Half of my career, I have worked for bosses who were actuaries, and half not.? Half of my career, I worked for bosses that were intellectually curious, and half not.? There was a strong, but not perfect correlation between the two — most actuaries are intellectually curious, but there are a few that aren’t.

Those that know me well, know that I am a pragmatic idealist.? I have strong beliefs, but I also have a strong desire to solve the problem.? Where I run into difficulty is where the problem is ill-constructed, and does not admit a good answer.? Any answer would be subject to numerous qualifications and explanations.? Perhaps I can give some examples:

“What’s my illiquid structured finance bond worth?”

Oh my.? Whether residential mortgage, commercial mortgage, or asset-backed, that depends a lot upon future loss activity across the whole financial sector.? Typically I only get this question when the bond is worth little, but the entity thinks it is worth a lot, but can’t get a bid anywhere near that.? Often they have been misled by third-party pricing services doing a facile job in exchange for a fee.

“How will this equity portfolio behave versus the market?”

Ugh. Beta is unstable, and estimates often lead to erroneous conclusions.? More detailed modeling can come up with a reasonable answer, but also state that the correct beta is a weak tendency, and is swamped by other effects.

“This investment will eventually come back, right?”

No.? Most will, but not all will.? Some do go to zero, or something really close.? Mean-reversion exists in the markets, and over long time periods it is strong on average, but in specific over short horizons it does not work.

“What’s the interest rate sensitivity of this illiquid structured finance bond?”

Often there is not a good model of prepayment/extension risk.? Or, the model exists, but the security in question is dominated by credit risk.? Will that tranche pay off or not?? In such a situation, the wrong question is being asked, because interest rate risk is not the main risk.

“What’s the right spread to Treasuries for this illiquid bond?”

Sorry, but the answer will be regime-dependent, and will vary by the liquidity of the era.? During times of high liquidity, it will trade near liquid bonds of similar risk.? In times of low liquidity, it will trade far behind its liquid cousins.

What’s the right yield tradeoff between bonds of different credit quality classes?

Again, it varies.? Even across a whole cycle, there is no right answer.? Personally, I would try to estimate the likelihood, subjectively, that we would enter the other side of the cycle within the life of the asset in question.? There are boom valuations, and bust valuations, and scarce little time in-between.

“Just Gimme the Answer, Will Ya?!? I need an Answer!”

Yeah, I got it.? I’m a practical man also, but I try to understand where I can go wrong.? Process is as important as the result.? For many investors, institutional as well as retail, they don’t understand the broader environment that we are in, and they think there are these long term averages that don’t vary that much.? Just invest, and you will make good money over a 2-5 year period.

Sorry, but life is more variable than that.? Investment processes are a function of human processes.? Where humans play a game of follow-the-leader for a long time, with positive results, the cycle will be long, and the unwind severe.? Truth is, the real economy grows at a 1-3%/year rate in inflation adjusted terms, with a lot of noise, absent rampant socialism, or war on our home soil.? The result over the long term should not be much more than 2% more than bond returns, with moderate risk.

You mean there are no answers?

No, there are answers, but there are confidence bands around the answers, and the answers are subject to the overall well-being of the financial economy.? We are playing a complex game here, because the boom-bust cycle is less than predictable on average.? Thus the advantage goes to those that play with excess margin, particularly when things are running hot, and they? pull back.? It is a tough discipline to maintain, but it yields results over the long term.

I will say it this way: focus on where we are in the risk cycle, and? it will aid you in where to invest.?? As Buffett says, “Be greedy when others are fearful, and fearful when others are greedy.”

I encourage caution.? Ask what can go wrong.? Consider what a prolonged downturn in the economy would do.? If the answer is “little,” then be a man and take real risks.

Be skeptical, but don’t be paralyzed in decision-making.? Look to the long-run as a weak tendency, and realize that over many years and with moderate certainty, the trend will revert on average, buit not necessarily for individual investments.

So what should I do?

• Keep a reserve fund of safe assets.
• Be skeptical of short, intermediate, and long-term results, but for different reasons.
• Resist trends during normal times, but during times of extreme movement, let it run.
• Always consider what could go wrong.? WHat is the upside and the downside, and the likelihood of each.

There is no single formula or answer for all investment problems, but a conservative attitude, and a reasonable analysis of where we are in the risk cycle will help.