Day: May 5, 2011

On Systemic Risk

On Systemic Risk

There are five factors for systemic risk.? Here they are:

  1. Asset size of the institution, including synthetic exposures.
  2. Degree of leverage of the institution, including synthetic exposures.
  3. Asset-Liability mismatch, particularly financing long assets with short liabilities (including derivatives and margin agreements — think of AIG, or mortgage REITs on repo).
  4. Degree to which the institutions owns financial companies equity or debt, or vice-versa, where other financial companies have claims on the institution in question.
  5. Riskiness of the assets owned by the institution in question.

Contributing to the risks include easy monetary policy, which can lead/has led? to the neglect of risk control.? Personally, if I were a regulator of systemic risk, I would throw my effort at companies that fit factors 1 and 2, and analyze them for the other three factors.

Systemic risk is layered levered credit risk. A lent to B, who lent to C, who lent to D, who financed a bunch of bad mortgages.

#5 is underwriting risk

#4 is connectedness risk

#3 is liquidity risk

#2 is financial risk

#1 is risk to the economy as a whole.

So when I read articles like this, or books about systemic risk by academics that are so bad that I don’t want to review them (set them to work picking fruit, it would be more valuable than what they currently do), I simply say systemic risk is easy.? Look at my five points.? You can eliminate systemic risk by:

  • Breaking up the big banks. (1)
  • Disallowing banks from owning the equity of other financials and vice-versa. (4)
  • Forcing strict asset-liability matching at banks, and? (3)
  • Sizing capital to the riskiness of loans made. (2,5)
  • Move to double liability on banks — they can’t be limited liability corporations.? Investors and managers must have their net worth on the line for any losses.

This isn’t hard, but the banks will scream.? Let them scream, and let the stocks of the banks fall.? Banks take risks beyond what they ought to because of poor regulation.? They should be regulated well, and have lower returns on equity as a group.

Why Amateurs Should Invest in Common Stocks

Why Amateurs Should Invest in Common Stocks

There is a benefit to investing directly in common stocks as an individual.? I’ll let Buffett help me explain this:

?I am a better investor because I am a businessman and I am a better businessman because I am an investor.?

My own life is one of having been an amateur investor, and became a professional investor over time.? My mother is an excellent amateur investor, one whose record would put 90%+ of professionals to shame.? I know some great amateur investors, but they are not the norm.? If they were the norm, we would not have lots of financial intermediaries trolling for business.

After yesterday’s piece, I want to say that though most amateur investors do not beat index funds, there is still one big reason to buy individual common stocks: it can make you a better businessman.

As an example, I had? never worked in a marketing department in my life, but because of my investing, and study of marketing on the side, I was able to lead a revamp of a marketing department, leading to a threefold increase in sales in five years.? Return on equity went from 10% to 50%, aided by the booming stock market of the ’90s, but that was only a help.

Technical specialists have to ask, “Do I want to remain a technical specialist, assuming that I have that option, or do I want to broaden my skill set and learn the economics of the business that I serve?”? Those that invest in stocks, and study them carefully learn practical economics.? You may earn money or you may not.? You may beat the market or you may not.? But you will become a more valuable employee, because you will grasp more and more about what makes your company tick economically.

I can tell you that while I was in insurance, the brightest move I made was investing in stocks privately, and studying equity and bond investment intensively.? It made me more valuable to my bosses, and helped me understand my own company better.? It made me better in interviews as well.? Questions that were designed to see if I could think beyond my narrow specialty became easier for me.

Now, some of the successes came with failures.? For a while, I told my kids never to mention the name “Caldor” to me.? Yeh, Michael Price may have lost a billion on that one, but I more than took my licks.? Until you lose a decent amount, you don’t really understand how the market works.? You can call it market tuition, but like tuition at college, you don’t know how much value you will get out of what you have paid.

I encourage new investors to paper-trade.? I did that when I was young.? It allows you to experiment and learn about what you think works in the market, without consequences.? I think it helps ease the transition into investing.? When you start investing, your emotions will be a lot higher, but it helps a lot to have a guiding theory going into it, it helps control the emotions that will come.? It took me 5-10 years to discipline my emotions, and think about markets rationally, not emotionally.

So, there are benefits to investing in individual common stocks, but they may not be the ones you expected.? It will help you understand your business better, your industry better, and perhaps even your nation and the world.

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But, this is not to say that if you act as a bettor, rather than an investor, that you will benefit.? Think of Buffett’s quote above — business and investing go together.? Inside a corporation, one of the highest levels of what is done is the investing.? Buffett looks for businesses that will throw off gross profits well in excess of financing costs — that is different than most investors think, because Buffett is a businessman.

For budding businessmen, you could ask where business value is growing the most rapidly relative to the price that you pay — Earnings relative to price helps but there are sometimes aspects of businesses where growth in value does not reflect in the earnings statement.

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And, all of this is not to say that professionals do better than amateurs.? Professionals don’t do well, and they add on fees.

There is one area where professionals seem to do better, but I could be wrong.? If I am wrong, could someone send me some research?? As I pointed out yesterday, amateur investors tend to become greedy and fearful at the wrong times.? Professionals seem to be less prone to this problem, perhaps because of discipline.

As Baruch commented at my blog:

I think it is also something you can learn, because so much of investing skill is not innate, in my opinion, rather it really comes from an attitude, and an act of will. Discipline comes from will. The rest comes from a basic knowledge of accounting, markets and finance which anyone with a university education is capable of grasping. A lot of people without a university education are as well.

To which I will agree — it’s not that you need a high IQ, but a lot of general learning, wisdom on accounting, markets, and finance, and common sense.? Read stuff by Charlie Munger, the man is under-rated in the shadow of Buffett, but at least he has written? a book.? Would that Buffett would do the same.? There are many that interpret him, but I would like to hear how he views investments in theory in full, so that the rest of us could benefit.? In many ways he has surpassed his teachers, Ben Graham and Phil Fisher.

So Warren, could you give us the 21st century version of “The Intelligent Investor?”? That could be an invaluable legacy that many would thank you for, as much as they do for Ben Graham today.

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Final note — if you invest in common stocks, it is likely you will underperform the major averages until you gain wisdom and discipline.

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