I’m thinking of starting a limited series called “dirty secrets” of finance and investing.  If anyone wants to toss me some ideas you can contact me here.  I know that since starting this blog, I have used the phrase “dirty secret” at least ten times.

Tonight’s dirty secret is a simple one, and it derives mostly from investor behavior.  You don’t always get more return on average if you take more risk.  The amount of added return declines with each unit of additional risk, and eventually turns negative at high levels of risk.  The graph above is a vague approximate representation of how this process works.

Why is this so?  Two related reasons:

  1. People are not very good at estimating the probability of success for ventures, and it gets worse as the probability of success gets lower.  People overpay for chancy lottery ticket-like investments, because they would like to strike it rich.  This malady affect men more than women, on average.
  2. People get to investment ideas late.  They buy closer to tops than bottoms, and they sell closer to bottoms than tops.  As a result, the more volatile the investment, the more money they lose in their buying and selling.  This malady also affects men more than women, on average.

Put another way, this is choosing your investments based on your circle of competence, such that your probability of choosing a good investment goes up, and second, having the fortitude to hold a good investment through good and bad times.  From my series on dollar-weighted returns you know that the more volatile the investment is, the more average people lose in their buying and selling of the investment, versus being a buy-and-hold investor.

Since stocks are a long duration investment, don’t buy them unless you are going to hold them long enough for your thesis to work out.  Things don’t always go right in the short run, even with good ideas.  (And occasionally, things go right in the short run with bad ideas.)

For more on this topic, you can look at my creative piece, Volatility Analogy.  It explains the intuition behind how volatility affects the results that investors receive as they get greedy, panic, and hold on for dear life.

In closing, the dirty secret is this: size your risk level to what you can live with without getting greedy or panicking.  You will do better than other investors who get tempted to make rash moves, and act on that temptation.  On average, the world belongs to moderate risk-takers.


This will be a short post, though I want to toss this question out to readers: what investment strategies do you know of that are simple, and work on average over the long-term?

Here are four (together with posts of mine on the topic):

1) Indexing

Index Investing is not Inherently Socialistic

Why Indexes are Capitalization-Weighted

Why do Value Investors Like to Index?

On Bond Investing, ETFs, Indexes, and the Current Market Environment

2) Buy-and-Hold

Buy-and-Hold Can’t Die

Buy-and-Hold Can’t Die, Redux

Buy and Hold Will Return — 2/15/2009 (what a time to write this)

Patience and a Little Courage

Risk vs Return — The Dirty Secret

3) The Permanent Portfolio

The Permanent Portfolio

Can the “Permanent Portfolio” Work Today?

Permanent Asset Allocation

4) Bond Ladders

On Bond Ladders

I chose these because they are simple.  Average people without a lot of training could do them.  There are other things that work, but aren’t necessarily simple, like value investing, momentum investing, low volatility investing, and a few other things that I will think of after I hit the “Publish” button.

That said, most people don’t need to work on investing.  They need to work on cash management, and I have written a small fleet of articles there.  Managing cash is simple, but it takes self-control, and that is what most people lack in their financial lives.

But for those that have gotten their cash under control, with a full buffer fund, the above strategies will help, and they aren’t hard.

Final note: I realize valuations are high now, so buy-and-hold is not as attractive as at other times.  I realize that interest rates are low, so bond ladders aren’t so great, seemingly.  Indexing may be overused.  Most of the elements of the Permanent Portfolio look unappealing.

But what’s the alternative, and simple enough for average people to do?  My answer is simple.  If they can buy and hold, these strategies will pay off over time, and far better than those that panic when things get bad.  There are few regularities in the markets more reliable than this.


I recently received two sets of questions from readers. Here we go:


I am a one-time financial professional now running a modest “home office” operation in the GHI area.  I have been reading your blog posts for a couple years now, and genuinely appreciate your efforts to bring accessible, thoughtful, and modestly stated insights to a space too often lacking all three characteristics.  If I didn’t enjoy your financial posts so much, I’d request that you bring your approach to the political arena – but that’s a different discussion altogether…

I am writing today with two questions about your work on the elegant market valuation approach you’ve credited to @Jesse_Livermore.   I apologize in advance for any naivety evidenced by my lack of statistical background…

  1. I noticed that you constructed a “homemade” total return index – perhaps to get you data back to the 1950s.  Do you see any issue using SPXTR index (I see data back to 1986)?  The 10yr return r-squared appears to be above .91 vs. investor allocation variable since that date.
  2. The most current Fed/FRED data is from Q32016.  It appears that the Q42016 data will be released early March (including perhaps “re-available” data sets for each of required components http://research.stlouisfed.org/fred2/graph/?g=qis ).  While I appreciate that the metric is not necessarily intended as a short-term market timing device, I am curious whether you have any interim device(s) you use to estimate data – especially as the latest data approaches 6 months in age & the market has moved significantly?

I appreciate your thoughts & especially your continued posts…


These questions are about the Estimating Future Stock Returns posts.  On question 1, I am pulling the data from Shiller’s data.  I don’t have a better data feed, but that should be the S&P 500 data, or pretty near it.  It goes all the way back to the start of the Z.1 series, and I would rather keep things consistent, then try to fuse two similar series.

As for question 2, Making adjustments for time elapsed from the end of the quarter is important, because the estimate is stale by 70-165 days or so.  I treat it like a 10-year zero coupon bond and look at the return since the end of the quarter.  I could be more exact than this, adjusting for the exact period and dividends, but the surprise from the unknown change in investor behavior which is larger than any of the adjustment simplifications.  I take the return since the end of the last reported quarter and divide by ten, and subtract it from my ten year return estimate.  Simple, understandable, and usable, particularly when the adjustment only has to wait for 3 more months to be refreshed.

PS — don’t suggest that I write on politics.  I annoy too many people with my comments on that already. 😉

Now for the next question:

I have a quick question. If an investor told you they wanted a 3% real return (i.e., return after inflation) on their investments, do you consider that conservative? Average? Aggressive? I was looking at some data and it seems on the conservative side.


Perhaps this should go in the “dirty secrets” bin.  Many analyses get done using real return statistics.  I think those are bogus, because inflation and investment returns are weakly related when it comes to risk assets like stocks and any other investment with business risk, even in the long run.  Cash and high-quality bonds are different.  So are precious metals and commodities as a whole.  Individual commodities that are not precious metals have returns that are weakly related to inflation.  Their returns depend more on their individual pricing cycle than on inflation.

I’m happier projecting inflation and real bond returns, and after that, projecting the nominal returns using my models.  I typically do scenarios rather than simulation models because the simulations are too opaque, and I am skeptical that the historical relationships of the past are all that useful without careful handling.

Let’s answer this question to a first approximation, though.  Start with the 10-year breakeven inflation rate which is around 2.0%.  Add to that a 10-year average life modification of the Barclays’ Aggregate, which I estimate would yield about 3.0%.  Then go the the stock model, which at 9/30/16 projected 6.37%/yr returns.  The market is up 7.4% since then in price terms.  Divide by ten and subtract, and we now project 5.6%/year returns.

So, stocks forecast 3.6% “real” returns, and bonds 1.0%/year returns over the next 10 years.  To earn a 3% real return, you would have to invest 77% in stocks and 23% in 10-year high-quality bonds.  That’s aggressive, but potentially achievable.  The 3% real return is a point estimate — there is a lot of noise around it.  Inflation can change sharply upward, or there could be a market panic near the end of the 10-year period.  You might also need the money in the midst of a drawdown.  There are many ways that a base scenario could go wrong.

You might say that using stocks and bonds only is too simple.  I do that because I don’t trust return most risk and return estimates for more complex models, especially the correlation matrices.  I know of three organizations that I think have good models — T. Rowe Price, Research Affiliates, and GMO.  They look at asset returns like I do — asking what the non-speculative returns would be off of the underlying assets and starting there.  I.e. if you bought and held them w/reinvestment of their cash flows, how much would the return be after ten years?

Earning 3% real returns is possible, and not that absurd, but it is a little on the high side unless you like holding 77% in stocks and 23% in 10-year high-quality bonds, and can bear with the volatility.

That’s all for now.

Here’s another letter from a reader.  If reading about my faith turns you off, stop reading now, because this will be thicker than usual.

Hi David,

 I’ve just started reading your blog, and greatly enjoy it. I noticed you integrated your faith with your perception of the world and economics/policy. I am a Christian who is attracted to the wonder of the financial markets. So many individuals making so many decisions being affected in so many ways; it can be overwhelming. My question regards how you view financial markets within your faith.

 I was originally going to work at an internship at a hedge fund in 2008. I thought it’d be the dream: making big money! But that summer, when all hell broke lose, the hedge fund closed down before I could even start. Fast forward six years, and I’m working in corporate finance at a non-financial company – nothing to do with the markets. I want to jump back in, but not as a trader. I feel there was some Divine Providence in how I’ve perceived my “close call” with the trading world. I’m currently trying to understand how I can approach careers involving the financial markets that don’t force me to leave my faith at home. How do you approach the world of finance with your faith?

 Thank you so much for taking the time to read this, and God Bless.


Dear Friend,

I went through a similar experience early in my Christian walk, because sadly, I ran into some Evangelicals who denigrated earning money – Evangelical Leftists were more common in the late ‘70s.  Thus, I turned against Finance though I was good at it.  My Master’s thesis anticipated price and earnings momentum, and most quantitative long-short equity hedge funds.  Too bad for me; I aimed at doing development work in the Third World.  As it was, when I figured out that development economics tended to inhibit growth, and its opposite encouraged it, I gave up.  I started a career in finance as an actuary.

When I did that, I realized that I must do many things:

Be a good example to those around me.

  • Be friendly and pleasant to my co-workers.
  • Oppose fraudulent practices.
  • Be honest with those with whom I dealt.
  • Apologize when I sin or make mistakes.
  • Avoid bad language.  That not only means foul language, but also cruel language, even if it is technically clean.
  • Work hard.
  • Learn, learn, and learn.  A dirty secret about Evangelical Christians is that we read more than non-Christians, and have more Ph.Ds per capita.  Okay, the Jews have us beat there, and badly.
  • Avoid working on the Lord’s Day [Sunday].
  • Don’t be afraid about using the Bible as an analogy or as an example.  After all, people cite all manner of garbage as authorities, and the Bible is not permitted?  Is it because the Bible claims universal authority that people want to ban it?  Yes, that is why.  No one wants the Owner of the Earth to remind us of His claims.
  • I was always honest with coworkers about my faith in moments where it was natural, but I never beat them over the head with it.
  • Love your coworkers, and those with whom you interact.
  • Avoid investments in companies that have sinful goals — gambling, illicit sex, etc.  Also avoid companies that try to cheat people.

Practically, the most important thing is to be honest, keep your word, aim for competence, and be faithful in your dealings with others.

Any vocation can be pursued in a worldly or Christian way – most of it is the attitude that you bring to it.  “Whatever you do, do it heartily, as unto the Lord.”

One final note: one time, I was given a very hard time by a boss who was under a lot of pressure.  Nominally, I was his assistant, and so the rest of the team was amazed with what he put me through, while I largely kept a good attitude (it was not perfect).  One of my co-workers, a Christian, came to me privately and asked how I was doing.  I said that I was fine.  She knew me well, and said that she was praying for me, and that the entire staff was astounded that I would put up with what the boss was doing.  I told her that he was the boss, under a lot of pressure, and that if I pushed back, it could do a lot of harm to all of us.  I was not doing it for me.

It made an impression on the staff, and though they liked me, when the boss left six weeks later, they chose me to run the unit.  Truth, management above chose me, but without their support and love, I would not have been half the leader that I was.

So, serve for the good of others, and you will succeed.  “Love your neighbor as yourself.” [Lev 19:18]




This was published in late 2007 at RealMoney.  I don’t know exactly when.


I came into the investment business through the back door as an actuary and a risk manager. For more than a decade, I worked inside several large life insurance companies creating investment products. My team’s dirty secret? We just wanted to clip a smallish profit on the assets, without taking much risk ourselves. If we could do that, and produce a reliable investment result for our clients, we were happy.

That was my job then; in a different sense, it is my job now.  My goal as a writer, commentator, and independent money manager is to take much of the risk out of personal investing while retaining most of the profit potential.

Nobody can avoid every up and down in the market. What you can do, however, is to ensure that you don’t get crushed when the market rolls over. My own portfolio is a case in point. Over the last seven years, starting in September of 2000, my investment process has yielded an annualized return of 20% a year.  I manage to a long horizon, so I don’t try to cut losses in the short run.  I am willing to take pain if I feel that the underlying fundamentals are intact.  I had only one losing year in that time, but it was a doozy. During four months in 2002, my portfolio lost 32% of its value.  I was shaken, but I scraped together my spare cash and invested. Over the next 16 months, my portfolio rallied 86%, which I found about as astounding as the 32% loss. 

The experience taught me that risk control works. Oddly enough, though, risk control doesn’t get a lot of attention. The most popular books and websites on investing spend nearly all their time focusing on the prospect of big returns; they rush over the matter of how to avoid big losses or how to deal with these losses when they happen. The result? Many people sour on investing because they take risks they don’t intend and lose a lot of money. They conclude that the investment game is rigged against them and they leave investing.


It doesn’t have to be that way. Let me suggest five simple ways you can control your worst tendencies, reduce your risk and become a happier investor.

Spread your bets around. The most basic rule of risk control is to diversify your investments. It is also the most neglected rule.

Perhaps the neglect is because most people don’t understand what diversification means. For starters, it means building a buffer against all the stuff you would prefer not to think about—unemployment, sickness, a horrible bear market, etc. Before you start investing, you need three to six months of living expenses set aside in bank deposits, money market funds and short-term bond funds. Having this cushion protects you from having to sell investments in an emergency, which in turn allows you to take risk with your remaining assets.

On top of your emergency funds, your portfolio should include a dollop of high quality bonds that mature in anywhere from two to 10 years. For older people, bonds cushion the downside of the total portfolio and ensure that you can’t be devastated by a stock market downturn. For younger people, bonds provide an additional benefit—you can sell them to buy stocks or other investments if the market plunges and you spot tempting bargains. So how much of your portfolio should you devote to bonds? As little as 20% of your portfolio if you’re in your twenties and a risk taker; 50% or more if you’re above 65 or naturally cautious.

Once you’ve got your emergency funds and your bonds stowed away, it’s time for stocks—and, once again, diversification should be your starting point. You don’t want to bet your entire future on a handful of stocks or on one industry or even on a single country. The easiest way to ensure that you’re widely diversified among many different stocks is to invest in a mutual fund or exchange-traded fund that holds scores of individual stocks, representing a multitude of different industries.

If, like me, you prefer to buy individual stocks, you have to balance your desire to be widely diversified against how much money you have to invest and—just as important—how much time you have to spend researching companies. My minimum for reasonable diversification is 15 stocks. When I started investing as a serious amateur back in 1992, I started with 15 stocks in my portfolio, and I bought $2,000 of each of them. Since then I’ve made maybe a dozen serious investing mistakes, but because I had my money diversified among many companies, none of my mistakes ever cost me more than 2% of my total capital.

These days I’m even more diversified: I run with 35 stocks, which is close to the maximum an individual can hope to track and research. Generally I devote an equal amount of money to each of my stocks—an equal weight, in investment jargon—because usually I can’t tell what my best ideas are. When a position gets more than 20% away from its target weight, I consider whether I should bring it back to equal weight or sell the whole thing.  Occasionally I deviate from equal weighting, but only when I have a very safe stock that is grossly undervalued. I never go above a double weight, which means that a single stock rarely accounts for even 6% of my overall portfolio.


The final way I diversify my portfolio is intellectually. I try to listen to as many viewpoints from as many different people as I can. I do this because the ideas of all but the most careful investors are internally correlated. They reflect some idea of what the economy is likely to do in the future, and they lean toward companies that fit that view. Some investors love companies with high P/E multiples and incredible growth stories. Other investors—and I’m one of them—love companies in distressed industries that are going for a song. You should listen to both camps. Doing so insures that you learn to think about investments from a wide number of perspectives. It makes investing more businesslike.

Here’s one trick you might find handy. As I gather my ideas from a wide number of sources, I print them out, and place them in a pile next to my computer.  I try to forget who gave me the idea, which forces me to look at the idea fresh, without the biases that come from trusting an authority figure.

Follow the cash. Most investors pay a lot of attention to how much a company earns; few investors realize how easily management can manipulate those earnings with fancy accounting. To reduce risk in the stocks you buy, keep an eye on a company’s cash flow as well as its earnings.

Your first step should be to look with a questioning eye at the non-cash, or accrual items, on the company’s financial statements. These include entries for such things as depreciation, inventory adjustments, or bad debt allowances. Cash is certain, but non-cash items such as these are anything but. Earnings can be thrown up or down by how quickly management decides to write down the value of a new factory or by how much it estimates its inventory of rotary-dial phones is really worth. The accounting industry tries to set guidelines for accruals, but management still has a lot of leeway.

For non-accountants, the easiest way to sniff out possible trouble is to compare the earnings statement with the cash flow statement—specifically the top segment of the cash flow statement, which shows “cash flow from operations.” This is the amount of cold hard cash the company’s operations are generating, before making any payouts to lenders or shareholders, or investing in new equipment. In most cases, if a company’s earnings are growing, its cash flow from operations should also be going up, since higher earnings just about always mean more cash going through the business. So what if a company says its earnings are growing, but its cash flow isn’t?  You should be very, very wary. The financial statements aren’t necessarily bogus, but you have to puzzle out how a company’s earnings can be rising without throwing off more cash.

Sometimes there is no good answer to this puzzle. Remember Sunbeam, the small-appliance maker that hired “Chainsaw Al” Dunlap to goose its business? I owned the stock in 1996 when Dunlap came on the scene. But after two earnings reports I became suspicious. “All of these restructuring efforts are improving earnings, but they’re not producing cash from operations,” I thought. “What gives?” I concluded something fishy was going on, so I sold for a nice gain. Over the next six months, the stock rose by 60%—then plunged 90% as it became clear that most of Sunbeam’s increase in earnings was the result of accounting shenanigans, not real business gains.

Love the unloved. Most people avoid industries that are under stress.  Who can blame them?  The industry outlook is horrible; there can’t be anything good here. 

I take a different view. I believe that some of the safest plays you can make consist of buying financially strong names in weak sectors. These companies are usually cheap in comparison to their earnings and to their book values. You can find out more about how to spot undervalued companies by visiting the website of Tweedy Browne, the famous value-investing firm, and reading their excellent paper on What Has Worked In Investing (http://www.tweedy.com/library_docs/papers/what_has_worked_all.pdf).

In addition to the standard measures, I look for companies with good bond ratings.  The ratings agencies are out of favor now, because of the current furor over securitization, but they produce the best single measure of a company’s creditworthiness. The raters award the best ratings to companies that can generate cash well in excess of what is needed to pay all their creditors and that possess a low ratio of debt to assets.


Once I’ve bought a stock, I try to be patient, because the payoff is usually not instantaneous. In 2001, when steel stocks looked horrible, I bought Nucor, the soundest company in the industry. Steel companies dropped like flies in 2002 and the stock did nothing—until the end of the year, when enough steel-making capacity had been closed down that steel prices began to rise. Nucor flew, and I made a nice profit.

The key to making this contrarian strategy work is to not overdo it. Some industries—newspapers, say, or fixed-line telecom companies—truly do have questionable futures. You have to analyze each situation on its own merits.  At present, my favorite industries are insurance, energy, agriculture/food processing, cement, and chemicals.


My value-hunting approach means that most of the stuff I buy is not popular. I veer away from firms that are pioneering new technologies or markets. Such companies are easy to get enthusiastic about, but difficult to value because there are so many unknowns.

When I talk about the companies I own, the response is often, “You invest in obscure stuff.  What do you think about Google?” I don’t have an opinion on Google.  I can’t tell you whether it will produce enough profits over the years to justify its current price or not.  So much depends on future tastes and competition. I’d rather own cement companies; they are very difficult to make obsolete.

Take emotion out of it You should look over your portfolio two to four times a year. In my own case, I follow a very structured process. I take all of the investment ideas that I have gathered up since my last portfolio pruning, and rate them on valuation, momentum, and accounting quality to arrive at a composite measure of their overall desirability. I compare these ideas to the companies that are already in my portfolio.

This sounds complicated and so it is. But exactly how you do your ranking is less important than having a system for comparing the stocks in your existing portfolio to the alternatives that the market is offering you. Your goal should to take some of the emotion out of investing. You don’t want to fall in love with the companies that you already own. To avoid this, I try to pinpoint what companies in my ideas list are better than the median idea in my portfolio.  These become purchase candidates and I do further research on them.

I also look at the companies in my portfolio that are below the median in desirability, and I ask why I’m keeping them. In many cases, the companies are less desirable because they’ve gone up in price and are no longer as cheap as the once were. In other cases, they’re less desirable for the opposite reason— the company’s business has deteriorated and shows no signs of turning around. Every three to four months, I typically sell two or three companies from my 35-stock list and replace them with more promising companies from the ideas list. I typically hold a stock for three years.  Many of my ideas go against me at first, but often turn and make money for me later.


Smart money is slow money. If a stockbroker or financial planner tells you that you’ll miss a huge opportunity if you don’t buy right now, ignore them. A smart investor moves at his or her own pace.

To make sure that you don’t get pressured into buying something, it’s nearly always a good rule to avoid salespeople. Stockbrokers, financial planners, mutual fund salespeople and even the experts on the television all have financial incentives that can pull them in directions opposite to what’s in your best interest. Before buying any stock or any financial product, you should do a bit of background reading so that you understand what you’re buying and how much rival products cost. In many cases—insurance is a good example—you’ll find that the simplest product is your best buy. Complexity in insurance, and many other investments, is usually a cover for increased fees.

Especially when it comes to buying stocks, patience is your best friend. If an idea seems like a sure thing, sit on it for a month.  If the idea is still a good one, you will usually still have time to act on it.  If the idea is a bad one, the extra time will help you do further research and may make its problems evident.

One of the best ways to make money is to avoid losing it. When I approach new ideas, I try to ask how likely it is that I will lose money, and how much I could lose if I am wrong. I lose about 20% of the time. Six times in the last 15 years, I have lost half my money on an investment. Those are actually pretty good numbers. I can’t avoid all losses, but if I wait, take my time and do my research, I can limit my losses, and make money on the rest of my ideas.

I really enjoyed answering the “Ask Our Pros” questions at RealMoney.  I answered the following on May 11th, 2005, and would add in Jeff Gundlach and Ed Meigs as active managers:

Ask Our Pros is a service we provide to RealMoney subscribers that enables them to get answers to their investment questions from our contributors. To ask a question, you must be a RealMoney subscriber.  Please click here for information about a free trial.


Can someone explain bonds, tax-free vs. taxable? What are some of the strategies that you use to purchase bonds, and what percentage of your portfolio typically should be in bond funds?

— A.A.

David Merkel:

Here is my simple advice for retail bond buyers:

Bonds are promises, from various entities, to pay back the money that you lent, plus interest. Most bonds are taxable. A few, like U.S. Treasury bonds, are exempt from state taxes, while many of the bonds of municipalities are exempt from federal taxes, state taxes (usually if the municipality is in your state) and city taxes (usually if it’s the city you live in).

With respect to taxability, what is best to buy depends on your marginal tax bracket. The higher your tax bracket, in general, the more municipal bonds can help. Beyond that, it is worthwhile to compare the after-tax yields on taxable and nontaxable bonds with equivalent risk. (As always, please be sure to check with a qualified tax professional for advice on your specific information.)

Now for the controversial bits. In general, I don’t recommend that individuals buy individual bonds, unless you are buying Treasury bonds and are following a simple strategy like a ladder.

A ladder is a set of bonds that mature sequentially. Say the ladder is five years long; each fifth of the bond money would be invested one, two, three, four and five years out. Each year, you would take the money from the maturing bond and buy a new bond five years out. Many bond managers pooh-pooh ladders because they think they can beat the performance of a ladder. But a ladder is the most robust bond strategy out there, period. I believe it gives the best return for the risk, particularly given the possibility of shifts in inflation, yield-curve twists, etc. But a bond manager can’t get paid for running a ladder.

There are other reasons for avoiding individual bonds: Bond dealers often rip off retail investors. I have stories, but they’ll have to wait for another day. Liquidity for retail investors is generally poor. Most of the bonds pitched to retail investors will be new issues, which aren’t necessarily the best bonds to buy; they just happen to be the bonds most available at a given moment. This is particularly true of municipal bonds. If you don’t believe me, read Joe Mysak’s column on Bloomberg for a while. The municipal market is a place you don’t want to go without an adviser.

Another reason you don’t want to buy bonds, single-issuer bond trusts or preferred stocks on your own is that many of them have funny features that make the yield look really good, but the bonds can be called away in low interest rate environments, leaving you to reinvest in that low interest rate environment. One dirty secret of bonds is that the excess yield inherent in callable bonds and residential mortgage-backed securities on average does not compensate for the call risk. Only a few experts win that game, and you likely are not one of them.

Finally, my word on bond funds: There are very few managers worth paying up for. Maybe Dan Fuss at Loomis Sayles, Bill Gross at Pimco and a few other, more obscure managers that I am less certain are worth paying up for. The only guarantee in bond funds is that low expenses win in the long run, so I’d go to Vanguard. Performance advantages are fleeting, and tend to revert to the mean, but expense advantages are permanent. Vanguard’s bond funds usually are in the top half each year; repeating that for 10 years makes them top decile.

So don’t take the hard road. I’d go to Vanguard and use their Total Bond Market index fund. Utterly unsexy, but a winner. The only place where Vanguard lacks is international bond funds; it has none. For that, if I want diversity, I go to T. Rowe Price, or buy a closed-end fund that doesn’t hedge currencies at a discount.

How much to invest in bonds? Consult your financial planner. This factor varies so much, it’s all over the map. The right proportion of bond investment depends on market conditions, investment horizon, your personal life factors, wealth level, risk aversion, etc. My experience is that most people are unbalanced in their asset mixes — too much is in stocks or too much is in bonds. The best default mix might be Ben Graham’s 50/50, or the pension mix of 60% stocks, 40% bonds. These are both very robust strategies, but again, what is best for you depends on your personal situation.

I have to say, from the business side of the desk, I really loved managing a multibillion-dollar bond portfolio. I really did well at it, but the best part about it was interacting with my brokers, who all were stupendous to work with. I find that running equities is antiseptic, particularly as an analyst who has an exceptionally competent trader to execute his decisions. Running bonds is colorful because of the human interaction and all of the games that can arise from that. I learned how to haggle in the bond market, and for a nerd like me, becoming good at that was a surprise. Would I want to manage bonds again? Yes. It was fun.



  • Here’s my plan for reducing the deficit: http://t.co/XJPjf8A5 #mydeficitplan via @wsj Draconian, I know, but the budget shoould b balanced Dec 21, 2012
  • Canada’s exports crucial as sluggish growth continues: IMF http://t.co/iIOJ6PoF Bank of Canada should raise rates 2 reduce excessive debt $$ Dec 21, 2012
  • Everything You Need To Know About the Economy in 2012, in 34 Charts http://t.co/aXnjSkR0 Good stuff; could have been formatted better $$ Dec 21, 2012
  • Fiscal Cliff’s Dirty Secret: It’s Not About Taxes At All, But Too Much Spending http://t.co/UY8rKW9h We need 2 deal w/SS, Medicare & Defense Dec 20, 2012
  • We’ve Nationalized the Home Mortgage Market. Now What? http://t.co/YSCrvVmK Congress loves 2 have cows around that they can milk for $$ Dec 20, 2012
  • EU Banking Re-Unions http://t.co/khSA0co0 The lack of a timetable indicates that things aren’t really finalized; not sure this will fly $$ Dec 20, 2012
  • ‘Spending Cuts’ Lose Something in Translation http://t.co/DYFxVMno Only in DC is reducing planned growth in spending called a cut $$ Dec 20, 2012
  • Money Funds Brace for Flood http://t.co/4J7VWuxx MMFs r between a rock & a hard place: loose Fed policy & regulatory over-reach $$ Dec 20, 2012
  • Wall Street’s Biggest Geniuses Reveal Their Favorite Charts Of 2012 http://t.co/at12mMsV Very long, but lots of good stuff $$ Dec 20, 2012
  • My forward estimates, derived from TIPS are rising, 2014 inflation, and 2018-2022 inflation. The latter has… http://t.co/tgrGfiDG Dec 19, 2012
  • Estimated 2018-2022 inflation rate continues to rise: http://t.co/ebqeM5KJ Stagflation may be coming. cc: @federalreserve #stagflation $$ Dec 19, 2012
  • Estimated 2014 inflation rate continues to rise: http://t.co/ZrvIc5Nk Stagflation may be coming. cc: @federalreserve #stagflation Dec 19, 2012
  • Economics may be dismal, but it is not a science http://t.co/I6B9LbSw No universal economic theory, & new economic thinking must be eclectic Dec 18, 2012
  • Fisher: Fed Risks ‘Hotel California’ Monetary Policy http://t.co/fRKOYl9d When the Fed starts 2 tighten, it will b hard 2 do $$ Dec 17, 2012
  • FDIC Guarantee Program Set to Expire After Senate Block http://t.co/qPdQNWQF Will squeeze the short end of the yield curve further $$ Dec 17, 2012
  • US Banks Lack Liquidity to Withstand Crisis, Study Says http://t.co/psmQEP1z Liquidity mismatches r pernicious; key risk gets ignored $$ Dec 17, 2012
  • Mkts r discounting mechanisms. Temporary events like bond ratings, debt ceiling & fiscal cliff should not affect market much $$ Dec 17, 2012
  • So, as an example, if the govt runs a deficit, it should not stimulate much b/c people discount future econ adjustment b/c of more debt $$ Dec 17, 2012
  • Same 4 monetary policy; the Fed can “stimulate” as much as it likes; mkt players discount the future removal of policy, inflation, etc. $$ Dec 17, 2012
  • Cliff? What Cliff? http://t.co/QEvklDQU Or maybe, just maybe investors don’t care whether we go over the “fiscal cliff” or not. $$ Dec 17, 2012


Stocks & Sectors


  • There are 272 gold & silver companies trading on US exchanges or OTC. 59 of them have mkt caps > $100M. 22 of them have mkt caps > $1B $$ Dec 21, 2012
  • Aviva Sells US Life Business to Apollo for $1.8B http://t.co/UqM2kqyr When Aviva bot Amerus, I said that they overpaid massively. Proof $$ Dec 21, 2012
  • Value Investing In Practice: A Conversation About Oaktree Capital http://t.co/4FVok5wz Good value investing does not hyper-diversify $$ Dec 20, 2012
  • ICE in Deal to Buy NYSE http://t.co/ik348vsZ New era; expect 2c more deals like this. As an aside average holders of $NYX stock lost $$ Dec 20, 2012
  • Buffett’s Leading The Corporate Buyback Surge http://t.co/U3piJgDv He has the $$, & 1.2x BV is a defensible floor ||| FD: + $BRK.B Dec 19, 2012
  • Investment Fads and Themes by Year, 1996-2012 http://t.co/cvLFKyRE @reformedbroker on what the broad themes this year & back to 1996 $$ Dec 19, 2012
  • Alterra up after deal, analyst positive on Bermuda peers http://t.co/Y5jTB40c Room 4 a new round of consolidation. $MKL buys $ALTE $$ Dec 19, 2012
  • $ALL Bets on Home Insurance as Stock Rally Withstands Sandy http://t.co/XBQOOSB5 Insured damages (excl flood) low4 Sandy; premratesflat $$ Dec 19, 2012
  • Stocks Held Hostage as CEOs Plan Spending Cuts http://t.co/5c7nBKAS It is difficult to avoid deflation; so much uncertainty presently $$ Dec 18, 2012


Credit & Fixed Income


  • Swaps ‘Armageddon’ Lingers as New Rules Concentrate Risk http://t.co/QK3s19Hz Clearinghouses r not a panacea; it is possible 4 them 2 fail Dec 21, 2012
  • Americans Hacked Don’t Know Chamber Left Them Alone http://t.co/DSBDUijq Common programs place yr computr @ risk; CoC defends SW makers $$ Dec 21, 2012
  • The Indianapolis 500 of Corporate Bonds Yields http://t.co/dCamXED3 Too much $$ flowing into corporate credit; feels like 2006 Dec 20, 2012
  • India Cash-for-Gold Loans Hide Shadow-Banking Risks http://t.co/BGnO4YWI 2much lending creates a mess; 2much secured lending creates a panic Dec 20, 2012
  • Pimco Sees Spreading Slowdown Boosting [Australian] Bonds http://t.co/oDFSkGoF Pimco buying the debt of fringe developed nations $$ Dec 19, 2012
  • CAB Legislation Expected in January http://t.co/TSuxBmM4 California legislation proposed 2 limit issuance of Capital Appreciation Bonds $$ Dec 19, 2012
  • Why China May Be Facing US-Style Credit Crunch http://t.co/99xMzC3M “To some extent, this is fundamentally a Ponzi scheme,” [Xiao] said. $$ Dec 19, 2012
  • Pimco’s Gross Cuts Back on MBS http://t.co/4FaxLTKq Lightening up on MBS & Corporates, buying developed fringe, sticking w/TIPS $$ Dec 19, 2012
  • Mind the rate risk http://t.co/nVqjlWW9 Rates may stay low 4 a while, but when they run up, total returns could b worse than 1994 $$ Dec 19, 2012
  • Spain House Prices – Deconstructing Spain http://t.co/7ARRPZqS Housing prices continue 2fall, more foreclosures, setting up bad bank fund $$ Dec 17, 2012




  • Valero Received Approval 2 Ship US Crude 2 Quebec Refinery http://t.co/ojABCqu1 Could b start of something big: US exports oil FD:+ $VLO Dec 20, 2012
  • Extracting shale oil from a Dead Cow http://t.co/bok4bNE7 Interesting: after the expropriation of Repsol that oil majors line up4more $$ Dec 20, 2012
  • Gasoline at US Pumps Drops to Lowest in a Year on Supply Gain http://t.co/4pI5SXiV Good news coming to users of refined fuel products $$ Dec 19, 2012
  • California refiners dreamin’ of shale oil face hurdles http://t.co/vJgiW4rm Many efforts t get cheap oil 2 CA; $24/bbl price difference $$ Dec 17, 2012




  • CEOs Concerned about the Time and Cost of Implementing Predictive Analytics http://t.co/QcABrcFH Big data facilitates cluster pricing $$ Dec 20, 2012
  • In the Flesh: The Embedded Dangers of Untested Stem Cell Cosmetics http://t.co/de2aio1V Adult stem cells can do as much harm as good $$ Dec 19, 2012
  • The First Time Tech Ruined the Music Business http://t.co/d0RE4002 As technologies improve all manner of “rights” issues crop up $$ Dec 18, 2012
  • Advisers Question Modern Portfolio Theory http://t.co/lLbCVvgL Look through the security 2 the underlying economics of the investment $$ Dec 17, 2012
  • Twitter has started rolling out the option to download all your tweets http://t.co/IIOVO6mJ Not common yet, but may b coming soon $$ Dec 17, 2012
  • Schools Safer Than 1990s as Educators Anticipate Killers http://t.co/aQaB6G6Q Students r far less likely2b killed in school than elsewhere Dec 17, 2012
  • Highest-Paid California Trooper Is Chief Banking $484,000 http://t.co/JwgYWfg2 Giving officers comp time rather than $$ 4 unused vacation Dec 17, 2012
  • ‘Followers for sale’: Twitter’s very own black market http://t.co/HKCqo074 Fake Follower Check will estimate how many followers r real $$ Dec 17, 2012
  • SEC Says Asset Firm Manipulated Trades to Enrich Some Clients http://t.co/L8IJQ77k I remember their ads, proclaiming their track record $$ Dec 17, 2012



  • Bad idea: Africa Dreams of Building Telescopes to Study Space http://t.co/gSwkKIBs Would make more sense 4 Africa to fix agriculture $$ Dec 20, 2012
  • Wrong: US should intervene in Nagorno-Karabakh process at the highest level http://t.co/2tJTKtht We should stick 2r own business $$ Dec 18, 2012
  • Wrong: This is why I generally don’t like Quartz; pretending to be smart $$ RT Our favorite charts of 2012 http://t.co/w2bvLDvX Dec 18, 2012


Replies & Comments

  • “This would have been a better article if you had put separators between each graph/explanation.” — David_Merkel http://t.co/uoMy61H1 $$ Dec 21, 2012
  • @EddyElfenbein Thanks, Eddy. Dec 19, 2012
  • @geekpryde Hey, thanks for the kind words, I appreciate that you follow me. Dec 19, 2012
  • @VIXandMore Ludwig is letting us down, and 3 days after his birthday. Call Schroeder 😉 Dec 19, 2012
  • @Alea_ Cool new avatar, I like it Dec 19, 2012
  • @Money_in_Stereo Well said, though I am not an expert there. Thanks for sharing that. Dec 18, 2012
  • @BarbarianCap Hint: if company is offering u a nice buyout, they r offering less than its worth, unless u no more about when u will die $$ Dec 18, 2012
  • @volatilitysmile @carney I knew a close adviser of Mozillo; he told me stories of how disconnected Angelo was w/reality in 2009 $$ Dec 17, 2012
  • @nicster There have been many changes, but they are all local, and don’t make the news. US Govt was stupid on the shoe bomb. Local better $$ Dec 15, 2012


  • Amazing RT @moorehn: “the average lifespan of American musical superstars in the pop, rock and rap genre is only 45.” http://t.co/uXVNuStF Dec 20, 2012
  • Practically. Old bond mgr rule: underweight the most rapidly growing debt class $$ RT @ToddSullivan: didn’t they already do student loan? Dec 20, 2012
  • Remember deriving formula when younger $$ RT @munilass: Twelve Days of Christmas and tetrahedral numbers http://t.co/VVNnyU2V (via @ptak) Dec 20, 2012
  • You can say that again $$ RT @japhychron: @AlephBlog Always funny the way they call economics a science. Studying people is anything but. Dec 18, 2012
  • Banks are insolvent & w/large & rapidly growing budget deficit $$ RT @FGoria: DJ: Cyprus May Be Days Away From Default — Fin Min Official Dec 17, 2012
  • Sad & dumb $$ RT @carney: You’d never guess who has a completely self-serving & bonkers theory of the financial crisis. http://t.co/LIAd8WqB Dec 17, 2012


Twitter Summary

  • My week on twitter: 72 retweets received, 1 new listings, 85 new followers, 132 mentions. Via: http://t.co/SPrAWil0 Dec 20, 2012


“Price discovery is the toughest part of managing bonds,” one of my brokers told me early on.  Right he was.  There may be 7000 or so stocks that trade with some regularity in the US, but there might be one million different bonds.  The last trade on a given bond that you might consider might be weeks or months ago, if you could find it at all.  I was managing pre-TRACE, where reporting got standardized.

I dealt in more illiquid bonds than most managers would.  Part of that was inexperience, another part was knowing that I had a balance sheet behind me that could handle it, and the last part was knowing that my credit analysts were usually right, so if I could find bonds that were off the beaten track and could be held to maturity, we could make some extra money.  Pay us with a good yield, and I will eat the illiquidity risk on behalf of my client.

One of the dirty secrets of bond management is that after adjusting for default risk, the #1 predictor of the return you will get is the yield on the portfolio.  If you do default risk right, that’s almost a tautology — default risks should be lowered after the bust phase of the credit cycle, and raised as the credit cycle gets long in the tooth.  The tighter spreads get, the more you should raise your default loss estimates.

But how to come to the right price/yield/spread?  I had a few trades, but they were dated.  I knew the spreads then, and used the spreads of more liquid similar credits to adjust it to a likely yield spread today.  I put in a fudge factor because illiquid bonds are higher beta, and then studied which of my brokers might have a bead on the bonds in question.  I would ask them their opinion, and if they were in my ballpark, I would back up my bid some, and bid for $1 or $2 million of the bonds.  The response would come back, and I would have a trade, or nothing, but maybe some color on where they would be willing to sell.  If a trade, I would back up my bid a little more, and offer to buy more.  If no trade, I would offer 50-70% of the distance between our bid/offer, and see what they would do.

I never thought I would be good at haggling.  I’m a quiet person for the most part, and I was surprised at how much I enjoyed being on the phone with my brokers most of the day, buying deals, setting up trades, discussing market color, etc.  But I was good at haggling, and I carried tools in my bag that many did not.

I decided to hold auctions and reverse auctions.  On the reverse auctions, I would solicit liquid bonds to be sold to me — maximum spread wins, subject to a reservation spread, or a minimum number of offerers.  On the auctions, I would offer liquid bonds, minimum spread wins, subject to a reservation spread, or a minimum number of offerers.  It worked well, until I read a fiction book that had auction theory as a subtext.  So I designed a new auction.

One of the problems with the auctions was that some investment bank would overbid, and win, and then the salesman would come back to me, confess the error, and say, “Can you show me some love here?”  I was taken aback by it the first time I heard this, but came back with a fairly rational solution, giving back one-third of the difference between the winning bid, and the second-place bid.

But I came up with a better way.  Here is a  Bloomberg post that I made to five of my brokers:

BWIC [Bid wanted in competition] — 1:30PM — 5 dealers only.  I am selling these just to raise cash.  This is a continuation of my experiment so bear with me.  In an effort to reduce buyers remorse (and thus get better bids) I am awarding the bond to the winning bid at the COVER level.  In case of a tie, I will award bonds pro-rata at the tie level.  If you don’t want to play, let me know.  Thanks, David. [Bond list follows]

Everything has meaning here:

  • 5 dealers — limit the auction to the dealers who have the most interest, it makes them fell comfortable that they have a shot at getting bonds.  I never used more than 6 dealers in an auction.
  • Just raising cash — says that you don’t know anything they don’t know.  Makes them more willing to bid.
  • Cover level is the second place bid.
  • You can’t come back begging for love here.
  • Ties were particularly valuable, because there was no love and both brokers got half of the bonds, and typically lost money on resale, since they were competing against each other.
  • If I did not get enough bids on an auction, typically three, I could cancel it.

I reviewed my auction results and found that it erased the advantages of my brokers.  I ended up selling bonds near their ask levels, on average.  What was worse, many thanked me for being innovative in creating an auction method that “showed love” in advance of the auction.  When I explained this gambit to my wife as we were traveling to prayer meeting one evening, she gave me a hard hit on the shoulder, and said to me, “David Merkel, you are horrible!  Not only do you beat Wall Street at its games, but you get them to thank you for it!”  Oh well, guilty as charged.  She doesn’t want me to be proud, and she was right.

There are limits on when to haggle, though.  Occasionally you are invited into deals that you know are good; only a pig would ask for more then.  Those that do ask for more will get dropped from the list.  So be a gentleman; if you are getting an unreasonable deal already, smile, thank them, and move on.  Don’t ask for more.  It is more important to be invited back, than to make a little more today, even if that were possible.

In haggling, I would bid/offer fewer bonds than was wanted by the seller/buyer at the level, and ask for better terms at their size.  That would make them more willing to deal.

I had more tricks in my arsenal, but one was always paying my brokers.  If at the end of a trade, my broker said to me, “Well, your prices match so I will cross the bonds to you,” I would say, “No, I am raising my price (by 1/64th on $100) so that you can be paid.  My broker must always earn something on my trades.”  This made my brokers more loyal to me.  They knew that I cared for them, which meant something, particularly with the regional brokers.

In one sense, trading was just an amplified version of character.  Could you be trusted?  Do you play fair?  I tried to be fair everywhere I could while making money for my client.  That had a lot of payoffs for my client, even though if they were watching over my shoulder on individual trades they might have said, “Why are you not pursuing the maximum here?”

I have a saying that playing for the last nickel might cost ninety-five cents in the long run.  Intelligent managers do not look like pigs, or their opportunities get shut off.

I would simply say that you should play for long run advantage.  Better to make modest gains in many opportunities, than to make a killing once, and be shut out from opportunity thereafter.

I have more tales on this topic, but they will have to wait until a later episode… I have four left at maximum I think.

One reader asked me:  David do you have a Top 10 book list on Economic Theory for beginners? Just finished “The Myth of the Rational Market” and loved it. But I don’t know what to read next. Or let me ask the question another way, should I start with reading books on Austrian economics? Hayek? Misses? Fisher?

I do want to give a list of economics books that I have read that I have found useful.  I am an odd duck here, because I have been schooled in the neoclassical theories, and I have largely rejected them.  Men, and the institutions of men are more complex than that.

Here’s my dirty secret.  Yes, read the Austrian economists, but I have not read any of them.  I have come to their conclusions on my own, but my views have also been influenced by Minsky and the Santa Fe Institute.  I view economics as ecology.

All that said, here is a list of economics books that I think are valuable, that I have read:

1) Manias, Panics and Crashes, by Kindleberger. Kindleberger explains how crises come into existence in a systematic way.

2) Devil Take the Hindmost, by Chancellor.  Chancellor describes the history of crises, and gives significant background data regarding economic crises.

3) The Alchemy of Finance, by Soros.  Explains why men are not rational as the neoclassical economists think.  Explains nonlinear dynamics — reflexivity, as he calls it.

4) A History of Interest Rates, by Homer.   Detailed studies of how interest has played a role in our world again and again, even as idealists attempt to limit or eliminate it.

5) The Volatility Machine, by Pettis.  Explains how smaller nations get whipped around by the economics of larger nations.  The author is an important read in my opinion at his blog.

6) The Mystery of Capital: Why Capitalism Triumphs in the West and Fails Everywhere Else, by de Soto.  Puts forth the idea that laws protecting property rights help create wealth.

7) Against the Dead Hand: The Uncertain Struggle for Global Capitalism, by Lindsey. Promotes global trade as a means of increasing wealth.  On the same topic, How Nations Grow Rich: The Case for Free Trade, by Krauss.

8 ) The Wealth and Poverty of Nations: Why Some Are So Rich and Some So Poor — Puts forth why culture matters.  Some cultures by nature will be poor and others rich.

9) The House of Rothschild: Volume 1: Money’s Prophets: 1798-1848 and The House of Rothschild: Volume 2: The World’s Banker: 1849-1999, by Ferguson.  Records tumultous years, and how some of the most clever capitalists ever known survived it.  Also notes that they never expanded to America when it would have counted.

10) The Birth of Plenty : How the Prosperity of the Modern World was Created, by Bernstein. Explains how the Western world grew into the present lack of scarcity that it now has.

11) The Elusive Quest for Growth: Economists’ Adventures and Misadventures in the Tropics, by Easterly. Development economics is at its best when there are few subsidies — economics in the developing world is the same as it is here, only more so.

12) The Nature of Economies, by Jacobs.  In story form, she explains the nonlinearities of economics.

My view is that governments should provide a few basic simple rules regarding the economy, and let the courts fill in the details.  Economies grow best when they are free, and where the culture concludes that growth is valuable.  That is not true everywhere.

Full disclosure: all of the books that I mention here I own, and I bought with my own money.  If you enter Amazon through my site and buy anything, I get a small commission, but your prices are he same regardless.

Update: These are books on macroeconomics.  I may have a similar post on microeconomics coming.  Also, I forgot one book that I recently reviewed: This Time is Different, by Reinhart and Rogoff.  They cover why crises happen, but unlike Manias, Panics, and Crashes or Devil Take the Hindmost, they quantify it.

No, this isn’t another discussion of SFAS 157, though there are some similarities.  There has been a bit of a brouhaha over repayment of TARP options.  Isn’t the government getting shortchanged?

Maybe.  Maybe not.  This one is tough to answer, because at least as yet, there is no active market available for really long-dated call options.  Let me give you an example from my own experience.

I used to run a reasonably large options hedging program for a large writer of Equity Indexed Annuities [EIAs].  Much as I did not like the product, still I had to do my job faithfully, and when we were audited by a third party, they commended us having an efficient hedging program.

But here was our problem:  the EIAs lasted for ten years, but paid off in annual installments, based on average returns over each year.  Implied volatility might be low today, and the annual options that we purchased to hedge this year might be cheap, but the product had many years to go.  What if implied volatility rose dramatically, making future annual hedges so expensive that the company would lose a lot of money?

Maybe there could be another way.  What if we purchased the future hedges today?  A few problems with that:

  1. We don’t know how much we need to purchase for the future — the amount needed varies with how much the prior options would finish in the money.
  2. But the bigger problem is once you get outside of three years, the market for options, even on something as liquid as the S&P 500, is decidedly thin.  There’s a reason for that.  The longer-dated the option, the harder it is to hedge.  There are no natural sellers of long dated options, and relatively few Buffetts in the world who are willing to speculate, however intelligently, in selling long-dated options.

There is an odd ending to my story which is tangential to my point, but I may as well share it.  Eventually, the insurance company wanted to make more money, and felt they could do it by hiring an outside manager (a quality firm in my opinion — I liked the outside manager).  But then they told them not to do a total hedge, which was against the insurance regs, given their reserving practices.  Not hedging in full bit them hard, and they lost a lot of money.  Penny wise, pound foolish.

So what about the TARP options?  Did the US Government get taken to the cleaners on Old National Bank?  Is Linus Wilson correct in his allegations and calculations?  Or is jck at Alea correct to be a skeptic?

It all boils down to what the correct long term implied volatility assumption is.  Given that there is is no active market for long-dated implied volatility / long-dated options for something as liquid as the S&P 500, much less a mid-sized bank in southern Indiana, the exercise is problematic.

In quantitative finance, one of the dirty secrets is that common parameters like realized volatility and beta are not the same if calculated  over different intervals.  Also, past is not prologue; just because realized or implied volatility has been high/low does not mean it will remain so.  It tends to revert to mean.  With the S&P 500, implied volatility tends to move 20% of the distance between the current reading and the long term average each month.  That’s pretty strong mean reversion, though admittedly, noise is always stronger in the short run.

Let’s look at a few graphs:

Daily Volatility for ONB:

Or weekly:

or monthly:

or quarterly?

Here’s my quick summary: the longer the time period one chooses, the lower the volatility estimate gets.  Price changes tend to mean revert, so estimates of annualized realized volatility drop as the length of the period rises.  Here’s one more graphic:

I’m not sure I got everything exactly right here, but I did my best to estimate what volatility level would price out the options at the level that the US government bought them.  I had several assumptions more conservative than Mr. Wilson:

  • In place of a low T-bill rate for the risk-free rate, I used the 10-year Treasury yield.  (Which isn’t conservative enough, I should have used the Feb-19 zero coupon strip, at a yield of 3.79%.)
  • I set dividends at their current level, and assumed they would increase at 5% per year.
  • I modeled in the dilution from warrant issuance.

But I was more liberal in one area.  I assumed that ONB would do an equity issuance sufficient to cut the warrants in half.  If the warrants were outstanding, the incentive to raise the capital would be compelling, and it would get done.

The result of my calculation implied that a 21% implied volatility assumption would justify the purchase price of the warrants.  That’s nice, but what’s the right assumption?

There is no right assumption.  Short-frequency estimates are much higher, even assuming mean reversion.  Longer frequency estimates are higher if one takes the present reading, but lower if one looks at the average reading .  After all, Old National is a boring southern Indiana bank.  This is not a growth business.  If it survives, growth will be modest, and the same for price appreciation.

The Solution

It would be a lot better for the US Treasury to get itself out of the warrant pricing business, and into the auction business, where it can be a neutral third party.  Let them auction off their warrants to the highest bidder, allowing banks to bid on their own warrants.  I’ll give the Treasury a tweak that will make them more money: give the warrants to the winning bidder at the second place price.

By now you are telling me that I am nuts — giving it to the winner at the second place price will reduce proceeds, not increase them.  Wrong!  We tell the bidders that we want aggressive bids, and that they will get some of it back if they win.  I’ve done it many times before — it makes them overbid.

So, with no market for these warrants, I am suggesting that the Treasury creates their own market for the warrants in order to realize fair value.  Is it more work?  Yeah, you bet it is more work, but it will realize better value, and indeed, it will be more fair.