Unsurprising drop

The stock market was down 2.5% on its first trading day of June. This follows a decline of 6.8% in May, leaving stocks down 10.2% since its high of April this year, and down 18.9% since the high of October 2007. This seems to have surprised, and even shocked, many investors.

When asked what the stock market would do, J.P. Morgan famously said, “It will fluctuate.” Benjamin Graham told investors (in his book The Intelligent Investor) to resign themselves in advance “to the probability rather than the mere possibility that most of his holdings will advance, say, 50% or more from their low point and decline the equivalent of one-third or more from their high point at various periods.”

In other words, the stock market is a roller coaster, and investors should anticipate and even expect frequent stomach-churning drops and thrilling climbs along the way. These drops are not a sign of something unusual and dreaded, but something expected and even eagerly anticipated. Why? Because drops lead to opportunity as merchandise that cost $100 a few days ago is now on sale for less (sometimes, much less).

As I pointed out in my posts, Better than zero and “Where’s the market going next year?”, the math underlying expected future returns should have warned investors to anticipate drops. And, as I expressed in my post, All eyes on China, news of slowing growth from China would likely lead markets lower, and it has.

I think investors were surprised because they don’t think of the stock market as a roller coaster, or they try too hard to relish the climbs and forget the inevitable drops. Perhaps they also suffer from myopia, attending to recent company reports and economic news instead of thinking about longer term data. 

Nevertheless, drops will happen, and they should be exploited instead of feared. Lower prices mean higher future returns–clearly a good thing. Panicky investors that sell as the market drops benefit longer term investors that buy from them. I’m not saying the drops won’t pull at your stomach–they will. What I’m saying is drops are to be expected and wise investors will have the courage to act as the market drops to exploit short-term oriented investors.

I’m not panicking as my portfolio drops, but lining up my buy list and making purchases as the market sinks. The more it sinks, the more I’ll buy. Just like riding a roller coaster, I look forward to the plunges and climbs, because that’s the nature of the beast.

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.

Unsurprising drop


To most people, good investing seems frustratingly counter-intuitive.

When the economy is on its back, looking like it will never recover, and the stock market is hitting new lows–that’s the best time to invest. When the economy is breaking growth records and the stock market is hitting new highs–that’s the absolute wrong time to pile in.

Or, as Warren Buffett more succinctly put it: “be greedy when others are fearful and fearful when others are greedy.” (He should know, you don’t become one of the richest people in the world and the most successful investor over the last 60 years if your approach is fundamentally flawed.)

But, most people can never really get their brain around this paradigm. They easily accept that they know nothing of particle physics, brain surgery and rocket science, but they just can’t accept the notion that investing and economics are similarly complex.

To most, investing is counter-intuitive.

But, to me, this counter-intuitiveness makes perfect sense. Investing is not like physics, surgery, rockets, home building, plumbing or most other things people do. In most fields, man is competing with nature.  

A physicist is trying to understand the rules of nature with mathematical precision such that it can be harnessed. The surgeon wants to understand disease and human physiology such that he can operate to restore health. A rocket scientist uses the rules discovered by physicists to harness nature’s power to propel and guide a payload into space. A home builder seeks to erect a structure that will keep out the elements and provide a comfortable and convenient abode for its dwellers. A plumber desires to harness water to serve man’s needs within buildings. All of these fields are concerned primarily with overcoming nature.

Investing is different. It’s more like sports or warfare in that it is inherently a competition of man against man. And that, I believe, is why it seems counter-intuitive to most.  

With investing, you are not just trying to figure out which company will survive and thrive, but how other people perceive that company. The price you pay is not based solely on a company’s underlying fundamentals, but on how investors in general understand and interpret those fundamentals (or just plain feel about a company).  

When people are excited about an investment, like Apple, they tend to bid the price up above underlying fundamentals. When they hate a company or think it is going the way of the dodo, they bid its price down below fundamentals.

When they think the economy will go ever higher, they want to be fully invested. When they think it will never improve, they want to pull all their money from the market–right now!

But, this herd-like behavior is almost always reflected in prices before such people buy and sell. The price they pay or receive is for the perception of a company or the economy, not just the underlying fundamentals.

In the long term, however, the fundamentals win out. As Benjamin Graham put it, “in the short run, the stock market is a voting machine, in the long run, it’s a weighing machine.” In other words, stock prices reflect human emotion in the short run and underlying fundamentals in the long run.

Which is why successful investing seems counter-intuitive. When everyone is selling and it seems like things can never get better (2009), you want to be buying. When everyone is buying and it seems like a new era of non-stop growth has dawned (2000), you probably want to be selling.

Because most people will never get their brain around this, counter-intuitive investing will continue to work for those who can harness other people’s short-term emotions. 

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.


Ahhh…the classics

Just as there are classics to be read and re-read in literature, history, philosophy, psychology, etc., there are classics that should be read and re-read in investing.

The most important, in my opinion, is Graham and Dodd’s 1934 classic, Security Analysis.  I just finished re-reading it recently, and found many gems to share here:

“A moment’s thought will show that there can be no such thing as a scientific prediction of economic events under human control.”

Free will makes precise economic predictions a fool’s errand.

“There are no dependable ways of making money easily and quickly, either in Wall Street or anywhere else.”

That seminar you and 40,000 other participants paid for and sat through will make the speakers a fortune, not you.

“Investment theory should recognize that the merits of an issue reflect themselves in the market price not by any automatic response or mathematical relationship but through the minds and decisions of buyers and sellers”

Take that efficient market clods!

“Perhaps [the intelligent student] would be well advised to devote his attention to the field of undervalued securities–issues, whether bonds or stocks, which are selling well below the levels apparently justified by a careful analysis of the relevant facts.”

Value investing…careful analysis of the relevant facts…there it is.

“Analysis connotes the careful study of available facts with the attempt to draw conclusions therefrom based on established principles and sound logic.”

Principles applied logically!

“The value of analysis diminishes as the element of chance increases.”

No, Virginia, everything is not worthy of analysis.

“The analyst must pay respectful attention to the judgment of the market place and to the enterprises which it strongly favors, but he must retain an independent and critical viewpoint.  Nor should he hesitate to condemn the popular and espouse the unpopular when reasons sufficiently weighty and convincing are at hand.”

Lemmings need not apply.

“Analyzing a security involves an analysis of the business.”

It’s shocking how infrequently this is the case.

“In general, the analyst should refrain from elaborate computations or adjustments which are not needed to arrive at the conclusion he is seeking.”

Occam’s razor for investing!

I could go on (and on and on and on, as my wife can tell you), but you get the idea.

It’s amazing how much wisdom can be derived from a book written 77 years ago, and how little can be found in thousands written since….

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.

Ahhh…the classics

Capital preservation

Investing is not as complex as most in the field like to make it out to be.  Economists, financial planners, market strategists, professors of finance and economics, etc. like to make the field seem more difficult to grasp than it is.  Not surprisingly, this serves their interests.

In the Middle Ages, when hardly anyone could read or understand Latin, men of the church had a stranglehold on religious doctrine.  If you wanted to understand or get guidance on the most important issues of the time, you had to go through the men of the church.  This served the church’s interests well.

And, so it is now with investing.  Today’s clergymen of finance work hard to cloak the simplicity of investing in higher math, floating abstractions, mindless charts, confusing terms.  Their efforts are not to clarify, but to obfuscate; for, if you’re completely confused, then you’ll need their help! 

(As an amusing aside: a former investing boss of mine, in criticizing my writing ability, complained that I wasn’t writing in a sufficiently high-minded way.  He told me that magazines and newspapers were written at an 8th grade level, and so was my writing, but he wanted it at an 11th or 12th grade level.  When I commented that it might make the writing unintelligible to many of his clients, he said that was okay because his clients would prefer someone who sounded smart over actually understanding!) 

So, why do I claim that investing is simple?  I read a description of investing 16 years ago that made perfect sense and was simple, and I’ve used it ever since.  This description, from Benjamin Graham and David Dodd’s Security Analysis, 1934:

“An investment operation is one which, upon thorough analysis, promises safety of principal and a satisfactory return.  Operations not meeting these requirements are speculative.”

No mention of alpha, beta, standard deviation, diversification, macro-economic forecasting, the efficient frontier, small cap blend, negative correlation, optimized portfolios.  You’re investing if you 1) do thorough analysis, and 2) invest in securities that promise a) safety of principal and b) a satisfactory return. 

If you don’t do thorough analysis or hire someone who doesn’t, it’s not investing, it’s speculation.  No stock tips, no hunches, no astrology, no gut feel, no “I just know…”, no buying lots of everything–just thorough analysis.

If you invest in securities that don’t promise–first–safety of principal and–second–a  satisfactory return, then you’re not investing, you’re speculating.  A lot of investors focus on that second part, the satisfactory return part, but few put the emphasis necessary on the first part (which Graham and Dodd correctly made primary).

Many financial planners and investment advisors give lip service to safety of principal, or capital preservation, but few give it the attention it needs.  This lip service to capital preservation is frequently waved away with the magic of diversification.  If you put your eggs in many baskets, they say, then there’s no way all your eggs will break at once.

2008, or any other financial crisis in history for that matter, should put that notion to rest.  Unfortunately, it hasn’t.  Putting your eggs in poorly built baskets, no matter how many of them, is unwise.

Capital preservation is also framed in terms of volatility.  If the basket goes up and down a lot, they say, you’ll get scared.  Fear is a relevant issue, but it’s not the same as capital preservation.  Capital preservation is whether the eggs break or remain whole, not whether they are jostled or swung about.

Capital preservation means you get back what you put in.  Not volatility, not fear, but whether you get back what you put in.  The price of an investment may go up and down and all over, but it’s still capital preservation if you get back what you put in. 

Risk, as Graham defined it, is the permanent loss of capital.  Not the temporary loss of capital, not the fear of the loss of capital, but the permanent loss of capital.  Not eggs jostled or raised and lowered, but eggs BROKEN.

If your investment returns the capital you put in, then capital has been preserved.  If not, or if the safety of that capital, upon thorough analysis, is suspect, then it’s not investing.

This raises an important issue which many overlook: capital preservation is preservation of the spending power of the capital.  Not the capital quoted in dollars, drachma, cows, or shells, but the real, sustainable purchasing power of that capital.  If you put in 6 large eggs and get back 6 small ones, or if even 1 is missing, then it’s not capital preservation. 

Many incorrectly think of cash or bonds as being the soundest means of capital preservation.  In most cases it is, but not if inflation occurs.  If inflation is a real threat over the time-frame that capital must be used, then capital preservation must necessarily include inflation protection.  Cash and bonds, by themselves, don’t cut it.

Most investing experts focus too much on secondary, tertiary, etc., issues.  They focus on diversification, statistical “guarantees,” unexamined impressions, recent history.  But, investing just isn’t that complex. 

You need to do thorough analysis (examine that basket in-depth), you need to preserve capital primarily (will I get back the same number of actual eggs I put in the basket, unbroken), and you’d like to get a satisfactory return secondarily (given that the number and size of eggs is safe, can I get back more eggs than I put in). 

It’s not rocket science or brain surgery–it’s quite simple.

But, as Warren Buffett put it, investing is simple, but not easy.  Which means: knowing how to invest is not complex, but doing it well is difficult.  Losing weight requires you to consumer more calories than you put in–that’s simple.  But doing it isn’t easy–it’s very difficult (especially around Christmas!).

Perhaps Buffett’s investment success should lead investors to focus on his methodology (including very little of what financial clergymen sell), which starts with: capital preservation.

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.

Capital preservation

Manic-Depressive Mr. Market

Benjamin Graham, Warren Buffett’s mentor, had a wonderful parable for thinking about the stock market.  He called it the parable of Mr. Market:

“Imagine that in some private business you own a small share that cost you $1,000.  One of your partners, named Mr. Market, is very obliging indeed.  Every day he tells you what he thinks your interest is worth and furthermore offers either to buy you out or to sell you an additional interest on that basis.  Sometimes his idea of value appears plausible and justified by business developments and prospects as you know them.  Often, on the other hand, Mr. Market lets his enthusiasm or his fears run away with him, and the value he proposes seems to you a little short of silly.”

“You may be happy to sell out to him when he quotes you a ridiculously high price, and equally happy to buy from him when his price is low.  But the rest of the time you will be wiser to form your own ideas of the value of your holdings…” (Graham, The Intelligent Investor, 1973)

The market has been particularly manic-depressive lately, and this has reminded me of the parable of Mr. Market.

One day, the market seems to foresee another recession on the horizon–the market sinks as investor sentiment tanks.  Another day, the market foresees an economic boom on the horizon–the market leaps and investor sentiment soars.

Is the data really that self-contradictory, or is the market just that short-sighted.  I believe the latter.

Much economic data, like unemployment claims, housing market numbers and income growth, indicate an economic slowdown.  Not a recession, mind you, just a slowdown.

Other economic data, like railroad traffic, commodity prices and industrial capacity utilization, indicate an economic expansion.  Not a boom, per se, but an expansion.

Mr. Market, in his manic-depressive way, takes these data points as signs of a collapse or boom.  As a result, market commentators have referred to the stock market’s reaction as risk-on/risk-off.  It’s either one or the other, and nothing in between.

What is the reality?  Not too surprisingly, given the data and my build-up, something in between.  The slowdown could turn into a recession, but hasn’t, yet.  The expansion could turn into a boom, but it isn’t at present.

Mr. Market should be more sober-minded and focus on the long term instead of the short term.  There is neither reason to dive for cover nor party like its 1999 (can you tell I’m about to turn 40?).

Given the data and a long term view, it is best to be cautiously optimistic.  The market is mildly over-valued, but nothing like it was in 2000 or 2007.  In fact, long term returns look promising, especially when compared to bonds or speculations like gold. 

Mr. Market needs to take a chill-pill, relax and take a deep breath.  Lucky for sober-minded investors, he probably won’t, and this will provide ample opportunities to exploit Mr. Market’s manic-depressive tendencies.

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.

Manic-Depressive Mr. Market

Why I don’t work in a big city

A question I regularly get from clients, prospects, family and friends is: “if you’re so good at what you do, why don’t you work in a big city like New York, Boston, Chicago or San Francisco like all other investment managers worth their salt?”

It’s a great question, and highlights what most people think: a) people who are good at what they do need to go to the biggest stage to do it, b) those who don’t go to that stage probably aren’t as good as they say.

Fair point.  No truly great baseball player plays pick-up games on weekends.  No virtuoso pianist only plays in her basement. 

Investing, however, is different.  With investing, all you have to do to compete against the best is buy or sell securities directly.  Each time you buy, you may be buying from the best; when you sell, you may be selling to the best.  You never know who is on other side of your trade, but the best are all participating in the same markets.

So, it’s not necessary to go do New York, London or Hong Kong to compete with the best.  All you have to do is decide to buy securities directly.  I do. 

The reason why I’m not in a big city can be summed up in one word: independence.

To be a great baseball player, you have to compete against the best.  To become a virtuoso pianist, you have to play against the best.  Direct competition makes each individual better.

Investing, however, requires independence.  Groupthink is the source of poor performance.  So are marketing departments. 

If you’re pressured to sell products because you work on commission, you’re not independent and unlikely to beat the market.  If you’re boss is pressuring you to post good quarterly results to increase assets under management, you’ll lack the independence required to out-perform.

If you’re surrounded by people who represent the market, it’s very hard to resist being affected by their thinking.  If you meet and talk daily with people who disagree with you and think you should follow the herd, you’re almost certain to be worn down and comply. 

Or, as Benjamin Graham, Warren Buffett’s mentor, put it in the Intelligent Investor, “To enjoy a reasonable chance of continued better than average results, the investor must follow policies which are (1) inherently sound and promising, and (2) are not popular in Wall Street.”

Sound and promising means long term oriented.  Marketing departments hate that because short term results are what sell. Not popular on Wall Street means contrarian.  But, that’s difficult when you’re amidst the Wall Street herd day in and day out.

I believe I have and will beat the market over the long term because I’ve kept my independence.  Being in Colorado Springs and without a marketing department breathing down my neck is an asset, not a liability. 

Keep in mind that Warren Buffett spent his first 10 years operating out of the sun room in his Omaha home.  He, too, saw the benefit of independence.  Perhaps he was on to something.

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.

Why I don’t work in a big city

Value investing principles

Value investing works.

Whether you look at academic research, or successful value investors like Warren Buffett, or examine it from a behavioral finance perspective, or just understand it intuitively, value investing is an investing discipline that beats all other methods (that I’ve examined).

The ideas behind value investing aren’t very complicated, but can be difficult for people to grasp:
1) a business has a value that can be determined
2) part of that valuation is based on an unknown future, so you want to buy far below assessed value
3) buying below value–with a margin of safety–reduces the cost of errors due to a) judgment, and b) an unknowable future.

The concept, then, is to value a potential investment and then compare that value to the price one can buy it from the market–its stock price. If the price is significantly below value, you should buy it. If the price is equal to or above assessed value, you shouldn’t buy it or you should sell it.

That’s it in a nutshell, but it’s more complicated to implement than that, and the main reason is psychology.

It’s very difficult for people to buy something going down in price because 1) it’s almost always cheap for a good reason, and 2) they think it will keep going down in price. Also, it’s difficult to sell something that’s gone up in value because people tend to think it will keep going up.

This psychology is the main reason, in my opinion, why most people either don’t get or can’t apply value investing principles.

Value investing also seems counter intuitive to a lot of people. They can’t stand buying what isn’t doing well, regardless of price to value. They want to buy what’s hot, not what’s not.

I’ve tried to explain value investing principles to many people over the years, and they either get it or they don’t. If they get it, you can see it in their eyes. If they don’t, they tend to say, “but…but…but….”

I say things like, “it’s not an issue of whether a $150 sweater is better than a $50 sweater, it’s an issue of whether you should buy a $150 sweater selling for $200 or a $50 sweater selling for $25.”

People who get value investing quickly grasp that analogy. People who don’t, don’t. In fact, they tend to reply, “But…but…but…the $150 sweater is nicer.” To which I reply, “For $200?”

The cold, hard fact is that people who pay $200 for $150 stocks get lousy returns, and people who buy $50 stocks for $25 build wealth over time.

The evidence supports that proposition quite convincingly.

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.