Castles built on quicksand.

Investment records that crush the market by a wide margin are incredibly tempting to potential investors. They look too good to be true, and frequently are.

Although I strongly believe beating the market is possible, doing so by a very wide margin is extremely difficult, and almost always means imprudent risks are or have been taken.

The best investor in the world, Warren Buffett, is said to have beat the market by around 10% a year over the last 60 years (taking into account both his personal and professional investments). That’s incredible performance! A 10% return over 60 years would multiply your money 304 times; beating the market by 10%, providing a 20% annualized return over 60 years, would multiply your money 56,000 times! Buffett is the second richest man in the world because he’s done something truly extraordinary.

So, when someone says they’ve beaten the market by anywhere close to 10% a year, you have to ask yourself if you’re talking to the second coming of Warren Buffett, or someone building castles on quicksand.

Beating the market by anything close to 10% a year can be done, but most who’ve done so took incredibly high risk to get there. It may not seem that way when you talk to someone who’s beaten the market by 8% a year for 15 years, at least not until their portfolio tanks by 60%. Making back a 60% loss requires a 250% gain, and that’s very difficult to do without taking even more imprudent risks.

Why do I say beating the market by a wide margin requires taking imprudent risk? Just look at history.

Individual investors received 3% annualized returns while the mutual funds they invested in went up 12% a year (Dalbar study, 2003). Only around 45% of professional investors beat the market over rolling 5 year periods, and most of those 45% beat by less than 1% and can’t do so consistently (Morningstar and Standard & Poors). Some of the best investing records in the business beat the market by a mere 3%+ annualized over long periods of time (I’m talking 20-30 years, not 3-5). Those in the business know how extraordinary 3% annualized out-performance is.

The way to beat the market is to invest differently than the market. That can be done in one of two ways: 1) prudently, with adequate diversification, or 2) imprudently, with highly skewed gambles and too much concentration.

Look at the records of investors that have blown up. They frequently had very long runs that look highly successful, until they blow up with 60%+ losses. It’s like building a castle on quicksand: it looks good for a while, until it sinks into the muck.

When looking at investing records, it’s more important to examine how the record was achieved than to focus exclusively on bottom line numbers.

Was the record generated over a long period of time, or was it less than 5 years? Were high returns due to a couple of lucky, out-sized bets, or a balanced portfolio that has edged up as a whole? Are returns due to a lot of investments over a long period of time, but all of those investments were in a single sector, like technology or financials? Can the investor non-defensively discuss their failures as well as successes?

If returns are over too short a period, or due to only a couple of out-sized bets, or focused in a narrow sector, or if the investor becomes overly defensive about how they generated results, you should be cautious. Those are warning signs.

I can’t say all outstanding records are frauds, because there are Warren Buffetts out there. But, you better be certain you’re talking to someone who really knows what they’re doing, and you better be prepared to ask tough questions.

Or, you just might find yourself living in a castle built on quicksand, too.

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.

As fragile as China.

As I’ve remarked before (here and here), much of the current worldwide economic recovery is due to China. For that reason, the greatest sensitivity to continued recovery is what happens in and with respect to China.

This recovery is as fragile as China (meaning delicate plates as well as the country).

Demand from China has driven up commodity prices and kept production flowing from manufacturing-based economies. For evidence, look no further than companies like Caterpillar and the land-office business they are doing in the far east.

If something were to go wrong in China, the economic impacts would reverberate throughout the global economy.

What could go wrong? If you haven’t noticed, there have been a lot of political issues surfacing between China and the U.S.

This includes the U.S.’s desire for China to allow it’s currency, the yuan/renminbi, to appreciate. This would make U.S. manufacturers more competitive with China. China has no interest in making itself less competitive, so this creates a lot of tension between the U.S. and China.

And then, there’s the spat between Google and China over censorship and hacking. It shows the inherent conflicts that exist between a command and control government like China’s and free market enterprises like Google.

Of course, there’s also the Dalai Lama. He represents the Tibetan government in exile and China doesn’t like his concerns being heard by the most powerful nation in the world. President Obama met with the Dalai Lama this week, infuriating China.

Then, there’s also our insistence on selling high-end weapons to Taiwan, whom China considers to be an errant state. It would be like Russia selling arms to Alaska, with Alaska being quite clear it would like to secede from the union.

So, there are a lot of political issues going on between the U.S. and China, not to mention they hold a ton of U.S. national debt. It’s a touchy situation.

China, too, has its own internal problems. Approximately 700 million people live in poverty in the Chinese interior while another 600 million are growing rapidly nearer the coast. Growth and trade has been great to the 600 million and less so to the 700 million. That is why some 20 million Chinese, a year, are moving from the hinterland to the coast looking for work.

This dynamic means that China simply can’t let growth slow too much. If it does, they will have a revolution in short order. Such is the history of China over the last…oh…2,000 years.

China is an island, geopolitically, and it has repeatedly cycled between external growth/interaction and internal strife/revolution. Until they change their political system from centralized command and control, as it’s been for 2 millennia, this external/internal cycle will continue.

This internal dynamic is the main reason why China won’t let its currency appreciate, and why they are working so hard to stimulate worldwide growth. China needs worldwide growth because they need someone to sell their low cost goods to.

The problem is that political tensions with large economies like the U.S., Europe and Japan are all working against this process. And, of course, the U.S., Europe and Japan all have major internal issues of their own that make them less than conciliatory towards China.

With all that on the table, how long until we see Chinese fragility? I don’t know, and neither does anyone else. But, it’s reasonable to assume the game can go on for several more years.

If China plays their cards right, then perhaps they can keep the game going long enough for the rest of the world to work out its problems and start growing again on its own.

If they slip up, though, which seems highly likely over the next five years, then that fragility could crack the delicate plate and lead to worldwide consequences.

We’d all like to see China succeed. If they do, then the world economy gets bailed out of its experiment with too much leverage. If not, it could lead to another major economic upheaval.

For now, expect China to keep the game in play. It should be good for stronger economic growth than most are forecasting. But, when the end-game arrives, it won’t be pretty.

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.

Going Greek

Markets were, again, disturbed by news from Greece this week.

For those of you who don’t pay much attention to these things, Greece is in a serious fiscal bind. You see, their fiscal deficit looks to be around 13% of gross domestic product.

When a country typically crosses the double-digit barrier, their interest rates spike and their currency tanks. Markets don’t like it when a borrower’s revenue falls short of it’s obligations by more than 10%. It indicates the borrower may default.

Greece, however, is in a unique position. It is part of the European Union and has adopted the euro as its currency. The result is that Greece’s problem is really western Europe’s problem.

It reminds me of the joke about borrowing from a bank. When you borrow $10 thousand and are having problems making payments, it’s your problem. But, when you borrow $10 million from the bank and are having problems making payments, it’s the bank’s problem.

Greece is Europe’s problem, and that has markets much more nervous than if it were just Greece’s problem.

Economic and currency unions have not stood the test of time. None have lasted. For this reason, many are skeptical the euro or European Union will last, either.

Greece is exacerbating these fears because many market participants worry that Greece’s problems could break up the union. The euro is down almost 15% from its peak (hopefully this trend will continue at least until my trip to Paris this May), and these issues are part of the reason.

What seems to be lost in this shuffle is that the rest of the world is going Greek, too. The movie in Greece may soon replay in the rest of the world, and by players too big to be bailed out by Germany or France. Niall Ferguson eloquently pointed this out in the Financial Times yesterday.

For example, look at the good ole U.S. of A. Our fiscal deficit is also in double digits this year. For that matter, Japan, the United Kindgom, Ireland and Spain find themselves with similarly difficult fiscal positions.

Some of the biggest economies are going Greek, and the investment implications are important.

For now, it looks like the global economy is recovering. This will likely provide a temporary respite from these fiscal problems. But, eventually, the piper will need to be paid.

When that happens, it might be nice to be far from government bonds and have some downside protection in place. When the world goes Greek, it won’t simply “disturb” markets.

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.

What everyone knows.

My favorite Will Rogers quote: “It isn’t what we don’t know that gives us trouble, it’s what we know that ain’t so.”

There’s no better place to illustrate this principle than Wall Street. Stock prices reflect what everyone knows. The problem isn’t what we don’t know, but what we know that just isn’t so.

For example, everyone knows China is a growth engine and that everyone “should” be invested there. If everyone knows it, then stock prices already reflect that fact. If what everyone knows turns out not to be so, then a lot of people are in for a lot of disappointment.

Another example. Everyone knows the cable industry is toast because everyone will download TV and movies over the Internet for free. But, if everyone knows, then stock prices reflect that fact already, so no profits can be made betting against cable. In fact, if everyone knows it, and it turns out not to fully reflect the facts (how will all those people download all those movies and TV shows, perhaps over cable?!), then it might be possible to make money betting the other way.

Everyone knows that bonds and cash are safer than stocks. Perhaps that is why retail investors flooded into bond mutual funds last year and a lot of people pulled their money out of the market and put it into bank accounts. But, what if inflation comes back with a vengeance? What everyone knows will turn out to be very painful for, well, everyone.

What else does everyone know? Old line software companies are toast. Every Apple product is a blockbuster. Google will provide everyone with software for free just because, gee whiz, they’re such nice people. All airlines are lousy investments, always. Content providers will happily provide consumers with high quality entertainment for free over the Internet. Old line pharmaceutical companies are toast. Old line telecom companies are toast. Regulators can see problems coming and act to prevent harm. Global warming is occurring, caused by man, can be stopped, and should be stopped (the benefits outweigh the costs).

The trouble isn’t what we don’t know, or admitting that we don’t know. The trouble comes when what we think we know turns out to be just plain wrong.

A lot of money has been made over the years in buying the opposite of what everyone knows. It’s certainly worked well for me.

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.