Diversification works great…until it doesn’t

Many financial advisers tout the benefits of diversification. They reason that spreading your eggs among many baskets can protect your aggregate egg count in case one basket drops.

But, what if there is some underlying reason that causes all baskets to drop all at once? Then, of course, all your eggs drop.

Most people didn’t think this was possible, and yet it happened in 2008. Almost every asset class dropped as the market panicked. The one major exception was U.S. Treasury Bonds.

As John Authers put it in his “The Short View” column in the Financial Times, “…last year’s sell-off was so extreme that diversification would not have helped one whit.”

But, isn’t it at times like this, when everyone is panicking, that diversification is supposed to provide benefits? Yes, it is supposed to. But, that doesn’t mean it does.

The reason why is that all financial markets are linked. Just because everyone is running from one investment does not mean another “historically uncorrelated” asset is necessarily doing well. This was very clear in 2008.

Diversification seems to work best when you don’t need it. People don’t get excited about diversification during normal times. It just gives you average instead of slightly better or slightly worse returns.

If you have half your money in U.S. stocks that provide a 5% return and half your money in foreign stocks that provide a 15% return, you get 10% returns. All you manage to do is lock in mediocre returns all the time. Getting 5% returns versus 10% or 15% returns in a single year won’t ruin someones retirement. Losing 40% the year after retiring almost certainly will.

When markets really panic, everything goes down together. Even a brief glance at economic history confirms this. Diversification fails when people want it most. Like…well, like in 2008.

There is a very real benefit to be gained from this situation, though. Not all investments have bad underlying characteristics. The very fact that a panic has occurred means both good and bad investments were sold off. So, you can currently buy excellent investments for the same price as the poor ones.

But, if you diversify you’ll get both the bad and the good returns going forward. Someone down 40% will see a world of difference between getting a 67% return (being in the good investments and returning to starting principal value) and getting a 33% return (being diversified in half the good investments that go up 67% and half the bad investments that go nowhere, thus still being down 20% from starting principal value).

Or, as John Authers put it, “If there is any consolation, it is that the sell-off was so indiscriminate. The odds are overwhelming that some stocks and asset classes will now begin to outperform.”

I don’t know when, exactly, those good stocks and asset classes will take off, but I’m quite comfortable I have identified them and believe very strongly my clients and I will benefit going forward.

This may very well be a case where not being too diversified will reap great benefits.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Economists are like diapers

Economists love to make forecasts. The problem is: most economists are like diapers, they require frequent changing and for the same reason (i.e. they are full of crap). Don’t spend too much time thinking or worrying about economic forecasts, they are seldom if ever right.

This may seem like an overly harsh judgment, but I cannot think of any profession that has a worse track record (even politicians seem to do better, and from me that’s quite a concession).

Most economists are either from or in academia. Their focus is on an other-worldly fantasy that has few similarities to the world we live in. Not surprisingly, this ivory tower approach leads to terrible forecasts.

You would think this would bug economists, but it doesn’t. Most seem quite happy to profess theories based on assumptions they will gladly admit are false. They are more concerned with theoretical elegance and mathematical precision than with accurately predicting reality.

One school of thought is that markets are always efficient–they are always rational in the sense of an unemotional investor with all the facts at their disposal. I don’t know any unemotional investors, and any experience with markets would quickly convince any honest person that markets are not rational in the short term (though they definitely are over the long term).

Another school of thought is that markets are irrational and thus require government intervention. But, if the human beings in the market are irrational, what prevents government employees–also human beings as far as I know–from not also make irrational decisions in their intervention? No answer is given.

Another school of thought is that the government printing money can solve bad lending. But, if printing money fixes problems, then why not just print it all the time and make everyone happy always. Sounds like a perpetual motion machine to me (more accurately: hyper-inflation).

Another school of thought is that the government can cut taxes while continuing to spend recklessly. But, if it’s dumb for an individual to spend beyond his means forever, why would it be smart for a government to do so? Because the government exists on another plane of reality?

Another school of thought refuses to make precise predictions because it acknowledges the impossibility in the realm of human endeavors. Paradoxically, this seems to be the only school that correctly foresaw the Great Depression, the inflation of the 1970’s, the Internet Bubble, and the Housing/Credit Bubble. No one listens to this school, it’s considered fringe by many, and is taught in only a handful of colleges (Auburn is one).

Next time you hear or see an economist make a prediction–on the radio, in print, on TV–keep in mind the field’s lousy record. Remember they are mostly academics with little success in predicting real world events.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

The perils of leverage

One of the biggest lessons of the current financial crisis is: don’t take on too much debt.

This may sound like common sense advice, but it’s amazing how often people forget it.

If you buy a house with cash and its value increases 20%, you’ve gotten a 20% return. If, however, you borrow 80%, put 20% down, and its value increases by 20%, you’ve just doubled your money. There’s a big upside to using leverage.

But, debt is a double-edged sword. It doesn’t just give you bigger returns if things go well, it also gives you bigger losses if they don’t go well.

Using the same example above, someone who pays cash for a house that decreases 20% in value losses 20%. Someone who only puts down 20%, though, has lost everything.

Archimedes said he could move the world with a large enough lever. The lever multiplies the impact of your input. But, such leverage works both positively and negatively.

When banks were as free as they’ve been, in the late 19th century (1800’s), they carried 40% equity and borrowed 60% (levered 2.5 to 1). Banks operated that way could generally survive the inevitable economic storms that come along with economic cycles.

But, banks nowadays are regulated to be levered 10 to 1: they borrow 10 dollars and only contribute 1 of their own (or shareholders’). Such leverage is a double-edged sword, too. If a bank levered 10 to 1 makes loans and 9.1% of them go bad, the bank is basically insolvent. That’s what’s been happening recently.

Investment banks were levered 30 to 1. The top 5 investment banks are all gone or have been forced to become levered 10 to 1. Mortgage insurers and bond insurers were levered as highly as 140 to 1, they are now almost all insolvent. Many other insurers were levered up too much, such as AIG, and they didn’t understand the leverage they had taken on. That lack of understanding didn’t save them (or taxpayers).

Our current crisis is a perfect illustration of the perils of leverage. Companies like GM and GE are in trouble because they financed their companies with too much debt. It is difficult for almost any but the least levered companies to borrow money, now. As a result, almost any company with too much leverage has had their stock price massacred.

Everyone seems to understand that too much leverage is bad. But many businesses and individuals took on too much leverage and they blew up. Those are the folks getting bailed out now, and they are being bailed out by those who didn’t take on too much leverage. That just doesn’t seem right.

It seems like taking on too much leverage is a lesson that must be learned periodically. Those who survived the Great Depression were terrified of borrowing money.

Unfortunately, our country is currently trying to fix our leverage problems by levering up our government. It’s hard to understand how you can solve the problem of leverage with more leverage.

When a government gets too levered, the resulting problem is almost always inflation. Inflation solves the government’s problem with leverage, but not its citizens’.

Beware leverage. Beware inflation.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

After a financial crisis, recessions are worse than average

Not all recessions are the same. Most recessions are a manifestation of the business cycle. But, when a recession is the result of a crisis in the financial sector, things get much worse.

What does that mean for investors? It means this is a once or twice in a lifetime opportunity to buy equities at very low prices. This opportunity may exist for some time, but trying to predict when markets will recover is a losing proposition. Get invested now and keep some cash on hand in case things get significantly worse.

A recent paper by Carmen Reinhart and Kenneth Rogoff, called “The Aftermath of Financial Crises,” provides support for the view that recessions following a financial crisis are worse than average.

In their paper, they show that asset markets collapse more deeply and for a longer time period. Real (after inflation) housing prices collapse an average of 35% over 6 years. Equity prices collapse by 55% over 3 1/2 years. Unemployment rises an average of 7% over 4 years. Output falls 9% over 2 years. The real value of government debt explodes.

The average recession lasts 10 months. Using that average, we would have come out of this recession last October because we entered it in December of 2007. As I’m sure you know by now, that didn’t happen. In fact, the recession hit high gear around that time.

Averages are not a proper expectation for what will happen. If you stuck your head in an oven and your feet in a freezer, your average temperature would be comfortable, but I guarantee you’d be miserable. Averages can be deceiving and misused.

But, averages can be useful for gauging what could happen. My intention here is to prepare you for the downside and how rough this ride will be, not to predict what will happen or when.

Asset markets have been down around 40%, so getting to down 55% would require another 25% decline from the down 40% level. I wouldn’t be surprised to see markets go significantly lower, but that’s impossible to predict. A decline to the 55% level, or even the 90% level like the Great Depression, is likely to be very short lived. The best thing to do is be prepared for the downside while acknowledging that the upside for equities from here is extraordinarily good. Try to pick the bottom is a fool’s errand.

We’re only a year and a half into the housing price decline, but this market was unusually over-valued at the top, so I expect it to end up more than 35% down. I also wouldn’t be surprised to see this last shorter than it has historically because of how rapidly it declined and how actively the government is intervening.

Unemployment bottomed around 4.4%, so it would have to get over 11% to reach historical average. The rate is around 7.2% currently, so we are well on our way there. Remember, unemployment is a lagging indicator. It will almost certainly hit its peak long after the markets and economy are recovering.

Output has only started to fall, and getting to the down 9% level will be painful. Like with employment, this will be a lagging indicator. By the time we see it recovering, markets will almost certainly be up significantly.

Government debt is already ballooning and will continue to do so. Government officials are already calling for a $1.2 trillion deficit this year, and that is only the tip of the iceberg. When an institution issues a lot of debt, even the U.S. government, their cost of debt will go up. Be prepared for higher interest rates and inflation. This may take years to develop, but when it does it will be truly life-changing.

Recessions following financial crises are deeper and longer lasting than average. It looks like we’re in such a situation. Be prepared for the downside. Be prepared for a lot of negative news going forward. But, most importantly, get invested to take advantage of the recovery and be prepared for even lower prices–in case they happen–in the future.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Happy New Year!

I enter 2009 as enthusiastic as I’ve ever been about future returns.

That’s not a forecast for returns this year. I don’t know what returns the market will generate over the next week, month or year, and anyone who tells you they do know is lying.

What I do know is that stock prices are as low as they’ve been relative to fundamental business values since the early to mid 1980’s.

Does that mean the stock market won’t go lower? No.

If the stock market bottoms where it did in the 1970’s, it would be 33% lower than it was at year end.

If the market bottoms where it did in the early 1950’s, it would be 40% lower than it was at year end.

If the market bottoms where it did during the early 1930’s–at its worst during the Great Depression–it would have to go down another 60% or more.

Those aren’t forecasts, that’s just a report of how bad things could get based on historical information.

But, as Mark Twain said, history doesn’t repeat, but it sure does rhyme. No one knows what precisely will happen, even if they get lucky and their prediction turns out to be right.

All a prudent investor can do is invest based on the facts, and the facts say that stocks are cheap. If they get cheaper, then even better bargains will be had. If they get dearer, investors will see their portfolio values climb.

Based on fundamentals, it’s reasonable to expect the S&P 500 to be up 10% – 15%, annualized, over the next 5 years. That’s unlikely to be a smooth path upward, but it’s a very likely outcome.

Even better, carefully selected stocks are likely to do much better than that.

And, that’s why I’m as optimistic as I’ve ever been in my 13 years of investing.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.