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Book Review: Heroes & Villains of Finance

Posted on 13 August 201513 August 2015 by David Merkel

I made it through this book while watching my daughter at a softball tryout. ?It was an overly easy read, because there is little in the book. ?For each of the 50 characters in the book, you get around 1.5?pages of text. ?An average article at Aleph Blog would be the length of 2-3 biographical vignettes contained in this book. ?At most, you learn the highest points of their lives.

But, I have other criticisms:

You don’t even necessarily get the highest points of their lives. ?I read through a few of them and thought I could have done a better job summarizing their lives with one hour of time.
Many of the characters don’t deserve to be in the book. ?Some?aren’t important or colorful enough. ?Others?are too recent to evaluate how truly “colorful” or important they are. ? Others aren’t truly in finance — they may be in business, politics, or academic economics, but they had little to do with finance in any direct way.
Occasionally, there are factual errors, such as with Nick Leeson, where it attributes his famous “I’m Sorry,” note to February 1994 (twice), while having him flee?one year later in 1995. ?Both happened in February 1995.

This book is bad enough that the author should be absolved from blame, and that the editors and anyone else in the approval process at Wiley should receive it. ?This book should never have seen the light of day in its present form. ?Wiley’s quality control is usually quite good — something went awry here.

Now, lest this be purely negative, I have two ideas. ?Simple idea one: go buy Kenneth Fisher’s 100 Minds that Made the Market. ?This is the book that Heroes &?Villains of Finance should be. ?As I say in my review:

Some people are hard to buy gifts for.? With books, there is often a trade-off between books that say a lot, and those that people are willing to read.? One book that I think hits the sweet spot is 100 Minds That Made The Market, by Ken Fisher.

Why do I think this?? This book is 100 little books in one volume.? You can pick this book up for five minutes, and read a well-written 3-4 page biography of person who has had a significant impact on how our markets work today.? Then you can put it down, get back to work, and think that you have learned something significant.

So if you want a book of short biographies, this is a better one. ?I think it makes an excellent gift.

Idea number two, for the folks at Wiley — here’s a book that could sell: [20-50] Greatest Financial Scandals Ever. ?Average people aren’t looking for heroes in finance. ?It’s not that there aren’t any. ?It’s just that the scoundrels are far more interesting to read about. ?Finance, when done right, is boring. ?Margin of safety, low debt,?ethical management, etc… good to learn from, but won’t tell interesting stories to the same degree.

I would encourage the author to take it one step further as well: add a final chapter to give the common themes that run through the scandals. ?Books like?Heroes &?Villains of Finance leave you with no generality at the end — is there some common thread behind heroes? ?What of villains? ?Are there lessons to be drawn here from the sum total of the lives considered?

Summary?

Don’t buy?Heroes and Villains of Finance. ?Instead, if you want such a book, buy?100 Minds That Made the Market. ?If you buy through the link I provide here, I get a small commission. ?At present, it is the only revenue source for my blog.

Full Disclosure

I review books because I love reading books, and want to introduce others to the good books that I read, and steer them away from bad or marginal books.? Those that want to support me can enter Amazon through my site and buy stuff there.? Don?t buy what you don?t need for my sake.? I am doing fine.? But if you have a need, and Amazon meets that need, your costs are not increased if you enter Amazon through my site, and I get a small commission.? Win-win.

Thinking About Pensions, Part 1

Posted on 8 August 20159 August 2015 by David Merkel

Dear Readers, I’m going to try a different format for this piece. If you think it is a really bad way to present matters, let me know.

Question: Why do pensions exist?

Answer: They exist as a means of incenting employees to work for a given entity. ?It can be a very valuable benefit ?to employees, because it is difficult to earn money in old age.

Q: How did we end up with retirement savings being predominantly associated with employment?

A: That’s mostly an accident of history. ?First some innovative firms offered defined?benefit [DB] plans [paying a fixed sum at retirement for life, often with benefits to surviving spouses, and pre-retirement death benefits] in order to attract employees. ?After World War II, many unions insisted and won such benefits, and many non-union firms imitated them.

Q: Why didn’t many defined benefit plans persist to the present day?

A: In general, they were too expensive.

Q: If they were too expensive, why did they get created?

A: They weren’t expensive at first. ?The post-WWII era was one of booming demand and excellent demographics — there was only a small cohort of oldsters to support, and a rapidly growing population of workers. ?Also, the funding mechanisms allowed by the government allowed for low levels of initial funding to get them started, and they assumed that corporations would easily catch up at some later date. ?Sadly, some of the funding was so low that there were some defaults in the 1960s, leaving pensioners bereft.

Q: Ouch. ?What happened as a result?

A: Eventually, Congress passed the?Employee Retirement Income Security Act in 1974. ?That standardized pension funding methods and tightened them a little, but not enough for my taste. ?It also created the Pension Benefit Guarantee Corporation to insure defined benefit plans. ?It did many things to standardize and protect defined benefit pensions. ?Protection comes at a cost, though, and costs went higher for DB plans.

Some firms began terminating their plans. ?In the mid-1980s, some firms found that they could get a moderate profit out of terminating their plans. ?That didn’t sit well with Congress, which passed legislation to inhibit the practice. ?That indirectly inhibited starting plans — few people want to in the “in” door, when there is not “out” door.

Some firms began funding their plans very well, and the IRS didn’t like the loss of tax revenue, so regulations were created to stop overfunding of pension plans. ?These regulations put sponsors in a box. ?Given the extremely strong asset returns of the ’80s and ’90s, it would have made sense to salt a lot of assets away, but that was not to be. ?Thanks, IRS.

Q: Were there any other factors aside from tax policy affecting DB plans?

A: Four?factors that I can think of:

Falling interest rates raised the value of pension liabilities.
Demographics stopped being so favorable as people married less and had fewer kids.
Actuaries got pressured to be too aggressive on plan valuation assumptions, leading to lower contributions by corporations and municipalities to their plans.
By accident, the 401(k) was introduced, leading to an alternative pension plan design that was a lot cheaper. ?Defined contribution plans were a lot cheaper, and easier for participants to understand. ?The benefits were valued more than the technically superior DB plan benefits because you could see the balance grow over time — especially in the ’80s and ’90s!

Q: Why do you say that?DB plan benefits were?technically superior?

A: Seven?reasons:

They were generally paid for entirely by the employer.
A lot more money was contributed by the employer.
It gave them a benefit that they could not outlive.
Average people aren’t good at investing.
Fees for investing were a lot lower for DB plans than for Defined Contribution [DC] plans. ?(Employer provides a sum of money to each employee’s account.)
The institutional investors were better for DB plans than DC plans, because plan sponsors would go direct to money managers with talent, while plan participants demanded name-brand mutual funds that were famous. ?(Famous means a lot of assets recently added, which means poor future performance. ?Should you give your kids what they want, or what you know they need?)
If the companies could continue to afford the benefits, the benefits would be much larger in present value terms than the lump sum accumulated in their DC plans.

The last point is important, because the benefits promised were too large for the companies to fund. ?Eventually, they will be too large for most states and municipalities to fund as well, but that’s another thing…

Q: So?people preferred something that was easier to understand, rather than something superior, and companies used that to shed a more expensive pension system. ?That’s how we got where we are today?

A: Yes, and add in the relative impermanence of most corporations and some industries. ?You need a strong profit stream in order to fund DB plans.

Q: What are we supposed to do about this then?

A: Stay tuned for part two, which I will write next week. ?Believe me, there are a lot of controversial ideas about this, and there are no easy solutions — after all, we got into this problem because most corporations and people did not want to save enough money for the retirement of employees and themselves, respectively.

Q: Till next time, then!

Buying The Next Hot Idea

Posted on 7 August 2015 by David Merkel

If you want to know what is the core problem of the average person approaching the market (though this applies more to males than females, women have more native caution on average), it is chasing a hot idea. ?This can take a number of forms:

Getting tips from friends who have bought some?stock?that is currently popular in the market.
Doing the same thing with investors who talk or write about investing. ?The best investment advice is not flashy, and does not make for good video.
Looking at charts and buying something that is rising rapidly, because popular media say?this is “The Next Big Thing.”
Buying the mutual fund or other pooled vehicle of some manager who has done very well in the past, and seems to never fail. ?(If you buy a mutual fund, don’t buy one that has had a lot of money pile into it recently… usually a bad sign. ?Spend more time to see if the manager thinks in a businesslike way about assets that he buys.)
Going to a broker who is very well-dressed and confident, and talks really well, but who has no obligation to act in your best interests. ?If you don’t know how he is earning his money from you, avoid him, because it usually means investments with high fees or hidden ways that you can lose, e.g. structured notes that offer a nice yield, but where possibilities to lose are more significant than you think. ?At best, he will give you consensus ideas and managers that deliver him above average remuneration.
Buying the newsletter of some overly confident person who claims to know the secrets of the market, which he will share with you and 100,000 other close friends for a mere $299/year! ?(Please read Mark Hulbert before buying a newsletter.)
Worse yet, giving into the fakery of those who try to bring you into a hidden opportunity. ?It can be a Ponzi scheme, a promoted stock, but they suggest returns that are huge… or, like Madoff, decent but not exorbitant returns that are altogether too regular.

Many of these appeal to our desire to get something for nothing, which is endemic — we all have it to some degree, and marketers play off this regularly by offering us “free” this, and “free” that. ?Earning returns from your investable?assets is a business in its own right, and there are costs to doing it well. ?You should not be surprised that doing well with it will take some time and effort.

You also have to avoid the impulse that there is some hidden knowledge, or group of insiders that have found an easy road to riches. ?The markets aren’t rigged in any material way. ?The principles of investing are well-known, but applying them takes creativity, time and effort. ?There are no significant players with a new theory?who make amazing money investing in secondary markets for stocks and bonds.

Most of the things that I listed above involve low-thought imitation of others. ?There is little advantage in investing to mimicry. ?Even if it worked for someone else, the prices are different now, and easy gains have been made. ?You will do worse than the one you are trying to imitate with virtual certainty, and likely worse than average. ?You need to plan to take an independent course, and learn enough such that if you do choose to use advice of any sort, that you can evaluate it rationally. ?If you choose to do it yourself, you will need to learn more than that. ?It takes effort, but that effort will pay off, if not in investing itself, but there are spillover effects in intelligent management of your finances, and in improving your abilities in the businesses that you serve.

In most areas of life, most things that pay off well take effort. ?If people?present you with easy or hidden ways to make above average money, be skeptical. ?Doing it right takes discipline and effort. ?(If you want the easy route while avoiding all the pitfalls see the postscript. ?It is boring, but it works.)

Postscript

As an aside — you can always index, and beat most average investors over the long haul. ?Buy broad funds that invest in a large fraction of all of the stocks that there are, and those that replicate the bond market as a whole. ?Make sure they have low fees. ?Buy them, hold them, and be done. ?You will still face one hurdle: will you be able to maintain your strategy when everything is in a crisis, or when your friends tell you they are earning a lot more than you, and it is easy to do it? ?Size the bond portion of your assets to the level where you can sleep soundly in all circumstances, and you will be fine.

Modeling Financial Liquidity and Solvency

Posted on 1 August 20152 August 2015 by David Merkel

Too often in debates regarding the recent financial crisis, the event was regarded as a surprise that no one could have anticipated, conveniently forgetting those who pointed out sloppy banking, lending and borrowing practices in advance of the crisis. ?There is a need for a well-developed model of how a financial crisis works, so that the wrong cures are not applied to the financial system.

All that said, any correct cure will bring about a predictable response from the banks and other lending institutions. ?They will argue that borrower choice is reduced, and that the flow of credit and liquidity to the financial system is also reduced. ?That is not a big problem in the boom?phase of the financial cycle, because those same measures help to avoid a loss of liquidity and credit availability in the bust phase of the cycle. ?Too much liquidity and credit is what fuels eventual financial crises.

To get to a place where we could have a decent model of the state of overall financial credit, we would have to have models that work like this:

The models would have to have both a cash flow and a balance sheet component to them — it’s not enough to look at present measures of creditworthiness only, particularly if loans do not fully amortize debts at the current interest rate. ?Regulatory solvency tests should not automatically assume that borrowers will always be able to refinance.
The models should try to go loan-by-loan, and forecast the ability of each loan to service debts. ?Where updated financial data is available on borrowers, that should be included.
The models should try to forecast the fair market prices of assets/collateral, off of estimated future lending conditions, so that at the end of the loan, estimates can be made as to whether loans would be refinanced, extended, or default.
As asset prices?rise, there has to be a feedback effect into lowered ability to finance new loans, unless purchasing power is increasing as much or more than asset prices. ?It should be assumed that if loans are made at lower underwriting standards than a given threshold, there will be increasing levels of default.
A close eye would have to look for situations where if the property were rented out, it would not earn enough to pay for normalized interest, taxes and maintenance. ?When asset prices are that high, the system is out of whack, and invites future defaults. ?The margin of implied rents over?normalized interest, taxes and maintenance would be the key measure, and the regulators would have to have a function that attributes future losses off of the margin of that calculation.
The cash flows from the loans/mortgages would have to feed through the securitization vehicles, if any, and then to the regulated financial institutions, after which, how they would fund their future liabilities would?have to be estimated.
The models would have to include the repo markets, because when the prices of collateral get too high, runs on the repo market can happen. ?The same applies to portfolio margining agreements for derivatives, futures, and other types of wholesale lending.
There should be scenarios for ordinary recessions. ?There should also be some way of increasing the Ds at that time: death, disability, divorce, disaster, dis-employment, etc. ?They mysteriously?tend to increase in bad economic times.

What a monster. ?I’ve worked with stripped-down versions of this that analyze the Commercial Mortgage Backed Securities [CMBS] market, but the demands of a model like this would be considerable, and probably impossible. ?Getting the data, scrubbing it, running the cash flows, calculating the asset price functions, implied margin on borrowing, etc., would be pretty tough for angels to do, much less mere men.

Thus if I were watching over the banks, I would probably rely on analyzing:

what areas of credit have grown the quickest.
where have collateral prices risen the fastest.
where are underwriting standards declining.
what assets are being financed that do not fully amortize, including all repo markets, margin agreements, etc.

The one semi-practical thing i would strip out of this model would be for regulators to score loans using a model like point 5 suggests. ?Even that would be tough, but even getting that approximately right could highlight lending institutions that are taking undue chances with underwriting.

On a slightly different note, I would be skeptical of models that don’t try to at least mimic the approach of a cash flow based model with some adjustments for market-like pricing of collateral and loans. ?The degree of financing long assets with short liabilities is the key aspect of how financial crises develop. ?If models don’t reflect that, they aren’t realistic, and somehow, I expect that non-realistic models of lending risk will eventually be the rule, because it helps financial institutions make loans in the short run. ?After all, it is virtually impossible to fight loosening financial standards piece-by-piece, because the changes seem immaterial, and everyone favors a boom in the short-run. ?So it goes.

Volume Is Usually Low At Turning Points

Posted on 1 August 2015 by David Merkel

A few days ago, I was trying to buy a little bit of a defense company that I own for myself and clients. ?It was relatively inexpensive, and had fallen out of favor. ?Now, it’s not the most liquid beastie on the US market, so I put in an order to buy 2000 shares, while showing 100 shares, offering to buy at the current bid of $25.50 while allowing purchases at up to $25.57, while the ask was at $25.65. ?I then shifted away from my trading application, and went to do other work.

After an hour, I went back to my trading screen, and saw that 1200 shares had executed between $25.50 and 25.57, but now the price was much higher, and by the end of the day, higher still. ?It is even higher now.

At the time, I took a look, and lo and behold: I got the bottom tick — the lowest price on that stock ever (for now). ?I also noted that I had almost all of the volume when it went down to the low price. ?But 1200 shares is small compared to the total trading in the name, and $30,000 is also a small amount of money. ?I concluded that it was a happy accident that I got the bottom tick.

I’ve had the same experience working at a hedge fund. ?I would occasionally get the bottom tick when buying, or the top tick when selling, and most of the time I ended up saying that it had to happen to someone — it was us that day. ?That said, the total amount of volume was almost always low near the top or bottom, so getting that versus a trade nearby was not worth that much.

To have a lot of volume near a top or bottom, you need two or more determined and anxious traders with large capacity to trade, a need for speed, and opposite opinions. ?That happens sometimes, but in experience, not that often. ?Near a peak, you would need a buyer anxious to buy a lot more NOW. ?Near a trough, a seller wanting to sell it all NOW.

Most of the time, large institutional investors are cautious, and try to minimize their impact on market prices — being too aggressive will likely give them a worse result than being patient. ?The exception would be someone who thinks he knows a lot more than the market, but feels that edge will erode soon, and therefore has to do the trade in full NOW.

That doesn’t happen often. ?Practically, that means to not be so picky about levels in buying and selling. ?If you are getting the trade off and there is decent volume at a price near where you want to do the trade, do the trade, and don’t worry much about the small amount of profit that you might be giving up. ?Better to focus on ideas that you think have long term potential for profit, than to waste time trying to squeeze the last bit of profit out of a trade where incremental returns will be minuscule.

Bid Out Your Personal Insurance Policies!

Posted on 31 July 2015 by David Merkel

Photo Credit: Dana || They charge more for "Arrest me red" too! — Photo Credit: Dana || They charge more for “Arrest me red” too!

This should be a relatively quick note on personal lines insurance. I’m writing this after reading the piece in this month’s Consumer Reports on Auto Insurance. ?I agree with most of it. ?For those that are short on time, my basic advice is this: bid out your auto, home, umbrella and other personal lines property & casualty insurance policies once every three years, or after every significant event that?changes your premium significantly.

Here are a few simple facts to consider:

Personal lines insurance — auto, home, umbrella, rental, etc. is a very competitive business, and the companies that offer it?all want an underwriting formula that would give them the best estimate of expected losses from each person insured.
After that, they want to know how much “wiggle room” that they would have to build in some profit. ?Where might the second place bid be? ?How likely are consumers to shop around?
Most insurers use a mix of credit scores and claim history to calculate rates. ?Together, they are effective at forecasting loss costs — more effective than either one separately.
Read my piece?On Credit Scores. ?They are very important, because they measure moral tendency. ?People with low scores tend to?have more claims than those with high scores on average. ?People with high scores tend to be more careful in life. ?This is a forward-looking aspect of a person’s underwriting profile.
It’s fair to use “credit scores” because they are positively and significantly correlated with loss costs. ?The actuaries have tested this. ?Note that it is legal in almost?all states to use credit scores, or something like them, but not all of them.
As the Consumer Reports article points out, many insurance companies take advantage of insureds that stick with them year by year, because they don’t shop around. ?Easy cure: bid out your policy every three years at minimum. ?If enough people do this, the insurance companies that overcharge loyal customers will stop doing it. ?(Note: when I was a buy side analyst analyzing insurance stocks, one company implicitly admitted to doing this, and I was insured by them. ?Guess what I did next? ?It was not to sell the stock, though eventually I did when I saw that their premium increases were no longer increasing profits.)
Also be willing to unbundle your home and auto policies — there may be a discount, or there may not as the?Consumer Reports article states. ?I’ve worked it both ways, and am unbundled at present.
If they have that much money for amusing advertising, it implies that the market isn’t that rational. ?Bid it out.
But — it is important to realize that insurers don’t all have the same formulas for underwriting, and those formulas are not static over time. ?Bidding out your insurance makes sure you benefit from changes that positively affect you.
Insurers tend to get more competitive as the surplus they have to deploy gets bigger, and vice-versa when it shrinks after a large disaster. ?If your premium goes up after a disaster, bid the policies out. ?If it drifts up slowly when there have been no significant disasters, or claims on your part, they are taking advantage of you. ?Bid it out.

Bid it out. ?Bid it out. ?Bid it out. ?What do you have to lose? ?If loyalty means something to the insurer, they will likely win the bid. ?If it doesn’t, they will likely lose. ?Either way you will win. ?If you have an agent, they will note that you are price-sensitive. ?The agent will become more of an ally, even if it doesn’t seem that way.

I went through this several times. ?Most people who have read me for a while know that I have a large family — I am going to start teaching number seven to drive now. ?I bid it out when kids came onto my policy. ?It produced a change. ?When two of my kids had accidents in short succession, my premiums rose a lot. ?They would not underwrite one kid. ?I got most of it back when I bid it out. ?Since that time, the two have been claim-free for 2.5 years. ?Guess what I am going to do next March, when I am close to the renewal where premiums would shift? ?You got it; I will bid it out.

There is one more reason to bid it out: it forces you to review your insurance needs. ?You may need more or less coverage than you currently have. You might realize that you need an umbrella policy for additional protection. ?You may decide to self-insure more by raising your deductibles. ?The exercise is a good one.

You don’t need transparency, or more regulation. ?You don’t get transparency in the pricing of many items. ?You do need to bid out your business every now and then. ?You are your own best defender in matters like this. ?Take your opportunity and bid out your policies.

Make sure that you:

Choose a range of insurers — Large companies, smaller local companies, stock/mutual, and any that favor a group you belong to, if the group is known to be filled with good risks.
Give them a standardized request for insurance, giving all of the parameters for your coverage, and data on those insured.
Tell them they get one shot, so submit their best bid now… there will be no second looks.
Some companies argue more about paying claims. ?(AIG once had a reputation that way.) ?Limit your bidders to those with a reputation for fairness. ?State insurance departments often keep lists of complaints for companies. ?Take a look in your home state. ?Talk with friends. ?Google the company name with a few choice words (cheated, claim?denied, etc.) to see complaints, realizing that complainers aren’t always right.
Limit yourself to the incumbent carrier and 4-6 others. ?Seven is more than enough, given the work involved.

So, what are you waiting for? ?Bid out your personal insurance business.

Full disclosure: long AIZ, ALL, BRK/B, TRV for myself and clients (I know the industry well)

Redacted Version of the July 2015 FOMC Statement

Posted on 29 July 2015 by David Merkel

Photo credit: jonesylife || Oh look, a dozen doves flying at the FOMC!

June 2015	July 2015	Comments
Information received since the Federal Open Market Committee met in April suggests that economic activity has been expanding moderately after having changed little during the first quarter.	Information received since the Federal Open Market Committee met in June indicates that economic activity has been expanding moderately in recent months.	No real change.
Growth in household spending has been moderate and the housing sector has shown some improvement; however, business fixed investment and net exports stayed soft.	Growth in household spending has been moderate and the housing sector has shown additional improvement; however, business fixed investment and net exports stayed soft.	No real change. Swapped places with the following sentence.
The pace of job gains picked up while the unemployment rate remained steady. On balance, a range of labor market indicators suggests that underutilization of labor resources diminished somewhat.	The labor market continued to improve, with solid job gains and declining unemployment. On balance, a range of labor market indicators suggests that underutilization of labor resources has diminished since early this year.	No real change. Swapped places with the previous sentence.
Inflation continued to run below the Committee’s longer-run objective, partly reflecting earlier declines in energy prices and decreasing prices of non-energy imports; energy prices appear to have stabilized.	Inflation continued to run below the Committee’s longer-run objective, partly reflecting earlier declines in energy prices and decreasing prices of non-energy imports.	No real change.
Market-based measures of inflation compensation remain low; survey-based measures of longer-term inflation expectations have remained stable.	Market-based measures of inflation compensation remain low; survey?based measures of longer-term inflation expectations have remained stable.	No change.? TIPS are showing higher inflation expectations since the last meeting. 5y forward 5y inflation implied from TIPS is near 2.10%, up 0.07% from April.
Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability.	Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability.	No change. Any time they mention the ?statutory mandate,? it is to excuse bad policy.
The Committee expects that, with appropriate policy accommodation, economic activity will expand at a moderate pace, with labor market indicators continuing to move toward levels the Committee judges consistent with its dual mandate.	The Committee expects that, with appropriate policy accommodation, economic activity will expand at a moderate pace, with labor market indicators continuing to move toward levels the Committee judges consistent with its dual mandate	No real change.
The Committee continues to see the risks to the outlook for economic activity and the labor market as nearly balanced. Inflation is anticipated to remain near its recent low level in the near term, but the Committee expects inflation to rise gradually toward 2 percent over the medium term as the labor market improves further and the transitory effects of earlier declines in energy and import prices dissipate. The Committee continues to monitor inflation developments closely.	The Committee continues to see the risks to the outlook for economic activity and the labor market as nearly balanced. Inflation is anticipated to remain near its recent low level in the near term, but the Committee expects inflation to rise gradually toward 2 percent over the medium term as the labor market improves further and the transitory effects of earlier declines in energy and import prices dissipate. The Committee continues to monitor inflation developments closely.	CPI is at +0.2% now, yoy.? No change in language.
To support continued progress toward maximum employment and price stability, the Committee today reaffirmed its view that the current 0 to 1/4 percent target range for the federal funds rate remains appropriate. In determining how long to maintain this target range, the Committee will assess progress–both realized and expected–toward its objectives of maximum employment and 2 percent inflation. This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial and international developments.	To support continued progress toward maximum employment and price stability, the Committee today reaffirmed its view that the current 0 to 1/4 percent target range for the federal funds rate remains appropriate. In determining how long to maintain this target range, the Committee will assess progress–both realized and expected–toward its objectives of maximum employment and 2 percent inflation. This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial and international developments.	No change.
The Committee anticipates that it will be appropriate to raise the target range for the federal funds rate when it has seen further improvement in the labor market and is reasonably confident that inflation will move back to its 2 percent objective over the medium term.	The Committee anticipates that it will be appropriate to raise the target range for the federal funds rate when it has seen some further improvement in the labor market and is reasonably confident that inflation will move back to its 2 percent objective over the medium term.	No real change. No rules, just guesswork from academics and bureaucrats with bad theories on economics.
The Committee is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and of rolling over maturing Treasury securities at auction. This policy, by keeping the Committee’s holdings of longer-term securities at sizable levels, should help maintain accommodative financial conditions.	The Committee is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and of rolling over maturing Treasury securities at auction. This policy, by keeping the Committee’s holdings of longer-term securities at sizable levels, should help maintain accommodative financial conditions.	No change.? Changing that would be a cheap way to effect a tightening.
When the Committee decides to begin to remove policy accommodation, it will take a balanced approach consistent with its longer-run goals of maximum employment and inflation of 2 percent. The Committee currently anticipates that, even after employment and inflation are near mandate-consistent levels, economic conditions may, for some time, warrant keeping the target federal funds rate below levels the Committee views as normal in the longer run.	When the Committee decides to begin to remove policy accommodation, it will take a balanced approach consistent with its longer-run goals of maximum employment and inflation of 2 percent. The Committee currently anticipates that, even after employment and inflation are near mandate-consistent levels, economic conditions may, for some time, warrant keeping the target federal funds rate below levels the Committee views as normal in the longer run.	No Change. ?Balanced? means they don?t know what they will do, and want flexibility.
Voting for the FOMC monetary policy action were: Janet L. Yellen, Chair; William C. Dudley, Vice Chairman; Lael Brainard; Charles L. Evans; Stanley Fischer; Jeffrey M. Lacker; Dennis P. Lockhart; Jerome H. Powell; Daniel K. Tarullo; and John C. Williams.	Voting for the FOMC monetary policy action were: Janet L. Yellen, Chair; William C. Dudley, Vice Chairman; Lael Brainard; Charles L. Evans; Stanley Fischer; Jeffrey M. Lacker; Dennis P. Lockhart; Jerome H. Powell; Daniel K. Tarullo; and John C. Williams.	No change, sadly. We need some people in the Fed and in the government who realize that balance sheets matter ? for households, corporations, governments, and central banks.? Remove anyone who is a neoclassical economist ? they missed the last crisis; they will miss the next one.

Comments

This FOMC statement was another great big nothing. No significant changes.
Don?t expect tightening in September. People should conclude that the FOMC has no idea of when the FOMC will tighten policy, if ever.? This is the sort of statement they issue when things are ?steady as you go.?? There is no hint of imminent policy change.
Despite lower unemployment levels, labor market conditions are still pretty punk. Much of the unemployment rate improvement comes more from discouraged workers, and part-time workers.? Wage growth is weak also.
Equities and long bonds rise. Commodity prices and the dollar are flat.
The FOMC says that any future change to policy is contingent on almost everything.
Don?t know they keep an optimistic view of GDP growth, especially amid falling monetary velocity.
The key variables on Fed Policy are capacity utilization, labor market indicators, inflation trends, and inflation expectations. As a result, the FOMC ain?t moving rates up, absent improvement in labor market indicators, much higher inflation, or a US Dollar crisis.
We have a congress of doves for 2015 on the FOMC. Things will continue to be boring as far as dissents go.? We need some people in the Fed and in the government who realize that balance sheets matter ? for households, corporations, governments, and central banks.? Remove anyone who is a neoclassical economist ? they missed the last crisis; they will miss the next one.

Pick a Valid Strategy, Stick With It

Posted on 29 July 2015 by David Merkel

I’m not going to argue for any particular strategy here. My main point is this: every valid strategy is going to have some periods of underperformance. ?Don’t give up on your strategy because of that; you are likely to give up near?the point of maximum pain, and miss the great returns in the?bull phase of the strategy.

Here?are three?simple bits of advice that I hand out to average people regarding asset allocation:

Figure out what the maximum loss is that you are willing to take in a year, and then size your allocation to risky assets such that the likelihood of exceeding that loss level is remote.
If you have any doubts on bit of advice #1, reduce the amount of risky assets a bit more. ?You’d be surprised how little you give up in performance from doing so. ?The loss from not allocating to risky assets that return better on average is partly mitigated by a bigger payoff from rebalancing from risky assets to safe, and back again.
Use additional money slated for investing?to rebalance the portfolio. ?Feed your losers.

The first rule is most important, because the most important thing here is avoiding panic, leading to selling risky assets when prices are depressed. ?That is the number one cause of underperformance for average investors. ?The second rule is important, because it is better to earn less and be able to avoid panic than to risk losing your nerve. ?Rule three just makes it easier to maintain your portfolio; it may not be applicable if you follow a momentum strategy.

Now, about momentum strategies — if you’re going to pursue strategies where you are always buying the assets that are presently behaving strong, well, keep doing it. ?Don’t give up during the periods where it doesn’t seem to work, or when it occasionally blows up. ?The best time for any strategy typically come after a lot of marginal players give up because losses exceed their pain point.

That brings me back to rule #1 above — even for a momentum strategy, maybe it would be nice to have some safe assets?on the side to turn down the total level of risk. ?It would also give you some money to toss into the strategy after the bad times.

If you want to try a new strategy, consider doing it when your present strategy has been doing well for a while, and you see new players entering the strategy who think it is magic. ?No strategy is magic; none work all the time. ?But if you “harvest” your strategy when it is mature, that would be the time to do it. ?It would be similar to a bond manager reducing exposure to risky bonds when the additional yield over safe bonds is thin, and waiting for a better opportunity to take risk.

But if you do things like that, be disciplined in how you do it. ?I’ve seen people violate their strategies, and reinvest in the hot asset when the bull phase lasts too long, just in time for the cycle to turn. ?Greed got the better of them.

Markets are perverse. ?They deliver surprises to all, and you can be prepared to react to volatility by having some safe assets to tone things down, or, you can roll with the volatility fully invested and hopefully not panic. ?When too many unprepared people are fully invested in risky assets, there’s a nasty tendency for the market to have a significant decline. ?Similarly, when people swear off investing in risky assets, markets tend to perform really well.

It all looks like a conspiracy, and so you get a variety of wags in comment streams alleging that the markets are rigged. ?The markets aren’t rigged. ?If you are a soldier heading off for war, you have to mentally prepare for it. ?The same applies to investors, because investing isn’t perfectly easy, but a lot of players say that it is easy.

We can make investing easier by restricting the choices that you have to make to a few key ones. ?Index funds. ?Allocation funds that use index funds that give people a single fund to buy that are?continually rebalanced. ?But you would still have to exercise discipline to avoid fear and greed — and thus my three example rules above.

If you need more confirmation on this, re-read my articles on dollar-weighted returns versus time-weighted returns. ?Most trading that average people do loses money versus buying and holding. ?As a result, the best thing to do with any strategy is to structure it so that you never take actions out of a sense of regret for past performance.

That’s easy to say, but hard to do. ?I’m subject to the same difficulties that everyone else is, but I worked to create rules to limit my behavior during times of investment pain.

Your personality, your strategy may differ from mine, but the successful meta-strategy is that you should be disciplined in your investing, and not give into greed or panic. ?Pursue that, whether you invest like me or not.

Twenty Enduring Posts

Posted on 28 July 201528 July 2015 by David Merkel

This morning, I looked at the fall in the Chinese stock market, and I said to myself, “It’s been a long journey since the last crash.” After that, I wrote a brief piece at RealMoney, and another at what was then the new Aleph Blog, which was republished and promoted at Seeking Alpha, and got featured at a few news outlets. ?It gave my blog an early jolt of prominence. I was surprised at all of the early attention. That said, it encouraged me to keep going, and eventually led me away from RealMoney, and into my present work of managing money for upper middle class individuals and small institutions.

I try to write material that will last, even though this is only blogging. ?Looking at the piece on the last China crash made me think… what pieces of the past (pre-2015) still get readers? ?So, I stumbled across a way to answer that at wordpress.com, and thought that the array of articles still getting readers was interesting. ?The tail is very long on my blog, with 2725 articles so far, with an average word length of around 800. ?Anyway, have a look at the top 20 articles written before 2015 that are still getting read now:

20.?Got Cash?

Though I write about personal finance, it’s not my strongest suit. ?Nonetheless, when I?wanted to write some articles about personal finance for average people, I realized I needed to limit myself mostly to cash management. ?A few of the articles in the new series “The School of Money,” should be good in that regard.

19.?Book Review: Best Practices for Equity Research Analysts

I write a lot of book reviews. ?I have some coming up. ?I was surprised that on this specialized got so many hits after four years.

18.?On the Structure of Berkshire Hathaway, Part 2, the Harney Investment Trust

This is a controversial piece on the most secretive aspects of what Buffett does in investing. ?I have tried to get people from the media to pick up this story, but no one wants to touch it. ?I think I am one of the few admirers of Buffett willing to be critical… but so what? ?Hasn’t worked on this story.

17.?Learning from the Past, Part 1

This short series goes through my worst investing mistakes. ?It’s almost finished. ?I have one or two more articles to write on the topic. ?This one covers my early days, where I made a lot of rookie errors.

16.?On Trading Illiquid Stocks

I describe some of my trading techniques that I use to fight back against the high frequency traders.

15.?De Minimus Laws

Here I do a post aiding all of my competitors, giving the relevant references to the de minimus laws for registered investment advisers in all 50 states, plus DC and Puerto Rico. ?Note that I got my home state of Maryland wrong, and I corrected it later.

14.?The Good ETF, Part 2 (sort of)

Reprises an article of mine explaining what makes for exchange-traded products that are good for investors.

13.?On Bond Risks in the Short-Run

A piece giving advice on institutional bond management. ?Kinda surprised this one still gets read…

12.?Should Jim Cramer Sell TheStreet or Quit CNBC?

Cramer generates controversy, and thus pageviews as well. ?As an aside, TheStreet.com is down another 20% since I wrote that. ?Still, the piece had my insights from brief discussions that I had with Cramer, way back when.

11.?An Internship at a Hedge Fund

Basic advice to a young man starting a new job at a hedge fund.

10.?Q&A with Guy Spier of Aquamarine Capital

I have always enjoyed the times where I have had the opportunity to interact with the authors of the books that I have gotten to review. ?Guy Spier was a particularly interesting and nice guy to interact with.

9.?The Good ETF

This is the predecessor piece to the one rated #14 on this list. ?Brief, but gets the points across on what the best exchange traded products are like. ?It was written in 2009.

8.?We Eat Dollar Weighted Returns ? III

I’ve been banging this drum for some time, and the last one in this series was quite popular also. ?This article highlighted how much average investors lose relative to buy-and-hold investors in the?S&P 500 Spider [SPY]. ?Really kinda sad, underperforming by ~7%/year.

7.?Portfolio Rule Seven

Now, why does my rebalancing trade rule get more play than any of my other rules? ?I don’t know.

6.?The US is not Japan, but there are some Similarities

I had forgotten that I had written this one in 2011. ?Why does it still get hits? ?In it I argue that the US will get out of its difficulties more easily than Japan. ?(Maybe this gets read in Japan?)

5.?Actuaries Versus Quants

My contention is that Actuaries are underrated relative to Quantitative Analysts, and have a lot to offer the financial markets, should the Actuaries ever get their act together.

4.?Can the ?Permanent Portfolio? Work Today?

Does it still make sense to split your portfolio into equal proportions of stocks, long Treasuries, T-bills, and gold?! ?Maybe.

3.?The Venn Diagram Method for Greatest Common Factors and Least Common Multiples

I was shocked at this one, written in 2008. ?This post explains a math concept in simple visual terms for teachers to explain?greatest common factors and least common multiples.

And now for the last three:

2.?On Berkshire Hathaway and Asbestos

1.?On the Structure of Berkshire Hathaway

0.?Understanding Insurance Float?(oops, miscounted when I started… so much for being good at math 😉 )

Should it be any surprise that the last three, the most popular, are on Buffett, Berkshire Hathaway and Insurance? ?People go nuts over Buffett!

The one novel thing I bring to table here is my understanding of the insurance aspects of BRK. ?Each of the three deal with that topic in a detailed way. ?Aleph Blog is pretty unique on that topic; who else has written in detail about the insurance company-driven holding company structure? ?Aside from that,?many don’t get how critical BRK is to covering asbestos claims, and don’t get the economics of insurance float. ?Many think float is magic, when it can lead to an amplification of losses, as well as an intensification of gains.

These last three pieces got really popular in March, around the time that BRK released its 2015 earnings, even though they were one year old.

Anyway, I hope you found this interesting… I was surprised at what gets read after time goes by. ?One final note: for every time the most popular pre-2015 article was read, articles that would have been rated #22 and beyond got read 10 times… and thus the long tail. ?It’s nice to write for the long term. 🙂

Full disclosure: long BRK/B for myself and clients

The School of Money, First Grade

Posted on 25 July 201527 July 2015 by David Merkel

This post is an experiment, and not meant to be definitive. If you have any comments to improve it, leave a comment, or email me. ?Thanks.

The School of Money

Most books dealing with money tend to be too advanced for average people. ?If you’ve read me long enough, you know that I am pretty conservative with my finances. ?That conservatism has generally worked well for me, my family, and the church that I help lead. ?It’s possible this post could lead to a series of posts; let me know what you think.

First Grade — Preparing to Work

It could be our culture. ?It could be the way that public schools are organized. ?My guess is that parents don’t talk about it much, and think that it will happen easily. ?The transition of children learning to eventually applying their learning to work is a difficult thing in a world where there are many things to do, and not enough practicality involved in education.

Part of the problem is not having or developing an attitude of service. ?There is no shame in helping others. ?In one sense, compensation derives from how many people you help, times how valuable your contribution to that good or service is.

So, rather than “following your bliss,” the best work comes from enabling the bliss of others. ?It is rare that anyone will pay you for doing what you enjoy, and only that. ?Most work involves some things that are disagreeable. ?It’s important to look for the good that you can do in the midst of difficulty. ?Sometimes that greatest value comes from finding a new way to deal with difficulties, and making processes more productive as a result.

Somewhere around age 15, young people need to see what areas in the economy need talent, and what sort of skills are needed. ?In addition to specific skills, remember that in much of life mathematical reasoning, verbal skills, and genuine curiosity for solving problems will apply to a wide number of situations. ?Remember, the economy will be different 20 years from now in ways that we do?not presently fathom. ?Being able to think creatively and critically, and being able to express it well in oral and written ways will never go out of fashion. (As an aside, that is one of the criticisms I hear in the local money management community. ?Young people come out of college, but cannot express themselves well in writing.)

Informational interviewing at younger ages could be useful. ?Even at older ages, when you get the chance to ask business owners or managers questions, ask them what are the biggest problems that they face, what keep them up at night, etc. ?If nothing else, you’ll get a better perspective on what it is like to be in charge, and the headaches thereof.

Software may eliminate many jobs where analytical processes can be easily replicated by code. ?Analyze any career for the threat posed by software, or, employ the software yourself to enable you to do more and better work.

You’ll need to consider whether you want to take more risk and run your own business, or less risk and work at a set of skills for someone else. ?That said, you can never eliminate risk. ?Most of the firms that I once worked for are out of business today, or doing business in such a way that I might not be employed by them now. ?There are advantages to trying to control your own destiny, even if you fail a few times in the process. ?The skills you will?might come in useful if you do choose to work for someone else later. ?But if you succeed, you could end up with a valuable business that helps many people — customers, employees, vendors, and of course you. ?High rewards go to those who lead and structure the work of others successfully.

College is needed for many high level jobs, and sometimes a master degree or a doctorate. ?In other cases, additional training at a special school or a junior college may be enough. ?Even after graduation, a plethora of certification situations may present themselves. ?Before entering any education situation, try to analyze whether it will genuinely pay off for you or not. ?Remember, even nonprofit colleges and universities rely on students to come and pay tuition so that the schools can survive. ?This is why it pays to have a range of ideas in mind of what you might like to do before going for higher education. ?There is nothing worse than taking on a load of debt that is not dischargeable in bankruptcy, and having no good way to pay it off. ?(Note: consider income-based repayment plans if debt is high, and income low.)

Also note that you may not find what you want to do on the first try, in addition to job obsolescence. ?Sometimes the path may involve retraining. ?If so, count the opportunity cost of the time and money spent. ?Sometimes?the best path may be indirect — get a lesser job at a firm that you might want to work for and then try to interact with those in the area that is your greater interest. ?In this day and age, many employers don’t advertise positions — the only way to find out about them within a firm, or by word of mouth. ?If you can show a degree of talent and diligence, greater opportunities may open up for you.

In the end, remember that your work is a means to an end of helping others, while?personally benefiting in the process. ?Look to the needs?of others, and find a way to serve well. ?In most cases, the rewards should follow.

Critical Questions

What human needs are not getting met?
Do you have an idea for a business that meets those needs?
Have I talked with enough different people, or read enough, to get a view of what is in demand, growing, etc.
What jobs pay well that don’t require college?
What sorts of jobs and people getting work visas for at present?
What education or skills do I need? ?How might that change?
Do I have good basic reasoning skills in math, science, reading, writing, general reasoning and logic, etc?