vice Chairman; James Bullard; Elizabeth A. Duke; Sandra Pianalto; Eric S. Rosengren; Daniel K. Tarullo; and Kevin M. Warsh.Oops, Kohn is gone.  I will not miss him not being on the FOMC.  Can we bottle up the replacements until after the 2012 elections?
Voting against the policy was Thomas M. Hoenig, who judges that the economy is recovering modestly, as projected. Accordingly, he believed that continuing to express the expectation of exceptionally low levels of the federal funds rate for an extended period was no longer warranted and limits the Committee’s ability to adjust policy when needed. In addition, given economic and financial conditions, Mr. Hoenig did not believe that keeping constant the size of the Federal Reserve’s holdings of longer-term securities at their current level was required to support a return to the Committee’s policy objectives.Voting against the policy was Thomas M. Hoenig, who judged that the economy continues to recover at a moderate pace. Accordingly, he believed that continuing to express the expectation of exceptionally low levels of the federal funds rate for an extended period was no longer warranted and will lead to future imbalances that undermine stable long-run growth. In addition, given economic and financial conditions, Mr. Hoenig did not believe that continuing to reinvest principal payments from its securities holdings was required to support the Committee’s policy objectives.No real change here; if anything, Hoenig is more firm in his opinions.
1. The Open Market Desk will issue a technical note shortly after the statement providing operational details on how it will carry out these transactions.Sentence dropped, since the announcement is over.

Comments

  • The FOMC makes a major step in policy change.  The question is this: will the mechanisms of credit transmit inflation to goods and services?  So far, it has not.  Lowering the policy rate does little to incent borrowing when enough people and financial institutions are worried about their solvency.
  • Beyond that, if they succeed, how will it be received on Main Street, especially if price inflation is not accompanied by increases in employment, and is accompanied by higher interest rates and lower stock prices.
  • Aside from that, there was little change from August to September in the FOMC Statement.
  • Hoenig still dissents; hasn’t gotten bored with it yet.
  • That said the economy is not that strong.  In my opionion, policy should be tightened, but only because I think quantitative easing actually depresses an economy.  It does the opposite of stimulate; it helps make the banks lazy, and just lend to the government.
  • The key variables on Fed Policy are capacity utilization, unemployment, inflation trends, and inflation expectations.  As a result, the FOMC ain’t moving rates up, absent increases in employment, or a US Dollar crisis.  Labor employment is the key metric.

Asset Allocation Book Reviews: 7Twelve and The Flexible Investing Playbook

Tuesday, September 21st, 2010

7TwelveThe Flexible Investing Playbook

When I get a book on asset allocation in the mail, I say to myself, “Another book on asset allocation?  What is there to say that is new on the topic?”

Tonight I review two decidedly different books, and end up praising the conventional book, and dissing the unconventional book.  Since I am not a fan of most conventional asset allocation, I am personally surprised by this result, but now let me explain why I reached this conclusion.

Where’s the Meat?

I don’t know about you, but personally, I hate books that talk big, and don’t reveal any of the significant details of their theories.  Can I figure out approximately how they did what they did?

Now, I am not looking for simple rule-based books either — “Follow this simple formula and make money!”   But there should be enough to allow someone reasonably well-attuned to the markets to be able to say, “Yes, this is reasonable.  I don’t know all of the details, but I have some reasonable idea of how they did it.”

I don’t have that reasonable idea with The Flexible Investing Playbook.   From what I can gather, they propose Dynamic Asset Allocation that is rather aggressive, trying to catch turns in markets.  I say aggressive, not because they advocate large moves; they don’t.  But the efforts to catch turns is a difficult endeavor, and they don’t give me enough grist for the mill, that I could set up my own approximate model for switching, if I wanted to do that.

One strength the book has is identifying alternative asset classes that can smooth the ride for investors.  Sadly, they don’t offer easy ways for investors to pursue these strategies.

On the other hand

7Twelve is static in asset allocation, urging investment in index funds (or active funds if you must), and rebalancing regularly.  The book urges investment in 12 index funds, which gives a very diversified mix.  The reason for the book’s name, is that the 12 funds have a limited track record, lasting from 2000-2009.  But an approximation to the 12, with only seven indexes, has a track record that goes from 1970-2009.

The twelve asset-subclasses are:

  • Large, Medium and Small US Stocks
  • Developed Foreign Stocks
  • Emerging Foreign Stocks
  • Natural Resources Stocks
  • Commodities
  • REITs
  • Barclays’s Aggregate Bonds
  • Inflation-protected Bonds
  • Foreign Bonds
  • US Cash

And the seven asset classes are:

  • US stocks
  • Foreign stocks
  • REITs
  • Resources
  • US bonds
  • Foreign bonds
  • US cash

And the book shows how in the past, an equal weighted blend provided  better total performance, and even better when compared to return volatility.

One additional note, the clever cover art helps prove that seven is half of twelve at least if using Roman numerals.  No wonder Rome fell.

Quibbles

In 7Twelve, there is a lot of “past is prologue.”  It ignore the factors that made 1970-2009 a special environment:

  • General peace.
  • Declining volatility
  • Increasing globalization.

It also ignores that not everyone could follow such a strategy because there would be scaling problems.  We would run out of small and midcap stocks, and emerging market stocks, and REITs and commodity stocks.  Even commodities would run up in price, and then provide subpar returns.

But if few follow such a prescription, such diversification could be wise, so long as there is no major war.  WW III can’t happen, right?

Who would benefit from these books:

I am not sure who could benefit from The Flexible Investment Playbook.  As for 7Twelve, those lacking a sound diversification strategy could benefit.  The strategy is simple enough to implement.

Both books provide significant and clever commentary in investing, if that is enough to commend buying books.

If you want to, you can buy either here: 7Twelve: A Diversified Investment Portfolio with a Plan, or The Flexible Investing Playbook: Asset Allocation Strategies for Long-Term Success.

Full disclosure: I received each book from the publisher; I don’t think I asked for either one.

If you enter Amazon through my site, and you buy anything, I get a small commission.  This is my main source of blog revenue.  I prefer this to a “tip jar” because I want you to get something you want, rather than merely giving me a tip.  Book reviews take time, particularly with the reading, which most book reviewers don’t do in full, and I typically do. (When I don’t, I mention that I scanned the book.  Also, I never use the data that the PR flacks send out.)

Most people buying at Amazon do not enter via a referring website.  Thus Amazon builds an extra 1-3% into the prices to all buyers to compensate for the commissions given to the minority that come through referring sites.  Whether you buy at Amazon directly or enter via my site, your prices don’t change.

Disclaimer


David Merkel is an investment professional, and like every investment professional, he makes mistakes. David encourages you to do your own independent "due diligence" on any idea that he talks about, because he could be wrong. Nothing written here, at RealMoney, Wall Street All-Stars, or anywhere else David may write is an invitation to buy or sell any particular security; at most, David is handing out educated guesses as to what the markets may do. David is fond of saying, "The markets always find a new way to make a fool out of you," and so he encourages caution in investing. Risk control wins the game in the long run, not bold moves. Even the best strategies of the past fail, sometimes spectacularly, when you least expect it. David is not immune to that, so please understand that any past success of his will be probably be followed by failures.


Also, though David runs Aleph Investments, LLC, this blog is not a part of that business. This blog exists to educate investors, and give something back. It is not intended as advertisement for Aleph Investments; David is not soliciting business through it. When David, or a client of David's has an interest in a security mentioned, full disclosure will be given, as has been past practice for all that David does on the web. Disclosure is the breakfast of champions.


Additionally, David may occasionally write about accounting, actuarial, insurance, and tax topics, but nothing written here, at RealMoney, or anywhere else is meant to be formal "advice" in those areas. Consult a reputable professional in those areas to get personal, tailored advice that meets the specialized needs that David can have no knowledge of.

 Subscribe in a reader

 Subscribe in a reader (comments)

Subscribe to RSS Feed

Enter your Email


Preview | Powered by FeedBlitz

Seeking Alpha Certified

Top markets blogs award

The Aleph Blog

Top markets blogs

InstantBull.com: Bull, Boards & Blogs

Blog Directory - Blogged

IStockAnalyst

Benzinga.com supporter

All Economists Contributor

Business Finance Blogs
OnToplist is optimized by SEO
Add blog to our blog directory.

Page optimized by WP Minify WordPress Plugin