Investing records and political handicapping

The investors with the best records over the last decade have proven themselves more adept than others at navigating the shifting investment landscape. 

Is it because they’re better at valuing businesses, digging into financial statements, analyzing competitive advantages, assessing the ability of management, forecasting economic outcomes?  No. 

Great investing records over the last 10 years have been generated by correctly assessing how, when and where the government will intervene.

Betting on AIG, Citigroup, Bank of America, General Motors, General Electric, and so on, before or shortly after the government bailed them out has made fortunes for a handful of hedge and mutual fund managers.  AIG, et al., should have gone bankrupt, and their share prices properly reflected that reality.  But, when Uncle Sam intervened, lumps of useless coal were transformed into valuable diamonds.  No one investing more prudently could beat such out-size returns.

Investors who have correctly forecast the Federal Reserve’s frequent and haphazard interventions have rung up major dollars, too.  If they had been wrong, they would have lost their fortunes.  But, they were right.

I’m not drawing attention to conspiracy, here, because I don’t believe a conspiracy exists.  Those investors with the best records have simply better realized that the investing landscape has changed, and that correctly guessing Uncle Sam’s intervention is the new way to make big dollars.

Am I envious of such results?  In a way, yes.  I wish I had been more perceptive that the game had changed.  But, in another way, I’m not at all envious.

First, guessing Uncle Sam’s next move may win for a while, but it will eventually fail.  Even Uncle Sam’s pockets aren’t infinitely full of economic stimulus. 

Second, correctly guessing Uncle Sam’s next move is as much a matter of luck as skill.  Just because someone wins the lottery or makes $10,000 in Vegas doesn’t mean that’s the way to plan for retirement.  Lady Luck will eventually come to collect the bill.

No, I’m quite satisfied to invest prudently, if unspectacularly, and slowly build wealth over time.  Just because the new game is popular and seems more profitable (remember the dot-com craze of 1999 or flipping houses in 2005?) doesn’t mean the old rules no longer apply.  They do.

Eisenhower warned of the military-industrial complex in his 1961 Presidential farewell address.  Did he know it would become the military-real estate-banking-automobile-pharmaceutical-tobacco-airline-firefighter-teacher-investment banking-college funding-steel manufacturing-etc.-industrial complex?

If he had, I think he, too, would have looked at Roman and British history and said such complexes are nothing new, and always end poorly.

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.

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Investing records and political handicapping

You say you want a revolution?

We in the United States of America romanticize revolution.  After all, our revolution ended in the greatest country in the world, so it must be good for others, right?

Well, not always. 

Take, for example, the French Revolution of 1789.  It occurred 13 years after our Declaration of Independence, but ended in the Reign of Terror and Napoleon steamrolling Europe and Russia.  France is now on their 5th Republic and still trying to get it right.  You say you want a revolution?

Or, take the Russian Revolution of 1917.  It was supposed to free the oppressed people of Russia from the yoke of the Czar (isn’t it mind-boggling that we now use this term to denote our government figures: Auto Czar, Drug Czar, Energy Czar, etc.?).  Instead of a worker’s paradise, they got Stalin, purges, millions dead by murder and famine, and Nazi slaughter.

Or, for instance, the Chinese Revolution of 1949.  Chairman Mao, millions dead of murder and famine, Cultural Revolution (there’s that word again!), etc.  You say you want a revolution?  Okay this story is, currently, going better than France and Russia, but that came about without a revolution. 

For those who think potential revolutions in the Middle East are necessarily a good thing, it’s time to review the history of revolutions.  They don’t all end happily.

The western press was quick to assume the 1979 Iranian Revolution was a good thing, too.  It wasn’t (unless you’re one of the goons in charge, I suppose).  The press thought the English speaking people they interviewed represented the revolution, but Islamic clerics were pulling the strings and ended up in charge.  You say you want a revolution?

I’m not saying all revolutions end badly, but enough of them do that they shouldn’t all be greeted gladly.  Things in the Middle East may get better through revolution, but don’t count on it. 

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.

You say you want a revolution?

In praise of recessions

Parenting is simple, but not easy.

What I mean by that statement is that it’s not hard to figure out what to do as a parent (simple), but it’s frequently difficult to implement in practice (not easy).

Little Vivian wants a glass of apple juice, but it’s an hour and a half before dinner and she’d prefer to drink apple juice 24/7 rather than eat any solid food–ever! 

I have a choice: I can give her the apple juice she so much desires and worry she won’t eat the food she needs, or I can give her some non-apple-juice options to make sure she’ll be hungry for dinner.

It’s easy to give her the apple juice, right?  But, will it result in the long run outcome I want?  Probably not.  So, I offer her water and tell her she doesn’t want to ruin her appetite for dinner.

The first several times I provide this option, Vivian–like any self-respecting 3-year-old– breaks down in tears.  Not being entirely hard-hearted, I feel sympathy at the cutest screaming fit you’ve ever seen (not easy).

I know the right option (simple), but I dread the implementation (not easy). 

After 3 iterations of this process, though, Vivian no longer breaks down and cries.  She expects this outcome and goes about her life quite happily knowing she can’t have what she wants whenever she wants it.

And so it is with the economy, too.  Knowing human nature, it’s easy to see that people take things to excesses at times.  Whether keg parties, American Idol, Nuremberg rallies, or investment fads, people tend to herd in ways that aren’t necessarily best for their long term well-being.

Every once in a while, economic excesses need to be purged, too, and that is what I think recessions do.  Investors, consumers, regulators, etc. get caught up in herd behavior, periodically, and recessions allow mis-allocated resources get re-allocated back to productive (positive return on capital) uses.

It’s easy to understand this process is necessary, assuming you understand human tendencies (simple), but it’s unpleasant (not easy) to watch the resulting pain inflicted.

I’m not hard-hearted enough to enjoy watching people become unemployed any more than I like watching my daughter collapse in tears.  But, I must consider the alternative.

If we try to prevent recessions, is the long term outcome better or worse?  Giving my daughter the apple juice prevents short term pain (for both her and me), but creates long term problems.  And, so it is with recessions.

Preventing recessions leads to a build-up of bigger and bigger problems.  Periodic purges prevent major disastrous purges.  If you don’t believe me, consider the Great Recession of 2008-2009, the Great Depression, and Japan’s lost decade.

In each case, political intervention was intended to keep the economy on stable footing.  The hope was to prevent short-term pain, but with little regard for long term consequences.

I think an analogy to nature here is useful.  A catastrophic fire occurred in Yellowstone National Park in 1988 that burned several orders of magnitude more acres of forest than had been experienced in the past (please see Mark Buchanan’s Ubiquity for more information).

At first, experts were bewildered at the damage and what could have caused it.  Over time, though, they began to recognize that not letting forest fires occur occasionally had led to a super-critical state where a catastrophic fire was inevitable. 

In other words, the attempt to prevent small periodic fires had caused a major forest fire that wouldn’t have even been possible without preventing small fires.

I believe the same thing is at work in the economy.  Small periodic recessions are good for purging the under-growth of our economic forest.  Without such small recessions, a super-critical state is created.  The attempt to prevent small recessions is the cause of large, disastrous ones. 

And so, I praise small periodic recessions as the necessary prevention for big, terrible ones.  It’s time to take some short term pain that is necessary, but not easy, rather than face the long term calamities that are simply not necessary. 

It’s time for the parents to say no to the kids who want something that’s bad for their long term well-being.

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.

In praise of recessions

All returns are not created equal

In my last two blogs, I wrote about 1) measuring what matters most: after-fee, after-tax returns and 2) capital preservation: maintaining purchasing power as the prime directive of investing.

Now, I want to bring those two thoughts together with a third: all returns are not created equal. 

Just as investors place undo emphasis on 1) tax avoidance and low fees instead of actual returns, and 2) volatility and “safe” securities instead of the risk of permanent loss and after-inflation purchasing power, I believe investors also commit a third sin: 3) undo emphasis on returns earned over some arbitrary period instead of the process by which those returns were generated.

A quick example here should illustrate my point.

Suppose you were given the choice to invest for the next 10 years with two money managers: Firm C or Firm M.  Suppose, too, that you were presented with their 5 year investing records: Firm C: -6% loss over 5 years; Firm M: +6% gain over 5 years.

For most people (and for me in the past), this is an easy choice.  Over 5 years Firm M has earned a positive 6% return and Firm C has lost 6%, so go with Firm M, right?

But, wait!  How were those returns achieved?  Let’s examine each firm’s annual returns over the last 5 years:

  • $100,000 invest with Firm C
    • Year 1: -4.5%, $95,500
    • Year 2: +1.0%, $96,500
    • Year 3: +1.0%, $97,500
    • Year 4: +1.0%, $98,500
    • Year 5: -4.6%, $94,000
  • $100,000 invested in Firm M
    • Year 1: +4.5%, $104,500
    • Year 2: -1.0%, $103,500
    • Year 3: -1.0%, $102,500
    • Year 4: -1.0%, $101,500
    • Year 5: +4.4%, 106,000

See anything funny, yet?  Don’t worry, I wouldn’t have, either.  Let me explain how those returns were achieved.

As a thought experiment, I put these two investing firms against each other.  Each year, one bets $1,000 that a 6-sided die will land on 1 and get paid $4,500, and the other takes that bet (hoping the die lands on 2 through 6).  In my example, Firm M is making the bet and Firm C is taking the bet.

Now, perhaps, you’re not so sure you want to invest with Firm M!  Sounds more like gambling than investing?  Yes, precisely. 

Each year, Firm M has a 1-in-6 chance of gaining $4,500 and a 5-in-6 chance of losing $1,000.  Although Firm M’s investing record looked pretty good over the last 5 years (because the way the die just happened to roll those 5 times), you may not feel too comfortable now that you know how the return was generated. 

In fact, the next 10 years have a very high likelihood of Firm M losing 4.2% a year and Firm C gaining 4.2% a year.  That’s where the firm names came from: M is for Madoff and C is for Casino.  The odds were on the casino’s side all along, even though the record looked bad over those five years, and the odds were always against Madoff.

And, that’s the point I’d like to make.  Most investors look at an investing record and believe past is prologue.  But, the past is rarely the best judge of the future.  Instead, the right way to judge returns is by examining the method used. 

Two investing firms can have the exact same investing record, but one can generate returns by taking bad bets (and getting lucky) and the other by taking good bets.  You need to figure out which firm is taking good bets to generate satisfactory returns in the future.

This is particularly the case today.  Some firms have deceivingly weak records over the last several years because they’ve taken smart bets and the die has rolled against them.  Other firms have brilliant-looking records although they’ve taken bad bets and the die has rolled in their favor. 

Only by looking behind the curtain will you see if there is a real wizard or a blathering fake.  It may seem trivial or time-consuming, but understanding how returns are generated is much more important than the return record itself–future returns will depend on it (as Madoff so ably illustrated).

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.

All returns are not created equal