Personal Finance – Page 22

Book Review: The Ivy Portfolio

Posted on 11 May 2011 by David Merkel

This is an unusual book, and a good book.? Unlike the book, “Outperform,” which reviews lesser known endowments, and endowment investing generally, this book reviews the Harvard and Yale endowments, which up until 2008, the year before the book was published, were among the best in terms of performance.

But this book is more than that.? It goes through the strategies of the major endowments, and looks for ways that average people can try to replicate the results.

But average investors don’t have the same set of investments available to them as the large endowments do.? If you aren’t a qualified investor who has access to the full range of investments ordinary mortals are denied — private limited partnerships (hedge? funds, private equity, commodity funds, etc), what can you do?? This book discloses investments that are similar if not equivalent, and versions that are lower cost through ETFs.

After that, the book takes a direction that would initially seem different than endowment investing.? It discusses trend following, which endowments do not in general use as a strategy.? Now, some hedge funds use it, but few endowments actively embrace it.? The book shows how return can be enhanced and volatility reduced by buying investments that are over their 200-day, or 10-month moving averages.? From my own research I can partially validate the approach.? It is a clever way of implementing a form of momentum investing, which may be a cheap way for average investors to mimic hedge funds who follow trends.

Then mimicry moves to a new level as the book goes through the basics of mining data out of 13F filings, where large investors file their long investments with the SEC.? Guess what?? Imitating bright people can help an investor beat the market — it can allow a bright person to mimic the long side of equity investing on the cheap, but with a lot of data analysis (or you can pay up for Alphaclone).

In one sense, the book seems like two books — one on endowment investing, and another on tools for clever investing available to average investors.? My way of reconciling the two is that the authors are clever guys who are trying to give their best ideas to retail investors so that they can do as well as sophisticated institutional investors who have a wider array of investments to choose from.? The retail investors don’t have the same array of investments to choose from, but they have the advantage of flexibility that institutions don’t and can more quickly trade out of investments that may be on the way to underperformance via trend-following.

And so with much effort, if you apply their ideas, you have the potential of doing as well in investing as the major endowments.? Or, absorb one of their passive strategies with little effort, and maybe you will do as well.? Strategies that have done well in the past may not do so in the future.

But on the whole, I heartily recommend this book.? There is a lot for investors of all types to learn from it.

Quibbles

Those reading the book should also read my essay, “Alternative Investments, Illiquidity, and Endowment Management. (Google it if there is no link)”? Taking on illiquidity is not a free lunch.? It can impose real costs when there is a need for cash among those endowed.? Personally, I think that ten years from now, illiquid investments will only be taken on by those that can lock them away.

Who would benefit from this book:

Those wanting to potentially mimic the high returns of the Harvard and Yale endowments could benefit from the book, but realize that a lot of the past is an accident, and that it might be difficult to achieve high returns in the future from strategies that worked in the past.? That said, the authors have offered strategies that take some degree of work to apply, so there may be barriers to entry for applying some of the strategies.

If you want to, you can buy it here: The Ivy Portfolio: How to Invest Like the Top Endowments and Avoid Bear Markets.

Full disclosure: I asked the publisher for this book, and they sent it to me.? I read and review ~80% of the books sent to me, but I never promise a review, or a? favorable review.

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.

Why Amateurs Should Invest in Common Stocks

Posted on 5 May 20115 May 2011 by David Merkel

There is a benefit to investing directly in common stocks as an individual.? I’ll let Buffett help me explain this:

?I am a better investor because I am a businessman and I am a better businessman because I am an investor.?

My own life is one of having been an amateur investor, and became a professional investor over time.? My mother is an excellent amateur investor, one whose record would put 90%+ of professionals to shame.? I know some great amateur investors, but they are not the norm.? If they were the norm, we would not have lots of financial intermediaries trolling for business.

After yesterday’s piece, I want to say that though most amateur investors do not beat index funds, there is still one big reason to buy individual common stocks: it can make you a better businessman.

As an example, I had? never worked in a marketing department in my life, but because of my investing, and study of marketing on the side, I was able to lead a revamp of a marketing department, leading to a threefold increase in sales in five years.? Return on equity went from 10% to 50%, aided by the booming stock market of the ’90s, but that was only a help.

Technical specialists have to ask, “Do I want to remain a technical specialist, assuming that I have that option, or do I want to broaden my skill set and learn the economics of the business that I serve?”? Those that invest in stocks, and study them carefully learn practical economics.? You may earn money or you may not.? You may beat the market or you may not.? But you will become a more valuable employee, because you will grasp more and more about what makes your company tick economically.

I can tell you that while I was in insurance, the brightest move I made was investing in stocks privately, and studying equity and bond investment intensively.? It made me more valuable to my bosses, and helped me understand my own company better.? It made me better in interviews as well.? Questions that were designed to see if I could think beyond my narrow specialty became easier for me.

Now, some of the successes came with failures.? For a while, I told my kids never to mention the name “Caldor” to me.? Yeh, Michael Price may have lost a billion on that one, but I more than took my licks.? Until you lose a decent amount, you don’t really understand how the market works.? You can call it market tuition, but like tuition at college, you don’t know how much value you will get out of what you have paid.

I encourage new investors to paper-trade.? I did that when I was young.? It allows you to experiment and learn about what you think works in the market, without consequences.? I think it helps ease the transition into investing.? When you start investing, your emotions will be a lot higher, but it helps a lot to have a guiding theory going into it, it helps control the emotions that will come.? It took me 5-10 years to discipline my emotions, and think about markets rationally, not emotionally.

So, there are benefits to investing in individual common stocks, but they may not be the ones you expected.? It will help you understand your business better, your industry better, and perhaps even your nation and the world.

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But, this is not to say that if you act as a bettor, rather than an investor, that you will benefit.? Think of Buffett’s quote above — business and investing go together.? Inside a corporation, one of the highest levels of what is done is the investing.? Buffett looks for businesses that will throw off gross profits well in excess of financing costs — that is different than most investors think, because Buffett is a businessman.

For budding businessmen, you could ask where business value is growing the most rapidly relative to the price that you pay — Earnings relative to price helps but there are sometimes aspects of businesses where growth in value does not reflect in the earnings statement.

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And, all of this is not to say that professionals do better than amateurs.? Professionals don’t do well, and they add on fees.

There is one area where professionals seem to do better, but I could be wrong.? If I am wrong, could someone send me some research?? As I pointed out yesterday, amateur investors tend to become greedy and fearful at the wrong times.? Professionals seem to be less prone to this problem, perhaps because of discipline.

As Baruch commented at my blog:

I think it is also something you can learn, because so much of investing skill is not innate, in my opinion, rather it really comes from an attitude, and an act of will. Discipline comes from will. The rest comes from a basic knowledge of accounting, markets and finance which anyone with a university education is capable of grasping. A lot of people without a university education are as well.

To which I will agree — it’s not that you need a high IQ, but a lot of general learning, wisdom on accounting, markets, and finance, and common sense.? Read stuff by Charlie Munger, the man is under-rated in the shadow of Buffett, but at least he has written? a book.? Would that Buffett would do the same.? There are many that interpret him, but I would like to hear how he views investments in theory in full, so that the rest of us could benefit.? In many ways he has surpassed his teachers, Ben Graham and Phil Fisher.

So Warren, could you give us the 21st century version of “The Intelligent Investor?”? That could be an invaluable legacy that many would thank you for, as much as they do for Ben Graham today.

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Final note — if you invest in common stocks, it is likely you will underperform the major averages until you gain wisdom and discipline.

The Jeans for the Scene — In, Out, or Ob?

Posted on 29 April 2011 by David Merkel

I was minding my own business, doing research when I saw an ad that showed a back view of a woman in very tight jeans, with the text: “If you think I?m hot you should see this stock! OBJE”

Remember my rule, “Don’t buy what someone wants to sell you.? Buy what you have researched for yourself.”? It is true with physical objects, but even more true where the goods are immaterial, and quality cannot be easily verified, as with stocks.? So when I hear a pitch for a stock through advertising, I am immediately skeptical.

Now, I am not the first to the scene here, partially because I delayed. 24/7 Wall Street noted that OBJE has a going concern problem.? Good job, Doug.

But there is more: where is the company located?? In a residence in Florida.? Not much for a company with a market cap of 30MM+.? But what else is located there?? These businesses:

Quite a lot to be going on in one residence.? But wait, the woman who lives there, who was a crucial part of OBJE’s strategies has been let go by OBJE.? Curious, huh?

Now the current CEO, Robert Federowicz has done many things, but nothing worthy of being a CEO of a small public company.

He previously served as Chief Information Officer of a start-up international power development company and as government affairs liaison for an international power company. From 2005 to 2009, Mr. Federowicz was an Owner and Operator of a fitness gym in Houston, Texas. During 2010, he served as an Account executive for Screentek, Inc., a seller of LCD screen technology for laptop computers.

Of course the company has press releases touting its non-existent products.? And there are penny stock touts that pick up the furor.? Just because a stock has a low price does not make it a buy.

Then there is the investor relations page at their website.? No credible company lays on the “buy us” mantra so thick.

That leaves us with the hard data.? Let me start with the opening lines from the risk disclosures in the 10K:

BECAUSE WE HAVE NOT PRODUCED A SAMPLE OF OUR OBSCENE BRAND JEANS AND COMPLIMENTED PRODUCTS, THESE PRODUCTS, MAY NOT WORK OR FIT PROPERLY AND/OR THE PRODUCTION COST CAN EXCEED EXPECTATIONS

OUR LACK OF AN OPERATING HISTORY GIVES NO ASSURANCE THAT OUR FUTURE OPERATIONS WILL RESULT IN PROFITABLE REVENUES, WHICH COULD RESULT IN THE SUSPENSION OR END OF OUR OPERATIONS

WE ARE A NEW COMPANY WITH NO OPERATING HISTORY AND WE FACE A HIGH RISK OF BUSINESS FAILURE WHICH WOULD RESULT IN THE LOSS OF YOUR INVESTMENT

As of the date of this prospectus, we have earned no revenue. Failure to generate revenue will cause us to go out of business, which could result in the complete loss of your investment.

BECAUSE OUR CURRENT OFFICER AND DIRECTOR DOES NOT HAVE SIGNIFICANT EXPERIENCE IN STARTING A JEANS PRODUCTS COMPANY AND WE LACK CUSTOMERS AND SUPPLIERS, OUR BUSINESS HAS A HIGHER RISK OF FAILURE

BECAUSE WE ARE SMALL AND DO NOT HAVE MUCH CAPITAL, WE MUST LIMIT OUR MARKETING ACTIVITIES. AS A RESULT, OUR SALES MAY NOT BE ENOUGH TO OPERATE PROFITABLY. IF WE DO NOT MAKE A PROFIT, WE MAY HAVE TO SUSPEND OR CEASE OPERATIONS

OUR PRODUCTS MAY NOT FIND ACCEPTANCE FOR OUR PRODUCTS IN HIGH END BOUTIQUES AND DEPARTMENT STORES.

OUR OPERATING RESULTS MAY PROVE UNPREDICTABLE WHICH COULD NEGATIVELY AFFECT OUR PROFIT

OUR SOLE OFFICER AND DIRECTOR MAY NOT BE IN A POSITION TO DEVOTE A MAJORITY OF HER TIME TO OUR OPERATIONS, WHICH MAY RESULT IN PERIODIC INTERRUPTIONS AND EVEN BUSINESS FAILURE

(and she has been let go)

KEY MANAGEMENT PERSONNEL MAY LEAVE THE COMPANY WHICH COULD ADVERSELY AFFECT THE ABILITY OF THE COMPANY TO CONTINUE OPERATIONS

IF OUR COMPANY IS DISSOLVED, IT IS UNLIKELY THAT THERE WILL BE SUFFICIENT ASSETS REMAINING TO DISTRIBUTE TO OUR SHAREHOLDERS

IF WE ARE UNABLE TO GAIN ANY SIGNIFICANT MARKET ACCEPTANCE FOR OUR PRODUCTS OR ESTABLISH A SIGNIFICANT MARKET PRESENCE, WE MAY BE UNABLE TO GENERATE SUFFICIENT REVENUE TO CONTINUE OUR BUSINESS

MANAGEMENT’S ABILITY TO IMPLEMENT THE BUSINESS STRATEGY MAY BE SLOWER THAN EXPECTED AND WE MAY BE UNABLE TO GENERATE A PROFIT

IF WE ARE UNABLE TO MANAGE OUR FUTURE GROWTH OUR BUSINESS COULD BE HARMED

OUR PRODUCT MAY NOT BE ABLE TO DISTINGUISH ITSELF IN THE MARKET AND WE MAY BE UNABLE TO ATTRACT ENOUGH CUSTOMERS TO OPERATE PROFITABLY, WITHOUT A PROFIT WE MAY HAVE TO SUSPEND OR CEASE OPERATIONS

WE MAY BE UNABLE TO MAKE NECESSARY ARRANGEMENTS AT ACCEPTABLE COST, WE MAY HAVE TO SUSPEND OR CEASE OPERATIONS ENTIRELY WHICH COULD RESULT IN A TOTAL LOSS OF YOUR INVESTMENT.

COMPETITORS MAY ENTER THIS SECTOR WITH SUPERIOR PRODUCTS, INFRINGING OUR CUSTOMER BASE, AND AFFECTING OUR BUSINESS ADVERSELY.

SINCE OUR SOLE OFFICER AND DIRECTOR CURRENTLY OWNS 100% OF THE OUTSTANDING COMMON STOCK, INVESTORS MAY FIND THAT HER DECISIONS ARE CONTRARY TO THEIR INTERESTS YOU SHOULD NOT PURCHASE SHARES UNLESS YOU ARE WILLING TO ENTRUST ALL ASPECTS OF MANAGEMENT TO OUR SOLE OFFICER AND DIRECTOR, OR HER SUCCESSORS

Notable, because she was let go with little fanfare, aside from an 8K.

THERE IS SUBSTANTIAL UNCERTAINTY ABOUT OUR ABILITY TO CONTINUE OUR OPERATIONS AS A GOING CONCERN

THE ENACTMENT OF THE SARBANES-OXLEY ACT MAY MAKE IT MORE DIFFICULT FOR US TO RETAIN OR ATTRACT OFFICERS AND DIRECTORS, WHICH COULD INCREASE OUR OPERATING COSTS OR PREVENT US FROM BECOMING PROFITABLE.

SINCE WE ANTICIPATES OPERATING EXPENSES WILL INCREASE PRIOR TO EARNING REVENUE, WE MAY NEVER ACHIEVE PROFITABILITY

IF WE CANNOT SECURE ADDITIONAL CAPITAL, OR IF AVAILABLE CAPITAL IS TOO EXPENSIVE, OUR BUSINESS WILL FAIL.

WE DO NOT HAVE SUFFICIENT CAPITAL TO CONTINUE MAINTAINING OUR REPORTING STATUS.

What do you see when you review the most recent 10K and 10Q?? They are starving for liquidity, and have negative earnings and a negative net worth.? This is not a recipe for success.

This would have been obvious from the share offering as well, which was done at far lower prices.

If I worked for the SEC, I would ask this question — who was willing to buy the shares after the offering, creating prices that would deceive others?? Answering that question could reveal networks that cheat.

Book Review: Dig This Gig

Posted on 20 April 2011 by David Merkel

I liked this book because I am doing this myself.? I am trying to create my own gig.? Let me put it this way: you can try to serve one boss who carefully directs you, or you can try to serve multiple bosses (clients) who may have varying goals for your services.

Unlike most of those featured in the book, I am older, trying to start my own business for the first time at age 50.? It would be nice to be twentysomething, but could I afford to sacrifice the knowledge that I have gained?

I think not.? The book takes an approach of reviewing four young people each in seven areas of employment, followed by an elder statesman who is an exemplar in that area.

The seven areas are:

Healthcare
Entertainment
Doing Good (Nonprofit, Teacher)
Green (Environmental)
News
Government
Unemployed

The book is well-written, and will provide inspiration to those looking to carve out a new niche in the current economy.

Quibbles

I must admit skepticism that a large number of people can “Dig this Gig.”? Most of the needs of mankind are similar, and unless you find a special point of unmet need, unusual gigs are hard to find.? I view much of what is said here as trying to accomplish something difficult.? Most people would be better off trying to do something conventional.? After all, that is why it is conventional.

Who would benefit from this book:

If you have a friend out of work but who is energetic, this book could be valuable.? Or someone competent and employed, but frustrated… this book could be valuable.? But anyone who is not motivated to work hard — sorry, this book will be of no help.

If you want to, you can buy it here: Dig This Gig.

Full disclosure: This book was sent to me after the author asked if I would like to see it.

When I was Young

Posted on 18 April 2011 by David Merkel

I can’t place it, but when I was 5 years old or so, sometime in 1966, my Mom showed me The Milwaukee Journal, and pointed me to an entry for Litton Industries preferred stock.? She told me that I owned some shares of the stock, and that it was good for me if the stock went up, and bad if it went down.? This was repeated two years later with shares of Magnavox common stock.

Both ended up being large losses, and I puzzled about it when I was young.? It did not dent my confidence in the markets because my Mom was such a good investor, looking for? growth at a reasonable price.? And to me, 10-18 years old, watching Wall Street Week with Louis Rukeyser on Friday nights, I gained insights into the markets, and began to appreciate the wisdom of my mother.? The 70s were a tough time to gain a love for the markets, but I played around with paper portfolios until 1982, when I did my last paper portfolio, before heading of to grad school.? (Value Line helped — if you have time, curl up with it and look for neglected companies that offer promise.)

Before that, I took one of my Mom’s former favorite stocks which had dipped, James River, and used it in a class at Johns Hopkins, and made a case that an acquisitive paper company could be a good investment.? My case was good to my professor, Carl Christ, “I never heard of this corporation before, what a great company.”? And my Mom, who had sold out of the company, reconsidered and bought again at a lower price, making money until the firm itself was bought out.? (Hey, gotta help with the tuition.)

The paper portfolio that I created in August of 1982 proved to be fun for my students when I was a TA at UC-Davis in Corporate Financial Management.? I mentioned the portfolio in class, and a subset of students asked to see it.? By the time the class ended, the market was up 20%, but the portfolio was up 40%.? By this time the professor had heard about it, and he said, “Oh, you have a portfolio with a beta of two.”? I tried to explain to him that the beta estimates of the portfolio were much lower than that, and that I had “bought” the names cheaply.? but to no avail… once the religion of efficient markets takes hold, no amount of? facts will prevail.

Then there was the Value Line contest around 1984-1985, where I was in the top 1%, but missed the top 25.? I used the top 100 from Value Line (Timeliness Rank 1), but screened them for value in their volatility buckets, as the contest went.? To this day, I think that stockpicking contest was the best ever designed.? If I ever get wealthy, I want to do a series of such contests, using the same principles.

After that, I married my wonderful wife Ruth, and began investing for real, first with mutual funds, and then with individual stocks.? But I failed to follow through in one way — I bought penny stocks through a “bucket shop” and lost a moderate amount of money, which fortunately was dwarfed by the purchase of a home in Davis, CA at just the right time, such that two years later when we had to leave for a new job (AIG), we had made 4x our capital, net of CA taxes.

Then my Mom gave me a copy of Ben Graham’s “The Intelligent Investor,” and my life changed again.? I spent the next seven years analyzing small company value stocks in the midst of a market that favored large caps, and growth.? Still, my picks were good, and kept up with the S&P 500 (beating the Russell 2000 Value by 5% per year).

I appreciate the past, and use the lessons for growth today.? Mom, she keeps investing well, though she has more of a desire for yield today.

Today I think my best skills are company and industry analysis.? Yes, I am a quant, and can design clever ways to outperform the market with some probability, but prefer my own insights to mathematical likelihoods.

As for what I wrote yesterday, I prefer my own stock investing to moving between equity and debt markets, because my alpha exceeds that of the switching strategy, at least for now.? Volatility is higher, but I am in Buffett’s camp, where I will take a noisy 15% over a calm 12%.

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I did not bump into investing as an adult, but had to wrestle with it as a child.? I got to view it through the lenses of practical people who were bright, rather than academics who have a blunted view of investing.? This will bite the academics, but there is more wisdom outside of academia on investing than there is inside academia on investing.? Far better that you leave the confines of academic research and try to apply your methods to investing, messy as it is.? I dare you.? It takes a while to develop the practical knowledge behind good investing.? I’ve seen it from so many angles; if there is anyone with a more diversified career in financial services, I have not met him yet.

I was never attracted to MPT because I had seen my Mom beat the market regularly.? It was confirmed to me, when I found that I could do it also.

But still, I like MPT, and indexing — it sidelines a lot of the competition.? And for most, buying an index is the right way to go.? They don’t have an edge, so why pay the fees and accept the added volatility?

But to those that think they understand investing in academia, I would simply say, “Join the party.? If your ideas are? good, you will do well.? It is a lot harder to turn theories into hard cash, or gold, if you are so inclined.”

When I was young, I trusted my Mom.? That trust was rewarded.? Today, the game is a lot tougher, but I persevere because I know my principles work on average over time.? I have had a poor last eight months, but I will come back in time, because my methods have worked in the past, and nothing that I can see has changed that environment.

PS — I sometimes say, ” I am a good investor because I learned from my Mom, and I am a good businessman because I learned from my Dad.”? My Dad did excellent work for clients, and was never sued once in 35 years of work.? His reputation of doing quality work at a moderate price preceded him, and allowed him to survive in bad economic environments.? I hope that I can be as good.

Valuation & Momentum — The Impossible Dream

Posted on 16 April 201116 April 2011 by David Merkel

This piece is a brief and final update to the piece The Holy Grail Projects, which I have since renamed “The Impossible Dream” projects.? I have solved both of them, and with far less effort than I would have anticipated.? There is a way to gain superior bond performance, with one factor, at least as far as the past is concerned, but with higher volatility.

For equities, two simple factors are required, but they beat the market by 2%/year with 70% of the equity volatility over 130 years.

Personally, I find these two results surprising, particularly in the short time that I received them.? That said, I only passed over the data once for each project, which gives me more confidence in the results.

If you have interest in this, e-mail me.? In general, I have not favored tactical asset allocation in the past, but these measures have given me some confidence.

PS — from my days at Provident Mutual in the 90s, what I have replicated is similar? to what one firm I interviewed showed us who had the best track record.? I was really impressed with them and that gives me more confidence.

The Holy Grail Projects

Posted on 9 April 201110 April 2011 by David Merkel

When I started my asset management business, I did not know what I was doing.? I probably still don’t, though finally I have a little more assets under management than I have of my own assets managed by my strategies.? I learned that I needed to manage both stocks and bonds, in order to provide both enterprising and safe investments, respectively.

But in an environment like this, where bonds are overvalued in general, is the safe option safe?? My methods of bond management produce rather blah yields at a time like this, because I am trying to preserve capital.

But then potential investors talk to me, and they ask two things of me.

1) Can’t you create a strategy that shifts between your stock and bond strategies, such that we can minimize losses and maximize gains?

2) Can’t you create a bond strategy that provides more yield on average, while still preserving capital?

I am tempted to say, “If I had such a strategy, I would be employing it from my yacht.”? Then again, the last time I went out on he open seas, I was as sick as a dog.? Time for a new analogy.? Okay, I am searching for the Holy Grail.? Not likely to find that… and as Calvin noted, if all of the alleged relics from the days of Christ were real, the amount would be a large multiple of what was there.

All that said, there are some cofactors for each problem that might work.? With bonds (problem 2), there are momentum effects, as well as mean-reversion effects.? Those can complement the intelligent bond manager who looking at the situation may see risk and return out of line, or fairly priced.

I may have a solution to this problem, which partially benefits from the ideas of Mebane Faber.? Buy the bond classes where the prices are above their 200 day moving averages.? This is an oversimplification, but it seems to work.

But stocks are more difficult, and I do not know whether I will end up with a solution here or not.? Here’s the trouble:

Stocks are driven by earnings expectations
Stocks are driven by valuation
Valuation is drive by cost of capital, as well as yield spreads.
Cost of capital is on average similar to BBB bond yields.
There are still momentum effects, as well as mean reversion effects

I don’t have a solution to the first problem, though I am struggling with it.? Truly if anyone had a good timing algorithm, would he share it?

On Con Men, Advanced Edition

Posted on 2 April 20113 April 2011 by David Merkel

The core discipline of value investing is not buying it cheap, but margin of safety.? Margin of safety means you aren’t going to lose too much if you are wrong, and face it, we make mistakes.? I do, and you do.? It goes back to the two rules: 1) Don’t lose money. 2) Don’t forget rule #1.

In my last piece On Con Men, I dealt with irregulars.? And even in my more recent piece, Avoid Investment Scams and Bad Advice, Web Edition, I dealt with irregulars.? By irregulars, I mean those that don’t come through a regular channel for investing.? These are people that try to attract those that want something off the beaten path, for either high return, or high safety.

But not all con men are irregulars.? Some are regulars, with all the trappings of success — they work for a well-known firm.? They dress well, speak well, and are aware of most major trends, and the concerns of investors.? They have seemingly well-designed financial plans that the firm’s models produce.? They have clever ways of helping you meet your income goals.? Everything about them says, “We can assure financial security for you.”

I have interacted with some of these fellows (no ladies yet) on boards that I have been on.? (Oddly, when I was a corporate and mortgage bond manager, the people I interacted with were far less slick.? I think the bond market tolerates people that are more down-to-earth than the equity market does.)? I usually have to bite my tongue, because? they are front men.? They know the limited bits that they have been fed by sales management, but they really don’t know much beyond that.

On rare occasion, I will take the floor and rant at the salesman.? I try not to; I only do it if they lie (as I see it).? Usually, they’re just trying to earn a living, and there is nothing to be gained by making fools of them.? But occasionally, they try to lure people into investments that are not in their best interests.

I have often said that the lure of free money brings out the worst in people.? I think that one key area of that is the seeking of yield.? I will say it plainly: Wall Street can give you whatever yield you like, if you don’t care about preservation of principal.? Yield is the oldest scam in the books.

Wall Street has a wide variety of yield products, and I highlight this now, because we are in a low yield environment, and they will bring these products out more often as a result.? One example that I have talked about before is structured notes.? What I would like to talk about tonight are reverse convertibles.

One easy way to enhance yield is to sell an option against your positions.? The problem with that is that the option could come into the money, and you suffer a capital loss as a result, often exceeding the extra income “earned.”

With convertible bonds, you have the best of all worlds.? The holder is long an option.? If things go well, it is convertible into stock.? If things go, badly, you have the downside protection of a bond (which can still default, but hey, you are higher in the bankruptcy pecking order.? Maybe you’ll get something?).? The cost of the best of all worlds is a lower yield than one would get on straight nonconvertible debt.

Reverse convertibles are the worst of all worlds.? The holder is short an option.? When things go well, it remains a bond.? If things go badly, it converts into stock, usually at a low price that delivers a capital loss.? But, the equalizer here is that if it remains a bond, you get a high yield.

That’s a big “if.”? My counsel to almost everyone is avoid complex products.? If you can’t get the yield that you need through ordinary vanilla products that are transparent, then either reduce your spending or consume a little capital.? Wall Street and insurance companies thrive on complexity, because you can’t price it or do comparisons.? You are playing their rigged game; they may not be trying to skin you, but just nick you.? Nicking you means they win, but you continue to play the game, so that they can nick you again.? It is like playing in a casino; the edge of the house is fixed, and will wipe anyone out that does not have an advantage (card counting in blackjack), but it does it so slowly and with volatility, that players do not perceive it.

Complex products are not created to do you a favor, but to cheat you on average.? Think about it: if you are invited to play a game for money, as an amateur, do you want to play against professionals?? I thought not.? But if you feel that way, why do you buy products from Wall Street that they know a whole lot better than you?

This goes back to my rule: don’t buy what others want to sell you; buy what you have personally researched and want to buy.? But what if I can’t understand enough to do anything with investing?? Then what?

Find your friend who knows the most about investing.? Ask him for his friend who knows the most about investing.? Repeat a third time if needed, but get to someone who can give you intelligent impartial advice.? If all else fails, go to Vanguard, and take their advice.? They will not harm you, though they might not help you a lot.

But be wary of those that offer easy solutions.? What is free is seldom cheap, as the Ferengi would say.? Get trustworthy intelligent third parties to look over your investments, and avoid slick salesmen with clever products that are hard to understand.

Book Review: Financial Jiu-Jitsu

Posted on 24 March 2011 by David Merkel

The genre of personal finance books is crowded.? I have read my share of good and bad books in this area, and the book that I am reviewing this evening falls in the good column.

It covers all of the main areas of personal finance adequately, and makes analogies from the world of martial arts.? Now, personally, to me that is an odd place to source analogies for investing.? I remember being in a meeting when I was a corporate bond manager, and the new head of credit research said to the credit analysts, “Credit analysis is war by another name.”? I rolled my eyes, and said to myself, “Oh, please, this is a business, and no more than a business.? Don’t make my analysts non-economically aggressive.”

This book is long on structuring your finances, and short on how one invests, as is common for most personal finance books.? The advice is simple and practical, and will benefit most individuals/families.

One of the many places where I agree with him is that you don’t have to have a budget.? Save first, and then survive on the remaining cash flow.? This is an excellent way of managing finances, but it takes discipline.? Not everyone can do this because they lack discipline on a month-to-month basis.? Those that don’t have that discipline should craft a budget.

I also found his approach to financial goals useful, because it asks the deeper questions on what the ultimate reasons for living are: not only ways in which we want to be served, but ways in which we want to serve.? Figure out the broad goals for life first, then figure out the financial means to serve those ends.

He also takes a conservative approach to how much money one needs in retirement, using a 4% withdrawal assumption, which in a low interest-rate and mid-to-high P/E environment like today is only reasonable.

It was a breezy read for me, getting through the 180 pages in 90 minutes or so.? Part of that is that it is a very familiar topic to me, but I suspect more of it is good structuring and chapter ends that repeat the main points in summary form, so that the main ideas are difficult to miss.

Everything important gets covered here for the life of an average person/family.? The reader faces the challenge of executing on the good advice, or finding a good adviser to guide him.

Quibbles

Though I was a wrestler in high school, I sometimes found the analogies to martial arts to be strained.? More importantly, I had a hard time following the logic in the appendix regarding investment performance.? I am no fan of Modern Portfolio Theory, but MPT does not require the concept of buy and hold.? Buy and hold stems from the idea that equities outperform equities and fixed income by a wide margin (the “equity premium”), so one can always win by holding onto equities, and not ever switching into safer asset classes.

The author’s concept of capital preservation investing does not get adequately defined.? Indeed, that could be a book in itself.? The idea? that there are seasons to take more risk and seasons to take less risk is obvious in hindsight, but implementing that idea is tough, and the author leaves us with not enough to do it.? That should not be too much of a surprise though, because if there were an easy solution here, we all would have adopted it years ago, and I would be opining to you from a life of leisure, rather than that of a working stiff.

As such, I don’t penalize the author too much, no one has the holy grail of market timing nailed down yet.

Who would benefit from this book: This is a basic book, and most suited for those that need to get their lives in order.? Personally, I suspect younger males would find the analogies between investing and martial arts most appealing.? I should try it out on my son who wants to be a police officer.

If you want to, you can buy it here: Financial Jiu-Jitsu: A Fighter’s Guide to Conquering Your Finances.

Full disclosure: The author sent this to me after asking me if I wanted it.

Responding to a Bright Reader

Posted on 21 March 2011 by David Merkel

One of my readers made some good comments, and asked some good questions, so I am responding here.? From the article, Dave, What Should I Do? (3):

DM: Some of my friends want to invest with me, but I am not a total solution to anyone?s financial needs, because the only stuff I am managing is the risk capital.

Reader: Just curious, why did you choose to go this route instead of the “total solution” route.

Later in this post, you have very detailed bond fund recommendations, so why not just manage the total portfolio with the appropriate asset allocation across risk capital versus bonds?

I’m not seeing the advantage of just the risk capital approach. It seems like less AUM, and less fees, and the client still has to figure out what to do with the remainder of the investable capital.

Between your comments, and requests from clients and potential clients, that is what led me to start the fixed income strategy.? I am moving some of my family’s assets into that strategy so that I have “skin in the game.”? I always thought I would do this, but I thought it would come later.? Reality has intervened.

And, from the article, Managing Fixed Income for Equity Clients:

Given your background, I would think managing the bond portion would be almost a triviality. I would assume for bigger accounts you could do individual bonds effectively, and I understand for smaller accounts going the CEF/ETF route. I am genuinely curious why for smaller accounts you would totally avoid actively managed bond funds. This is what I currently do. I use Hussman Total Return and PIMCO Total Return for my bond allocation, but I have been thinking about further diversifying that. I?ve been thinking of adding Jeff Gundlach?s new fund now that he is on his own. My understanding is he is considered one of the top bond fund managers. I?ve also heard Dan Fuss from Loomis Sayles is really good. My thought with the bond allocation is to put it on auto-pilot as much as possible, and focus my efforts on generating alpha in the risk asset part of the portfolio.On a broader point, I think you are right about offering this, because I think most people are looking for a ?total solutions? provider. If one only manages the equity allocation, then I think you almost have to stress that to the client, and then they are still left to their own devices on what to do with the rest of the investable money. My thought is why give up that business and more importantly are you really helping that person by basically saying I only do A and you are on your own for the rest. In my view, managing the total portfolio is really win-win for both the advisor and client, and I am actually surprised at the number of advisors who only do stock-picking. My thought is they largely only do that because that is what they like.

Anyways, I hope this has been somewhat helpful, and I?d love your feedback on some of the funds I mentioned if you care to offer it.

I have respect for Dan Fuss, Jeff Gundlach, John Hussman, Vanguard and Pimco.? Pimco is misunderstood, because it is a quant shop, and uses a ton of fixed income derivatives.? Vanguard has the most durable advantage because of low expenses.

Why am I not using actively managed bond funds?? I would rather work with simple vehicles that allow me to express my macro views, and have low costs for clients.? I am the manager.? If I use actively managed funds, I am the manager of managers.? That is not what I want to be.? Eventually, if my fixed income assets get big enough, I will stop using funds and buy bonds directly.? And that will be a lot of fun, because when I managed a lot of bond assets, I was able to add a lot of value through clever trading.

And from the article Abandon All Hope All Ye Who Enter Here:

1.? What do you mean by “dual currency”?

2.? In your view, what are the investment/portfolio implications of what appears to be the inevitability of nothing meaningful getting done on fiscal policy until the crisis hits with full force.? Seems to me many, even highly intelligent people, believe we can put off adjustments for another day down the road.

http://oldprof.typepad.com/a_dash_of_insight/2011/03/constructive-postponement.html

Dual currency means that a nation has two currencies, one for domestic dealings, and one for international dealings.? I do not advocate it, but such a system can be used to favor domestic interests over international interests, or vice-versa.? It depends what the government wants to do.? Historically, there have been cases where a government under stress:

defaults on foreign obligations
defaults on domestic obligations
defaults on both

The dual currency helps with the first two options, because it allows the government to easily choose who to pay.

On the fiscal policy deadlock: the credit cycle is unpredictable in term of detailed timing.? How much more the credit cycle as applied to governments, which “never go broke.”? Things are great until they aren’t.? Who predicted that the PIIGS would erupt specifically in 2010?? Seeing the troubles is easy, naming the time is tough.

Delay merely makes the future solutions tougher, because the problem to solve is bigger.? The trouble is, we don’t know what actions our government will take.? I lean toward inflation, given the tendency of American history, but who can tell?

This is a tough time to be managing bonds, but what time isn’t?