All of my articles from RealMoney have been irreparably lost because of a change in file systems.  Anything written prior to 2008 is gone.  That may not matter for most writers at RealMoney, but I tended to write things of more permanent validity.

So it is with gratitude to Barry Ritholtz that I republish a popular piece of mine that ran on January 13th, 2004.  Barry Ritholtz republished it in 2006, and captured most of it, except for one thing — at the end I said that the rally would go on, which it did.

Anyway, here is Barry’s copy of my piece, without adjustment:


David Merkel wrote this a year ago; it’s a brilliant set of observations of what market tops look like.

David starts by noting he is “basically a fundamentalist in my investing methods, but I do see value in trying to gauge when markets are likely to make a top or bottom out.”  He adds that his methods “are somewhat vague, but I always have believed that investment is a game that you win by being approximately right. Precision is of secondary importance.”

Item 1: The Investor Base Becomes Momentum-Driven

Valuation is rarely a sufficient reason to be long or short the market. Absurdity is like infinity. Twice infinity is still infinity. Twice absurd is still absurd. Absurd valuations, whether high or low, can become even more absurd if the expectations of market participants become momentum-based. Momentum investors do not care about valuation; they buy what is going up, and sell what is going down.

You’ll know a market top is probably coming when:

a) The shorts already have been killed. You don’t hear about them anymore. There is general embarrassment over investments in short-only funds.

b) Long-only managers are getting butchered for conservatism. In early 2000, we saw many eminent value investors give up around the same time. Julian Robertson, George Vanderheiden, Robert Sanborn, Gary Brinson and Stanley Druckenmiller all stepped down shortly before the market top.

c) Valuation-sensitive investors who aren’t total-return driven because of a need to justify fees to outside investors accumulate cash. Warren Buffett is an example of this. When Buffett said that he “didn’t get tech,” he did not mean that he didn’t understand technology; he just couldn’t understand how technology companies would earn returns on equity justifying the capital employed on a sustainable basis.

d) The recent past performance of growth managers tends to beat that of value managers. In short, the future prospects of firms become the dominant means of setting market prices.

e) Momentum strategies are self-reinforcing due to an abundance of momentum investors. Once momentum strategies become dominant in a market, the market behaves differently. Actual price volatility increases. Trends tend to maintain themselves over longer periods. Selloffs tend to be short and sharp.

f) Markets driven by momentum favor inexperienced investors. My favorite way that this plays out is on CNBC. I gauge the age, experience and reasoning of the pundits. Near market tops, the pundits tend to be younger, newer and less rigorous. Experienced investors tend to have a greater regard for risk control, and believe in mean-reversion to a degree. Inexperienced investors tend to follow trends. They like to buy stocks that look like they are succeeding and sell those that look like they are failing.

g) Defined benefit pension plans tend to be net sellers of stock. This happens as they rebalance their funds to their target weights.

Item 2: Corporate Behavior

Corporations respond to signals that market participants give. Near market tops, capital is inexpensive, so companies take the opportunity to raise capital.

Here are ways that corporate behaviors change near a market top:

a)  The quality of IPOs declines, and the dollar amount increases. By quality, I mean companies that have a sustainable competitive advantage, and that can generate ROE in excess of cost of capital within a reasonable period.

b) Venture capitalists can do no wrong, so lots of money is attracted to venture capital.

c)  Meeting the earnings number becomes paramount. What is ignored is balance sheet quality, cash flow from operations, etc.

d)  There is a high degree of visible and/or hidden leverage. Unusual securitization and financing techniques proliferate. Off balance sheet liabilities become very common.

e) Cash flow proves insufficient to finance some speculative enterprises and some financial speculators. This occurs late in the game. When some speculative enterprises begin to run out of cash and can’t find anyone to finance them, they become insolvent. This leads to greater scrutiny and a sea change in attitudes for financing of speculative companies.

f) Elements of accounting seem compromised. Large amounts of earnings stem from accruals rather than cash flow from operations.

g) Dividends become less common. Fewer companies pay dividends, and dividends make up a smaller fraction of earnings or free cash flow.

In short, cash is the lifeblood of business. During speculative times, watch it like a hawk. No array of accrual entries can ever provide quite the same certainty as cash and other highly liquid assets in a crisis.

These two factors are more macro than the investor base or corporate behavior but are just as important.  Near a top, the following tends to happen:

1. Implied volatility is low and actual volatility is high. When there are many momentum investors in a market, prices get more volatile. At the same time, there can be less demand for hedging via put options, because the market has an aura of inevitability.

2. The Federal Reserve withdraws liquidity from the system. The rate of expansion of the Fed’s balance sheet slows. This causes short interest rates to rise, making financing more expensive. As this slows down the economy, speculative ventures get hit hardest. Remember that monetary policy works with a six- to 18-month lag; also, this indicator works in reverse when the Fed adds liquidity to the system.

Occasionally, I write negative book reviews.  I am not always right, but sometimes I locate books that are not up to par, or are downright mistaken.  I try to back up my findings with facts, but there is still a problem.  If I publish the negative review at Amazon, it is in the interests of the author and publisher to recruit people to vote my review down.  My Amazon reviewer rank isn’t bad, but it would be a lot higher if I hadn’t written negative reviews that I believe are correct.

So what to do?  There are some books that should not have seen the light of day, and others that are just subpar — don’t waste your money.

As I see it, there is an asymmetry in voting on reviews at Amazon, and it comes down to concentration of interests.  Though I have a bigger voice than many reviewers because of my readership here, if I write a negative review, it is easier for the author/publisher to gather a group to vote me down, than it would be for me to get it voted up, should I try that.

I will continue to post negative reviews at Amazon, and I will try not to care about my reviewer rank.  But Amazon needs to tweak its system — when a voter votes too much for a given reviewer, he is deemed a “fan,” and his votes stop counting.  The same does not apply to negative votes, but I could be wrong there.

Advice is welcome, but it really seems that constructive critics are at a disadvantage with book reviews.

US Politics & Policy


  • How the Tea Party Will Die Gets 1thing right: gerrymandering is behind much of our gridlock $$ Oct 18, 2013
  • Even When the GOP Loses, It Wins New baseline favors deeper cuts as we may go through sequestration again $$ Oct 18, 2013
  • The Tea Party and the GOP Crackup t-party represents Jacksonian America: angry & in full revolt against new elite $$ Oct 17, 2013
  • How Delayed Inflation Data Mess With Social Security and More US Treasury will have 2 estimate best they can $$ Oct 16, 2013
  • Though it might b better if the govt weren’t calculating the data; gives them too much power to fiddle w/the #s. But no one is neutral $$ Oct 16, 2013
  • McConnell’s Favored Dam Project Included in Debt Deal Pork is not dead in DC, whether GOP or Democrats $$ #shame Oct 18, 2013
  • Crop-Insurance Cuts Test Farm Power as Lobbies Push Back If can’t be cut when Ag does well, then nothing can b cut $$ Oct 16, 2013
  • Factional conflicts have the power to destroy empires – and republics Reminds me of Europe in 1840s: too much debt $$ Oct 14, 2013
  • Reformers hail limit on US crop insurance subsidies Let’s c if it actually gets passed; Ag subsidies tough 2 kill $$ Oct 14, 2013
  • EPA’s McCarthy Says No Decision Made on Renewable Mandate Believe no rumor until it is officially denied $$ Oct 14, 2013
  • A Slowdown on the Road to Recovery Decaying Bridges, Highways Raise Costs for Truckers, Manufacturers $$ $SPY $TLT Oct 14, 2013
  • Fiscal negotiations sputter as deadline looms Obama could end this here by tossing the GOP a bone 2 avoid MAD $$ Oct 14, 2013
  • America’s default on its debt is inevitable America has defaulted 3 times already. No way we can fund entitlements $$ Oct 13, 2013
  • Republicans Need a Graceful Exit Strategy, Now @asymmetricinfo explains y the GOP should cut their losses here $$ Oct 12, 2013
  • Is US Political Bubble About to Burst? If there is no permanent default, no, b/c the world needs flexibility of US $$ Oct 12, 2013
  • How to Handle a Debt Default. You Know. Just in Case. In a longwinded way comes 2 correct answer: no good strategy $$ Oct 12, 2013
  • 10 ‘Poorest’ Members of Congress Owe Big The same list with a little more data to flesh it out $$ Oct 12, 2013
  • The 10 least wealthy members of Congress, from Roll Call They r not just least wealthy; they r broke 8 Ds, 2 Rs $$ Oct 12, 2013

PPACA / Obamacare


  • Health Website Woes Widen as Insurers Get Wrong Data 4 something so critical, the healthcare website has failed $$ Oct 18, 2013
  • Another reason y PPACA is a sham; resources don’t appear from nowhere; low cost plans don’t chg the underlying cost of services $$ $SPY $TLT Oct 16, 2013
  • Patients Pay Before Seeing Doctor as Deductibles Spread Big: as deductibles rise, so does prepayment, b/c bad debt $$ Oct 16, 2013
  • Obamacare Needs a Drop-Dead Date @asymmetricinfo ably argues if exchanges aren’t functioning by 11/1, delay PPACA $$ Oct 16, 2013
  • Petco, Applebee’s employees join growing list on private exchanges If this works, maybe can replace govt exchanges $$ Oct 16, 2013
  • Obamacare marketplace could get partial rebuild If ppl have a hard time signing up, they will have to fix or delay $$ Oct 14, 2013


Rest of the World


  • Time to take bets on Frexit and the French franc?! Weird: Marine Le Pen’s Front National most popular French party $$ Oct 16, 2013
  • China CPI Speeds Up in September, Mainly on Food Prices Woe betide when Chinese Inflation starts running hot $$ Oct 14, 2013
  • Merkel Faces Decision on Coalition Partner Grand coalition coming, may have impact on German Constitution $$ Oct 14, 2013
  • The Long, Slow Process of IKEA Design Company’s Commitment to Shaving Costs Makes Designing a Kitchen a 5-Yr Task $$ Oct 14, 2013
  • Japan May Hire Firms to Manage Foreign Reserves A small experiment where they take illiquidity & credit risk $$ Oct 14, 2013
  • Malaysia Rules Catholic Paper Can’t Use ‘Allah’ Go back to the original, and use “Elohim,” not the Arabic version $$ Oct 14, 2013
  • French Fume Over Speed Traps That Cut Hollande Budget Gap An irritating way 2 tax people, would try 2 avoid that $$ Oct 14, 2013



Berkshire Hathaway


  • Buffett’s Son Calls Junk Bonds Model for Charities Howard Buffett wants charities 2try hard projects, risk failure $$ Oct 18, 2013
  • Buffett Adds Stocks in Pension Handoff to Lieutenants Long duration, higher cost float 4 $BRK.B 2 invest $$ Oct 18, 2013
  • Buffett Defends Dimon, Says Regulators Take Ton of Flesh Difficult to pin down liability w/large complex firms $$ Oct 16, 2013
  • As a result, there is the bias toward fines, a little criminal prosecution. Fines should go to those harmed, rather than govt $$ $JPM $BRK.B Oct 16, 2013
  • Tracy Britt Cool on Management Lessons From Warren Buffett Buffett gives his managers freedom & flexibility $$ $BRK.B Oct 16, 2013
  • Buffett Turns to Deputies to Help Find Successors for Unit CEOs Berkshire is a complex company; requires much mgmt $$ Oct 14, 2013
  • Warren Buffett’s Lieutenants at Berkshire Hathaway Possible Buffett replacement Matthew Rose, CEO of BNSF $$ $BRK.B Oct 14, 2013
  • CEOs to Face Berkshire-Loyalty Test How will $BRK.B retain managers after there is no Warren Buffett 2 disappoint? $$ Oct 14, 2013


Companies & Industries


  • Can Coke and Pepsi Overcome Shrinking Juice Demand? Far better to have fruit & get the fiber, not just the sugar $$ Oct 18, 2013
  • A SWAG Surprise in the $19 Billion Chevron Case Defense atty surprised when witness says the damage # was made-up $$ Oct 18, 2013
  • Ursula Burns: ‘Chill out a little bit’ Pick the places where u want 2b great, focus energies there & then go do it $$ Oct 18, 2013
  • Hollywood Steps Up Security to Keep Scripts Secret Interesting: tech & methods Hollywood uses 2 protect scripts $$ Oct 14, 2013
  • ‘Clean Coal’ Costs Are on Display at Mississippi Plant Clean coal is likely a pipe dream 4 coal producers $$ Oct 14, 2013




  • Dimon Said to Have Given Up Role at Bank Unit on OCC Request He stepped down, but not w/o the OCC giving a push $$ Oct 18, 2013
  • Stockbroker Requests to Scrub Complaints Are Often Granted Bad stuff; makes u want to beef up the SEC & end FINRA $$ Oct 17, 2013
  • NY Fed Fired Examiner Who Took on Goldman $GS $$ $SPY She analyzed conflict of interest rules & found them lacking. Oct 16, 2013
  • Simon Says: ‘Toughen Up’ Simon Business School attempts to get students ready 4 the hard aspects of business $$ Oct 14, 2013
  • Big Banks Can Be Dismantled, Say US & UK Regulators I will believe it when I see it. Regulators r2 optimistic $$ Oct 14, 2013
  • Debt moves the world This article moves the ball forward; overall debt levels should help decide monetary policy $$ Oct 14, 2013
  • Beyond Earnings: A Simple Method 2Pick a Winning Stock “Quality” or gross return on assets, measures moat strength $$ Oct 12, 2013
  • When Analysts Sober Up Sell side analysts tend 2b very optimistic & revise as reality intrudes. CFOs don’t mind $$ Oct 12, 2013




  • Houston Texans Running Back Arian Foster Is Going Public Step right up, buy a share of a football player’s pay $$ #no Oct 18, 2013
  • How I Learned to Haggle Over Prices Never thought I would b good at haggling until I traded corporate bonds $$ Oct 17, 2013
  • Harrisburg’s Parking Bond Sale Avoids Chicago Regret Key is 2align incentives; Harrisburg/investors both make $$ same Oct 16, 2013
  • Axel Merk: In our assessment, a central bank pursing an employment target… has given up its independence $$ $TLT Oct 16, 2013
  • Regional Fed Bosses Struggle With Communication Issue Talk is cheap 4 the Fed; the expenses get charged to us $$ Oct 14, 2013
  • BuzzFeed’s Brazen, Nutty, Growth Plan Translation by foreign-language speakers learning English using Duolingo $$ Oct 14, 2013
  • Google Is Going to Include Your Face in Its New Ads U did not know that u have signed up 2b an ad pitchman w/G+ $$ Oct 14, 2013
  • The Cheap Way to Watch Every NFL, NBA, NHL Game Online The genie is out of the bottle, will b hard 2get it back in $$ Oct 14, 2013
  • Bit by Bit, Virtual Reality Heads for the Holodeck Think the technology will get bogged down on multiple players $$ Oct 14, 2013
  • ‘Jumping Genes’ Bring Unexpected Twists 2 DNA 1 shouldn’t b overly impressed w/idea of strict genetic heritability $$ Oct 12, 2013
  • Wire Fraud Is on the Rise Double check transfer requests; you could be on the hook for any losses $$ Oct 12, 2013


The Swedish Central Bank Prize


  • If you have 2shorten it further, call it The SCB Prize. But it is not a Nobel Prize; none of the economists winning it deserve the honor $$ Oct 14, 2013
  • The official name is The Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel. Call it the Swedish Central Bank Prize. $$ Oct 14, 2013
  • Note2journalists: there is no Economics Nobel Prize . Nobel knew economics was not a science. We should agree given failures of ec theory $$ Oct 14, 2013
  • Fama, Shiller, Hansen Win 2013 Nobel Prize in Economics Can anyone explain why Hansen shared the SCB prize? $$ Oct 14, 2013




  • Unreliable research: Trouble at the lab The main problem is that scientists do not understand statistics $$ Oct 19, 2013
  • Also, they r incented to find positive results, when there may be none, & they are not neutral observers, sometimes they push an agenda $$ Oct 19, 2013
  • Wrong: Fed Official Says Big Banks Should Be Required to Hold Long-Term Debt Job is 2 protect subs not holdcos $$ Oct 18, 2013
  • Wrong: Hey China, Stop Laughing at the US W/any fair rendering, China’s economic &political problems > those of US $$ Oct 18, 2013
  • Wrong: Al Gore: “Carbon Bubble” Is Going to Burst – Avoid Oil Stocks The “carbon bubble” is between his ears $$ Oct 18, 2013
  • Difficult to say: Investors Seek Bargains in Battered Munis 2 many major weak credits & 2 many weak holders $$ Oct 14, 2013
  • Tenuous: US Corporate Profit Growth Slows as Shutdown Risks Rise Link more tenuous as economy was slowing already $$ Oct 14, 2013
  • Bad HL: Default Doubters Repudiated by Republican Economists Comments of GOP economists r more nuanced than that $$ Oct 14, 2013
  • Wrong: Don’t Shoot the Messaging Fed puts 2much effort into fwd guidance, should not b surprised @ mkt reactions $$ Oct 12, 2013


Replies, Retweets & Comments

  • @marcmakingsense A competitive market in data. Let the best data win. Democracy ain’t what it used 2b w/gerrymandering, thus current fight Oct 16, 2013
  • @JPDesloges not my article, but the Economist’s. Do what you like. Oct 16, 2013
  • @pkedrosky I wouldn’t have said it that way, but you are correct. Oct 15, 2013
  • Commented on StockTwits: Good point. The successor will have 2go2 great pains to prove he will keep the old hands … Oct 14, 2013
  • RT @EpicureanDeal: Want cleaner banking? Pay litigation, settlement, and penalty costs directly out of the employee bonus pool. $JPM Oct 13, 2013


Toby was an unusual guy.  Unlike many men, he never outgrew his childlike wonder at the world.  Some thought he was delusional, but he made his way in the world as a mechanic, and he was very good at it — intuitive, as his clients would say.

Toby had an unusual friend.  He called him “Peanut.”  Peanut was his pet, and he had had him since his youth, but Peanut was unusual.  Peanut was small when he first got him at age 15, but he grew dramatically such that at age 40 for Toby, to Toby, he looked as large as an elephant.  But that’s where things got weird.  Peanut looked different to different people, and as far as Toby could tell, the main factor was how old the person was.  Peanut would look small to older people, and would look monstrous to the young.  At least, mostly this was true — with some people that didn’t work, and that puzzled Toby.

One day, Toby decided to take a vacation, and bring Peanut along.  Toby had never seen Washington, DC, and being proud to be an American, prepared to go.  He gathered supplies for Peanut and himself, and loaded his truck, with which he could carry Peanut.  He notified his boss that he would be taking vacation for two weeks, and headed off for the US capital.  The boss was surprised because Toby rarely took vacation, but he granted it; in his mind it was well-deserved.

Washington, DC

Toby was amazed at the architecture of Washington, DC.  Nothing very tall, but buildings designed to capture the former splendor of Greece and Rome.  Peanut didn’t blink at DC — he just walked along with Toby.  But as Toby passed by with Peanut, little children would go into hysterics, while parents would ponder why.  Oldsters would smile and wave, and the ladies would comment on how cute Peanut was.  Toby was used to this, but it puzzled him.

Eventually Toby made it to Capitol Hill.  Toby was tired, and so was Peanut, so they ate & rested.  To their great surprise, Alan Greenspan walked toward them.  Unlike most people, Greenspan recognized Peanut and said, “Peanut old boy!  It’s been so long since I first met you.  My but you have grown!  You are so much larger than when I met you 30+ years ago!  Then to Toby he said, “Are you the one that takes care of Peanut? I knew him when he was no bigger than a golf ball.”

Toby said, “Peanut is my friend.  I take care of him, but I don’t think of him as a pet.”  He talked with Greenspan for a bit, and Greenspan left to head back to Georgetown.

The Next Day

Toby might have been unusual, but he got his Congressman to have a staff member give him a tour of the US Treasury Building.  Peanut came along.  Toby was amazed at all of the portraits of all of the Treasury Secretaries, and how male fashion changed over 200+ years.  Toward the end of the tour, Toby asked, “So where do they store the government debt?”

The congressional staffer blinked, and said “Huh?”

Toby said, “The government debt.  I’ve heard it’s big.  If something is big, I want to see it, to see how big it is.”

The congressional staffer mumbled, and said, “I’m sorry, but the tour is over.  Have a nice day.”

Toby smiled, but he felt like he was let down.  Peanut didn’t care.  He was with Toby, and he was happy.



From an e-mail from one of my readers:

I’m not sure if you have the time to respond to this, but figured I’d send to you and just see!…

(Just FYI, I’m not an investment professional of any sort, so I don’t have any “skin in the game” as they say, just a geek who follows the markets and DIY financial-planning issues and long-time reader of the Aleph blog)

I recently read an FP article by a guy I’ve read a lot (Alan Roth).  He suggested that, when your analyzing an investment portfolio and making asset-allocation decisions, you need to treat mortgage debt as an “inverse-bond” or an “anti-bond”…such that any mortgage debt held would dollar-for-dollar negate or reduce your actual bond investment holdingsAnd the result is that this made the investor’s actual portfolio risker than they realized, since their “true” bond allocation was smaller than they had considered.

I thought it was a novel concept, but I found some problems with that approach, within the context of asset-allocation.  My main point was that the primary purpose of analyzing a portfolio’s asset allocation is to manage risk through diversification of assets (generalizing here in interests of being concise).   The pinnacle of diversification is non-correlation: generally in economic environments where equities soar, bonds will underperform, and vice versa.  However, classifying a debt as an “anti-bond” doesn’t actually provide any portfolio diversification, or introduce any non-correlation.  It won’t actually negate the amount that your bonds would rise, and it won’t actually offset the amount your bonds would fall, in those respective market environments.  And even if you consider that the real value of the debt is decreased if inflation rises (as the NPV calculation would be using a greater discount rate), that doesn’t have any real-world effect on the portfolio and it’s risk and return behavior.  Since borrowers aren’t allowed to “mark-to-market” their mortgages, that debt holding value does not fluctuate–it is fixed, and amortized from its historical cost, regardless of any market conditions or any theoretical NPV/DCF changes.  Therefore, the inverse- or anti- bond holding in the portfolio has zero impact on the portfolio’s actual risk/return behavior, and so it seems to me it doesn’t add any functional value to frame debt as an “anti” portfolio holding of some sort.

Also, if you were going to do that, to be fair and complete, you must apply that same principle to every single debt the client has (otherwise, it would be rather arbitrary just selecting the mortgage debt).  This adds unnecessary complexity in the asset allocation analysis.

Instead, the appropriate (and only) way to analyze debt is, separate from investable portfolio assets, on the cash-flow side of things.  Simply asking what is the “optimal” use of the available capital; i.e. what net “return” do you earn by using capital to eliminate debt, versus what net return could you earn if you kept the debt and employed the capital elsewhere (this will be different for each investor and their unique situations).  This is the way to analyze and evaluate debt, not to mingle it in with your invested assets and classify it as an “anti-bond” holding within your portfolio.

I was just curious your take on this, and if I am misunderstanding or missing something.  Do you ever consider client’s debt as “inverse-“ or “anti-“ bonds in the context of asset allocation?


When you manage money financial firms, if you do it right, you consider the promises that your firm needs to fulfill.  When will cash be needed to pay obligations?  That helps drive asset allocation, because assets should broadly match liabilities.

Now, I am not a financial planner.  That said, the same principles apply to personal asset allocation.  If someone has a large mortgage or other debts, and he can’t invest his fixed income assets at levels that exceed the yields on those debts with reasonable risk, he should not invest in bonds — he should pay down his debt.  In the case of 401(k)s or IRAs, where there might be matches or tax advantages, the calculation becomes more complicated.  You have to weigh the match and tax deferral vs the negative arb on bond yields vs the mortgage and personal debts.

There is another factor here — how stable is your job?  If stable, it is bond-like, and you can take more equity risk with investments.  If your job has payoffs that vary a great deal with the market — commissions, bonuses, etc., it is stock-like, and you should take less risk in your investing — take excess earnings and pay down the mortgage.  I did that when I went from being a bond manager inside an insurance company, to being an equity analyst inside a hedge fund.  I paid off my mortgage in full, so that I would be free to take risks for my new employer.

As for the article, the concept is not novel.  It is well-known and practiced by institutional asset managers who manage money to the horizons needed by their clients.  As an example, the cash flows of a pension plan are relatively determinate, and the discount rate calculates the value of the liability.  The portfolio should throw off cash when needed in order to minimize risk.

In some cases, where bonds don’t offer enough yield, and equity prices are depressed, it might make sense to tactically mismatch, betting that equities will offer better returns versus the liabilities than bonds would on a risk-adjusted basis.

This argument has made its rounds for the last 20 years in insurance and pension management?  Do we match asset and liability cash flows, or do we trust in the equity premium, and invest in risk assets?  The correct answer is hybrid.  In general, match assets and liabilities, but if there is a significant tactical advantage to not match, then do that.  Think of buying junk bonds in late 1998.  Time to throw matching out the window.  And then in mid-1999, buy equities.

Now, not all clients will allow for that much risk-taking.  Many institutional investors will not let the asset manager take advantage of temporary dislocations.

In general, I think Mr. Roth is correct, but with an adjustment.

  • In extraordinary times, where bonds yield more than the earnings yields of stocks (think 1987 & 2000), buy bonds heavily, even if you have mortgage and other debts.
  • In extraordinary times, where stocks earnings yields are much higher than bonds, mismatch and own more stocks relative to bonds.  Just beware deflation, with falling future earnings.
  • In normal times, an indebted investor should not add to his leverage, but should invest in bonds, or better, pay down his debt.  Being debt-free is an excellent thing, and allows the investor to take more risks when the market is offering bargains.

Debt is either something to be funded by bond assets, or funds a margin account where you outperform the yield, or die.  All of this depends on where the market is in its risk cycle.  Only take risk where it is rewarded.


Leverage and risk eventually transfer to the least regulated

I’m coming near the end of this series.  It will either end at LX or LXI.  To refresh, I started a file in 1999 of insights before I started writing at RealMoney or Aleph Blog.  I ended it in 2003, near the time I started writing for RealMoney.  I threw a few of the insights away, but not many — there may have been near 70 when I was done.  These ideas stemmed for all of the new ideas I ran into as I transitioned from being an investment actuary to being a portfolio manager.  Onto tonight’s idea!

After the recent crisis, tonight’s insight may seem rather banal, but I saw it as an actuary many times as onshore insurers would shed reserves using reinsurance treaties to Bermuda companies and other domiciles with weak reserving, capital or tax rules.  It was reinforced to me when I blew it badly regarding Scottish Re.  It was only in the midst of their crisis, that I finally saw a full diagram of their corporate structure.  It was a hodgepodge of all of the weak insurance domiciles, with many lines going this way and that.

A picture is worth a thousand words, and as I have often said, complexity within financial companies is rarely rewarded.  That diagram focused my research, and changed my view of what was going on.  After having bought into the decline, we sold into an incredible one day rally when some positive news was released, while my view had shifted that cash could not make it to the holding company, and the common would go out at zero.

What a mess, and the best thing I can say was that selling into the rally was the right thing to do, as the common did go out at zero.

But in the recent crisis:

  • How many weakly capitalized investment banks died or were acquired?
  • How many REITs, particularly mortgage REITs died or were acquired?
  • How much of the mortgage insurance industry died?
  • How much of the financial guaranty industry died?
  • How many significant GSEs died?
  • And with all of these, how many barely survived?

These all had weak financial models, taking on too much credit risk, with weak, backward-looking models for risk.  It is no surprise that the bad credit risks found the fools that assumed that housing prices could only go up, and incurred considerable leverage to make their bets.

All of these were weakly regulated.  There was more than a bit of the “this is free money” attitude to many of these businesses — it was an era that rewarded yield hogs for a time.

Thus, when you see financial firms with weak balance sheets taking on significant credit risks, be wary, it is often a sign that the credit cycle is about to turn.

Financial intermediation reduces volatility.  In bull markets, demand for financial intermediaries drops.

Ordinary people do well if they have a budget and stay within it.  They do even better if they save and invest, but really, they don’t know what to do.  Market returns are like magic to them.  They don’t know why they occur, positively or negatively.  Life would be best for them if a mutual financial company gave them smooth returns 0n a regular basis, and absorbed all of the market volatility over a market cycle.  That would be hard for the mutual financial company to do, because they don’t know what the ultimate returns will be, so how would they know what smooth returns to credit?

There is a reason why banks, mutual funds, money market funds, life insurers, and defined benefit pension plans exist.  People need vehicles in which to park excess cash that are more predictable than direct investing.  Set an average person free to make his own investment decisions with individual bonds an stocks, and he will make incredibly aggressive or scared moves.  Fear and greed will seize him, making him sell low, and buy high.

That’s why entities that reduce volatility, whether absolutely or relatively, whether short-run or long-run, exist.  But there is seasonality to this: average people seek intermediaries during and after bear markets, when they have been burnt.  After losses, they seek guarantees.  That is often the wrong time to seek guarantees, because often the market turns when average people are running.

During bull markets, the opposite happens.  When easy money is being made by amateurs, the temptation comes to imitate.

  • If my stupid brother-in-law can make money flipping houses, so can I.
  • If my stupid cousins can make money buying dot-com stocks, so can I.
  • If my stupid neighbor can make money buying gold, so can I.

First lesson: don’t be envious.  Aside from being a sin, it almost always induces bad investment and consumption decisions.

Second lesson: build up your investment expertise, piece-by-piece.  Don’t follow the crowd.  Develop the mindset of  a businessman who calmly analyzes opportunity, asks what could go wrong, and estimates likely returns dispassionately.  Pretend you are a Vulcan; if they actually existed, they would be some of the best investors, and not the Ferengi.

Third lesson: an experienced advisor can be of value even if he does not beat the market, by avoiding selling out at the bottom, and avoiding taking more risk near the top.

Fourth lesson: remember that market returns tend to be lumpy.  The economy may be volatile, but markets are more volatile, and not in phase with the economy, because markets anticipate.

Fifth lesson: if you can do it in a disciplined way, invest more during bad times, after momentum has slowed, and things cease getting worse.  Also, if you can do it in a disciplined way, invest less during good times, after momentum has slowed, and things cease getting better.

The main idea here is to be forward looking, and avoid the frenzies that take place near turning points.


I’ve been reading your blog for quite sometime and I’ve always been astounded by your vast knowledge of just about everything in investments. I’m new to this game and I hope to learn from you, which brings me to the following:

I know we have to calculate “float”, “cost of float” and find the “combined ratio” for an insurance company to value it more accurately. However, I’ve spent hours googling around and I still can’t find what exactly in the balance sheet/P&L/CF statement (or even in the footnotes!) that constitutes as:

loss adjustment expense, unearned premiums, other policyholder liabilities, premium balance receivable, loss recoverable from reinsurance ceded, deferred policy acquisition costs, deferred charges on reinsurance, related deferred income tax, etc. 

In most insurance companies’ balance sheets, all I see are the usual suspects “cash & cash equivalents”, “goodwill”, “intangible assets”, “derivative financial instruments”, “PPE” and the likes. I’ve never seen any of those above-mentioned terms, are there substitute words for them? I’m obviously missing something out. Thank you for your time!

Let’s clear something up here — there is no GAAP financial statement item called float.  What is float?  Let me teach you something deeper.  How does a property & casualty insurer invest?

There is some wiggle room around this, but typically, the premium reserves are invested in high quality short-term debt.  Premium reserves represent the premiums paid in advance that have not yet been taken into income, because some insureds don’t pay month-by-month, but they have paid for many months in advance.  They are often called unearned premiums.

Claim reserves are typically invested in longer-term debt, where the term of the debt will approximately match the period over which the claim will be paid.  Much of the claim reserves fall into the category “Incurred but not Reported [IBNR].  Insurance claims are not always filed immediately.

Finally, the surplus of the insurance company is usually invested in risk assets — equities, private equity, real estate — whatever area the insurance company thinks they have expertise to make money.

The first two categories, premium and claim reserves, comprise float.  You can try to measure them by looking at the statutory statements of the insurer, where those are real line items on the liabilities page, or you can approximate it by looking at the current liabilities, and adding in the claim reserve, which is usually in one of the footnotes.

Reinsurance can mess this up a little, so try to work with numbers net of reinsurance.

Property & Casualty Insurers do not have to credit interest as they delay paying claims, or receive premiums in advance.  Thus the concept of float.  Few insurers use float to be as aggressive as Buffett.  They invest more conservatively, especially among insurers where claims get paid quickly (home & auto).  With long-tailed claims, like asbestos & environmental, the claims may take so long to emerge that the insurer can be investing in stocks, and that will be the optimal investing decision.

The so-called “cost of float” is net underwriting losses.  If there are no net underwriting losses, float is free, or more often, is a source of profit.

But float isn’t worth much unless you have a clever investor investing the cash that stems from the delay of paying claims.  Even with Buffett, that advantage is uncertain.

Tell you what, I never analyze float in insurance.  I analyze management teams.  Insurance is uncertain enough, that I want a margin of safety, and the best way that I can do that is find management teams that are conservative.  Do they consistently make money on underwriting?  Do they occasionally/frequently deliver negative surprises?

I wouldn’t spend time on float.  Any insurer can generate float.  Look at how they make money.  How do they underwrite?  How do they invest?  Are they conservative in their accounting?  That is what you should look for.

Next letter:

I hope you are doing well.  I have been reading your blog for the last few years and have found myself thoroughly educated and entertained.  My favorite series of posts has been your explanation on the holders’ hands, which is a unique and more useful way of classifying market participants, rather than just using timeframe.

A little bit about myself: I am currently a student at zzzzzzzzz studying Economics and before that I was in the Marine Corps Reserves where I served a tour in Iraq. 

I managed to save some money from that time and began investing, which dovetailed nicely with my burgeoning interest in macroeconomics (particularly through the Austrian and Post-Keynesian lens).

As I learned from my mistakes and improved, I recently felt confident enough to form my own LLC in the hopes of bringing on close family and friends as part owners (essentially limited partners) and manage our savings in a more productive and less expensive manner than the current meta of mutual funds or indexing.

This brings me to the the reason I am emailing you: suppose I would like to expand this type of business…How would I go about this? Am I reliant on word of mouth via friends and family?  I also plan to talk to the Small Business Administration for investors, but I don’t think anybody will even give me a chance until at least after a few years. 

Would it be feasible to talk to pension/asset management firms for interest in investing?  I would love to hear your opinion on the matter and please let me know if there is someone more appropriate for me to send this email to.

If I have this straight, you have started a firm that invests in other firms, not all that much different from Buffett in his days after ending his limited partnership.  In this case, you are limited by the number of people that can invest in your private firm, which in these days, I believe is 1000 people.  I could be wrong here, so consult competent legal counsel to guide you.  Not sure how the SBA would fit in here, though I know they aid funding small firms together with venture capitalists.

What you are doing is too small for pension and asset managers.  Given the JOBS Act, your best option is to recruit medium-sized investors, and invest wisely.  Given that you run a private firm, you might not want to limit yourself to public companies.  You might be able to compound capital faster by buying whole small companies, or large portions of medium-sized companies.

Of course, this all presumes that you have a real talent here.  If you’re not sure, give it up now, and give the capital back to your shareholders.

I wish you well, but if you are doing public assets, far better that you do what I do and manage separate accounts for investors.  It’s a lot cleaner.

Rest of the World


  • Catalonia Wants ECB Seat After Referendum So Catalonians want to be free? Guess what, the EU does not want that $$ Oct 12, 2013
  • French State’s Bluster Belies Alcatel’s Job-Cutting Reality France will lose; companies will leave, so will jobs $$ Oct 12, 2013
  • Danes With World-Beating Debt Loads Prepare 2 Dig Deeper This will eventually blow up; it is only a matter of time $$ Oct 12, 2013
  • Tepco Gets Japan’s First LNG Spot Cargo From Angola at Futtsu Future of energy is more efficient hydrocarbon use $$ Oct 11, 2013
  • France Calls for Alcatel-Lucent to Revise Job Cuts Plan France won’t b happy until every large business leaves $$ Oct 10, 2013
  • Korean Banks’ Margins Seen at 4-Year Low on Rate Decline High pread loans mature, low spread loans originated $$ Oct 10, 2013
  • Icelanders Run Out of Cash to Repay Foreign Debts Perhaps they can default on these debts as well $$ #externaldefault Oct 09, 2013
  • Swedish Bubble Concern Grows With Soaring Home Prices What happens when monetary/financial policy is too loose $$ Oct 09, 2013
  • Algerians Cry Currency as Euro Black Market Thrives Really bad currencies attract competition from betr currencies $$ Oct 08, 2013
  • Finns Foraging for Cheap Food Shows Price of AAA Obsession Really, it’s being in the E-Zone, not having own curncy $$ Oct 07, 2013


US Politics


  • 7 doomsday default scenarios There is nothing good here, particularly banks and money market funds blowing up $$ Oct 12, 2013
  • Budget Battle Ends Soon With Tea Party Loss: King, Corker Discharge petition coming as liberal GOP teams w/Dems $$ Oct 11, 2013
  • Now Is the Time to Delay ObamaCare Make case off of lack of technical readiness of computer systems $$ Oct 11, 2013
  • EPA may reduce ethanol blending volumes for 2014 -sources End the RIN-sanity & watch refiner stock prices fly $$ Oct 10, 2013
  • Legislative History of Sec 4 of 14th Amndmnt Must Executive prioritize payments? Must Congress raise debt ceiling? $$ Oct 10, 2013
  • Justice Kennedy Offers Views on Shutdown, Congress, Gay Marriage Love him, hate him, you have to understand him $$ Oct 10, 2013
  • Obama Seems 2Think Presidency Gives Him Absolute Power Scotus has ruled presidents can’t delay, amend or repeal laws Oct 09, 2013
  • Surplus to Cost Uncle Sugar Up to $300M Environmentalists & free marketers can agree: Eliminate sugar subsidies $$ Oct 09, 2013
  • Once the budget is balanced, businessmen will have greater certainty over sustainable tax policy, & will become more aggressive $$ Oct 09, 2013
  • Ryan: Here’s How We Can End This Stalemate Behind every economic debate in DC, entitlements is the hidden issue $$ Oct 09, 2013
  • President Obama Might Ask Who Benefits from US Debt Default Anybody know how big total notional amt on CDS on US? $$ Oct 09, 2013
  • White House Backs Temporary Debt-Ceiling Fix This may be how agreement is reached, w/some budget compromise also $$ Oct 08, 2013
  • Meltdowns Hobble NSA Data Center Investigators Stumped by What’s Causing Power Surges That Destroy Equipment $$ Oct 08, 2013
  • USDA Buyers Stuck in Limbo as Shutdown Hurts Housing USDA should not be in the lending business. Ag is doing well $$ Oct 08, 2013
  • He Beat Us in War but Never in Battle John McCain writes on recently deceased N. Vietnamese Gen. Vo Nguyen Giap $$ Oct 08, 2013
  • Americans are more conservative than they have been in decades I find this difficult 2 believe, would b more chg $$ Oct 07, 2013


Market Impact


  • Better Beta Is No Monkey Business High dividend stocks are overvalued; dividends are not the best proxy for value $$ Oct 12, 2013
  • The BIGGEST Problem with Buy and Hold Biggest companies, bot&held do not have the same room to grow vs smaller cos $$ Oct 12, 2013
  • How Investors Lose 89% of Gains from Futures Funds Long article on how managed futures doesn’t make $$ 4retail invtrs Oct 08, 2013
  • Worst Stocks to Reverse With Commodity Profits Rising 18% A contrarian idea w/precious metals doing poorly of late $$ Oct 08, 2013
  • Finra to Consider Requiring Brokerages to Carry Arbitration Insurance A very good idea; mkt would weed out the bad $$ Oct 06, 2013


Companies & Industries


  • Boeing’s New 777X Could Make the Largest Jumbo Jets Obsolete Efficient engines, folding wings end the 747 era $$ $BA Oct 11, 2013
  • US eyes cutting ethanol usage This should be a no-brainer, aside from corn farmers, $ADM, & ethanol refiners $$ Oct 11, 2013
  • Jeff Bezos and the Age of Amazon: ‘The Everything Store’ Looong & interesting about Amazon & its founder’s origins $$ Oct 10, 2013
  • Costco Stands Behind Its Cheap Rotisserie Chicken Strategy $5 for a Rotisserie Chicken? Can’t buy raw that cheap $$ Oct 10, 2013
  • Verizon and Vodafone Talks Took Four International Cities and Eight Months Patient $VOD wins against needy $VZ $$ Oct 09, 2013
  • US Banks Margin Under Tremendous Pressure Funding costs can’t get much lower, while old high-yielding loans mature $$ Oct 09, 2013
  • Ohio Smelter Faces Shutdown Without Utility Rate Relief & aluminum is in oversupply; why should we subsidize this? Oct 06, 2013


  • Mapping America’s Coronary Stent Hot Spots Check & c whether u live in an area that over-installs stents $$ #savelife Oct 10, 2013
  • Mother Dies Amid Abuses in $110B US Stent Assembly Line Sad tale of medicine done 4 profit 2 the harm of patients $$ Oct 10, 2013
  • Micro Businesses Find Health-Care Rollout Is Slow State Small-Business Exchanges Still Aren’t Ready $$ #gigo Oct 08, 2013
  • Republicans Didn’t Sabotage Health Exchanges, Obama Did Very difficult 2get complex programming projects done fast $$ Oct 08, 2013
  • Robot Surgery Damaging Patients Rises With Marketing Check out track record of any doctor doing robotic surgery $$ Oct 08, 2013
  • Exchanges Will Raise US Healthcare Costs Removing economic incentives has always raised healthcare costs $$ Oct 07, 2013
  • IT experts question architecture of Obamacare website System architecture flaws caused problems, not traffic alone $$ Oct 07, 2013


US Local Economics


  • GED Faces New Rivals for High School Dropouts Passing the GED doesn’t mean much, but if you pass a tougher test? $$ Oct 12, 2013
  • Machines Gauging Your Star Potential Automate HR Hiring Can playing games well reveal u better than your resume? $$ Oct 11, 2013
  • Montana Towns Struggle With Oil Boom Cost as Dollars Flee Small town’s budget can’t keep up w/Infrastructure needs $$ Oct 10, 2013
  • Housing Boom Bigger in Texas as Home Bidding Wars Erupt the Texas economy very strong & the builders can’t keep up $$ Oct 09, 2013
  • Puerto Rico Debt Troubles Regulators Check your muni bond fund, b/c even single state funds bot PR 4extra yield $$ Oct 07, 2013
  • Pay Raises for Teachers With Master’s Under Fire The next study should b whether education BAs harm teaching skill $$ Oct 07, 2013




  • Colleges Try Cutting Tuition—& Aid Packages Unlikely 2 work; higher sticker w/greater aid helps selectivity/cachet $$ Oct 11, 2013
  • Snowden Says He Has No Regrets satisfied his actions had an impact; Sam Adams Award 4Integrity in Intelligence $$ Oct 11, 2013
  • Baseball Battling Dominican Drug Use While Grappling With A-Rod Doping begins in the minors, w/many from DR league $$ Oct 11, 2013
  • Light Point Security: A Software ‘Jail’ 4 Malware? Clever idea: browse in the cloud, image relayed 2local browser $$ Oct 10, 2013
  • Chemistry Nobel Goes to Three for Computer Program Work Interesting. Didn’t know u could do chemistry w/computers $$ Oct 09, 2013
  • Sudden Collapse of Cloud Provider Rattled IAC If cloud provider announces shutdown, act fast 2preserve your data $$ Oct 08, 2013
  • New York Bans Harbinger’s Falcone From Insurance Role Interesting how the NY Commish got Falcone out of MD ins sub $$ Oct 08, 2013
  • Gold Befuddles Bernanke as Central Banks’ Losses at $545B Central Banks r not immune from the fear/greed cycle $$ Oct 08, 2013
  • Younger Americans Fare Poorly on Skills Against International Peers But Americans r more flexible & creative $$ Oct 08, 2013
  • Finance People To Follow On Twitter A great list, at least for those that I know, should u have time 2follow 106 $$ Oct 08, 2013
  • Humans Trump Robots at the Grocery Store Cashiers Trump Self-Checkout Machines at the Grocery Store $$ Oct 07, 2013


Janet Yellen

  • When Yellen Speaks World Listens as Fed Plans US Course More hagiography as media/acdmics overestimate her ability $$ Oct 11, 2013
  • Senate Confirmation Hearing 2Test Yellen’s Skills of Communication Can she think on her feet w/hostile questioners $$ Oct 10, 2013
  • The Yellen Difference How Yellen is different than Bernanke: Tobin Keynesians will b in charge at Federal Reserve $$ Oct 10, 2013
  • Janet Yellen: 5 Things You Should Know About Obama’s Fed Chair Nominee Wealthy, apolitical, Akerlof, forecasting $$ Oct 09, 2013
  • Yellen 2b Named Fed Chairman, First Female Chief What’s done is done; someone has 2b the fall guy/gal $$ #glasscliff Oct 09, 2013


Tower Group

  • Commented on StockTwits: It’s a question of probabilities. Clearly the odds are higher now than a week ago, much h… Oct 10, 2013
  • Commented on StockTwits: I used 2b a corporate bond manager. When u c a 1-yr obligation trading below $95, solven… Oct 10, 2013
  • Risky equities should be priced to earn 20%+. The bonds of $TWGP yield 20%+. Makes me think bonds r the true equity & stock a call option $$ Oct 10, 2013
  • 20%+ yield = panic $$ RT $TWGP just watch the bonds they are $88 and B-. Off lows they do not reveal panic. HOLD. Oct 10, 2013



  • Wrong: Obamacare Foes Using Shutdown Echo South’s Nullifiers Not a fair portrayal. Obamacare was badly thought out $$ Oct 12, 2013
  • Dubious: How Yellen Will Shape Fed’s Banking Regulation Surprise me if much happens; Fed rarely strong regulator $$ Oct 10, 2013
  • Uncertain: Recession Looms If Treasury Uses Tools to Prevent a Default Not so sure it would create a recession $$ Oct 09, 2013
  • Wrong: Detroiters Living Amid Ruins Resist Moving as City Reorganizes Article purely anecdotal, population shrinks $$ Oct 07, 2013


Replies, Retweets, & Comments

  • @SilentMachinery I wondered about that also. There may be something there. Oct 12, 2013
  • I need 2brighten my mood. Ah, @AARP has sent me membership cards. Snip, snip, snip. Much better. Old people suck the blood of the young $$ Oct 10, 2013
  • Luck seems to even out for me. I miss gains & losses evenly. I usually don’t spend much time on a stock after I sell it $$ @merrillmatter Oct 10, 2013
  • RT @researchpuzzler: on endowment investing ~ 1) @AlephBlog: ~ 2) @advperspectives: Oct 09, 2013
  • To @TheUncorrelated : my article on your whitepaper, with my advice to endowment investment managers is here: $$ Oct 08, 2013
  • @rishad Beautiful, but it follows the footsteps of Detroit. One poet said, “Chicago is a pompous Milwaukee.” The skylines don’t compare tho. Oct 08, 2013


I looked for this article out on the web, and at the CFA Institute website, and didn’t find it.  I asked for permission to use this and no one responded after more than one week.  The following was excerpted from an interview with Nassim Taleb by Rhea Wessel in the September/October 2013 issue of the CFA Institute Magazine on pages 40-43.  CFA Institute, I consider this fair use.   If it is not, let me know, and I will take it down.

Is there an investment strategy that fits with the idea?

I will get there. Let me make some investment rules in general.

Number 1: I introduced earlier the 1/n rule—be as broad as you can in whatever risky assets you are investing in to minimize the risk.

The second trick, or rule, [is to] implement that barbell to reduce your fragility. Because if you see the barbell, then no fragility is in the tail. In other words, if you are “bar- belied,” putting a floor on your losses at 90%, the maximum you could lose is 10%. If the markets go down 20%, you don’t lose twice as much as [you would] if the market went down 10%. You lose much less. That puts you in the antifragile category. [For a third rule] I’d say, look for companies that have optionality.

What is optionality?

Optionality means to have more upside than downside because the company has options. An “option” in this sense acts like a financial option, and a financial option is an instrument of antifragility because you pay a premium and you have all this upside and very little downside.

The companies make more from the upside of something than from the downside. Make sure the optionality is not priced by the market. And of course, go away from companies that have negative optionality.

An optionality that is priced in the market is, for example, buying energy companies and gold companies before a rally in gold. Instead of investing in gold, people invested in companies that made a lot more than gold. But after a while, this got priced in. In other words, if you’re wrong on gold, you do a lot better than those who invested in gold outright. If you’re right on gold, you do a lot better than those who invested in gold.

You have to avoid the lottery-ticket effect of investing in companies that are overpriced because people are looking at the big upside.

So, now we have three rules [1/n, implement the barbell, and pursue optionality].

Let me make one more—never invest in company stocks or strategies that have very low volatility without ascertaining that there’s a floor on the return.

[Consider that] a Sharpe ratio measures return divided by risk, as measured by past variation. You have to be wary of companies that exhibit no volatility yet have a high return, unless they are genuinely low volatility. Most of them are fake low volatility.

What do you mean by “fake low volatility?

You know the funds of Bear Stearns that blew up in the subprime crisis? They were funds that never had a down month. A lot of people who blew up in subprime did not have a down month—ever. And people rushed to invest in them because they were low volatility. And then they blew up.

Typically, I never get close to anything that has no volatility, unless it’s justified, like Treasury bonds. If you go to a balance sheet, you can see why there is low volatility, whether it is genuine. The company can have a barbell. The company can have very, very low leverage. Or you might discover that a company is doing the equivalent of selling remote options, and the company can lose a lot of money in one blow.

Let’s link it to make it more intuitive: In general, I can say that a system that has very, very low volatility is likely to blow up. Take the example of Syria. Syria had no political volatility for 40 years, and look what happened.

Forests that never have fires are likely to be completely eradicated by fires when they happen. Forests that have regular fires are much more stable.

You mentioned the concept of leverage. You could make another investment rule regarding debt?

Yes. You know the rule—what you don’t do is more important than what you do. In natural systems, you need redundancy to make the system work better. People think that redundancies are inefficient. I think they’re the most efficient thing in the world, if you do them right.

Redundancy is bad if you buy the same morning newspaper twice or if you have two subscriptions to the same website. But redundancy is fine if you have a stock of cash in the bank or if you’re a company that needs oil and you have extra oil.

Let’s assume that you have cash in the bank and there’s a big crisis. You have dry powder. It will make you antifragile to have the extra dry powder if nobody else has money. You can buy anything you want. Cash is the opposite of leverage.

In fact, the number one indicator of fragility is leverage. It can be operational or financial. Leverage corresponds to people’s overconfidence about the future.

Most people who have leverage will be completely squeezed in a crisis, and you will have cash.

Whose compensation models do you agree with?

Most investment advisers are not harmed by the downside. The only people who have a good compensation model are hedge fund managers. Typically, when I managed money, I was harmed 50 times more than any of my clients as a percentage of my net worth.

The hedge fund managers I know are typically far more invested than their average client. When that person is on board calling the shots, I sleep like a baby. You don’t get this with fund managers.

Okay, Taleb has offered up six ideas for us to consider regarding risk control.  Here they are:

  • 1/n
  • Barbell – safe & risky
  • Positive optionality
  • Want a floor – no “fake low volatility”
  • Avoid leverage – operational & financial
  • Alignment of Interests

Let’s take them one-by-one, but before we do, every risk mitigation scheme has to pass the test: “what would happen if everyone did this?”


This is a fancy way of saying equal-weight everything.  In such a scheme, ExxonMobil and Apple get the same weight as Phoenix Companies and American Independence Corp.  Nifty idea until too many people follow it.  This is an idea that cannot scale.  Yes, owning small companies and the debts of small companies have yielded high returns, but if many people do that, it will cease to be true.

Barbell – safe & risky

Yes, owning safe and risky investments is a bright idea — that’s where the 60/40 stocks/bonds came from.  You get positive optionality and your downside is clipped.  Taleb argues for a lower risk version of this.  But again, this can’t scale.  Most assets are in-between — they carry moderate risks.  What is the risk premium at which you buy moderate risks?

Positive optionality

Everyone wants the best of both worlds, but how much are we willing to pay to get it?  Options normally carry a cost.  When you can get them for free, rejoice.  The market is competitive, and there are few places where free options exist.

Want a floor – no “fake low volatility”

Taleb is looking for guarantees, or near-guarantees.  He does not trust low volatility investments, and I agree.  He wants something that tells him that that floor for the asset price is not too far below the current price.  Makes him sound like a value investor.

Avoid leverage – operational & financial

Margin of safety is the credo of all good value investors.  That makes us avoid financial leverage, and to a lesser extent operating leverage.  As I have stated before, good investing takes moderate risks.  Low risks avail little, while high risks take too many losses.  Moderate risks have a greater probability that humans can deal with them.

Alignment of Interests

Yes, it is important that management and fund managers have incentives aligned with shareholders.  I aim for this and have no argument against this, unless it costs too much to get this.

The Main Point

If something in the markets is a good thing, it will get bought, and the price of it will go up.  Free optionality is rare.  Assets that offer easy guarantees are also rare.

Thus I think the advice of Nassim Taleb is vacuous, because the methods that he recommends for safety are risk factors which have prices.  They are great ideas when they can be executed at no cost.  But most of the time, there are costs.

In 2002, we had the “we eat asbestos for lunch” trade.  After aversion to asbestos risk, some were willing to take the risk because they thought it was overstated.

Any risk can be overplayed.  There are fair levels for taking and avoiding risk.  Good investors and businessmen understand this.