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Archive for September 15th, 2010

On Financial Antigravity Machines

Wednesday, September 15th, 2010

I like my son Peter.  He works hard, but is occasionally overconfident.  (Where does he get that from? ;) )  A typical example:

Peter: No, Dad, I am right on this Precalculus problem.  The book is wrong.

Me: Peter, don’t sell me an antigravity machine.  I had one once, but it floated away.  The book is right, and I will show you.

After which, I would write out the answer longhand, and show him that the book was right.  And at the end of the year, when he took the final, I scored his test, and found a wrong answer, so I wrote out the right answer to show it to him, but I got his answer, not the book’s answer.  So I did it another way. Same answer.  I solved it numerically, not analytically — same answer.  The book was wrong. But I never told him, because I did not want to reinforce the overconfidence.

But often, people trust in antigravity machines in the economic arena: ideas that sound good, but have no basis in fact.

1) Start with Japan intervening on the yen.  This is but stage three on the five stages of grieving.  Why does Japan think that it can successfully intervene by itself in the currency markets?  The history of such actions supports the idea that Japan will lose the battle without help.  Also, they were working against momentum, and without economic news that would support a stronger yen.  The intervention should not work, and what will the BoJ do with all the new Dollar bonds that they bought?

2) Or think of Cisco Systems.  They are going to pay a dividend.  Hooray, maturity has come!  Okay, it has come 10+ years too late.  The question is not whether Cisco has excess cash, but whether its management is good at allocating capital, and the answer is no.  Cisco has spent years buying up marginal firms and buying back stock, with no sense for what their company is really worth.  I might have interest at a price near $15.

What most investors don’t get is that earnings matter, but what firms do with retained earnings / free cash is even more important, because that directs the path of future profits.

3) Then there is Social Security Disability — what a foolish program.  If you can’t control the benefits, don’t start the program.  Yet here are three articles:

I’ve seen able bodied people on SS disability.  I’m not saying that all of it is a scam, but some of it is, and the government should make many requalify for aid.

4) One casualty of quantitative easing is DB plans.  The value of their liabilities rises as high quality interest rates fall.  And that drives investment in alternative assets, because it is that much tougher to earn the needed returns in a low nominal rate environment.

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This environment is particularly fertile for financial “antigravity,” because many hope against hope in a time of scarcity, and believe that they will do well, even if they have done nothing truly defensive in their investing.

Hope is not a solution.  You may as well believe in antigravity.

Book Review: The Club No One Wanted To Join

Wednesday, September 15th, 2010

When life gives you lemons, make lemonade.  Over two dozen people that survived losing a lot of their money in the Madoff Ponzi scheme wrote down their stories.  For one thing, I’m sure it was cathartic to do so.  Something that many regarded as being one of the most dependable parts of their lives ended up proving utterly undependable.

Out of loss, many of the writers rediscovered the simpler joys of life — family and friends.  Even new friends, as many of them banded together to figure out which end was up.

The tales that the authors tell are not identical, but they certainly rhymed.  Here would be my stylized example of the outline of one of their stories:

  • Growing up in a lower-to-middle class family
  • Being taught to work hard and be frugal
  • Achieved some degree of success
  • Was not sure what to do as the excess assets grew
  • A family member or friend introduced me to Madoff
  • Looked like a smart deal; Madoff always seemed to do well, so the person put most to all of his investable assets there.
  • Sometimes even borrowed money rather than tap the Madoff funds.
  • Life was good; he was charitable, enjoyed life, was generous with friends.
  • The shock came that Madoff was a fraud, a Ponzi scheme.
  • Adding insult to injury, learned that the SIPC would not pay off much at all of the losses, seemingly contrary to their prior actions in other cases.
  • The best option for many was to file as a total loss, and recover back taxes.
  • Retirement dreams turned back to work, and who would hire an old person?
  • Friends and family often proved helpful, but it is hard to go from being a giver to being dependent.

Personally I would like to meet most of these people, give them a hug, and affirm to them that true wealth isn’t money, but relationships.  Poor people are poor because they lack the connections the they can trust, and have the power to help them.

Now, I don’t want to say they should not have seen this coming.  This blog is about risk control in investing.  Remember, you are your own best defender when it comes to investing, and saying “no” is almost always safer than saying “yes.”  Let me quote from a piece written near the time that Madoff was sent off to the pokey:

The sad aspect of plumbing for the financial markets today is that we are drawn to the front end of investing processes.  This man looks successful.  He has a great story; a way to make money that others do not know about.  There are documents showing his track record — impressive, though he doesn’t solicit publicly; investing with him is a family affair.  Do you want to be part of the family and gain the benefits thereof?

There are questions to be asked, particularly of nonstandard ventures:

  • How are the returns earned?
  • Who checks the results?  (Auditing — should not be a small firm.)
  • Who has custody of the assets?
  • Is the trustee a reputable third party?
  • Is liquidity proportionate to the asset class invested in?
  • Is this under US law?
  • Do the returns look too good to be true, either in absolute amount, or always positive with low volatility?
  • Is this marketed to everyone, or just a select few suckers?
  • Is the profit motive of the sponsor obvious and standard?
  • How are asset values calculated each accounting period?

Whether we are talking about Madoff, Stanford, or any of the other recent frauds, an attention to the details of how the financial plumbing works can pay off in terms of avoiding situations that are too good to be true.

You are ultimately responsible for losses that you receive.  Yes, no one can know everything, but if you don’t have any idea of how someone investing for you is making money, you probably should not invest with that person, because you are incapable of evaluating what they do in broad.

No one with a serious risk control discipline invested with Madoff or Stanford.  These are cases where paying a little for expert help would have paid off big.

Does that mean I look down on those that lost?  Not at all.  Most ordinary investors don’t have the vaguest idea what they are doing.  They are blessed because no one they knew would introduce them to Madoff.  For those that lost, I only have sorrow and pity.  I wish that you had friends and family that would have steered you better.  We all rely on friends, but there is still a danger in that reliance.

Quibbles

As I read more of the book, it felt like some of the authors had rehearsed story lines with each other.  Now, that is natural, because they talked with each other and planned strategy together regarding the SIPC and other hurdles.  So, I don’t begrudge that much.

What I do begrudge is the 8-page investment “analysis” at the end of the book that says that no one should have been suspicious of an 11%/year return, because equity funds from many major mutual fund companies earned 11%/year over the same period.  Total hooey.  Few would have invested with Madoff given the lack of disclosure had not the returns been so regular on a monthly basis.  The mutual funds had large runs up, and large drawdowns.  Investors, not savers, would buy such mutual funds.  The attraction of Madoff’s scam was that it was designed for savers, not investors.  No volatility, high returns, no worries.  Thus someone with the personality of a saver could put money there, and not worry, because Uncle Bernie was a genius who was taking care of them.

And indeed, Madoff took care of them, with malice.  The underfunded SIPC could do little to help, given the enormity of the fraud.

Who would benefit from this book

Anyone who wants to sympathize with and support those who lost to Madoff would benefit from this book.  It does a fairly complete job, and is not long at ~230 pages.  As I write this it is, out of stock at Amazon, but when available, you can buy it here: The Club No One Wanted To Join-Madoff Victims In Their Own Words Barnes & Noble does have copies.

Full disclosure: An author sent me a copy, after asking if I would like to receive a review copy.

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.

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