Personal Finance – Page 17

On Bond Ladders

Posted on 28 June 2012 by David Merkel

I received the following from a reader:

My primary motivation for writing to you is this post by Jeff Miller:

http://oldprof.typepad.com/a_dash_of_insight/2012/06/the-quest-for-yield-part-7-what-about-bonds.html

In my mind, you are the foremost expert blogger when it comes to bonds so I wanted to get your take.? It’s been a long time since my bond class getting my MBA and I haven’t dealt with bond math in quite awhile.

I’m wondering about this whole individual bond ladder versus bond fund issue.? Maybe I?am wrong so I wanted to ask you.? Duration is duration.? Whether one owns an individual bond ladder or a bond fund, if the duration is the same, the price sensitivity to an increase in interest rates is the same?? If a person owns an individual bond ladder and rates move up, those bonds will be marked to market and show a capital loss even if they pay off at par at maturity, and you’ve locked in your cashflow.? With a bond fund, you take a price hit to the fund, but those cashflows from the fund get reinvested in the fund at lower prices and higher yields?

I guess I am just wondering if someone is going to buy and hold and sit tight for?say 5-7 years whether they construct a bond ladder or buy a?bond fund if the duration is the same, they are going to end up pretty much in the same place 5 years later.

Anyways, I hope maybe you will do a post on the ins and outs of bond math vis a vis interest rate changes and the pros and cons of bond funds versus a bond ladder from the perspective of duration.? Thanks.

From 1995-2001, I spent a lot of time doing interest rate modeling.? With the growth in computer power and modeling techniques, we finally hit the barrier of the “Turing test” as far as interest rates went in 1995 with my modeling.? As a part of our regular weekly meeting with the investment department, I brought examples of full yield curve interest rate modeling for a 30-year horizon.? When I showed what the future yield curves looked like, the bond managers said to me, “This is the first time we have ever seen a random model produce interest rate scenarios that look reasonable.”

For a brief period, my model was the best that I knew of.? By 2002 the actuarial profession as a whole came up with a better model, which they still use today for asset/liability management calculations.? Once I used it, I accepted it as better than my model, and used it for other processes beyond regulatory compliance.

Regardless, I did tests using my model and the more advanced model to see what the best strategy was for individual investors in bonds.? The only consistent result was that the ladder strategy was the second best strategy.? Never best.? Never worst. Reliable.

And I spent some time thinking about it.? Structurally, ladders work well when you don’t know what is going to happen.? If you are really, really smart, and you can consistently predict changes in yield curve steepness and levels, yes, you can do far better.

Ladders make sense from a cash flow standpoint because they are a sustainable strategy.? Maturing proceeds are invested in the longest bonds that the ladder accepts.? That keeps the interest rate risk even, and with a positively sloped yield curve, offers a relatively high yield.

I agree with the concept of ladders.? But ladders are not incompatible with mutual funds. Over the years, I have run into mutual funds that embed a ladder concept into their interest rate management strategy, but it is far enough back in time that I can’t name any that do that now. In general, I think most bond mutual funds would be better off if they used some form of ladder to implement their interest rate strategy.

But to your question, yes, there is little difference, aside from fees, whether one owns a mutual fund with the same duration profile as a laddered portfolio.? When you deal with short portfolios, the duration statistic is very descriptive of the interest rate risk.

If someone is looking to invest for many years, in the present environment, stocks may be the better choice, but if limited to bonds, choose a portfio that replicates the time horizon on average.? Then as the horizon draws nearer, adjust to reflect the need for cash paid out.

That’s my best answer for now, though I am more than willing to answer other questions related to this.

Don’t Blame Money Market Funds

Posted on 23 June 201224 June 2012 by David Merkel

So SEC Chairman Mary Shapiro wants money market funds to use mark-to-market accounting, and publish a daily NAV.? Well, why not impose mark-to-market accounting on banks, and force them to report the fair market value of their surplus every day? Large depositors over the guaranty limit and the repo market might be interested in this data.? Oh wait, that’s procyclical, so many claim, even though it reveals cash flow mismatches, which are material to the running of a banking business.

There’s a lot of hypocrisy involved in the SEC’s proposals on money market funds.

Banks are a larger problem.? When money market funds fail, the losses are a couple percent on NAV, versus much larger on banks.
Having a balance sheet enables a bank to postpone the day of reckoning; there are more games to play.
Some banks run “money market funds” that are essentially savings accounts, but do not have identified pools of assets behind them.? In an insolvency, a holder of such is a general creditor after FDIC coverage.
Money market funds cost consumers a lot less than banks in order to provide transactional services.? In one sense, money market funds deserve to exist far more than banks — they have a very low asset liability mismatch, asset quality is very high, and they exist to pass through interest earnings on a short-term portfolio.

Money market funds should be treated like book value ETFs.? They should pass through interest net of fees, and impose credit events should the NAV fall below 0.995. [Link to my letter to the SEC]? This is a simple, stable solution, that would not require any regulation beyond that.? It would keep money market fund losses small, end deliver them to holders, not taxpayers. (Even indirectly, by borrowing from the Fed.)

So there are 300+ cases where the sponsors of money market funds put up money or offered loans where money market funds were about to break the buck.? Where Mary Shapiro sees weakness, I see strength.? Isn’t it great that financial organizations, without being required to do so by regulation, kick in their own funds or liquidity in order to preserve the interests of savers? Most banks could never do the same when they are about to go bust.

Money market funds are a way of avoiding the high expenses of banks, and offer savers a decent rate of return.? If there are losses, holders of the money market fund should bear it through a reduction in units, as described in my proposal, unless sponsors generously want to preserve their franchise.

Consumers get a better deal with money market funds.? Those that are in the pocket of the banks argue against money market funds.? I do not ever want the? government to bail out money market funds, and the US Government erred greatly when they did so in 2008.? Those holding money market funds should have borne their small losses.? There would have been little risk from letting money market funds deliver losses to holders.

Those losses were not the cause of the crisis, but the banks with their bad residential mortgage loans.? That was the crisis, and continues to be so, with so many mortgages underwater.

Best of the Aleph Blog, Part 17

Posted on 19 June 2012 by David Merkel

These articles appeared between February and April 2011:

On the Percentage of Market Cap held by Domestic Stock ETFs

Implications

Domestic stock ETFs tend to pick more volatile stocks.

Domestic stock ETFs tend to pick stocks held by major institutions.

Domestic stock ETFs tend to pick stocks less held by insiders.? (They tend to be more boring.)

Goes Down Double-Speed

Bear markets move at 1.9x the rate of bull markets. (double speed)

Consider the Boom in the Bust; Consider the Bust in the Boom

We would all be better off if policymakers thought at least half a cycle ahead in the credit cycle. Sadly, they are linear thinkers, and would be better off working at the county landfill, if they qualified for such authority.

Critical Analysis of Buffett?s Annual Letter

Critical Analysis of Buffett?s Annual Report

Analyzes Berkshire Hathaway in 2011.? Points at the growth in debt at BRK, and concentration risk in the subsidiaries.

Musings on Yield

Why you should not use yield as a criterion for investment.

On the Usefulness of Yield Spreads

So what does this tell us?

There is a credit factor that effects yields, and the effect on Baa bonds is roughly 1.5x that of Aaa bonds.

As Treasury yields get lower, Baa bond yields rise at roughly 45% of the rate.? There is the nominal yield need ? even Baa bonds tend to need a certain nominal yield, particularly for 20+ year bonds.

Present yield levels are fair for long Baa bonds, to the extent that Moody?s measures them accurately.

On Con Men

So avoid complex investments.? Particularly avoid investments that you don?t understand.? At minimum, find a competent friend, or some neutral party that will look at the deal.? If you can?t find such a friend/party, don?t do the deal.? The friend is important, because he does not want you to come to harm, or lose you as a friend if things go bad.

Three Years from Now

There are real advantages to managing for the intermediate term.

Responding to a Bright Reader

Why I started a bond product.

Things are not as good as they look

Analyzing economic statistics when they don’t sound right.

Limits: Models, Governments, and Central Banks

Most writers say the governments and central banks are all-powerful.? I disagree, and I try to explain why.

Regarding David Sokol

Regarding David Sokol, Redux

Regarding David Sokol, Part 3

Regarding David Sokol, Part 4

The growing sentiment, though ahead of the crowd, that David Sokol should leave Berkshire Hathaway.

Everything Old is New Again in Bonds

On unconstrained mandates and managing for total returns with bonds.

When I was Young

What I went through in investing in my younger days.? Taught me a lot.

When Everything is Strong

When Everything is Strong, Redux

When the only thing weak is high quality bonds, what do you do?

It Would Have Happened Already, Redux

What do you do when all you hear are consensus opinions?

On the Facebook IPO

Posted on 7 June 2012 by David Merkel

If you are a manager of corporate bonds, you get to learn the speculation cycle.? New IPOs may close in weeks if things are cold, and close in minutes if things are hot.

When things are hot in bonds, eventually the syndicate (“Wall Street”) decides that it is time to test the bullishness of buyers.? At such a time, they extend the time of the offering, and either lower the yield spread (raise the price), or increase the size of the deal.

When I was a corporate bond manager, if a deal was upsized by a large amount during a period while the market was hot, I would not buy.? Tough decision, but cutting against the grain is usually a good thing.? My brokers marveled that I was not participating in these large “benchmark” deals.? More often then not, they failed, and I smiled on the sidelines.? The brokers “stuffed” the ignorant buy-side that was all too willing to take risk.? Typically after that, corporate investors were more careful.

I don’t know the right value for Facebook, and I don’t think anyone does.? Too much of the value depends on future decisions, competitor actions, and economic conditions.? Valuing stocks where the positive cash flows are far out into the future is tough, should the cash flows materialize.

The last IPO I bought was Assurant [AIZ] where I was buying the company for <90% of book value,? and 9x earnings.? I’m a value buyer, so I buy companies where prospects are not fairly calculated by the market, but I avoid new issues where the price is outlandish.

Look, Wall Street works on two levels: distribute paper at a slight discount price, until buyers take it for granted and bid aggressively, leading to a mini-crisis, like it is for Facebook now.

Did Wall Street get the best price for Facebook’s current shareholders at the IPO? Probably yes.

Was that the right price? For recent investors, the answer is no.? But in any IPO process there were a wide number of ways to protect themselves:

1) Don’t participate in IPOs. When general valuations in the market? are high, IPO valuations are higher.

2) Avoid buying IPOs in hot sectors, they are often overvalued.? Only go for IPOs in sectors no one cares about, like insurance, where I offer you Assurant [AIZ} and Safety Insurance [SAFT], among others.? (I don’t suppose it helps you to learn that insurers return better than almost any other industry?? Didn’t think so… because it is a boring yet complicated business.? Even Buffett said about Assurant — “too complicated,” and he is one of the greatest insurance executives of all time.)

3) Avoid IPOs where the deal size is upsized.? When a deal is upsized that often means the underwriters are taking advantage of demand, which diminishes the likelihood of any short-term outperformance.? For this point, in the bond market, I would cut my bid, unless I really liked the credit, together with my analyst.

4) Avoid IPOs where the price talk is raised, which also limits the likelihood of any short-term outperformance.? Same thing as a bond manager, I would drop out out if the new yield did not meet my yield needs.

5) Buy IPOs when they are forced to occur and are hated, like my experience with the Prudential “C” bonds, and most mutual insurer conversions.? IPOs are like the market on steroids, you want to avoid them when things a hot, but they are interesting when things are cold.? After all, who wants to IPO when things are cold?? There are occasional situations where legal matters force a company to go public, and that can be an interesting time to be an opportunistic buyer.

6) Avid IPOs where the valuation is stretched.? It may be a great business concept, but can it grow into that fancy valuation?? Unlike Dr. Damodaran, I don’t go in for fancy reasoning that justifies high valuations.? Most investors are better off avoiding high valuation situations, and focus on more down-to-earth types of businesses.? (My recent purchases include: Crude Oil Refining & Transport, Integrated Oil Major, two basic technology companies with forward P/Es under 10, a specialty retailer that is the strongest in its category, and two insurers, one that is a holding company, and one that is a hedge fund.)

7) Finally, avoid IPOs where those that know nothing about investing are interested.? Facebook is a perfect example here, with a large number of users who love the company, but have little idea of how profits are made, or how they will grow.

IPOs are tough, I think tougher than ordinary investing, so? avoid them unless you have an edge that justifies participation.? Be tough on yourself here — what is your edge?? Share it with a friend who has expertise, and see if he agrees with you.? This is not easy stuff, it only seems easy when the market is running hot, and that is a bad place to be when it goes cold.

Full disclosure: long AIZ, for me and clients

Works if Small, Fails if Large

Posted on 3 June 2012 by David Merkel

The Wall Street Journal had an article on risk control that had the attitude of “here are some silver bullets.”? Ugh.? When will journalists learn that there are no simple solutions to portfolio management?

“Risk-allocation turns 50 years of portfolio theory on its head.”

Ain’t true.? Modern Portfolio Theory is garbage, but so is this.? So volatility is more stable than returns.? Volatility can be up or down, and you want to buy volatile asset classes that have gotten trashed.? You won’t do it because you are scared, but that is part of why you aren’t a good investor.? Good investors make the “pain trades.”

Here’s the question to ask: What would happen if everybody did this?? Unlike share-weighted indexing, not all strategies can be applied by everyone at the same time.? I have written about risk parity before:

So long as there are few using the strategy, it may work well, but it will not scale because volatility does not match the proportion of assets available to be purchased.? The same is true of “risk control” and “risk budgeting” strategies.? They will be “flashes in the pan;” there is no necessary reason why they will work.? There is no such thing as risk, but there are risks.

Avoid faddish ideas as described in the WSJ article.? Far better to focus on what risks you face in the investment markets, and choose assets that will not be affected by those risks,or, might even benefit from them.

Using volatility as a guide to investing will fail if it gets large enough, and during bull markets, it will be forgotten.? Non-scalable strategies work if there is a barrier to entry, and there is no barrier here.? Thus I see no long term value in the strategies proposed.

Aim for the Middle

Posted on 1 June 2012 by David Merkel

“Ya gotta take more risk to get more return.”? That’s the street language version of what is commonly trotted out, but it is only half true.

The truth is that moderate risk taking outperforms taking no risk or taking high risks.? This is true in bonds.? BBB bonds return best of all — they are the middle of credit risk.? There is no native group that wants to own them exclusively.? Higher-rated bonds do next best, and junk bonds do worse still on average.

Think of it this way: Those that invest in cash get a low return.? But those that invest in high-risk growth companies also get a low return, on average.? Those that take moderate risk have the best potential of making money.? That is why I focus on investors that take moderate risk relative to their peers.

Moderate risk taking does best on average, at least as far as public capital goes.?? Private capital may have more control and expertise, and can take more risk as a result.? In general, the less control and expertise, the less risk should be taken. With private equity, this is one of the tough truths: Private capital can change matters if it is large enough. Then it has to deal with changing the management of the business.? Public equity does not get there, except in rare cases.

That is a major reason why moderate risk-taking wins on average. In one sense, it is why low volatility investing and value investing work.? You are putting your money at risk, but you are doing so with a margin of safety.? Part of making money is survival; if you don’t survive round one, you won’t make money in round two and the rounds that follow.

That’s why swinging for the fences with stocks doesn’t work.? You get too many strikeouts, and few home runs.? Personally, I try to be a singles hitter in investing.? It’s doable, both intellectually and financially.

This applies to asset allocation as well. 60/40 stocks/bonds does as well as 100% stocks, and with less volatility.? 80/20 stocks/bonds did best the last time I tested — perhaps the true ratio is 70/30 given the outperformance of bonds over stocks over the last decade, but I am reluctant to think so because over the long haul, the best a bond can do is pay its coupon and return the principal.? Even in the case of premium calls, you get your principal back at what is typically an unfavorable time to reinvest.

Another reason to aim for the middle is that you will not get jolted hard during downdrafts, and be tempted to trade out at the maximum point of pain, or, buy in near the peak when the bulls are running their last lap.? A lot of money gets lost that way.

It’s also a reason to hang onto some slack cash or other safe assets, like high-quality noncallable bonds lacking weird features.? It may diminish returns in the short run, but it allows you to stay in the game of investing.? Too many people give up at the wrong time — many friends that I had that gave up on stocks in late 2002 – early 2003, deciding to focus on “what they knew”: residential real estate.? Another group gave up on stocks late 2008 – early 2009, with no place to go with their cash.

Realistic expectations are needed as well.? If you earn more than the growth rate of GDP plus a few percent, count yourself blessed and realize that it is very hard to do that consistently over the long-term.

So aim for the middle: take moderate risks, diversify, be realistic, and adjust your portfolio slowly as conditions change.? Then you can stay in the game, and compound your returns.

Elderly Poor?

Posted on 17 May 2012 by David Merkel

There will be elderly poor.? Look at page 26 of this PDF.? I interpret those that don’t know or declined as being well below $50K in assets.? That means 60% of those reaching “retirement age” will have less than two years income stored up.

That said I feel more sorry for younger workers who have to pay high amounts into Social Security/Medicare, and they will not get out of program what they put in.? There’s a longish article here, excerpting from a recently released book on the topic.? In general, the older you are, the sweeter the deal was for those who received payments from Social Security, at least until 2026 when benefits will be cut by 25%, or taxes raised.

What this means is that in aggregate, Americans don’t save enough, particularly the Baby Boomers, of which I am one, but not a negligent one.

We are heading for elderly poverty/work for a large portion of Americans.? I suspect that many older people will continue to work, solving their problem but taking jobs from those who are younger.

This should be no surprise.? Incomes should be declining for lower skilled people in the US, because there are more people who can do that work abroad.? My advice to all readers is to make sure you cannot be obsoleted by foreigners.

One more note: don’t expect the asset markets to bail you out.? Returns to financial assets will do poorly as so many begin to sell them to pay for living expenses, whether directly as individuals, or indirectly as defined benefit plans pay retirement benefits.

This is on top of the problem that when high-quality long interest rates are so low, it is typically a bad time to try to make money in financial assets, because returns on risky assets are typically only 0-2% percent higher than the yield on long BBB/Baa debt over the long run.

All for now…

The Best of the Aleph Blog, Part 15

Posted on 10 May 201220 June 2017 by David Merkel

This stretches from August 2010 to October 2010:

The Education of a Corporate Bond Manager, Part VII

On the value of credit analysts.

The Education of a Corporate Bond Manager, Part VIII

On price discovery in dealer markets, and auctions gone wrong.? I never knew that I could haggle so well.

The Education of a Corporate Bond Manager, Part IX

On the vagaries of bulge-bracket brokers, and how a good reputation helps on Wall Street.

The Education of a Corporate Bond Manager, Part X

On how we almost did a CDO, and how it fell apart.? Also, how to make money in the bond market when you reach the risk limits. 😉

The Education of a Corporate Bond Manager, Part XI

On my biggest mistakes in managing bonds.? Also, on aggressive life insurance managements.

The Education of a Corporate Bond Manager, Part XII (The End)

On bond technical analysis, and how to deal with a rapidly growing client.?? Also, the end of my time as a bond manager, and the parties that came as a result.?? Oh, and putting your subordinates first.

Queasing over Quantitative Easing

Queasing over Quantitative Easing, Redux

Queasing over Quantitative Easing, Part III

Queasing over Quantitative Easing, Part IV

Queasing over Quantitative Easing, Part V

Queasing over Quantitative Easing, Part VI

The problems with the Fed’s seemingly “free lunch”strategy.? Pushes up asset prices and commodity prices, benefiting the rich versus the poor.

The Economic Geography of Publicly-Traded Companies in the United States by Sector

The Economic Geography of Publicly-Traded Companies in the United States by Sector (II)

Shows what US states have diversified vs concentrated economies by sector, and what states dominate each sector.

Portfolio Rule One

Industries are under-analyzed, relative to the market on the whole, and relative to individual companies. Spend time trying to find good companies with strong balance sheets in industries with lousy pricing power, and cheap companies in good industries, where the trends are not fully discounted.

Portfolio Rule Two

Purchase equities that are cheap relative to other names in the industry. Depending on the industry, this can mean low P/E, low P/B, low P/S, low P/CFO, low P/FCF, or low EV/EBITDA.

Portfolio Rule Three

Stick with higher quality companies for a given industry.

Portfolio Rule Four

Purchase companies appropriately sized to serve their market niches.

Portfolio Rule Five

Analyze financial statements to avoid companies that misuse generally accepted accounting principles and overstate earnings.

Portfolio Rule Six

Analyze the use of cash flow by management, to avoid companies that invest or buy back their stock when it dilutes value, and purchase those that enhance value through intelligent buybacks and investment.

Portfolio Rule Seven

Rebalance the portfolio whenever a stock gets more than 20% away from its target weight. Run a largely equal-weighted portfolio because it is genuinely difficult to tell what idea is the best. Keep about 30-40 names for diversification purposes.

Portfolio Rule Eight

Make changes to the portfolio 3-4 times per year. Evaluate the replacement candidates as a group against the current portfolio. New additions must be better than the median idea currently in the portfolio. Companies leaving the portfolio must be below the median idea currently in the portfolio.

The Portfolio Rules Work Together

How the portfolio rules work together to create a “margin of safety.”

The Rules, Part XVIII

When rules become known and acted upon, the system changes to incorporate them, making them temporarily useless, until they are forgotten again.

When a single strategy becomes dominant, it can become temporarily self-reinforcing.? Eventually, it will become self-reinforcing on the negative side.

A healthy market ecology has multiple strategies that are working in separate areas at the same time.

The Rules, Part XIX

There is room for a new risk model based on the idea that risk is unique among individuals, and inversely related to the price paid for an asset.? If a risk control model has an asset becoming more risky when prices fall, it is wrong.

?The Rules, Part XX

In the end, economic systems work, and judicial systems modify to accommodate that.? The only exception to that is when a culture is dying.

?Managing Illiquid Assets

Illiquidity is an underrated risk.? Most financial company failures are due to illiquidity, which usually takes the form of too many illiquid assets and liquid liabilities.? Adding to the difficulty is that it is generally difficult to price illiquid assets, because they don?t trade often.

Of Investment Earnings Assumptions and Century Bonds

If we could turn back the clock 65 or so years and set up a more conservative method of accounting for pension liabilities, we would be much better off today.

Who Dares Oppose a Boom?

This piece won a small prize, and in turn, I received three speaking engagements.

Fairness Versus Economics

Fairness Versus Economics (2)

People care more about fairness than improving their own economic/social position.

Earnings Estimates as a Control Mechanism, Flawed as they are

Earnings Estimates as a Control Mechanism, Flawed as they are, Redux

Earnings estimates have their problems, but they exist to give us a flawed method of estimating the future performance of companies.

-==-=-=-=-=–=-=

That’s all for now.? Never thought I would do so many long series when I started blogging.

Book Review: The Little Book of Bull’s Eye Investing

Posted on 9 May 2012 by David Merkel

Before I start this evening, if you like my reviews generally, please go to Amazon and tell them that my reviews are helpful.? From this link, it does not take long to do so.? Thanks.

This was one of those books that grew on me.? The author, the well-known John Mauldin, strings together a bunch of ideas originated by others.? That’s not much different than what Tadas Viskanta does at Abnormal Returns.? He brings us the best ideas that he has culled from others.? That is a significant piece of work that should not be denigrated by others.

The beginning of the the book is consumed with 12-20 year market cycles.? There are times when investing in risky assets where you face headwinds and tailwinds. The headwinds and tailwinds are driven by valuation, often expressed through Q-ratio, CAPE, or Michael Alexander’s Price-to-Resources ratio, out of which the book makes a lot (link here for an example).? It’s a Price-to-Adjusted Book value ratio as I see it.

Regardless of the method, if you buy in at high valuations, the wind is in your face, and you are not likely to earn much.? The opposite is true for low valuations, but at the valuation trough, everyone is disgusted, and few are willing to buy.

So it takes a strong stomach and mind to follow a method like this.? Strong stomach, because when it is time to buy one will fear that the money will be lost.? Strong mind, because near valuation peaks people will tell you that you are nuts to leave the party — it’s just getting started.

But what if a decent sized portion of institutional money did this?? The cycles would go away, or be muted.? That’s not likely to happen in my opinion: some men may change, but you can’t change mankind.? Emotions of fear and greed dominate over clear thinking.

The book touches on many other topics:

Why strategies go in and out of favor
Why to be skeptical of those who give investment advice (including Mauldin & me)
That the growth rate of the economy eventually limits the growth rate of any company.
The effect of demographics on the markets
Why chasing performance doesn’t work.
Why most newsletter writers strategies could never be as good as they state, or they manage money in tiny niches.
How to detect value in stocks.
How to use bonds and commodities in asset allocation.

I say “touches on” because in line with its title, it is a “little book.”? You are only getting a taste of what an intelligent investor who hires other managers to manage money for clients thinks.? This is especially true as you go through the section on value investing, which does not get much beyond dividend yield, dividend growth, and price-to-book (common equity).

As such, this book will not be a complete answer to any investor wanting to learn about the markets.? It introduces basic concepts in ways that most ordinary people could learn.? Reading time should be less than two hours.? One more thing, the book has very little in the way of math.

I appreciated the short summaries at the end of each chapter.? If someone wanted to get the gist of the book, they could read all of the short summaries in about 10 minutes, and then they would have the skeletal ideas of the book, allowing them to read all or part of the book with greater understanding.

Quibbles

The book could have used an index.

Who would benefit from this book:People who want an introduction to investing, including long-term market cycles would benefit from this book.? It would be of modest help to experienced investors who understand market cycles.? If you want to, you can buy the book here: The Little Book of Bull’s Eye Investing: Finding Value, Generating Absolute Returns, and Controlling Risk in Turbulent Markets (Little Books. Big Profits).

Full disclosure: This book was sent to me without my asking for it.

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.

Correlating Risky Assets

Posted on 4 May 2012 by David Merkel

Asset allocation is tough, because the correlations are not stable.? Here’s an example: in the 90s, at many conferences that I went to, I was told that one of the smartest moves you could make was to invest heavily in every new class of Asset Backed Security [ABS] created, because they all tighten in yield spread terms after issuance, leading to price gains.

I didn’t believe it then, and that was a good thing, because the most exotic of ABS classes got whacked in the financial crisis.? As it was was, I had already seen debacles in Franchise Loan ABS (spit, spit), and Manufactured Housing (post-1997 vintage).? At a conference for Life Insurance, I was a skunk at the party in 2006, as one ignorant presenter suggested that AAA structured assets never went bad.? History already taught us better, and as I tried to say to the then-CEO of Principal Financial as he was exiting the conference, he needed to look at the mezzanine and subordinated structured product in his company.? Free consulting, but but worth more than the consensus.? As far as I can tell, he didn’t listen.? For many reasons the stock price is lower today.

I have many other tales where in fixed income (bonds), everyone “followed the leader,” which worked in the short run, but failed in the long run.? The point is that investor behavior correlates asset classes.? There may be underlying economic differences, such as owning a natural gas producer and utility that uses natural gas, but most of those differences get erased as most investors seek portfolios immune from factors of secular change.

So as new asset or sub-asset classes are introduced, in the short-run they are uncorrelated, and likely rally, because few own them.? But after the rally, many now own it, and the future correlations are high because so many own it.? The correlations ultimately depend on two things: the underlying economics, and investor behavior.? Investor behavior is the dominant aspect of pricing.

I don’t think there is a lot of diversification in most risky asset classes from an economic standpoint.? Does it matter whether a business is public or private??? I think the answer is no.

What that means in the present environment is that there is a gap between business risk, and those that finance business risk.? In other words, there is a difference between investment grade bonds, and risk assets.? That’s the negative correlation in this market.? Do you want diversification?? Buy some ETFs that invest in long high investment grade debt.? You will not get any effective diversification out of buying different classes of risky assets.? Those are already owned by those that compete with you.

Promises to pay from sound entities that can be relied upon in the future behave very differently than risky assets.? In your asset allocation, to the degree that you need real diversification, look at that as the critical distinction.? All other distinctions are secondary at best.