In my view, these were my best posts written between February 2015 and April 2015:

One Dozen Reasons Why the Average Person Underperforms In Investing, Part 1

One Dozen Reasons Why the Average Person Underperforms In Investing, Part 2

Most of this boils down to chasing past performance, neglecting fundamentals, and neglecting basic risk control.

Learning from the Past, Part 4

Learning from the Past, Part 5a [Institutional Bond Version]

In this series, I disclose my WORST investing mistakes ever.  Personal errors: cellular auctions, mistiming small cap value, and small deal arbitrage.  Professional error: Manufactured Housing Asset Backed Securities — Mezzanine and Subordinated Certificates.

Smell the burning money!

The “Secret” of Berkshire Hathaway

You can’t imitate what they do, because you would have to tear up everything you are doing now.

One Potential Weakness of Berkshire Hathaway

Reserving is weakening, new places to find float are few, and if policy on asbsetos settlements changed, BRK could be in a world of hurt.

From Stream to Shining Stream

How a stream of excess income during working years becomes a stream of income in retirement years.  It’s harder to do than you might expect.  Includes a list of strategies and pitfalls.

2000 More Points To Go; Look Elsewhere!

Even today, the NASDAQ Composite still hasn’t hit an inflation adjusted high.

On Bitcoin

I feel stronger about this than when I originally wrote this.  Bitcoin and the other cryptocurrencies are just a speculative crapshoot, and the attempt to have a currency without the legal structure of a government will fail, unless it is a commodity like gold.  Also, the blockchain is an overrated resource hog that lacks the flexibility possessed by life insurance company policy management systems.

On Negative Interest Rates

Explains why they exist, and what dangers could come from them.

An Idea Whose Time Should Not Come

Financial complexity should usually be avoided, particularly with financial guaranty schemes.

We Don’t Need To Be Able To Short Private Companies

Like the prior article, there are people with too much time on their hands thinking up nutty and useless ideas.  There is enough risk in the world already; we don’t have to add to it.

The Bond Market Tells The Fed What To Do, Not Vice-Versa

Sometimes we forget that the collective lending and borrowing decisions of the US bond market are more powerful than the Fed.

Index Investing is not Inherently Socialistic

I think active managers have to grow up and accept that passive investing isn’t evil; it just cuts against the economic interests of active managers like me, at least for now.  When it gets really big, the paradigm will shift…

On Being A Forced Seller in a Panic

Very few people want to panic, and fewer want to sell at the bottom — but many do just that.  How can you avoid it?

Why Life Insurers, Defined Benefit Plans, and Endowments Invest Differently

How investing differs for investors that have different types of long-duration liabilities to fund.

Fade High Price-Sensitivity Assets in Crude Oil

A short and lonely post where I told you in advance that crude oil would hang around $50/barrel “for a few years.”  And, my reasoning was on target as well.

Simple Stuff: On Bid-Ask Spreads

Do you have basic concepts that you want to have explained?  Shoot me an email, and if I think enough people would be interested, I will do it.

Photo Credit: Carl Wycoff || It is a long way to the end of retirement.  People are getting ready for it.  Are you?

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Assuming that you could throw stones on the financial internet, it would be hard to toss a stone and miss articles talking about how high the stock market is.  One good article from last week was Why Do U.S. Stocks Keep Hitting Records? Here Are Five Theories from the Wall Street Journal.  Here were the five theories:

  1. Stocks Reflect the Resurgent Health of American Corporations
  2. The Global Outlook Is Looking Brighter
  3. The U.S. Economy Is in a ‘Goldilocks’ Situation
  4. Passive Funds Are Propping Up Prices
  5. There Is No Alternative

Of this list, I think answers 1, 3 and 5 are correct, and 2 and 4 are wrong.  I have a few other answers that I think are right:

  1. Demographics are leading people to buy assets that will provide long-term cash flows. Monetary policy has led to asset price inflation, not goods price inflation.
  2. People are overestimating the resiliency of the political and social constructs that make all of this possible.
  3. The “Dumb Money” hasn’t arrived yet, but the sale of volatility by retail contradict that.

I disagree with point 2 from the WSJ article because a stronger global economy not only means that profits will rise, but also the cost of capital.  Depending on which factor is stronger, a stronger global economy can make stocks go up, down, or be neutral.

On point 4, I’ve written about that in Overvaluation is NOT Due to Passive Investing.  What matters more than the active/passive mix is the total shift in portfolio holdings into stocks versus everything else.  When people hold a lot of their portfolio in stocks, stock prices tend to be high.

The active/passive mix does have effect on the relative prices of securities in the indexes versus outside the indexes. The clearest place to see the impacts of ETFs and indexing is in bonds, where bonds that are in the indexes trade at lower yields and higher prices than similar non-index bonds.

With stocks, it is probably the same, but harder to prove; I wrote about this here.  In the short run, the companies in the popular indexes are getting a tailwind. That will turn into a headwind at some point, because the voting machine always eventually becomes a weighing machine.

Why are stocks high?

Profit margins are high because of productivity increases from the application of information technology.  Also, there is a lot of lower paid labor to employ globally which further depresses wage rates in developed countries.

Points 3 and 5 of the WSJ article are almost saying the same thing.  Interest rates are low.  They are low because inflation is low,, and general economic activity is not that robust.  As such, the cost of capital is low, people are willing to pay high prices for stocks and bonds relative to their cash flows.

Part of this stems from demographics, which was my first additional point.  For those that are retired or want to retire, there aren’t a lot of ways to transfer money earned in the present so that you can get the equivalent purchasing power or better far into the future.  There are a few commodities that you can store, like gold, but most can’t be stored.  Thus you can buy bonds if you don’t think inflation will be bad, or inflation-protected bonds if you can live with low real returns.  Money market funds will keep your principal stable, but also provide little return.  You can buy stocks if you are willing to get some inflation protection, and run the risk of a rising cost of capital at some point in the future.  Same for real estate, but substitute in rising mortgage rates.

A shift can happen when the marginal dollar produced by monetary policy shifts from being saved to being spent.  For now, monetary policy inflates asset prices, not goods prices (much).

My second point says that people are willing to spend more on stocks when they think that the system will remain stable for a long time.  That seems to be true today, but as I have pointed out before, it discounts the probability of trade wars, real wars, resurgent socialism, and bad future demographics.  Nations with shrinking populations tend to have poor asset returns.  Also, nations with unproductive cultures don’t tend to make economic progress.

My third point is equivocal.  I don’t see a lot of people yelling “buy stock!”  There’s a lot of disbelief in the market; this is what Jason Zweig was talking about in his most recent WSJ column.  That said, when I see lots of activity from people shorting volatility through exchange traded products in order to earn returns, it makes me wonder.  As I have said before, “Nothing brings out the financial worst in people like the lure of seemingly free money.”  Eventually those trades sting those that stay at the party too long.

So, where does that leave me?  The market is high, as my models indicate.  It may remain high for a while, and may get higher still.  That said, it would be historically unprecedented to remain in the top decile of valuations for more than three years.  It would be healthy to have the following:

  • A garden-variety recession
  • A garden-variety bear market
  • More varied sector/industry performance

Will we get any of those?  I don’t know.  I can tell you this, though.  For now, my asset allocation risk is on the low side for me, with stocks at around 70% (that is high for most people, but that is how I have lived my life).  If we get over the 95th percentile of valuations, I will hedge what I can.  For now, I reluctantly soldier on.

Photo Credit: Leo Newball, Jr. || I visited that building when I was 24.

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June 2017July 2017Comments
Information received since the Federal Open Market Committee met in May indicates that the labor market has continued to strengthen and that economic activity has been rising moderately so far this year.Information received since the Federal Open Market Committee met in June indicates that the labor market has continued to strengthen and that economic activity has been rising moderately so far this year.No change.  Feels like GDP is slowing, though.
Job gains have moderated but have been solid, on average, since the beginning of the year, and the unemployment rate has declined.Job gains have been solid, on average, since the beginning of the year, and the unemployment rate has declined.Shades labor conditions up
Household spending has picked up in recent months, and business fixed investment has continued to expand.Household spending and business fixed investment have continued to expand.No real change
On a 12-month basis, inflation has declined recently and, like the measure excluding food and energy prices, is running somewhat below 2 percent.On a 12-month basis, overall inflation and the measure excluding food and energy prices have declined and are running below 2 percent.Changes, but to little effect.
Market-based measures of inflation compensation remain low; survey-based measures of longer-term inflation expectations are little changed, on balance.Market-based measures of inflation compensation remain low; survey-based measures of longer-term inflation expectations are little changed, on balance.No change
Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability.Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability.No change; somebody tell them that things that can’t change don’t belong here.
The Committee continues to expect that, with gradual adjustments in the stance of monetary policy, economic activity will expand at a moderate pace, and labor market conditions will strengthen somewhat further. Inflation on a 12-month basis is expected to remain somewhat below 2 percent in the near term but to stabilize around the Committee’s 2 percent objective over the medium term.The Committee continues to expect that, with gradual adjustments in the stance of monetary policy, economic activity will expand at a moderate pace, and labor market conditions will strengthen somewhat further. Inflation on a 12-month basis is expected to remain somewhat below 2 percent in the near term but to stabilize around the Committee’s 2 percent objective over the medium term.No change; monetary policy solves all.
Near term risks to the economic outlook appear roughly balanced, but the Committee is monitoring inflation developments closely.Near-term risks to the economic outlook appear roughly balanced, but the Committee is monitoring inflation developments closely.No change.
In view of realized and expected labor market conditions and inflation, the Committee decided to raise the target range for the federal funds rate to 1 to 1-1/4 percent.In view of realized and expected labor market conditions and inflation, the Committee decided to maintain the target range for the federal funds rate at 1 to 1-1/4 percent.No change.
The stance of monetary policy remains accommodative, thereby supporting some further strengthening in labor market conditions and a sustained return to 2 percent inflation.The stance of monetary policy remains accommodative, thereby supporting some further strengthening in labor market conditions and a sustained return to 2 percent inflation.No change, but monetary policy is no longer accommodative.  The short end of the forward curve continues to rise, and the curve flattens.
In determining the timing and size of future adjustments to the target range for the federal funds rate, the Committee will assess realized and expected economic conditions relative to its objectives of maximum employment and 2 percent inflation.In determining the timing and size of future adjustments to the target range for the federal funds rate, the Committee will assess realized and expected economic conditions relative to its objectives of maximum employment and 2 percent inflation.No change
This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial and international developments.This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial and international developments.No change.  If you don’t know what will drive decision-making, i.e., it could be anything, just say that.
The Committee will carefully monitor actual and expected inflation developments relative to its symmetric inflation goal.The Committee will carefully monitor actual and expected inflation developments relative to its symmetric inflation goal.No change. Symmetric: we can’t let inflation get too low, because we don’t regulate banks properly.
The Committee expects that economic conditions will evolve in a manner that will warrant gradual increases in the federal funds rate; the federal funds rate is likely to remain, for some time, below levels that are expected to prevail in the longer run.The Committee expects that economic conditions will evolve in a manner that will warrant gradual increases in the federal funds rate; the federal funds rate is likely to remain, for some time, below levels that are expected to prevail in the longer run.No change
However, the actual path of the federal funds rate will depend on the economic outlook as informed by incoming data.However, the actual path of the federal funds rate will depend on the economic outlook as informed by incoming data.No change
The Committee is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and of rolling over maturing Treasury securities at auction.For the time being, the Committee is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and of rolling over maturing Treasury securities at auction.No change
The Committee currently expects to begin implementing a balance sheet normalization program this year, provided that the economy evolves broadly as anticipated.The Committee expects to begin implementing its balance sheet normalization program relatively soon, provided that the economy evolves broadly as anticipated;Accelerates the timing of change.
This program, which would gradually reduce the Federal Reserve’s securities holdings by decreasing reinvestment of principal payments from those securities, is described in the accompanying addendum to the Committee’s Policy Normalization Principles and Plans.this program is described in the June 2017 Addendum to the Committee’s Policy Normalization Principles and Plans.Promises the slow end of QE, as they may start to let securities mature.
Voting for the FOMC monetary policy action were: Janet L. Yellen, Chair; William C. Dudley, Vice Chairman; Lael Brainard; Charles L. Evans; Stanley Fischer; Patrick Harker; Robert S. Kaplan; and Jerome H. Powell.Voting for the FOMC monetary policy action were: Janet L. Yellen, Chair; William C. Dudley, Vice Chairman; Lael Brainard; Charles L. Evans; Stanley Fischer; Patrick Harker; Robert S. Kaplan; Neel Kashkari; and Jerome H. Powell.No dissents; it’s relatively easy to agree with doing nothing.
Voting against the action was Neel Kashkari, who preferred at this meeting to maintain the existing target range for the federal funds rate.No dissents.

 

Comments

  • Labor conditions are reasonably good. GDP is meandering.
  • The yield curve is flattening, with long rates falling.
  • Stocks, bonds and gold rise a little.
  • I think the Fed is too optimistic about the economy. I also think that they won’t get far into letting securities mature before they resume reinvestment of maturing bonds. [miswrote that last time]

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In my view, these were my best posts written between November 2014 and January 2015:

Stay Calm

Political changes rarely create the policy/legal changes that people fear or hope for, so relax.

Problems in Simulating Investment Returns

There are seven problem areas in investment return modeling that are rarely dealt with, and certainly never as a group.  That’s why I would encourage you to be at least least slightly skeptical of any simulation analysis that you might receive.  This goes 10x for the schmendricks that propound multivariate normal simulations.

Revenue Misses Can Be Good

Every dollar in the door may be the same, but not every sale or promise made is equally good.  The contribution margin matter a lot.  Earnings, especially future earnings, always matters more than revenues.

Is This Legit?

It is little known that I analyze simple and complex investment situations for third party clients so that they can know whether they have a good deal or not.  Do you need help with an investment situation that puzzles you?

It’s Their Money

Don’t argue with your clients when they leave.  Wish them well, and do your best for them until the end.

Lagging Long Yields

Yield curves only shift in a parallel fashion about 40% of the time.  The actual way that yield curves tend to move tend to overstate long bond durations [interest rate sensitivity] by two years versus a parallel yield curve shift.

Learning from the Past, Part 1

Learning from the Past, Part 2

Learning from the Past, Part 3

The start of a nine-part series on my worst investment mistakes, beginning with a boiler room scam, undue pessimism from macroeconomic forecasts, and Caldor (spit, spit).

Should Jim Cramer Sell TheStreet or Quit CNBC?

My personal reflections about Jim Cramer, and why I think efforts to make him change his ways will fail.

Have Your Cake, Eat It Too, And End Up With Only Crumbs

Why you should avoid margin loans; they are the best, until they are the worst.

On Financial Risk Statements, Part 1

I never completed this series, but here I explain how most financial risk statements are useless to average people.  It would help a lot if plain language and straight talk scenarios were employed.

Living in the Land of Worries, Part 1

How do you cope with worry in investing?  What if there are other things to worry about that you aren’t considering? (I also never wrote part 2 for this one.)

Relying on the Kindness of Strangers

If you relied on the Swiss Central Bank to keep its peg to the Euro, you deserved to lose the money.  Study history, and listen to the naysayers.

 

In my view, these were my best posts written between November 2015 and January 2016:

Don’t be a Miser in Retirement (Or Ever)

“There is a fine line between over-saving and under-living.”

Another way to phrase it: God isn’t a miser; you shouldn’t be either.

On Lump Sum Distributions

Managing a lump sum distribution for income is one of the hardest things to do in investing.

Easy In, Hard Out (III)

Continuing the series on the troubles the Fed will have shrinking its balance sheet.

Understand Your Liabilities

Your investment decisions should be driven by when you will need to convert the assets to cash for spending purposes.

The Limits of Risky Asset Diversification

Because of the behavior of investors, and increasing interconnectedness between markets, the degree that risky assets diversify each other has been decreasing over time.  There is really only one diversifier for risky assets — high quality bonds, whether short or long.

How Much is that Asset in the Window? (III)

Continues the fictitious conversation between me and a friend on the topic of how there are no objective prices in the market, much as we might like them.

Seven Thoughts on the Markets

  • Learning Investments
  • OPEC
  • High Yield
  • F&G Life
  • Missing Opportunities
  • FOMC, and
  • What could the next crisis be?

Direction Matters More Than Position with Monetary Policy

Accommodation ended a lot sooner than the FOMC said it did

Sell a Fraction of Your Home?

In general, highly idiosyncratic and indivisible assets like a home should not be sold in pieces.  That said, this idea is better than most.

Annotated “In Hoc Anno Domini” 

Response to “In Hoc Anno Domini”

My critique of Vermont Royster’s vapid Christmas message which gets published in the Wall Street Journal each year.

On Currencies that are Not a Store of Value

What do you do if you live in a place where high inflation is the norm?

On Currencies That Are A Store Of Value, But Maybe Not For Long

What do you do with the currencies of countries that are currently stable, but aren’t running the most stable economic policies?

Cheapness versus Economic Cyclicality

What do you do when the only cheap, safe companies embed a lot of economic cyclicality?  I.e., they rely on economic growth in order to do really well…

 

Photo Credit: Hagens_world || I want to buy 1% of all of the items there in one nice neat package! 😉

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There’s been a lot of words thrown around lately saying that indexing has been leading to overvaluation of the US stock market.  I’m here to tell you that is wrong.  I have two reasons for that:

1) Active managers have been pseudo-indexing for a long time.  The moment they get benchmarked to an index they do one of two things:

a) accept it, gain funds for mandates that are like the index, and then they constrain their investing so that they are never too different from the index, and hopefully not in the fourth quartile of performance, so they don’t lose assets.  This is the action of the majority.

b) Ignore it, get less fund flows, and don’t let the index affect your investment decisions.  The assets should be stickier over time if you explain to clients what you are doing, and why.  Only a minority do this.

This has been my opinion since my days of writing for RealMoney. All of the active managers out there add up to something close to a passive benchmark, less fees.  It can’t be otherwise.

The one exception of any size would be stocks excluded from indexes because they don’t have enough free float available for non-insiders to own/trade.  Even that is not very big — it might be 5% of the total stock market, though this is just a wild guess.

2) If you want to talk about valuation issues, you really want to talk about the trade-off between stocks and bonds, or stocks and cash.  Stock valuations are never absolute — it is always a question of the other assets you are measuring the stocks against, and how you desirable those other assets will be in the future, and how sustainable the profitability of stocks will be over time.  I broke apart some of these issues in my piece The Dead Model.  Desirability of stock investing can be broken into three components: maturity risk, credit risk and business risk.  At present, the first two are getting thinner.  The last one is thicker, and at least at present, there is no great rush to encourage people to trade slack cash for newly issued shares of stock.  If anything, stock is getting retired on net.  (Just a guess.)

Part of this stems from demographics: the Baby Boomers and others still sock away money so that they can get payments in the future, when they are too old to work much.  That’s the maturity risk that I mentioned above, and the reward from that is low because so many are trying to do it.  Flat yield curve and low overall yields are the cause of a lot of worries for investors.  The same thing applies to credit spreads: people are searching for yield, and it leads them far afield — that said, I don’t see a lot of obvious places where credit metrics look bad, aside from auto loans, student loans, and overleveraged governments.

The demographic effect means that nothing looks safe and cheap.  Yields are low, and price/earnings multiples are high.  The question is what could lead those to change.  When the markets are pricing in something like continued perfection, sometimes it doesn’t take much to jolt them out of what is an unstable equilibrium. (Note: contrary to neoclassical economics, most economic equilibria are unstable.)

Profit margins could fall, but most of the factors underpinning high profit margins look pretty strong — using technology to make labor more productive, ability to shift work globally to talented people who are paid less, and clever uses of accounting to reduce taxable income and tax rates seem intact, if not growing.

That said, remember my saying:

Governments are smaller than markets; markets are smaller than cultures.

There is always the possibility of a shock happening that no one expects:

  1. War, even if undeclared
  2. Cultural unrest leading to political change: remember the partial nationalization of Amazon and Google that took place in 2030?  They got broken up and parts were turned into utilities by the US government because they were so pervasive, and then foreign governments expropriated their local assets, and banned them in their countries.
  3. Another example could be a type of Luddite behavior that attempted to force corporations to hire people proportionate to the profits.
  4. Hyperinflation in Japan, or somewhere else big.
  5. China has a bigger credit crisis than its last one, leading to drops in commodity prices, and further global deflation.

Point 2 was a joke, but meant to illustrate how cultural systems abhor entities that get too powerful.

Closing

I do think stock valuations are high, but the best way to see that is in my quarterly post on stock valuations.  It takes into account the changing preferences economic actors have regarding what assets they hold — this is one indicator that explicitly reflects actual changes in stock and bond issuance and retirement, as well as changes induced by the Fed in creating more cash and credit, or, destroying it.

Passive investing is a sideshow as far as stock valuations go.  Pay attention to the supply and demand for stock on the whole, and the factors that might lead supply and demand to change.

Picture Credit: Denise Krebs || What RFK said is not applicable to investing.  Safety First!  Don’t lose money!

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Investment entities, both people and institutions, often say one thing and mean another with respect to risk.  They can keep a straight face with respect to minor market gyrations.  But major market changes leading to the possible or actual questioning of whether they will have enough money to meet stated goals is what really matters to them.

There are six factors that go into any true risk analysis (I will handle them in order):

  1. Net Wealth Relative to Liabilities
  2. Time
  3. Liquidity
  4. Flexibility
  5. Investment-specific Factors
  6. Character of the Entity’s Decision-makers and their Incentives

Net Wealth Relative to Liabilities

The larger the surplus of assets over liabilities, the more relaxed and long-term focused an entity can be.  For the individual, that attempts to measure the amount needed to meet future obligations where future investment earnings are calculated at a conservative level — my initial rule of thumb is no more than 1% above the 10-year Treasury yield.

That said, for entities with well defined liabilities, like a defined benefit pension plan, a bank, or an insurance company, using 1% above the yield curve should be a maximum for investment earnings, even for existing fixed income assets.  Risk premiums will get taken into net wealth as they are earned.  They should not be planned as if they are guaranteed to occur.

Time

The longer it is before payments need to be made, the more aggressive the investment posture can be.  Now, that can swing two ways — with a larger surplus, or more time before payments need to be made, there is more freedom to tactically overweight or underweight risky assets versus your normal investment posture.

That means that someone like Buffett is almost unconstrained, aside from paying off insurance claims and indebtedness.  Not so for most investment entities, which often learn that their estimates of when they need the money are overestimates, and in a crisis, may need liquidity sooner than they ever thought.

Liquidity

High quality assets that can easily be turned into spendable cash helps make net wealth more secure.  Unexpected cash outflows happen, and how do you meet those needs, particularly in a crisis?  If you’ve got more than enough cash-like assets, the rest of the portfolio can be more aggressive.  Remember, Buffett view cash as an option, because of what he can buy with it during a crisis.  The question is whether the low returns from holding cash will get more than compensated for by capital gains and income on the rest of the portfolio across a full market cycle.  Do the opportunistic purchases get made when the crisis comes?  Do they pay off?

Also, if net new assets are coming in, aggressiveness can increase somewhat, but it matters whether the assets have promises attached to them, or are additional surplus.  The former money must be invested coservatively, while surplus can be invested aggressively.

Flexibility

Some liabilities, or spending needs, can be deferred, at some level of cost or discomfort.  As an example, if retirement assets are not sufficient, then maybe discretionary expenses can be reduced.  Dreams often have to give way to reality.

Even in corporate situations, some payments can be stretched out with some increase in the cost of financing.  One has to be careful here, because the time you are forced to conserve liquidity is often the same time that everyone else must do it as well, which means the cost of doing so could be high.  That said, projects can be put on hold, realizing that growth will suffer; this can be a “choose your poison” type of situation, because it might cause the stock price to fall, with unpredictable second order effects.

Investment-specific Factors

Making good long term investments will enable a higher return over time, but concentration of ideas can in the short-run lead to underperformance.  So long as you don’t need cash soon, or you have a large surplus of net assets, such a posture can be maintained over the long haul.

The same thing applies to the need for income from investments.  investments can shoot less for income and more for capital gains if the need for spendable cash is low.  Or, less liquid investments can be purchased if they offer a significant return for giving up the liquidity.

Character of the Entity’s Decision-makers and their Incentives

The last issue, which many take first, but I think is last, is how skilled the investors are in dealing with panic/greed situations.  What is your subjective “risk tolerance?”  The reason I put this last, is that if you have done your job right, and properly sized the first five factors above, there will be enough surplus and liquidity that does not easily run away in a crisis.  When portfolios are constructed so that they are prepared for crises and manias, the subjective reactions are minimized because the call on cash during a crisis never gets great enough to force them to move.

A: “Are we adequate?”

B: “More than adequate.  We might even be able to take advantage of the crisis…”

The only “trouble” comes when almost everyone is prepared.  Then no significant crises come.  That theoretical problem is very high quality, but I don’t think the nature of mankind ever changes that much.

Closing

Pay attention to the risk factors of investing relative to your spending needs (or, liabilities).  Then you will be prepared for the inevitable storms that will come.

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During this era, I started contributing articles via tumblr to Yahoo Finance.  That also meant that every article would start with a picture, graph, or photo.

In my view, these were my best posts written between August and October 2014:

The Investments Matter More than their Form

Hedge funds and mutual funds are shells — what goes into them matters more than the form itself.

On Genworth

Down 70%+ since then.  In general, complexity is not rewarded in investments, and particularly insurance companies.  It also helps if you choose lines of business that are good risks, which long-term care and mortgage insurance aren’t.

The Tip Culture in Amateur Investing

Shortcuts in investing are generally not a good idea.

Ranking P&C Reserving Conservatism

Prescient — the liberal reservers have not done well as a group.  I will be doing an update on this.

The Victors Write the History Books, Even in Finance

Survivorship bias has an effect on all of our investment statistics.  Try to combat that by reading history books — the only thing more volatile than markets is history.

Should I Invest in Private Equity?

It’s not as easy at it looks, and often IRRs overstate the realized returns when you consider capital that is locked up.

The Art of Extracting Large Commissions From Investors

Beware of being sold an investment; rather, research your investments carefully, perhaps with the aid of a skilled and trusted friend

One Less Mentioned Reason for Stock Buybacks

Managements want to prevent hostile takeovers through not leaving a lot of idle cash on the balance sheet.

The FSOC is Full of Hot Air

The Financial Stability Oversight Council doesn’t understand what firms contribute to systemic risk.

End the “Code of Silence”

Why the CFA “Future of Finance” project was unlikely to go far.  Is that still around?

Making Systematic Risk Disappear, Not

If you stop measuring performance and risk, the performance doesn’t change, and the risk doesn’t go away

Retirement – A Luxury Good

The first thing to remember is that retirement is a modern concept. That the world existed without retirement for over 5000 years may mean that it is not a necessary institution. For a detailed comment on this, please consult my article, “The Retirement Tripod: Ancient and Modern.”

Volatility Can Be Risk, At Rare Times

When assets are highly levered, volatility can morph into permanent destruction of capital.

Possible Bond ETF Problems

If a large amount of bonds inside an ETF are illiquid, all sorts of funny things could happen, but they wont make us laugh.

What Should the Cost of Equity Be to Value Investors?

It should reflect the opportunity cost of the unlevered funds.

Buying an Inexpensive Car

A few tips and tricks

Managing Money for Retirement

Money management is far harder when you have to draw funds regularly to cover expenses.  Also, most people overestimate how much money they can draw from investments.

Numerator vs Denominator

…Howard Simons, astutely would comment something to the effect of: “The stock market is not a futures contract on GDP.”  This much is true, but why is it true?  How can the market go down on good economic news?

Factor Glut

Are factors getting overused?

Even with Good Managers, Volatility Matters

An examination of the Fairholme Fund, and what returns that an average investor received from it.

Mantra: Interest Rates Have to Rise, Interest Rates Have to…

An examination of why interest rates don’t have to go up.

Meeting the “Bond King”

What happened when I met Bill Gross…

The Butterfly Machine

It’s harder to create a giant crisis than you think, but if enough parties borrow enough money at the same time, we just might be able to do it.

This is a small update of my last piece.  I wish that I had put this graph in that piece, because it completes it.

Over the interest rate range of 0% to 30%, the average absolute deviations from perfect doubling using the Rule of 72 was 2.794%.  Given the simplicity of the Rule of 72, that is wonderful.

But the “Rule of K” is virtually exact.  The average absolute deviations from perfect doubling using the Rule of K was 0.036%.

Is this great?  Well, with modern computers, exactitude is easy to come by.  But if you are in a pinch to figure out the time to double, and all you have is a pencil and paper, the rule of K can do it with addition, subtraction and division.  No fancy powers or logarithms.  A four-function calculator will handle it, which, if you are using a rate that does divide into 72 easily, you will still need for the calculation.

At 8% the two are equal.  Near 8%, the Rule of 72 is pretty good.  The Rule of K gives an almost exact answer at the cost of a little complexity.  Your choice depends on whether you need exactness or simplicity when all you have to work with is a four function calculator.

The Rule of K: If R is the interest rate multiplied by 100, money doubles in K/R years, where K = 70 + (R – 2)/3

Picture Credit: Vincent Brown || Einstein never said this, either…

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If you are famous and dead, many people will attribute clever sayings to you that you never said.  As Yogi Berra said:

I really didn’t say everything I said.

Except that Yogi did say that.  Now, if Einstein didn’t do enough for us, he supposedly made many statements praising compound interest, but the articles I have seen haven’t been able to trace it back to an original source.  Personally, I think compound interest is overrated, because business processes can’t forever compound wealth at a steady rate.

But some also have tried to credit Einstein with the Rule of 72.  You know, the rule that says the time it takes to double your money in years is equal to 72 divded by the annual compound interest rate expressed as as an integer.  E.g., at 8% your money doubles in 9 years.  At 9% you money doubles in 8 years.

Pretty nice, and easy to remember.  It is an approximation though.  If Einstein ever did look at the rule of 72, he would have noticed that the approximation is pretty good between 3% and 13%.  Outside that it gets further away.

One advantage of the rule of 72 is that it is simple.  The second one is that 72 = 3 x 3 x 2 x 2 x 2.  That makes it divide more intuitively by many integral interest rates, e.g., 3, 4, 6, 8, 9, 12 — allowing for some intuitive interpolation to aid it.

There is a more complex version of the doubling rule though:

The doubling constant starts (in the limit) at 100 times the natural logarithm of 2 [69.3147], and increases almost linearly from there.  If you estimate a “best linear fit” line on the observations where the interest rate is between 0 and 30, the R-squared will be over 99.98%.  The equation would be:

K = 69.3856 + 0.3313 * interest rate  [Linear Fit K]

To make it a little more memorable rule, it can be turned into:

K = 70 + (interest rate – 2)/3  [Rule K]

Thus at 2% the doubling constant would be 70 — money doubles in 35 years.  At 5%, 71, money doubles in 14.2 years.  8% is the rule of 72 — nine years to double.  At 11%, 73, 6.6 years to double.  At 14%, 74, 5.3 years to double. 17%, 75, 4.4 years to double. 20%, 76, 3.8 years to double.  I did those in my head.

As you can see from the graph above, the actual doubling constant and its two approximations lie on top of each other.  Not that I hope we see ultrahigh interest rates, but Rule K does quite well over a long span of rates.  Here’s how small the deviations are:

Now, almost no one will use “Rule K” because the two advantages of the Rule of 72 are huge, and if interest rates get really high, someone could create an easy smartphone app to calculate the doubling period. (and constant if they wanted)

This is interesting for me, because I ran across what I call the “Rule of K” earlier in my career, and I was able to reproduce it on my own after reading the WSJ article that I cited above.  Who knows, maybe Einstein took the doubling rule and did a first order Taylor expansion around 2% — that would have produced something very close to the “Rule of K” back when regressions were hard to do.

That’s all, and if you made it this far, thanks for bearing with me.