Tonight’s topic comes from a note sent to me by a friend. Here it is:

David, I have heard you say that you have entered into partnerships in the past.  What are your rules for partnerships, who will you enter with?  I have a neighbor who is interested in starting a business, the start up cash is small $5000.  I think there might be good opportunity, but I am concerned for good reason about my time availability, as well as Not being “unequally yoked”.  What business relations do Paul’s words govern.  do you have different rules for minority, majority, or controlling shares?

I appreciate your thoughts.

I have two “partnership” investments.  One is very successful and is an S Corporation.  The other is a limited partnership, and I wonder whether it will ever amount to anything.  Both were done with friends.

There are a few things that you have to think about with partnerships:

  1. Is your liability limited to the amount of money you invested, or could you be on the hook for more if there are losses/lawsuits?
  2. Are there likely to be future periods where capital might need to be raised?  Under what conditions will that be done?
  3. What non-capital obligations are you taking on as a result of this?  Labor, counsel, facilities, tools, etc?
  4. How will profits and losses be allocated?  Voting interests? How will it be managed? When will the partnership end?  How can terms be modified? How can partnership interests be transferred, if at all?  Etc.
  5. Do you like the people that you will be partners with?  You may be partners for a long time.
  6. Be ready for the additional tax complexity of filling out schedule C, or a K-1, or some other tax form.

Go into a partnership with your eyes wide open, and check everything.  If your partnership interests have limited liability, and the economics are structured similar to that of a corporation, then things are clearer, and you don’t have to worry as much.

Take note of any obligations that you might have that don’t fit into the “passive provider of limited capital with proportionate ownership” framework.  Those obligations are the ones that need greater scrutiny.  Include in that how those working on the partnership get compensated for their labor.  Parties to the partnership may have multiple roles, and there can be conflicts of interest — imagine a partnership where one partner works in the business and receives a large salary, thus depressing profits for the non-working partners.  How does that conflict of interest get settled?  (Note that the same problems that exist in being an outside, passive, minority public stock investor reappear here.)

Also be aware of how ownership interests can change, and whether you may be forced to add more capital to maintain your proportionate interest in the business.

Try to have a good sense of the skill of the partner or employee managing the business.  That makes all the difference in whether a business succeeds.

Most of what I say here assumes that you will not be a controlling majority partner, and that you will have limited influence over the business.  If you do have control, the problems of getting cheated by someone else go away, but get replaced with the problem of making sure the business is run adequately for the interests of all partners.  Your ethical obligations also expand.

You mention the “unequally yoked” passage from Second Corinthians 6, verses 14 and following.  In one sense, that doesn’t have much more application here than it does in all investing if one is a Christian.  Don’t involve yourself in businesses that of necessity involve you in things that you would not do yourself as a Christian.  Don’t invest in enterprises where it is obvious that management does not care about ethics — you can see it in their behavior.  This will be a little clearer and close to home in a partnership with a friend — you will know a lot more about what is going on.

With a non-limited partnership, there is an additional way the “unequally yoked” passage applies.  You expose your entire economic well-being to risk when you are a general partner.  It is like a marriage — it is very difficult to negotiate your way out of the unlimited guarantee that you make there.  It is like being a co-signer, which the Bible says to avoid.

Of itself, that doesn’t expose you to the unequal yoke, but when you are in an economic agreement that binding, if your partner takes the business in an ethical direction you find dubious, you will be in a weak position to do something about this.  There is where the unequal yoke appears amid unlimited liability.

That’s all for now.  There’s a lot more to consider here, but this is meant to be an introduction to the issues involved in partnerships.  Hope it works well for you.

How does capital get allocated to the public stock markets?  Through the following means:

  • Initial Public Offerings [IPOs]
  • Follow-on offerings of stock (including PIPEs, etc.)
  • Employees who give up wage income in exchange for stock, or contingent stock (options)
  • Through rights offerings
  • Company-issued warrants and convertible preferred stock, bonds, and bank debt (rare)
  • Receiving equity in exchange for other claims in bankruptcy
  • Issuing stock to pay for the purchase of a private company
  • And other less common ways, such as promoted stocks giving cheap shares to vendors to pay for goods or services rendered.  (spit, spit)

How does capital get allocated away from the public stock markets?  Through the following means:

  • Companies getting acquired with payment fully or partially in cash.  (including going private)
  • Buybacks, including tender offers
  • Dividends
  • Buying for cash company-issued warrants and convertible preferred stock, bonds, and bank debt
  • Going dark transactions are arguable — the company is still public, but no longer has to publish data publicly.

I’m sure there are more for each of the above categories, but I think I got the big ones.  But note what largely does not matter:

  • The stock price going up or down, and
  • who owns the stock

Now, I have previously commented on how the stock price does have an effect on the actual business of the company, even if the effects are of the second order:

My initial main point is this: capital allocation to public companies does not in any large way depend on what happens in secondary market stock trading, but on what happens in the primary market, where shares are traded for cash or something else in place of cash.  When that happens, businessmen make decisions as to whether the cash is worth giving up in exchange for the new shares, or shares getting retired in exchange for cash.

In the secondary market, companies do not directly get any additional capital from all the trading that goes on.  Also, in the long run, stocks don’t care who owns them.  The prices of the stocks will eventually reflect the value of the underlying claims on the business, with a lot of noise in the process.

My second main point is this: as a result, indexing, or any other secondary market investment management strategy does not affect capital allocation much at all.  Companies going into an index for the first time typically have been public for some time, and do not issue new shares as a direct consequence of going into the index.  The price may jump, but that does not affect capital allocation unless the company does decide to issue new shares to take advantage of captive index buyers who can’t sell, which doesn’t happen often.

The same is true in reverse for companies that get kicked out of an index: they do not buy back and retire shares as a direct consequence of going into the index.  They may buy back shares when the price falls, but not because there aren’t indexers in the stock anymore.

So why did I write about this this evening?  I get an email each week from Evergreen Gavekal, and generally, I recommend it.  Generally it is pretty erudite, so if you want to get it, email them and ask for it.

In their most recent email, Charles Gave (a genuinely bright guy that I usually agree with) argues that indexing is inherently socialist because you lose discipline in capital allocation, and allocate to companies in proportion to their market capitalization, which is inherently pro-momentum, and favors large companies that have few good opportunities to deploy capital.

I agree that indexing is slightly pro-momentum as a strategy, and maybe, that you can do better if you remove the biggest companies out of your portfolio.  Where I don’t agree is that indexing changes capital allocation to companies all that much, because no cash gets allocated to or from companies as a result of being in an index.  As a result, indexing is not an inherently socialistic strategy, as Gave states.

Rather, it is a free-market strategy, because no one is constrained to do it, and it shrinks the economic take of the fund management industry, which is good for outside passive minority investors.  Let clever active managers earn their relatively high fees, but for most people who can’t identify those managers, let them index.

If indexing did lead to misallocation of capital, we would expect to see non-indexed assets outperform indexed over the long haul.  In general, we don’t see that, and so I would argue the indexing is beneficial to the investing public.

I write this as one who makes all of his money off of active value investing, so I have no interest in promoting indexing for its own sake.  I just agree with Buffett that most people should index unless they know a clever active manager.

Photo Credit: wackystuff

Photo Credit: wackystuff

No one wants to be a forced seller in a panic. So how does anyone get into that situation?  Two things: bad planning and a bad scenario.

Let’s start with the obvious stuff: the moment you start using leverage, there is a positive probability of total failure, and more leverage increases the probability.  Other factors that raise the probability are lack of diversification of assets, a short term for repayment on the leverage, a run on the bank, or restrictive rules on what happens if your assets decline too much in value.

For the big guys, I think that covers most of it.  With little guys, there is one more painful way that it happens, with insult added to injury.

Assume the man in question has no formal leverage, except maybe a mortgage on his house.  He has a stock portfolio, and like many, has bought popular stocks that everyone thinks will do well.  Then a significant panic hits the market because enough corporate or banking debts are incapable of being repaid.

The value of his portfolio falls a lot, but he doesn’t sell or worry immediately, because he has a solid job and has a buffer of a few months expenses set aside.  Then the shock hits.  In the midst of the panic he faces one of the following:

  • The loss of his job (or severe trouble in his business)
  • Disability with no insurance
  • An uninsured casualty of some sort
  • Divorce
  • Health problems not covered by insurance
  • Death (and his wife has to pick up the pieces)
  • Etc.

Guess what?  Even though he planned ahead, the plan did not consider true disasters, where two things fail at the same time.  His buffer runs out, and in order to live, he has to sell stocks at a time when he thinks they are undervalued.

This happens to some degree in the depths of bear markets, because unemployment and credit panics are correlated.  Other contingencies may not be correlated, but a certain number of them happen all the time — the odds of them happening when the stock market is down is still positive.

What can be done?  Here are a few ideas:

  • Hold a bigger buffer.  Maybe toss in some high quality long bonds, as well as cash.
  • Reduce fixed commitments.
  • Insure most reasonably possible large insurable contingencies — death, disability, health, liability, etc.
  • Keep a rolling hedge of protective puts (costly)
  • Increase portfolio quality and diversification to lessen the hit.

The time plan for a flat tire is before you have one.  As an example, I keep wrenches that are better than what the automakers put in their tire changing kits in my cars.  The same is true for financial disasters.  The planning is best done in the good times, like now.  Consider your financial and personal risks, and adjust your positions accordingly, realizing that no one can survive every panic.  Eventually you have to trust in God, because no earthly security system is comprehensive.

Photo Credit: Mark Stevens

Photo Credit: Mark Stevens

There’s one thing that is a misunderstanding about retirement investing. It’s not something that is out-and-out wrong. It’s just not totally right.

Many think the objective is to acquire a huge pile of assets.

Really, that’s half of the battle.

The true battle is this: taking a stream of savings, derived from a stream of income, and turning it into a robust stream of income in retirement.

That takes three elements to achieve: saving, compounding, and distribution.

What’s that, you say?  That’s no great insight?

Okay, let me go a little deeper then.

Saving is the first skirmish.  Few people develop a habit of saving when they are relatively young.  Try to make it as automatic as possible.  Aim for at least 10% of income, and more if you are doing well, particularly if your income is not stable.

Don’t forget to fund a “buffer fund” of 3-6 months of expenses to be used for only the following:

  • Emergencies
  • Gaining discounts for advance payment (if you know you have future income to replenish it)

The savings and the “buffer fund” provide the ability to enter into the second phase, compounding.  The buffer fund allows the savings to not be invaded for current use so they can be invested and compound their value into a greater amount.

Now, compounding is trickier than it may seem.  Assets must be selected that will grow their value including dividend payments over a reasonable time horizon, corresponding to a market cycle or so (4-8 years).  Growth in value should be in excess of that from expanding stock market multiples or falling interest rates, because you want to compound in the future, and low interest rates and high stock market multiples imply that future compounding opportunities are lower.

Thus, in one sense, you don’t benefit much from a general rise in values from the stock or bond markets.  The value of your portfolio may have risen, but at the cost of lower future opportunities.  This is more ironclad in the bond market, where the cash flow streams are fixed.  With stocks and other risky investments, there may be some ways to do better.

1) With asset allocation, overweight out-of-favor asset classes that offer above average cashflow yields.  Estimates on these can be found at GMO or Research Affiliates.  Rebalance into new asset classes when they become cheap.

2) Growth at a reasonable price investing: invest in stocks that offer capital growth opportunities at a inexpensive price and a margin of safety.  These companies or assets need to have large opportunities in front of them that they can reinvest their free cash flow into.  This is harder to do than it looks.  More companies look promising and do not perform well than those that do perform well.

3) Value investing: Find undervalued companies with a margin of safety that have potential to recover when conditions normalize, or find companies that can convert their resources to a better use that have the willingness to do that.  As your companies do well, reinvest in new possibilities that have better appreciation potential.

4) Distressed investing: in some ways, this can be market timing, but be willing to take risk when things are at their worst.  That can mean investing during a credit crisis, or investing in countries where conditions are somewhat ugly at present.  This applies to risky debt as well as stocks and hybrid instruments.  The best returns come out of investing near the bottom of a panic.  Do your homework carefully here.

5) Avoid losses.  Remember:

  • Margin of safety.  Valuable asset well in excess of debts, rule of law, and a bargain price.
  • In dealing with distress, don’t try to time the bottom — maybe use a 200-day moving average rule to limit risk and invest when the worst is truly past.
  • Avoid the areas where the hot money is buying and own assets being acquired by patient investors.

Adjust your portfolio infrequently to harvest things that have achieved their potential and reinvest in promising new opportunities.

That brings me to the final skirmish, distribution.

Remember when I said:

You don’t benefit much from a general rise in values from the stock or bond markets.  The value of your portfolio may have risen, but at the cost of lower future opportunities.

That goes double in the distribution phase. The objective is to convert assets into a stream of income.  If interest rates are low, as they are now, safe income will be low.  The same applies to stocks (and things like them) trading at high multiples regardless of what dividends they pay.

Don’t look at current income.  Look instead at the underlying economics of the business, and how it grows value.  It is far better to have a growing income stream than a high income stream with low growth potential.

Also consider the risks you may face, and how your assets may fare.  How are you exposed to risk from:

  • Inflation
  • Deflation and a credit crisis
  • Expropriation
  • Regulatory change
  • Trade wars
  • Etc.

And, as you need, liquidate some of the assets that offer the least future potential for your use.  In retirement, your buffer might need to be bigger because the lack of wage income takes away a hedge against unexpected expenses.

Conclusion

There are other issues, like taxes, illiquidity, and so forth to consider, but this is the basic idea on how to convert present excess income into a robust income stream in retirement.  Managing a pile of assets for income to live off of is a challenge, and one that most people are not geared up for, because poor planning and emotional decisions lead to subpar results.

Be wise and aim for the best future opportunities with a margin of safety, and let the retirement income take care of itself.  After all, you can’t rely on the markets or the policymakers to make income opportunities easy.  Choose wisely.

Photo Credit: Jen Goellnitz

Photo Credit: Jen Goellnitz

Okay, let’s roll the promoted stocks scoreboard:

TickerDate of ArticlePrice @ ArticlePrice @ 1/20/15DeclineAnnualizedDead?
GTXO5/27/20082.450.011-99.6%-55.6%
BONZ10/22/20090.350.000-99.9%-72.5%
BONU10/22/20090.890.000-100.0%-82.3%
UTOG3/30/20111.550.000-100.0%-92.0%Dead
OBJE4/29/2011116.000.069-99.9%-86.3%Dead
LSTG10/5/20111.120.004-99.7%-82.5%
AERN10/5/20110.07700.0000-100.0%-93.4%Dead
IRYS3/15/20120.2610.000-100.0%-100.0%Dead
RCGP3/22/20121.470.003-99.8%-89.5%
STVF3/28/20123.240.360-88.9%-54.2%
CRCL5/1/20122.220.004-99.8%-90.2%
ORYN5/30/20120.930.013-98.6%-80.1%
BRFH5/30/20121.160.466-59.8%-29.2%
LUXR6/12/20121.590.002-99.9%-92.3%
IMSC7/9/20121.50.910-39.3%-17.9%
DIDG7/18/20120.650.003-99.6%-89.1%
GRPH11/30/20120.87150.021-97.6%-82.5%
IMNG12/4/20120.760.010-98.7%-86.9%
ECAU1/24/20131.420.000-100.0%-98.4%
DPHS6/3/20130.590.003-99.5%-96.0%
POLR6/10/20135.750.001-100.0%-99.5%
NORX6/11/20130.910.008-99.1%-94.7%
ARTH7/11/20131.240.200-83.9%-69.7%
NAMG7/25/20130.850.013-98.5%-94.1%
MDDD12/9/20130.790.022-97.2%-95.9%
TGRO12/30/20131.20.056-95.3%-94.5%
VEND2/4/20144.340.655-84.9%-86.1%
HTPG3/18/20140.720.008-98.9%-99.5%
WSTI6/27/20141.350.150-88.9%-97.9%
APPG8/1/20141.520.035-97.7%-100.0%
1/20/2015Median-99.3%-89.8%

It is truly amazing how predictable the losses are from promoted stocks, and that is why you should never buy them. Today’s loser-in-waiting is Cardinal Resources [CDNL].  The promoters purport that this company will provide cheap clean fresh water to the world, and will make a fortune off of that.  Now let’s look at some facts:

What commends this stock to you?  Is it:

  • That it has never earned any money?
  • That the firm has had a negative net worth for the last four years?
  • That their auditors doubted on the last 10-K that this company would be a “going concern?”
  • That the company 12 months ago was known as JH Designs, which was in the “home staging and interior design services business?”
  • That the writers of the promotion got paid $30,000 to write the speculative fiction of the promotion?
  • That affiliated shareholders of CDNL paid another $670,000 to publish speculative fiction about the company to unwitting people in an effort to raise the stock price, so that they can sell their shares?

Here, have a look at part of the disclaimer written in five-point type on the glossy ad they sent me in the mail:

Resources Kingdom Limited was paid by non-affiliate shareholders who fully intend to sell their shares without notice into this Advertisement/market awareness campaign, including selling into increased volume and share price that may result from this Advertisement/market awareness campaign. The non-affiliate shareholders may also purchase shares without notice at any time before, during or after this Advertisement/market awareness campaign. Non-affiliate shareholders acted as advisors to Resources Kingdom Limited in this Advertisement and market awareness campaign, including providing outside research, materials, and information to outside writers to compile written materials as part of this market awareness campaign.

Thus, we know who is sponsoring and profiting from this scam.  It is existing shareholders who want to sell.  I can tell you with certainty that you should not buy this, and that if you own it, you should sell it.  There is one significant party that implicitly agrees with that assessment — the company itself, which issued shares at a price of ten cents per share in 2014, according to the recent 10-Q, if you look at the balance sheet and cash flow statements.

Avoid this company, and avoid all situations where stocks are promoted.  They are bad news for all investors.  Good investments never need promotion.

Photo Credit: Alon

Photo Credit: Alon

There is always a reason to worry, and always enough time to panic.

Look over there, behind that bush: interest rates are rising. In Europe and China, deflation is threatening. The geopolitical situation is in many ways tense over Russia and Middle East issues. Japan is a mess. Emerging markets will get hit when the Fed starts to tighten.

I could go on, and talk about the longer term demographic problems that we face, and other aspects of lousy government policy, but it would get too long. The point is, there are things that you can worry about. But what should you do?

For many people, worry paralyzes. If there are significant potential problems, they won’t invest, or they will keep their investments very simple and safe. They may fall prey to those who scam by offering “safety” though gold, guns, food storage, life insurance products, etc. Is there a better way to avoid worry?

The first way to avoid worry is to realize that more things can go wrong than do go wrong. Many of the things you might worry about will not happen. Second, even when things do go wrong, the market prices often reflect those possibilities, so the markets may not react badly. Third, the markets have endured many crises in the past and have come back from those crises. Fourth, in the worst crises you can imagine, it will not matter what you do if those take place — you will lose a lot, but so will everyone else. If no strategy can work in the worst problems, you should spend your time praying rather than worrying.

Some might say to me, “But I don’t want to lose a lot of money! I’m relying on it for my retirement (or whatever).” If that is your problem, the answer is simple — invest less in risk assets. Give up some potential return so that you can sleep at night. That has been my advice to a bunch of pastors who generally don’t understand the markets at all. We offer them blended portfolios of risky and safe assets ranging from low volatility to the volatility level of the stock market. I tell them to look at what the blended portfolios have lost in 2008, and size the risk of their holdings to what they can live with in terms of risk if they had to liquidate at a bad time. If they are still squeamish, I tell them to take the risk level down another notch.

There is a risk to not taking enough risk, and that will be the point of part 2, but it is better for the squeamish to implement a sub-optimal plan than no plan. It is also better for the squeamish to implement a sub-optimal plan than a plan that they can’t maintain, because they get too scared.

Solutions have to be real-world to meet people where they are. After that, maybe we can try to teach people not to worry, but human nature is difficult to change.

PS — for any that might say that they are worried that they aren’t going to earn enough to be able to retire or stay comfortably retired, part 2 will have something to say there as well.

Photo Credit: PSParrot

Photo Credit: PSParrot

Happy New Year to all of my readers. May 2015 be an enriching year for you in all ways, not just money.

This is a series on learning about investing, using my past mistakes as grist for the mill.  I have had my share of mistakes, as you will see.  The real question is whether you learn from your mistakes, and I can say that I mostly learn from them, but never perfectly.

In the early 90s, I fell in with some newsletter writers that were fairly pessimistic.  As such, I did not do the one thing that from my past experience that I found I was good at: picking stocks.  Long before I had money to invest, I thought it was a lot of fun to curl up with Value Line and look for promising companies.  Usually, I did it well.

But I didn’t do that in that era.  Instead, I populated my portfolio with international stock and bond funds, commodity trading funds, etc., and almost nothing that was based in the USA.  I played around with closed-end funds trying to see if I could eke alpha out of the discounts to NAV.  (Answer: No.)  I also tried shorting badly run companies to make a profit.  (I succeeded minimally, but that was the era, not skill.)

I’ve been using my tax returns from that era to prompt my memory of what I did, and the kindest thing I can say is that I didn’t have a consistent strategy, and so my results were poor-to-moderate.  I made money, just not much money.  I even manged to buy the Japanese equity market on the day that it peaked, and after many months got out with a less-than-deserved 3% loss in dollar terms because of offsetting currency movements.

One thing I did benefit from was learning about a wide number of investing techniques and instruments, which benefited me professionally, because it taught me about the broader context of investing.  That said, it cost time, and some of what I learned was marginal.

But not having a good overall strategy largely means you are wasting your time in investing.  You may succeed for a while with what some call luck, but luck by its nature is not consistent.

Thus, I would encourage all of my readers to adopt an approach that fits their:

  • Knowledge
  • Personality
  • Available time

You have to do something that you truly understand, even if it is hiring an advisor, wealth manager, etc.  You must be able to understand the outer edges of what they do, or how will you evaluate whether they are serving you well or not?  Honesty, integrity, and reputation can go a long way here, but it really helps to know the basics.

Picking fund managers is challenging enough.  How much of their good performance was due to:

  • their style being in favor
  • new cash flows in pushing up the prices of the assets that they like to buy
  • a few good ideas that won’t be repeated
  • a clever aide that is about to leave to set up his/her own shop
  • temporary alignment with the macroeconomic environment
  • or skill?

Personality is another matter — some people don’t learn patience, which cuts off a number of strategies that require time to work out.  Few things also work right off the bat, so even a good strategy might get discarded by someone expecting immediate results.

Time is another factor which I will take up at a later point in this series.  The best investment methods out there are no good for you unless you can make them fit into the rest of your life which often contains the far more important things of family, recreation, faith, learning, etc.  It’s no good to be a wealthy old miser who never learned to appreciate life or the goodness of God’s providence in life.

And so to that end, I say choose wisely.  My eventual choice was value investing, which isn’t that hard to learn, but requires patience, but can scale to the time that you have.  For those that work in a business, it has the side-benefit that it is the most businesslike of all investment methods, and can make you more valuable to the firm that you work for, because you can learn to marry business sense with your technical expertise, potentially leading to greater profit.

For me, I can say that it broadened my abilities to think qualitatively, complementing my skills as a mathematician.  The firms I worked for definitely benefited.  Maybe it can do the same for you.

Till next time, where I tell you how value investing is *not* supposed to be done. 😉

PS — one more note: it is *very* difficult to make money off of macro insights in equities.  Maybe there are some guys that can do that well, but I am not one of them.  Limiting the effect of my insights there has been an aid to doing better in investing, because it forces me to be modest in an area where I know my likely success is less probable.

Photo Credit: Rob Pym

Photo Credit: Rob Pym

This is another Aleph Blog series of indeterminate length.  I won’t bleed as much as my friend James Altucher, but I will reveal the worst investments of my life.  There have been a lot of them.  Good investments have more than paid for the losses, but the losses were significant in two ways:

  • The losses were large enough to hurt.
  • Each loss taught me something; usually I did not make the same mistake twice.

After I finish this series, I hope that it can serve as a guide on what to avoid in investing for younger folks, so they don’t repeat my errors.  Okay, older folks can benefit as well… and maybe along the way, I’ll throw in a few colorful stories of investments that weren’t losses, but still taught me something.

Here we go!

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In the late 1980s, I fell prey to a boiler room scam.  I was relatively new to investing for myself, though I had paper-traded stocks for years, and was seemingly able to pick good stocks.  So why did I give in to the slick sales pitch?  Inexperience, for one, and slack capital for two — in my late 20s I really did not have a plan for what I wanted to do with my slack capital.  I had done some investing in the stock market, but made money too quickly, and I feared that the market was once again too high (isn’t it always?).

Regardless, it was pretty dopey, and ended up being a 98% loss.  A class action suit was created, which after 8 years ended up with nothing for any of the plaintiffs, and as far as I can tell, the lawyers lost money as well, since they were seeking a share of the recovery.  Somewhat bitter at the end, the law firm closed its last letter saying something to the effect of, “At least we have the satisfaction that all of those that we have sued have lost all of the money that we can find.”  Cold satisfaction, that.

I can tell you that the experience made me unwilling to transact any personal business over the phone that I did not initiate.  For long-time readers, this helped lead to my saying,

Don’t buy what someone wants to sell you.  Instead, research what you need, and buy that.

That’s a good lesson to begin with.  Till next time.

1. Recently I appeared on RT Boom/Bust again.  The interview lasts 6+ minutes.  Erin Ade and I discussed:

  • Who benefits from lower energy prices.
  • The No-Lose Line for owning bonds,
  • Whether you are compensated for inflation risks in long bonds
  • How much an average person should invest in stocks with any assets that they have after buying their own house.
  • The value of economics, or lack thereof, to investors today.

2. Also, I did an “expert interview” for Mint.com.  I answered the following questions:

  • What is your most basic advice on investing?
  • What can you tell young people to help them stay financially secure in their futures?
  • How can a potential investor go about finding the best investment professional to work with for his or her individual needs?
  • Please explain how being a good investor and a good businessman go hand in hand.
  • What is your favorite part of your job?
  • You clearly do a lot of reading, as seen from your book reviews. What other genres of books do you enjoy?

3. Finally, Aleph Blog was featured in a list of the Top 100 Insurance Blogs at number 29.  I find it interesting because my blog has maybe 18% of posts on insurance topics.  That said, I have a distinctive voice on insurance, because I will talk about consumer issues, and what are companies that might be worth owning.

Enjoy the overly long infographic.

Top 100 Insurance BlogsAn infographic by the team at Rebates zone

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Photo Credit: Chris Piascik

Photo Credit: Chris Piascik

Most formal statements on financial risk are useless to their users. Why?

  • They are written in a language that average people and many regulators don’t speak.
  • They often don’t define what they are trying to avoid in any significant way.
  • They don’t give the time horizon(s) associated with their assessments.
  • They don’t consider the second-order behavior of parties that are managing assets in areas related to their areas.
  • They don’t consider whether history might be a poor guide for their estimates.
  • They don’t consider the conflicting interests and incentives of the parties that direct the asset managers, and how their own institutional risks affect their willingness to manage the risks that other parties deem important.
  • They are sometimes based off of a regulatory view of what can/must be stated, rather than an economic view of what should be stated.
  • Occasionally, approximations are used where better calculations could be used.  It’s amazing how long some calculations designed for the pencil and paper age hang on when we have computers.
  • Also, material contract provisions that are hard to model/explain often get ignored, or get some brief mention in a footnote (or its equivalent).
  • Where complex math is used, there is no simple language to explain the economic sense of it.
  • They are unwilling to consider how volatile financial processes are, believing that the Great Depression, the German Hyperinflation, or something as severe, could never happen again.

(An aside to readers; this was supposed to be a “little piece” when I started, but the more I wrote, the more I realized it would have to be more comprehensive.)

Let me start with a brief story.  I used to work as an officer of the Pension Division of Provident Mutual, which was the only place I ever worked where analysis of risks came first, and was core to everything else that we did.  The mathematical modeling that I did in there was some of the best in the industry for that era, and my models helped keep us out of trouble that many other firms fell into.  It shaped my view of how to manage a financial business to minimize risks first, and then make money.

But what made us proudest of our efforts was a 40-page document written in plain English that ran through the risks that we faced as a division of our company, and how we dealt with them.  The initial target audience was regulators analyzing the solvency of Provident Mutual, but we used it to demonstrate the quality of what we were doing to clients, wholesalers, internal auditors, rating agencies, credit analysts, and related parties inside Provident Mutual.  You can’t believe how many people came to us saying, “I get it.”  Regulators came to us, saying: “We’ve read hundreds of these; this is the first one that was easy to understand.”

The 40-pager was the brainchild of my boss, who was the most intuitive actuary that I have ever known.  Me? I was maybe the third lead investment risk modeler he had employed, and I learned more than I probably improved matters.

What we did was required by law, but the way we did it, and how we used it was not.  It combined the best of both rules and principles, going well beyond the minimum of what was required.  Rather than considering risk control to be something we did at the end to finagle credit analysts, regulators, etc., we took the economic core of the idea and made it the way we did business.

What I am saying in this piece is that the same ideas should be more actively and fully applied to:

  • Investment prospectuses and reports, and all investment and insurance marketing literature
  • Solvency documents provided to regulators, credit raters, and the general public by banks, insurers, derivative counterparties, etc.
  • Risk disclosures by financial companies, and perhaps non-financials as well, to the degree that financial markets affect their real results.
  • The reports that sell-side analysts write
  • The analyses that those that provide asset allocation advice put out
  • Consumer lending documents, in order to warn people what can happen to them if they aren’t careful
  • Private pension and employee benefit plans, and their evil twins that governments create.

Looks like this will be a mini-series at Aleph Blog, so stay tuned for part two, where I will begin going through what needs to be corrected, and then how it needs to be applied.