In this post, I want to talk about enhancing fixed income returns.  Next week, I will talk about hedging, or Tactical Asset Allocation.

My views on managing fixed income (bonds) are quirky.  I don’t look to maximize yield, as many do, but my view is to preserve the purchasing power of capital, which might lead to underperformance in the short-run.  There are times to grab yield, and times not to do so, and preserve capital.  Typically, the times to grab for yield are the times one would be scared to death to do so, like November 2008 and March 2009.

But to do that means being willing to take risk when everything seems to be dying.  Before I explain more, here is my stylized view of how the investment cycle works for equities and corporate bonds.  Gains and losses are not purely random, they tend to streak.  Here’s my stylized view of how an equity/credit cycle works:

  1. After a washout, valuations are low and momentum is lousy.  People/Institutions are scared to death of equities and any instruments with credit exposure.  Only rebalancers and deep value players are buying here.  There might even be some sales from leveraged players forced by regulators, margin desks, or “Risk control” desks.  Liquidity is at a premium.
  2. But eventually momentum flattens, and yield spreads for the survivors begin to tighten.  Equities may have rallied some, but the move is widely disbelieved.  This is usually a good time to buy; even if you do get faked out, and momentum takes another leg down, valuation levels are pretty good, so the net isn’t far below you.
  3. Slowly, but persistently the equity market rallies.  Momentum is strong.  The credit markets are quicker, with spreads tightening to normal-ish levels.  Bit-by-bit valuations rise until the markets are fairly valued.
  4. Momentum remains strong.  Credit spreads are tight. Valuations are high, and most value-type players have reduced their exposures.  Liquidity is cheap, and only rebalancers are selling.  (This is where we are now.)
  5. The market continues to rise, but before the peak, momentum flattens, and the market meanders.  Credit spreads remain tight, but are edgy, and maybe a little volatile.  This is usually a good time to sell.  Remember, tops are often a process.
  6. Cash flow proves insufficient to cover the debt at some institution or set of institutions, and defaults ensue.  Some think that the problem is an isolated one, but search begins for where there is additional weakness.  Credit spreads widen, momentum is lousy, and valuations fall to normal-ish levels.
  7. The true size of the crisis is revealed, defaults mount, valuations are low, credit spreads are high.  A few institutions and investors fail who you wouldn’t have expected.  Momentum is lousy.  We are back to part 1 of the cycle.  Remember, bottoms are often an event.

You could call part 4 of my stylized cycle “borrowed time.” But it is borrowed time that can last a long time.  At the end of the bull cycle, the equity market catches up to the credit market, creating a situation where the valuation of the equity can no longer be sustained by further increases in leverage (part 5 leading to part 6).

Now, value investors typically play the game from part 1 to part 4.  This is what drives the idea that value investors are always early.  Focusing solely on valuation, they arrive too soon, and leave too soon.

In 1994, I was part of a team that hired a clever small cap value manager to help manage money for our multiple manager funds.  The firm’s name was Moody, Aldrich & Sullivan; they were based in Boston.  One partner, Avery Aldrich, was their quantitative analyst, and he had a chart that I had never seen before: a two-dimensional grid for buy/hold/sell using valuation and momentum.  He said that it solved the problem of being early.  Using my seven parts, MA&S would take on the most exposure to risk in parts 2-5, when the most reward was received.

Applying this to Bonds

Here is the challenge: investment performance is a product of two main factors:

  • Valuation, a long run factor, and
  • Momentum, a short run factor.

These two factors interact with each other.  If momentum is positive, rising prices will make valuations rise, which lowers long-term return potential.  If momentum is negative, falling prices will make valuations fall, which raises long-term return potential.

In general, momentum changes more than valuation.  That’s to be expected.  When J.P. Morgan was asked by someone what the market would do that day, Morgan reportedly replied, “It will fluctuate, young man. It will fluctuate.”

There are numerous articles, books, and posts that show that momentum tends to persist in the intermediate-term.  Here is one example from a study that I did, A Different Look at Industry Momentum – II (and part one).  Mean-reversion can play a role over a 4-year period or so, but that seems to be a weaker effect.  Now momentum is not infallible, because when a lot of people follow it, the market goes nuts (1998-2000 for example) and then you get a wipeout.

But typically at times like that, valuations are high, so someone with an eye on valuation could avoid the wipeout as momentum flattens.

Now, with bonds, I have a model for valuation, but it is not simple.  I can analyze the relative risks of loss among different bond asset classes and compare that against spreads, and allocate to those that offer the best relative return.  I this environment, it means principal preservation is preferred to stretching for yield.

But what would a momentum model say?  I have a little more than 90 years of data on three yield series, the Aaa and Baa series on long corporate bonds from Moody’s, and Shiller’s long (usually 10-year) Treasury series.

Using a method that borrows from work done by Mebane Faber, I look at a ten month moving average of yields for each series, and invest in the one that has current yield lowest versus the moving average.  As yields fall, prices rise, and the bond subclass that has done best for the last ten months is likely to do better than most in the next month.

So, consider five strategies:

1.      Invest and reinvest only in Treasuries.

2.      Invest and reinvest only in Aaa corporate bonds.

3.      Invest and reinvest only in Baa corporate bonds.

4.      Invest in the one that has the yield the most below, or least above its 10-month moving average.

5.      Invest and reinvest 36% in Treasuries, 19% in Aaa corporate, and 45% in Baa corporates.

Here are the results of those strategies over the last 91+ years:

TreasuriesAaaBaaSwitchingWeighted Average
Annualized Return4.86%5.94%7.10%6.58%6.23%
Standard Deviation9.02%6.62%8.12%8.37%6.04%

Impossible Dream

Now for a confession: when I first ran the analysis, the switching strategy had a return that was 1.5%/yr higher than what it shows now.  One simple math error did that.  Thus, I don’t have a worldbeater to trot out to you. At a later point I will revisit this, after thought, and not data abuse.

That said, the switching strategy isn’t bad, and seems to work well in high volatility environments.  But let me explain.

Buying and holding Baa corporate bonds (BBB for those speaking the language of S&P or Fitch) has always been the high returning option for corporate bonds.  After that comes Aaa, Aa, A, Ba, B, Caa.  For more on this look at Eric Falkenstein’s book Finding Alpha.  It is similar to what we know about the equity markets.  Those who take moderate risks do best.  After that, those who take little risk, then no risk, then a lot of risk.

You would think that Baa/BBB corporate bonds would be an asset of choice, but for most bond managers who have to compete against a broad benchmark, it would be too big of a bet to use them indiscriminately.  Some life insurers use them more aggressively, but it would be rare to go above 30%.

Now, relative to the standard deviation of returns the weighted average portfolio did well.  It mimics a AA- portfolio, which is pretty high quality.  The percentages came from the switching strategy.  Those percentages came from how often was the switching portfolio in Treasuries, Aaa, or Baa securities.


Now, I only made one pass through the data.  I am not torturing the data to make it confess.  There might be better ways to do things.  But observing the momentum improves matters.  It is not as good as investing in Baa bonds, but who would run such a strategy?  If one is beating the Aaa bonds, it is good.

Another lesson is that investing for the average investment grade credit quality is good also.  The average mix is roughly Aa3/A1 (AA-/A+).  That would be similar to the main bond averages.

Lesson three is the pursing yield is rewarded, within limits.  If a society survives, and general order prevails, credit risk is generally rewarded.  It can’t be otherwise, aside from revolutions.

Lesson four is that switching yields better than its average, but the volatility is higher.  It kept up with Baa bonds for some time, but missed in the last cycle.  Had this analysis be run three years ago, the endorsement would have been strong for the switching strategy.  And that endorsement might be strong 10 years from now, because the strategy did well during periods of high volatility.


1) Transaction costs would cut the fees of the switching strategy, but if ETFs and closed-end funds are used the effect can be minimized.

2) It’s easy to find Treasury funds, but hard to find Aaa and Baa corporate funds.  Most investment grade corporate funds are a blend of everything from Aaa to Baa.  This strategy as written will prove hard to implement.

But, maybe a variation might not prove so hard.  I plan on testing the difference between the current yield and the 10-month (or 200-day) moving average on a variety of ETFs, and seeing if it has any usefulness.

But the work for next week is writing up a trading model for stock indexes, and I have something more substantial to say there.

When currencies do not serve as a long-term store of value, economic actors search for ways to preserve future purchasing power, which often mean purchasing commodities. But most commodities are not cheaply storable over long periods, so actors get forced into the few that do: gold, silver, etc. There is a problem here, stemming from dumb money. When dumb money shows up for purchase of generic “commodities” distortions follow: backwardation, large storage demand, and warped market incentives.

Eventually overproduction catches up, but the volatility when it breaks can be huge and self-reinforcing, with c0unterparties raising margin to protect themselves.  Extreme volatility causes exchanges to raise margin requirements substantially, which reveals which side of the trade is inadequately financed, which typically is the side that was winning, which leads to a reversal in price action.  The dumb money is revealed.

Now after a washout, the dumb money often assumes that powerful entrenched interests colluded against them to deny them their long-deserved free ride to prosperity through speculation.  The exchanges are in cahoots with the other side.  Well, no, the exchanges have two interests, which are solvency and transaction volume, which drives their profits.  Solvency is a more primary goal for an exchange, because the second goal can’t exist without it, and exchanges are not thickly capitalized.

Many different types of financial systems are subject to these risks.  Think of AIG: they were rendered insolvent by rising margin requirements as their creditworthiness was downgraded, largely because the rating agencies concluded they were going to lose a lot of money off of their many bets on subprime residential credit.  Think of all of the mortgage REITs that got killed as repo haircuts rose on all manner of mortgage-backed securities at the time that values for the securities were depressed.  Alternatively, think of Buffett, who entered into derivative trades where he received money and bore the risk, but his agreements limited the margin that he would have to post.

Commodity-linked exchange traded products serve four functions:

  1. Allow sponsoring financial institutions to get cheap financing through exchange traded notes.
  2. Allow sponsoring financial institutions to inexpensively hedge their commodity risks.
  3. Allow commodity producers to have cheap financing of their inventories via backwardation.  (And indirectly allow more clever speculators to earn extra profits from gaming the rolling of futures contracts.)
  4. Allow retail speculators who cannot access the futures market to make or lose money.  Scratch  that, that should probably read “lose money in aggregate.”

Wall Street does not exist to do small investors/speculators a favor.  It exists to make money off of the issuance of securities, and their trading in secondary markets.

As Buffett put it, “What the wise man does in the beginning, the fool does in the end.”  Yes, there is monetary debasement going on.  We should expect gold, crude oil, and other commodity prices to rise to reflect that.  But rises can overshoot, particularly in smaller markets like gasoline and silver.

So in answer to the question, “Which came first – the margin call or the commodities mayhem?” my answer is simple: The cause of the bust is found in the boom, not in the bust.  The boom happened because of loose monetary policy, which led many people to adjust their risk posture up, whether in commodity speculation, or in high yield debts.  (Oh wait, there are ETFs for that now too.)  Eventually self-reinforcing booms have self-reinforcing busts.  The elites think they can tame this, but they can’t, because you can’t change human nature, which means you can’t change the boom-bust cycle.

James Grant, at a recent meeting of the Baltimore CFA Society said that we had exchanged a “gold standard” for “Ph. D. economist standard.”  And indeed, the value of our currency is manipulated by that intellectual monoculture at the Fed, who pass Einstein’s test of insanity: doing the same thing over and over again and expecting different results.  I say that because the Fed thinks that it can produce prosperity by reducing interest rates.  All that their policy does is produce an asset bubble, or price inflation in goods and services.

The Fed drove us into this liquidity trap through increasing application of an easy money policy.  It will take different ideas and different people, and a lot of pain to get us out, because the Fed is blinded by their bankrupt theories.


I have written reviews on two Madoff books, No one Would Listen, and The Club No One Wanted To Join.  In the latter of those book reviews, I argued that the Madoff fraud was detectable in advance, which offended one who was defrauded by Madoff.  Ken Fisher lays the blame at her door; she should have been able to see it coming.

Look, I sympathize with her loss, but there are basic rules that are common sense for any investment where discretion is given to a money manager.  I am such a money manager, but I consider it a benefit to me and my clients that I have no ability to touch their funds.  The third-party custodian takes care of that.

Imagine playing a game — before we enter the game, both teams want to know that the umpires will be neutral.  So it is in investment management — we need neutral custodians to assure fairness between investment advisors and clients.

Ken Fisher manages ten thousand times more money than I do.  But he is aware of the many ways that people get skinned by fraudsters.  The leading way is to get investors to give the investment advisor both discretion and custody over the assets.  That opens the door for unscrupulous advisors to misappropriate assets.

This is critical.  Don’t entrust your assets to an advisor without a neutral third party providing custody.  This is more than normal — it should be expected.

There are four other lesser signs of fraud:

  • Returns are too good to be true — volatility that is too low, or returns that are too high.
  • Not being able to understand what is going on as the money is invested.
  • Being blinded by the trappings of wealth.
  • Trusting the opinions of others, rather than doing your own due diligence.

You have to understand that there are no magic bullets, and those who have great past returns should be willing to undergo extra due diligence, because great returns are rare, and need extra due diligence to prove that they are valid.

Beyond that, don’t be greedy or credulous.  Ignore wealth, and do your own due diligence — the book provides a good outline for doing so.  And unless you are so wealthy that you hire someone else  to hire your asset managers, don’t hire any manager whose processes you don’t understand.

These are basic rules that all investors should heed.  Enough said.



Who would benefit from this book:

Most average investors would benefit from this book, because they are the ones who get targeted for fraud — not that all of them will be defrauded, but all of them need the warning, so that they can be prepared against those who defraud.  I wish I had read this when I was 25.

If you want to, you can buy it here: How to Smell a Rat: The Five Signs of Financial Fraud (Fisher Investments Series).

Full disclosure: I asked the publisher for this book, and they sent it to me.  I read and review ~80% of the books sent to me, but I never promise a review, or a  favorable review.

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.

This is an unusual book, and a good book.  Unlike the book, “Outperform,” which reviews lesser known endowments, and endowment investing generally, this book reviews the Harvard and Yale endowments, which up until 2008, the year before the book was published, were among the best in terms of performance.

But this book is more than that.  It goes through the strategies of the major endowments, and looks for ways that average people can try to replicate the results.

But average investors don’t have the same set of investments available to them as the large endowments do.  If you aren’t a qualified investor who has access to the full range of investments ordinary mortals are denied — private limited partnerships (hedge  funds, private equity, commodity funds, etc), what can you do?  This book discloses investments that are similar if not equivalent, and versions that are lower cost through ETFs.

After that, the book takes a direction that would initially seem different than endowment investing.  It discusses trend following, which endowments do not in general use as a strategy.  Now, some hedge funds use it, but few endowments actively embrace it.  The book shows how return can be enhanced and volatility reduced by buying investments that are over their 200-day, or 10-month moving averages.  From my own research I can partially validate the approach.  It is a clever way of implementing a form of momentum investing, which may be a cheap way for average investors to mimic hedge funds who follow trends.

Then mimicry moves to a new level as the book goes through the basics of mining data out of 13F filings, where large investors file their long investments with the SEC.  Guess what?  Imitating bright people can help an investor beat the market — it can allow a bright person to mimic the long side of equity investing on the cheap, but with a lot of data analysis (or you can pay up for Alphaclone).

In one sense, the book seems like two books — one on endowment investing, and another on tools for clever investing available to average investors.  My way of reconciling the two is that the authors are clever guys who are trying to give their best ideas to retail investors so that they can do as well as sophisticated institutional investors who have a wider array of investments to choose from.  The retail investors don’t have the same array of investments to choose from, but they have the advantage of flexibility that institutions don’t and can more quickly trade out of investments that may be on the way to underperformance via trend-following.

And so with much effort, if you apply their ideas, you have the potential of doing as well in investing as the major endowments.  Or, absorb one of their passive strategies with little effort, and maybe you will do as well.  Strategies that have done well in the past may not do so in the future.

But on the whole, I heartily recommend this book.  There is a lot for investors of all types to learn from it.


Those reading the book should also read my essay, “Alternative Investments, Illiquidity, and Endowment Management. (Google it if there is no link)”  Taking on illiquidity is not a free lunch.  It can impose real costs when there is a need for cash among those endowed.  Personally, I think that ten years from now, illiquid investments will only be taken on by those that can lock them away.

Who would benefit from this book:

Those wanting to potentially mimic the high returns of the Harvard and Yale endowments could benefit from the book, but realize that a lot of the past is an accident, and that it might be difficult to achieve high returns in the future from strategies that worked in the past.  That said, the authors have offered strategies that take some degree of work to apply, so there may be barriers to entry for applying some of the strategies.

If you want to, you can buy it here: The Ivy Portfolio: How to Invest Like the Top Endowments and Avoid Bear Markets.

Full disclosure: I asked the publisher for this book, and they sent it to me.  I read and review ~80% of the books sent to me, but I never promise a review, or a  favorable review.

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.

When Everything is Strong

When Everything is Strong, Redux

It Would Have Happened Already

It Would Have Happened Already, Redux

Four recent posts of mine.  They warn against assuming that trends will continue.  This past week, we gained some evidence that trends won’t continue.  I’m not talking about the upset in commodities, led by silver and crude oil.

Those matter little compared to the low yields for Treasury bills and notes (from

3-Month0.00008/04/20110 / .01-0.005 / -.00505/06
6-Month0.00011/03/20110.06 / .060 / -.00005/06
12-Month0.00005/03/20120.16 / .16-0.01 / -.01005/06
2-Year0.62504/30/2013100-04+ / .550-01½ / -.02405/06
3-Year1.25004/15/2014100-29¾ / .930-01¾ / -.02005/06
5-Year2.00004/30/2016100-21½ / 1.860-03 / -.02005/06
7-Year2.62504/30/2018100-20 / 2.530-02 / -.01005/06
10-Year3.62502/15/2021104-00 / 3.150-01 / -.00405/06
30-Year4.75002/15/2041107-24½ / 4.29-0-17 / .03005/06

These low rates threaten the repo market and money market funds.  They also force people into riskier investments.

This is why I view the commodity market weakness as a hiccup.  Speculators, those that follow momentum, got ahead of themselves.

But there is weakness in Europe that should not be ignored.  Will Greece be tossed out of the EU or not?  Given past actions, the answer is no, but who can tell for sure?

We face cross-currents here, there is no yield for savers, which makes many speculate.  But speculation in commodities has blown up recently.  What to do?

Personally, I would edge into commodities, and commodity-related stocks.  When one-year Treasury rates are so low, it is an incentive to buy stuff/commodities.  Why should I hold a worthless dollar when I can hold a lump of copper?

This is a guess, and it is only a guess, but I would favor commodity strength over the weakness in short-term bond yields.  Play it carefully, and wait for strength before joining in.

It annoys me that Republicans argue against elimination of special tax benefits for anyone, calling it a tax increase.  Let’s get things straight here: tax increases are things that affect everyone.

The tax code needs to be cleaned up, as do subsidies.  It is not the proper place of government to be handing out special favors.  If the Republicans want to do what is right they need to trade — eliminate a subsidy/tax break that some of their constituents like in exchange for eliminating a subsidy/tax break that the Democrats like.  Rinse, lather, repeat, until we are back to something like the Tax Reform Act of 1986, or better.

Much as I am a libertarian, I would like the government to survive after shrinking considerably.  Part of that involves paying debts, unless we are thinking of doing an external default.  My but the rest of the world, particularly China, would be hurt by that.

Cutting taxes has a limit, unless one wants to see our entitlement programs end.  I’m all for that, but I think it is political suicide, because a large portion of the American public believes in magic — they think that they are entitled to a meager pension and healthcare in their old age, whether the government can afford it or not.

Look, I am for cutting the Defense budget bigtime, because it is offense, not defense; we do not need so much to defend us.  Fold Homeland Security into Defense.  Also cut Social Security and Medicare — we can’t afford them at the level indicated, but not promised… remember that these programs are statutory and not guaranteed.

After that, go after the discretionary budget, and eliminate whole departments.  Why do we need an energy department when prices are beyond control?  Why do we need an agriculture department when food prices are high, and likely to remain so?

Education department?  Things have gotten worse since its creation — eliminate it.  HUD, HHS — great big wastes, eliminate them.  Commerce, Treasury, Labor, State, Interior, Transportation, Veterans Affairs — cut them in half, and see how they adapt.  Make the Fed shrink by 90% or more… what does it take to do monetary policy?

I have no doubt that this policy would make my house price fall, but it is the right thing to do.

The deficit can be cut.  It is all a question of will.

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.

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.


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.


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.


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

Human nature is not changeable.  If people do significantly less well managing defined contribution assets on average than a comparable index fund, then they should not be managing their own assets, much less concentrating into a small number of stocks.  I don’t care what Baruch says (whoever he is), or what my friend Josh says.  Markets are complex, and investing is hard, not easy.

Just as I believe that most people don’t have the capacity to run their own businesses, the same is true of investing.  Both require a lot of discipline, and most people do not have a lot of discipline.

It takes time to learn how to analyze investments.  I think of people taking the CFA courses/exams, and I say to myself, “”Yes, better than nothing, but we need practical experience to truly train them.”

As an aside, when I went to take CFA exam level one, a few younger people snickered at me and said, “Who’s the old guy?”   (Note: I was 34 at the time; the beard probably didn’t help, and I sometimes let it grow longish back then.)  I turned to them and said, “I am an actuary.  I have already been through a set of ten-plus exams far more difficult than the CFA exams.  I am skilled in compound interest, accounting, statistics, economics, modern portfolio theory, and mathematics to a degree that AIMR does not consider. I am battle-tested in exams more difficult than this, where we had to read far more, and wonder whether we would be tested on minutiae such that AIMR would never consider for CFA candidates.  Further, I have lived under an ethics code for ten years, so I get the AIMR code.  Do you get it?”  After an uncomfortable silence they looked away, and I did too.

My portfolios are concentrated by industry, but diversified within industries.  I have worked hard at my theories for around 18 years now, with my current strategy running for 10+ years.

It is not easy to do well in investing.  First, you may not understand the basics of valuation.  Second, you may not understand what factors can drive stock prices.  Third, you may not understand how industries move a groups.  Fourth, you may not understand how changes in the economy may affect your investments.  ANd there is more.

What’s that, you say?  You don’t need to know those things because you can read a chart?  Okay, good.  Momentum tends to work, but chart-reading after momentum may not work.  Yes, things that have gone up tend to go up further, because of disbelief among investors.  Here’s the test — how often have you made money buying negative momentum, or selling positive momentum?  My guess is that momentum incorporates most of technical analysis, and that most of the detailed technical analysis ideas are empty.  Test: show your technical analysis idea to technicians of a different flavor, and see what they say.  It’s like Evolution versus Special Creation — Evolutionists trash Creationism, but they don’t agree among themselves to any significant degree.  There are few, if any ideas, that all Evolutionists agree on except the negative, “Not Creation.”  (I had a more offensive version using Canadians and Americans.  I passed.)

I incorporate momentum into my fundamental investing.  It helps to erase the problem of value investors always being early.

Most people that I have known that have ventured into individual stocks gave up because they lost money, or didn’t make much money.  Skilled amateur investors are few.  This is my razor: if they can’t manage owning an S&P 500 index fund, what makes us think that they can manage a more volatile portfolio of common stocks?