Category: Personal Finance

Asset Value Illusion

Asset Value Illusion

Posted on by David Merkel

Are some Baby Boomers retiring because the current value of their assets is?high? ?This article from Bloomberg gives an ambivalent answer to the question. ?Personally, I don’t know the answer to that question, but I can answer a related question: In the current market environment, where interest rates are low and stock valuations?are high, should Baby Boomers accelerate their retirements?

The?answer is no. ?Here’s why: in retirement, you aren’t earning income from wages. ?You need income to be able to pay for expenses. ?If?interest rates are low and?stock valuations?are high, you won’t be able to create much income relative to your assets.

It’s like owning a long bond that you intend to buy and hold for the income. ?Do you care that interest rates have fallen, and the value of your bond is above where you bought it? ?No. ?It doesn’t give you any more income. ?If you sold it, where would you reinvest to get more income at equivalent risk?

Let me digress: rather than looking at asset values, look at anticipated cash flow streams. ?Have you grown you anticipated cash flow stream? ?In a bull market, many look like geniuses, but if it is only due to a rise in valuations, it means that the cash flow streams are unchanged.

I realize this is a harder way to look at the markets, but for those that have managed the interest rate risk at life insurers, this is the way the best do it. ?Have you created a higher income rate over the funding horizon? ?That is true improvement of the economic position.

Don’t merely look at the current value of your assets. ?That is an illusion of the true value in terms of income. ?Think of it this way. ?Say that you have surpassed your prior peak assets of 2007 recently in 2014. ?Now look at the income you could have purchased in 2007 (use the long bond as a proxy — 5%), versus what you could buy today — 3.4%. ?The ability to generate income is reduced by 30%+.

You might argue that the long bond is the wrong proxy — too long, too safe. ?I would argue that the safety is necessary. ?If you want to take more risks in fixed income, go ahead, but that is an option. ?As for length, the length?is close to what is needed, but if you used 20-year bonds, the argument would not change.

Final Notes

You might think you have a lot of money, but how much income can it generate? ?Are you protected against inflation? Deflation? Credit risk? ?Don’t assume because the asset balance is high that you are necessarily better off, because you might not be able to earn as much income off your assets.

Playing for Pennies, Risking Dollars

Playing for Pennies, Risking Dollars

Posted on by David Merkel

I try to avoid investments where the upside is limited, but the downside is unlimited. ?That’s the way I feel about junk bonds now. ?Have junk?yields been lower?before?? No, we have eclipsed the time in 2013 when the junk?market was in a yield frenzy, until Bernanke uttered the word “taper.”

There are a lot of desperate retirees seeking income, assuming it is free, and not merely a return of capital. ?There are a lot of desperate people seeking certainty in investing and do not realize that dividends are a handmaiden of value, and not value itself.

There are a lot of desperate pension plans looking to make up for lost time, and hoping against hope, buying dividend paying and growth stocks, high-yield bonds, alternatives like hedge funds, private equity, etc., at the wrong time.

Those are the things you should buy when stocks are cheap and people are scared to death. ?You sell them when people are confident, and valuations are high.

Valuations are high; not nosebleed high as in 2000, but high as in comparable to the peak in 2007. ?Could things go higher? ?Yes, but you are playing for pennies and risking dollars in the process. ?Those with a value and quality discipline will likely fare better in the process, but markets are messy, and what actually happens will be a surprise.

Thus I would encourage you to consider the credit quality of your stocks and bonds. ?What kind of shock could they withstand? ?When yields?are?low, like they are now, the system is less resilient to credit crises. ?Be aware, and be on your guard.

 

Look to the Liabilities to Understand the Assets

Look to the Liabilities to Understand the Assets

Posted on by David Merkel

There’s a puzzle of sorts in asset allocation, and it falls under the rubric of uncorrelated returns. ?When a new asset class arrives, and it is small and few invest in it — lo, it is uncorrelated!

But then the word spreads, and more investors begin investing in the alternative asset class. ?This has two effects:

  1. It drives up the price of the alternative assets, temporarily boosting performance, and
  2. It makes the asset class returns more sensitive to the actions of large institutional investors, such that the correlations rise with stocks and other risk assets.

How an asset is funded matters a great deal as to future price performance. ?I often talk about strong hands and weak hands in investing, but I can make it simple:

  • Strong Hands — Well capitalized, little debt, and what debt there is, is long-dated. ?Such people can buy assets and ride out storms, not worrying about mark-to-market losses.
  • Weak Hands — Poorly capitalized, much debt, and what debt there is is short-dated. ?A storm will capsize them, making them forced sellers of the assets they acquired with debt.

Buffett understands this. ?His insurance companies have relatively low underwriting leverage, but they benefit from high allocations to stocks. ?He can own stocks because there is a core amount of liabilities that will fund the stocks that he owns.

Think of housing for a moment. ?Asset prices were highest when the ability to use short-term low-cost financing was abundant. ? Eventually, there was no demand for housing when prices would lock in losses for buyers who would rent the property out.

If an asset is owned by entities that have weak financing, there is a real risk of loss if the financing can’t be maintained. ?You become subject to the credit cycle, which governs much of investing. ?Invest when credit spreads are wide; don’t invest when they are narrow.

I know that advice is vague, but that’s a part of the game. ?You have to adjust the riskiness of your portfolio to overall conditions, and resist trends, if you want to make money over the long run.

How people and other entities fund the assets that they own has an effect on the future price performance, because it affects how they might buy or sell.

 

On a Letter From A Younger Friend

On a Letter From A Younger Friend

Posted on by David Merkel

A younger friend of mine sent me an email asking for investment advice. ?Here is the redacted version of it:

 

I’m not sure if you are aware of a blog called mrmoneymustache.com. The guy who runs the blog retired in his late twenties just working a software development job. Granted, he was really fortunate to have graduated college and started his career in the dot-com bubble, but he didn’t have a really high-paying job by any means during that time. Anyways, his main strategy was saving 70-80% of his income and investing heavily into Vanguard index funds. He stopped contributing to his 401Ks early on and started putting the rest of his savings into taxable accounts with Vanguard (index funds) in order to retire early and withdraw his 4% from his portfolio every year for living expenses. I think it’s a pretty interesting blog and might be worth checking out if you had the time. I’d be really interested in your general thoughts about him and his blog and if you think he gives wise investing advice.

[Wife] and I both have IRAs ([Wife] has a traditional 401k and I have a Roth). [Wife]?actively?contributes to her 401k every?paycheck and I think it has about $XX in it. I put the max contribution amount into my Roth every year, currently $XXXX, and it is at about $XX. I always hear it’s important to max out your tax deferred and tax free accounts before opening a taxable account. I think we’re at the point where I want to start investing in a taxable account. I like Vanguard and their low expense ratios and I know index funds outperform actively managed funds in the long-term.

?I was thinking about opening a vanguard taxable account and starting off small (5-6k) with my investments into VTSMX and VFWIX with a 50/50 split. Do you think this would be a wise move? I don’t want our money sitting in savings accounts and not even keeping up with inflation. I almost feel like it’s foolish not to invest as much as possible.

Anyways, looking forward to your response and thoughts on MMM and his blog.

Thanks Dave!

First, I want to commend you for making an effort to save and invest early. ?Most people don’t do that, and it is a major reason why they never become financially secure.

Second, I want to thank you for introducing me to Mr. Money Mustache. ?As one that has sported a full beard for the last 20+ years, I can appreciate the name. ?He saved lots of money in his twenties, and invested it in stock index funds at Vanguard. ?I am a Vanguard fan also, though I use them less often now, because my stockpicking has done well.

MMM reminds me of a more severe version of Dave Ramsey, minus the Christianity. ?If you can deny yourself in the early years, work hard, keep expenses down, and build up a nest egg early, wow, do it. ?Most people can’t do that. ?You and your wife have already accumulated more than most have at similar ages. ?Keep it up. ?Having a bias against unnecessary spending is a good thing. ?When my kids ask me why we don’t get new cars, I tell them that they run, and I will drive them until the cost of maintaining them is greater then the cost of buying and maintaining another car over the long run.

It is wise to avoid too much debt, and wise to pay it down early. ?I have been debt-free for the past 11 years, including the mortgage. ?Excluding the mortgage, 22 years. ?It changes you, and frees you, because when you don’t have worries over paying debts, you don’t have the same degree of concern of are you going to run into financial trouble.

In inflation-adjusted terms, you are roughly as well-off as my wife and I were when we were your average age. ?Good job, and keep it up.

Third, you are young, so investing 50/50 in US/Foreign Total equity index funds from Vanguard is fine, especially the Foreign part of it. ?I say that because the US Stock Market is priced to deliver 5.5%/year returns for the next 10 years. ?Foreign markets offer more return now. ?When MMM was investing his savings the market was priced to earn 9-13% or so per year.

This brings up another point. ?I don’t like earning nothing on my money, as it is with most banking and savings accounts, but sometimes that is the best option. ?In September of 2000, the US stock market was priced to earn -2%/year returns for the next 10 years. ?That was a time to throw stocks out the window. ?I didn’t do that, and my value investing made money in 2000 and 2001, though I got whacked hard in 2002.

Not every moment in the market offers the same degree of opportunity to make money. ?To the degree that you can, be ready to invest when markets have fallen, and things look bad. ?If you want to be clever, after a severe fall invest after the S&P 500 is higher than its 200-day moving average.

But investing regularly to some degree immunizes market environments. ?You will invest in good times and bad. ?In the end, the discipline will benefit you. ?You have saved, invested, and did not panic when things went bad. ?You lived to prosper when things went good.

But, you might tilt your US assets to the US value index fund, and if Vanguard has a foreign value index fund, you might do that as well. ?Value outperforms over the long haul, so do that if you can. ?If small stock valuations weren’t so high now, I would tell you to look for small cap value, but I won’t, it doesn’t make sense now.

Fourth, yes, start the taxable brokerage account with your excess money. ?I started mine at age 29, and the economic help it has been to me has been significant. ?I would not have been able to start my business in 2010 if I had not done that. ?Or survive the low earnings years 2008-2012.

Fifth, all that said, I have one more insight to add. ?I’m sure that MMM enjoys his life and works, even though he is “retired.” ?The Bible warns us about not wearing ourselves out to get rich, in Proverbs and Ecclesiastes. ?Hey, it is nice to live off of a passive income, but the Lord made us to work six days, and rest on the seventh. ?Work is an ordinary part of life even if you are managing your assets, and it is to be enjoyed.

What MMM suggests may be harder to bear than many people are capable of bearing. ?We should appropriately enjoy life and not be misers. ?The Larger Catechism in talking about the Eighth Commandment encourages us to enjoy what God has given us. ?As we prosper, we should thank God for it, and enjoy it.

You have a wonderful wife, and that is reward enough. ?But save and invest in good times and bad, and it will work out far better for you than those that don’t do so.

The Good ETF, Part 2 (sort of)

The Good ETF, Part 2 (sort of)

Posted on by David Merkel

About 4.5 years ago, I wrote a short piece called?The Good ETF. ?I’ll quote the summary:

Good ETFs are:

  • Small compared to the pool that they fish in
  • Follow broad themes
  • Do not rely on irreplicable assets
  • Storable, they do not require a ?roll? or some replication strategy.
  • Not affected by unexpected credit events.
  • Liquid in terms of what they repesent, and liquid it what they hold.

The last one is a good summary.? There are many ETFs that are Closed-end funds in disguise.? An ETF with liquid assets, following a theme that many will want to follow will never disappear, and will have a price that tracks its NAV.

Though I said ETFs, I really meant ETPs, which included Exchange Traded Notes, and other structures. ?I remain concerned that people get deluded by the idea that if it trades as a stock, it will behave like a stock, or a spot commodity, or an index.

What triggered this article was reading the following article:?How a 56-Year-Old Engineer?s $45,000 Loss Spurred SEC Probe. ?Quoting from the beginning of the article:

Jeff Steckbeck?didn’t?read the prospectus. He?didn’t?realize the price was inflated. He?didn’t?even know the security he?read?about?online was something other than an exchange-traded fund.

The 56-year-old civil engineer ultimately lost $45,000 on the wrong end of a?volatility?bet, or about 80 percent of his investment, after a?Credit Suisse Group AG (CSGN)?note known as TVIX crashed a week after he bought it in March 2012 and never recovered. Now Steckbeck says he wishes he?d been aware of the perils of bank securities known as exchange-traded notes that use derivatives to mimic assets from natural gas to stocks.

?In theory, everybody?s supposed to read everything right to the bottom line and you take all the risks associated with it if you don?t,? he said this month by phone from Lebanon,?Pennsylvania. ?But in reality, you gotta trust that these people are operating within what they generally say, you know??

No, you don’t have to trust people blindly. ?Reagan said, “Trust, but verify.” ?Anytime you enter into a contract, you need to know the major features of the contract, or have trusted expert advisers who do know, and assure you that things are fine.

After all, these are financial markets. ?In any business deal, you may run into someone who offers you something that sounds attractive until you read the fine print. ?You need to read the fine print.? Now, fraud can be alleged to those who actively dissuade people from reading the fine print, but not to those who offer the prospectus where all of the risks are disclosed. ?Again, quoting from the article:

Some fail to adequately explain that banks can bet against the very notes they?re selling or suspend new offerings or take other actions that can affect their value, according to the letter.

[snip]

?My experience with ETN prospectuses is that they?re very clear about the fees and the risks and the transparency,? Styrcula said. ?Any investor who invests without reading the prospectus does so at his or her own peril, and that?s the way it should be.?

[snip]

The offering documents for the VelocityShares Daily 2x?VIX (VIX)?Short Term ETN, the TVIX, says on the first page that the security is intended for ?sophisticated investors.? The note ?is likely to be close to zero after 20 years and we do not intend or expect any investor to hold the ETNs from inception to maturity,? according to the prospectus.

While Steckbeck said a supervisor at Clermont Wealth Strategies advised him against investing in TVIX in February 2012, he bought 4,000 shares the next month from his self-managed brokerage account. The adviser, whom Steckbeck declined to name,?didn’t?say that the price had become unmoored from the index it was supposed to track.

David Campbell, president of Clermont Wealth Strategies, declined to comment.

Steckbeck, who found the TVIX on the Yahoo Finance website, doesn?t have time to comb through dozens of pages every time he makes an investment, he said.

?Engineers — we?re not dumb,? said Steckbeck, who founded his own consulting company in 1990. ?We?re good with math, good with numbers. We read and understand stuff fairly quickly, but we also have our jobs to perform. We can?t sit there and read prospectuses all day.?

If you are investing, you need to read prospectuses. ?No ifs, ands, or buts. ?I’m sorry, Mr. Steckbeck, you’re not dumb, but you are foolish. ?Being bright with math and science is not enough for investing if you can’t be bothered to read the legal documents for the complex contract/security that you bought. ?I read every prospectus for every security that I buy if it is unusual. ?I read prospectuses and 10-Ks for many simple securities like stocks — the managements must “spill the beans” in the “risk factors” because if they don’t, and something bad happens that they didn’t talk about, they will be sued.

In general I am not a fan of a “liberal arts” education. ?I am a fan of math and science. ?But truly, I want both. ?We homeschool, and our eight kids are “all arounds.” ?They aren’t all smart, but they tend to be equal with verbal and quantitative reasoning. ?Truly bright people are good with both math and language. ?Final quotation from the article:

?The whole point of making these things exchange-traded was to make them accessible to retail investors,? said?Colbrin Wright, assistant professor at?Brigham Young University?in Provo,?Utah, who has written academic articles on the indicative values of ETNs. ?The majority of ETNs are overpriced, and about a third of them are statistically significant in their overpricing.?

So, I contacted Colby Wright, and we had a short e-mail exchange, where he pointed me to the paper that he co-wrote. ?Interesting paper, and it makes me want to do more research to see how great ETN prices can be versus their net asset values [NAVs]. ?That said, end of the paper errs when it concludes:

We assert that the frequent and persistent negative WDFDs [DM: NAV premiums] that appear to be driven by?uninformed return chasing investors would not exist to the conspicuous degree that we observe if ETNs?offered a more investor-driven and fluid system for share creation. We believe the system for share?creation is ineffective in mitigating the asymmetric mispricing investigated in our study. Hence, we?recommend that ETN issuers reformulate the share creation system related to their securities.?Specifically, we recommend the ETN share creation process be structured to mirror that of ETFs. At a?minimum, the share creation process should be initiated by investors, rather than by the ETN issuers?themselves, as we believe profit-motivated investors will be more diligent and responsive in creating?ETN shares when severe mispricing arises.

Here’s the problem: ETNs are debt, not equity. ?To have the same share creation system means that the debtor must be willing to take on what could be an unlimited amount of debt. ?In most cases, that doesn’t work.

So I come back to where I started. ?Be skeptical of complexity in exchange traded products. ?Avoid complexity. ?Complexity works in favor of the one offering the deal, not the one accepting the deal. ?I have only bought one structured note in my life, and that was one that I was allowed to structure. ?As Buffett once said (something like this), “My terms, your price.”

To close, here are four valuable articles on this topic:

So avoid complexity in investing. ?Do due diligence in all investing, and more when the investments are complex. ?I am astounded at how much money has been lost in exchange traded investments that are designed to lose money over the long term. ?You might be able to avoid it, but someone has to hold every “asset,” so losses will come to those who hold investments long term that were designed to last for a day.

I?m Not in This for Love

I?m Not in This for Love

Posted on by David Merkel

Much as I appreciate those who like what I write at this blog, I don’t write to be loved. ?I don’t write to be hated, either. ?I am sensitive to what people think of me, but not to the degree that it changes what I write.

I may have nonconsensus views on:

  • The Federal Reserve
  • Gold
  • Social Security & Medicare (and their cousins around the globe)
  • The current Bull Market in Stocks and Corporate Bonds
  • Long Treasuries
  • and more…..

But I write what I write to disclose the truth. ?I am an active equity manager, but I encourage people to use passive investing via index funds, unless they can find a manager who can reliably obtain outperformance.

I don’t blog for economic advantage. ?If I wanted to do that, I could channel a wide variety of ideas on investing that are popular, but I know are marginal at best in terms of effectiveness.

Some friends of mine have told me, “Why don’t you write about companies that you own, or companies that look attractive to you?”

I’ve been burned by doing that. ?For every ten that you get right, you get the same response from every one you get wrong. ?As with most of the web, the complainers dominate. ?That’s why I don’t trot out many individual stock ideas. ?It’s not that I don’t have them, but I only share them as a group, not as a single idea, most of the time.

Summary

I’m here to tell the truth, even if it cuts against my own short-term economic interests. ?Most of the time, I adjust my portfolio so that it is ready for everything, but sometimes I delay, because I know that changes in the market usually happen slowly.

I do not write to be popular. ?I write to change the consensus, unlikely as that will be. ?Finance is a perverse area of life where fear and greed take over. ?And with academics, they have these lame models that are fit for Vulcans (maybe) but not humans (and certainly not Ferengi).

We need new models that reflect the fear-greed cycle, and make valuation a significant input in risk assessments.

I’m not in this for love; I only want to change the way that we view investment decisions.

To Live off of, and Die from, the Equity Premium and Alpha

To Live off of, and Die from, the Equity Premium and Alpha

Posted on by David Merkel

I’m working on my taxes. ?I’m not in a good mood. ?Okay, writing that made me chuckle, because I am usually in a good mood.

Let me divide my working life into four segments:

  • 1986-1998: Actuary — reasonably well paid, and significantly underpaid compared to the value I delivered.
  • 1998-2007 — Investment risk manager, Mortgage bond manager, Corporate bond manager, and Senior Analyst at a long/short hedge fund. ?Paid well for my efforts, and the ?rewards to clients were far more than what I was paid.
  • 2007-2010 — Almost no pay, as I deal with home issues, provide research to a small minority broker-dealer, and try to gain institutional asset management clients. ?Living off of assets from earlier days.
  • 2010-2014 — Living off of asset income as I slowly build a retail and small institutional client base for my value investing.

The last two periods are the most interesting in a way, because I was drawing more income from investments than I was from any other source. ?Even during my time at the hedge fund, I made more money from my own investing every year than I was paid, and I was paid well. ?That said the mid-2000s were a hot time, particularly if you made the right calls on a growing global economy.

My net worth today is roughly where it was at the peak of the markets in 2007, despite my low wage income. ?I have been bailed out by the returns of the equity market and my alpha.

This is not a comfortable place to be, because general equity returns are not predictable, and alpha, though I have had it for years, is not predictable either. ?That said, my client base has been growing, and in another year or so, my practice should support my family even if the markets don’t do well.

=-=-=-=-=-=–==-=-=–=-==-=–=-==–=-=-=-=-==-=–=-==-=-=-=-=-=-=-=-=-=-=-

Though I just told a story about me, the real story isn’t about me. ?Think of all of the people who are trying to manage their lump sum in retirement. ?They are relying on strong equity markets; they are hoping for alpha. ?They are not ready for setbacks.

Unless you are seriously wealthy, when you are not receiving reliable income from a wage-like source, you can feel like you are in a weak position. I have felt that on occasion, but in general ?I have not worried.

I write this because equity outperformance over bonds will likely be limited over the next ten years. ?I peg equities at about a 5%/year average nominal return, with a diversified portfolio of bonds at around 2-3%/year. ?Also the ability to add alpha is limited, because alpha is zero in total, and are you smart enough to find the managers that can do it?

In desperate times desperate men do desperate things. ?Low interest rates are leading many to speculate more than they ordinarily would. ?Equity allocations go higher. ?Allocations to “alternatives” go higher. ?People start using nonguaranteed income vehicles as if they had the structural protections of bonds.

As I always say, be careful. ?Those trying to manage a lump sum for income in retirement are playing a dangerous game where if you try to draw more than 3.5%/year with regularity will prove challenging, because that is playing at the boundary of what the assets can deliver, and leaves little room for an adverse scenario. ?Be careful.

Best of the Aleph Blog, Part 24

Best of the Aleph Blog, Part 24

Posted on by David Merkel

These articles appeared between November 2012 and January 2013:

On Time Horizons

Investment advice without a time horizon is not investment advice.

This Election Will Solve Nothing

So far that is true of the 2012 elections.

NOTA Bene

We need to add “None of the Above” as an electoral choice in all elections.

Eliminating the Rating Agencies, Part 2

Eliminating the Rating Agencies, Part 3

Where I propose a great idea, and then realize that I am wrong.

The Rules, Part XXXV

Stability only comes to markets in a self-reinforcing mode, from buy and hold (and sell and sit on cash) investors who act at the turning points.

The Rules, Part XXXVI

It almost never makes sense to play for the last 5% of something; it costs too much. Getting 90-95% is relatively easy; grasping for the last 5-10% usually results in losing some of the 90-95%.

Charlie Brown the Retail Investor

Where Lucy represents Wall Street, the football is returns, and Charlie Brown is the Retail Investor. Aaauuuggh!

On Hucksters

Why to be careful when promised results seem too good, and they get delayed, or worse.

Bombing Baby BDC Bonds

Avoid bonds with few protective covenants, unless the borrower is very strong.

On Math Education

Why current efforts to change Math Education will fail. ?Pedagogy peaked in the ’50s, and has been declining since then.

On Human Fertility, Part 2

On the continuing decline in human fertility across the globe.

If you Want to be Well-off in Life

Simple advice on how to be better off. ?Warning: it requires discipline.

Young People Should Favor Low Discount Rates

If we had assumed lower discount rates in the past, we wouldn’t have the problems we do now. ?(And maybe DB pensions would have died sooner.)

Problems in Life Insurance

On why we should be concerned about life insurance accounting.

Investing In P&C Insurers

On why analyzing P&C insurers boils down to analyzing management teams.

Selling Options Cheaply (Did You Know?)

Naive bond investors often take on risks that they did not anticipate.

Book Review: The Snowball, Part One

Book Review: The Snowball, Part Two

Book Review: The Snowball, Part Three

Book Review: The Snowball, Part Four

Book Review: The Snowball, Epilogue

My review of the most comprehensive book on the life of Warren Buffett.

On Watchlists

How I met one of the Superinvestors of Graham-and -Doddsville, and how I generate investment ideas.

Why do Value Investors Like to Index?

How I admitted to not having ?a correct perspective on value indexing.

Evaluating Regulated Financials

Why regulated financials are different from other stocks, and how to analyze them.

Locking in a Smaller Loss

Why people are willing to lock in a loss against inflation, because of bad monetary policy.

Why I Sold the Long End

Great timing.

The Evaluation of Common Stocks

Value investing is still powerful, but the competition is a lot tougher.

The Order of Battle in Financial Planning for Ordinary Folks

The basics of personal finance

Sorting Through the News

How to use my free news screener to cut through the news flow, and eliminate noise.

On Financial Blogging

So why do we spend the time at this?

Matching Assets and Liabilities Personally

How to manage investments to fit your own need for cash in the future.

Penny Wise, Pound Foolish

How short-sighted, incompetent managers destroy value.

Expensive High Yield ? II

No such thing as a bad trade , only an early trade… high yield prices moved higher from here.

2012 Financial Report of the US Government

Chronicling the financial promises made by the Federal Government

On Insurance Investing, Part 1

On Insurance Investing, Part 2

On Insurance Investing, Part 3

The first three parts of my 7-part series on how to understand this complex group of sub-industries.

How to Become Super-Rich?

Even Buffett didn’t get super-rich by only investing his own money. ?He had to invest the money of others as well. ?The super-rich form corporations and grow them; they build institutions bigger than themselves.

The Product that Never saw the Light of Day

On the Variable Annuity product that would simply be a tax scam. ?Later I would learn that product exists now, just not in the form I proposed 8 years earlier when it didn’t exist.

Book Review: “The Up Side of Down”

Book Review: “The Up Side of Down”

Posted on by David Merkel

Failure. We’ve all experienced it. Can we benefit from it?? The answer is maybe, depending on the costs of failure.

If the costs of failure are high, e.g., repaying debts for the rest of life, people will avoid taking risks.? As a result, society will stagnate, because few take risks.

But if the costs of failure are low, people will take more chances, start more businesses, try experiments that might prove something bold.? That is one great thing about America; the penalties for failure are low.? Some have said we are the land of unlimited second chances.? After resigning from the presidency, Richard Nixon became an influential voice on foreign policy.

Megan McArdle uses her own life and many other societal problems to illustrate how a proper use of failure? can benefit individuals and society as a whole.? Failure is how we learn.? As some have said, “The wise learn from the failures of others, normal people learn from their own failures, but the stupid don’t learn.”

I enjoyed this book a great deal, but I want to point out a few of the chapters that particularly struck me.

In Chapter 8, she described the various ways that ideologues described the causes of the financial crisis.? The Left and the Right chose their own monologues to explain the economic failure that occurred.? The truth was far more banal, as average people bought into a housing mania, with financial institutions more than willing to facilitate it, levered as they were.? When the bull market ended, many people found themselves with too much debt relative to the value of their houses.

Chapter 9 was the one from which I learned the most, as it described a probation method used in Hawaii, that I would describe as the judicial equivalent of spanking.? When one on probation violates a term of probation, he gets sent to a rather grim prison for a short period of time.? Like spanking, it is short, and sharp.? Those on probation get tested randomly and regularly.? Most quickly get the idea that they need to change their lives.? The recidivism rate on this program is low.? Small failures get punished.? Resistance to the system means permanent jail.? No failures means freedom.

But what I really appreciated in the book was the willingness of the author to expose her own life failures — jobs, caring for her mother’s health, bad relationships, etc.? She learned from her mistakes, and ended up with a husband who loves her, a good job, and a home in DC, where there is not much debt on the property.? Well done.

My own life has had its share of failures, and they have all taught me something.? The question to you, reader, is what have you learned from your failures?? Memorialize failures, so that you can avoid them and their cousins in the future.? In that sense you can fail well.

There is not a bad chapter in this book.? I recommend it highly, and you will learn a lot.? I learned a lot.

Quibbles

None.

Who would benefit from this book: Anyone could benefit from this great book.? If you want to, you can buy it here: The Up Side of Down: Why Failing Well Is the Key to Success.

Full disclosure: The PR people offered me a book, and I accepted it.? I am glad that I did.

If you enter Amazon through my site, and you buy anything, I get a small commission.? This is my main source of blog revenue.? I prefer this to a ?tip jar? because I want you to get something you want, rather than merely giving me a tip.? Book reviews take time, particularly with the reading, which most book reviewers don?t do in full, and I typically do. (When I don?t, I mention that I scanned the book.? Also, I never use the data that the PR flacks send out.)

Most people buying at Amazon do not enter via a referring website.? Thus Amazon builds an extra 1-3% into the prices to all buyers to compensate for the commissions given to the minority that come through referring sites.? Whether you buy at Amazon directly or enter via my site, your prices don?t change.

 

An Expensive Kind of Insurance

An Expensive Kind of Insurance

Posted on by David Merkel

Strategy One: “Consistent Losses, with Occasional Big Gains when the Market is Stressed”

Strategy Two: “Consistent Gains, with Total Wipe-out Risk When Market is Highly Stressed”

How do these two strategies sound to you?? Not too appealing?? I would agree with that.? The second of those strategies was featured in an article at Bloomberg.com recently — Inverse VIX Fund Gets Record Cash on Calm Market Bet.? And though the initial graph confused me, because it was the graph for the exchange traded note VXX, which benefits when the VIX spikes, the article was mostly about the inverse VIX?exchange traded note XIV.

Why would someone pursue the second strategy?? Most of the time, it makes money, and since January 2011 we haven’t a horrendous market event like the one from August 2008 through February 2009, it makes money.

I would encourage you to look at the decline in the second half of 2011, where it fell 75% when the VIX briefly burped up to around 50.? But given the amazing comeback as volatility abated, the lesson that some investors drew was this: “Volatility Spike? Time to buy XIV!”? And that explains the article linked above.

You might remember a recent book review of mine — Rule Based Investing.? In that review, I made the point that those that sell insurance on financial contracts tend to win, but it is a volatile game with the possibility of total loss.? To give another example from the recent financial crisis: most of the financial and mortgage insurers in existence prior to 2007 are gone.? Let me put it simply: though financial risks can be insured, the risks are so volatile that they should not be insured.? You are just one colossal failure away from death, and that colossal failure will tend to come when everyone is certain that it can’t come.

But what of the first strategy?? How has it done?

Wow!? Look at the returns over the last few weeks!? Rather, look at a strategy that consistently loses money because it rolls futures contracts for the VIX where the futures curve is upward-sloping almost all the time, leading to buy high, sell low.

Does it pay off in a crisis?? Yes.? Can you use it tactically?? Yes.? Can you hold it and make money?? No.

Back to the second strategy.? People are putting money into XIV because they “know” that implied volatility always mean-reverts, and so they will make easy money after a volatility spike.? But what if they arrive too early, and volatility spikes far higher than expected?? Worse yet, what if Credit Suisse goes belly-up in the volatility?? After all, it is an exchange-traded note where owners of XIV are lending money to Credit Suisse.

Back to Basics

Do I play in these markets?? No.

Do I understand them?? Mostly, but I can’t claim to be the best at this.

What if I try both strategies at the same time?? You will lose.? You are short fees and trading frictions.

What if I short both strategies at the same time?? Uncertain. It comes down to whether you can hold the shorts over the long term without getting “bought in” or panic when one side of the trade runs the wrong way.

Recently, someone pinged me to speak to CFA Institute, Baltimore, where he wanted to talk about “not all correlations of risky assets go to one in a crisis” and pointed to volatility investing as the way to improve asset allocation.? Sigh.? I’m inclined to say that “you can’t teach a Sneech.”

I favor simplicity in investing, and think that many exchange traded products will harm investors on average because the investors do not understand the underlying economics of what they own, while Wall Street uses them as a cheap way to hedge their risk exposures.

There may be some value to speculators in using “investments” like strategy one for a few days at a time.? But holding for any long time is poison.? Worse, if you are accidentally right, and the world comes to an end — this is an exchange-traded note, and the bank you lent to will be broke.? That will also kill strategy two.

So, my advice to you is this: avoid either side of this trade.? Stick with simple investments that do not invest in futures or options.? Complexity is the enemy of the average investor.? I can understand these investments and they don’t work for me.? You should avoid them too.

PS — before I close, let me mention:

Good article in both places.

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