The great modern philosopher of our age, Pogo, describes the nature of the failure of the human condition by intoning, “I have met the enemy, and the enemy is us.” In essence, what he is saying is that, individually and collectively, we cause our own problems. How can this be? Aren’t we the most brilliant people with the best education and the greatest media support the world has ever seen? And we seem to make the same mistakes as our ancient ancestors. I would suggest that the primary reason for our failure to develop a higher percentage of winning bets is that we have limited our learning capacity.
Our first fundamental mistake, as mentioned in last week’s blog, is a lack of full understanding of Newton’s Third Law of Motion, that every action creates an and equal and opposite reaction: You kill me, my son or brother will kill you, etc. As a “certified bright person,” I may perceive buying something as cheap, while the seller, equally bright and perhaps with more or different information considers the sale as off-loading an expensive piece of merchandise. If a government restricts a profitable trade for someone, a willing buyer and seller will find other ways to transact, even if trading costs are higher.
Our second mistake is where we look for guidance and how we receive it. Consider if you were going to have a critical medical operation, or have a major piece of architecture begun, you probably would search for the most knowledgeable expert that was available. In our selection process, experience usually plays a major role. In contrast, I would look for an expert who had some failures (e.g. a patient died, or a building did not meet with its essential critical requirements). Personally, I would have little confidence in an all-knowing arrogant personality, who would be unlikely to quickly identify when something was going wrong and thus less prepared to shift course.
In contrast to the somewhat painful experience searching for medical or architectural experts, when seeking financial advice we rely on 20 second sound bites, 55 minute university lectures and newspaper columns limited to 700 words or less from very thoughtful columnists such as Jason Zweig, in the weekend Wall Street Journal.
As all of us are insecure about making financial and investment decisions, we tend to find comfort in conforming to what other individuals of perceived similar intelligence do with their money. (The prudent man principle is based on this conformity, not on what was actually prudent under the circumstances.) Our decision-making may be compared to a voting machine or a set of scales. Most often the quantity of popular views weighs more heavily in our decisions than the apparent expertise of one or more experienced leaders.
To overcome this quantity over quality trap in building portfolios of funds for wealthy families or institutions, I try to select a few managers who see the market and the world differently than the rest. To me, the greater the arrogance, the greater there is the need to hedge and find different smart views. One way I try to reduce the power of the enemies is to control my own arrogance.
Sunday, July 26, 2009
Sunday, July 19, 2009
Learn from London and Paris
But Invest Creatively Elsewhere
Ruth and I have just returned from a trip to London and Paris. In addition to accompanying my wife on New Jersey Symphony Orchestra business, one of the reasons for the trip was to gain insights from various financial professionals. I spoke with the leaders of two publicly-traded companies, several portfolio managers, the strategic adviser to a large hedge fund, a successful currency trader and a data provider with an academic orientation. While all of these gentlemen were very intelligent, they did not share similar approaches or views of the future (I should note that I have visited many accomplished professional financial women in prior visits.)
I did notice that many of my discussions relatively quickly evolved into the use of complex derivatives, which represented 30-100% of the net equity of portfolios managed by these professionals. In almost all cases, the derivatives were used in various hedging strategies. While they expressed a generally positive long-term view, they were also using short positions through derivatives to hedge against a sudden, unexpected sharp decline. In almost all cases, the gentlemen relied heavily on their academic training and their experience of survival. To most, the future would be some pale extrapolation of the past. All feared changing regulation that will increase their operating costs, restrict their flexibility, and in the end, hurt the public’s ability to make money. They seem to have good reason not to try future-oriented strategies. Their instincts are similar to many analysts found on this side of the Atlantic. I have often said that if you scratch an analyst, a historian will bleed. There is comfort in knowing how the movie, play, or opera ends.
Investing in China, India, and selected other Asian countries was the source of good performance numbers for a number of the funds based in London and Paris. While some managers conduct research from London, others use Hong Kong and occasionally Singapore. If they do have Tokyo offices, it is to track Japanese, and possibly Korean securities. China is the biggest single bet or actually twin bets. The first investment bet is on product producers for the export markets (largely dollar earners). The second wager is on the growing home market for goods and services. The potential dynamite of rising expectations in a controlled environment is recognized as a difficult situation, and can go wildly wrong at times.
Currencies are viewed as trading vehicles rather than assets of long-term value certainty.
What does this all mean to those of us who manage money for retirement plans, non-profits and families of substantial means? I am still recovering from some jet-lag, thus my current thinking is evolving. First, most European analysts are much more financial statement-oriented than I am. They do not seem to want to understand how a company or a fund actually works. As statement-oriented analysts, they are much more likely to be enthusiastic about “value” than “growth.” They seem to see things in an orderly solar system and will use their intellectual skills to protect themselves against change. I tend to look forward to finding change, and discovering those investments that benefit from change. In America, we use far less leverage than they do in Europe. The fact that many European managers tended to invest in companies that used leverage is one of the reasons that financials often represented 50% of their portfolios. Even for someone who manages a financial services hedge fund, this commitment to financials seems a bit high to me.
The bottom line: While we can expect many new techniques will originate in London and Paris, it will be the United States’ distribution power that will generate the largest share of the profits. To use Peter Lynch’s term, we should be focusing on the creative skill sites of the world for our next “ten bagger.”
I did notice that many of my discussions relatively quickly evolved into the use of complex derivatives, which represented 30-100% of the net equity of portfolios managed by these professionals. In almost all cases, the derivatives were used in various hedging strategies. While they expressed a generally positive long-term view, they were also using short positions through derivatives to hedge against a sudden, unexpected sharp decline. In almost all cases, the gentlemen relied heavily on their academic training and their experience of survival. To most, the future would be some pale extrapolation of the past. All feared changing regulation that will increase their operating costs, restrict their flexibility, and in the end, hurt the public’s ability to make money. They seem to have good reason not to try future-oriented strategies. Their instincts are similar to many analysts found on this side of the Atlantic. I have often said that if you scratch an analyst, a historian will bleed. There is comfort in knowing how the movie, play, or opera ends.
Investing in China, India, and selected other Asian countries was the source of good performance numbers for a number of the funds based in London and Paris. While some managers conduct research from London, others use Hong Kong and occasionally Singapore. If they do have Tokyo offices, it is to track Japanese, and possibly Korean securities. China is the biggest single bet or actually twin bets. The first investment bet is on product producers for the export markets (largely dollar earners). The second wager is on the growing home market for goods and services. The potential dynamite of rising expectations in a controlled environment is recognized as a difficult situation, and can go wildly wrong at times.
Currencies are viewed as trading vehicles rather than assets of long-term value certainty.
What does this all mean to those of us who manage money for retirement plans, non-profits and families of substantial means? I am still recovering from some jet-lag, thus my current thinking is evolving. First, most European analysts are much more financial statement-oriented than I am. They do not seem to want to understand how a company or a fund actually works. As statement-oriented analysts, they are much more likely to be enthusiastic about “value” than “growth.” They seem to see things in an orderly solar system and will use their intellectual skills to protect themselves against change. I tend to look forward to finding change, and discovering those investments that benefit from change. In America, we use far less leverage than they do in Europe. The fact that many European managers tended to invest in companies that used leverage is one of the reasons that financials often represented 50% of their portfolios. Even for someone who manages a financial services hedge fund, this commitment to financials seems a bit high to me.
The bottom line: While we can expect many new techniques will originate in London and Paris, it will be the United States’ distribution power that will generate the largest share of the profits. To use Peter Lynch’s term, we should be focusing on the creative skill sites of the world for our next “ten bagger.”
Friday, July 10, 2009
Modified Behavior =
Intervention vs. Newton
Recently, The Wall Street Journal surveyed 51 economists as to the need for a second stimulus. In the same survey they asked these learned people about the Obama administration’s plan to overhaul financial regulation. Of the survey respondents, 44% thought that the proposal was acceptable under the current political conditions and 15% believed that proposals will make the financial system safer. Either at least the 15% of those surveyed, and possibly most of the 44%, have absolutely perfect children or they have not taken a course in Physics.
As they say, it takes two to tango. Almost none of the evils were pre-meditated. The problems that have befallen people would not have been possible without both sides agreeing on something. Purchases of homes, cars, securities, and the inherent acceptance of debt (or as we prefer to label it, leverage) would not have been possible without a signature. In almost all instances, the signature was accompanied by a difficult-to-comprehend legal document. In many cases, the obtuse legalese was in documents that were never opened, even to examine their length. What motivated these buyers, some of whom were companies and, in many cases large, publicly-traded corporations, was the desire to own something they could not afford. These loans were packaged in a number of different wrappings and sold to both individual and institutional buyers. Despite the weighty legal documents, the attraction to buyers was a perceived, essentially, riskless, above-average yield (or performance). Many of those who lost their assets in various frauds and Ponzi schemes suffered from the same desire for unrealistic returns.
The very human desire to prevent such tragedies in the future is understandable and even commendable. However, it starts with a fallacy that “they” did it to the unsuspecting public. In the current political environment, “they” is usually a financial intermediary. There is little or no recognition of the culpability of the tango partner, or the sweet music played by the government. I believe that until there is some self-recognition of the initial source of the problem, there will be few solutions achieved.
One of the frightening elements of the Journal’s survey and reporting is that government intervention would make the economy and/or the market “safer.” First of all, it is not the function of government to make all human relations safe. At best a very clever government, continuously monitoring all communications between people, could possibly make disclosure fairer, but that would go up against the legal protections that one or both parties want.
In general there is a lack of appreciation on the part of governments, particularly this one, as to the nature of intervention. Initially, the authors of intervention attempt (almost in a biblical sense) to divide the good from the bad with one quick stoke of His staff. There are lots of problems with this glorious picture. First, the intervener has to gather up all the good people on one side. (Are they always, in every respect going to be the good people?) All the bad guys (no matter how bad), will need to be forced to the other side of this bipolar world. Second, since the beginning of wars and conflicts, some of the participants on each side have traded with the enemy. In turn these trading relationships have blossomed into friendships and even marriages of some type. Third, almost no single intervention, by itself can stand the test of time. Even that most precious of all interventions in the English language, The Declaration of Independence, could not stand alone by itself for long. After much wrangling, the U.S. Constitution, the operating document for our enterprise, was created. Despite that effort, amendments soon became necessary, the first ten resulting in the Bill of Rights. Further, our founding Fathers recognized that the language of the Constitution may not be perfectly understood, and the various states (the political powers of the day), could interpret the document differently. Thus, to bring these concepts into line with their original intent, they created the Supreme Court. The purpose of this very brief history lesson is to show that no single intervention can be, in and of itself, a solution. In biblical terms it could be said the first intervention begat the second intervention which begat the third, etc.
I have two warnings for those who plea for an intervention: First, they will get more than they intended. The second warning is that it will not work as completely intended, no matter who designs it. Why? Get out your Physics book. Sir Isaac Newton’s third Law of Motion states that each action is met with an equal and opposite reaction. With diligence equal to that of the government, clever people will succeed at finding ways around any regulation.
There is even a more important reason why pure intervention won’t work. How many of you, as parents, successfully intervened with your children by just taking away some privilege, which they thought was their absolute right. Did it work? In most cases this pure punishment did not work. What usually worked was to forge some form of behavior modification, so that the child first understood the consequences of an action, and second (and much more importantly), modified their behavior. The solution to preventing future problems is behavior modification, not reliance on intervention.
One of the challenges in working with families of wealth is the desire of the senior member to posthumously intervene in their children’s, grandchildren’s or favorite charity’s lives. There are all sorts of provisos written into wills and trusts that are an attempt to allow the dead to control from the grave. A number of these stipulations withhold funds unless certain things are done, e.g. going to the Alma Mater, getting married, having children, completing a certain task, teaching a particular view, playing only a certain kind of music, etc. There was even one family that we worked with that tied the physical weight loss of the contingent beneficiary with the provision to receive an inheritance. Some of the more difficult situations occur when there is a family business involved, with some members of varying skills working within the business while others are non-working members. In each case, the senior member is desperately trying to make up for failures of the past. My job as the adviser to the senior member is try to get him or her to recognize, like the government, that benefits of intervention may not last, and we need to focus on current behavior modification.
The bottom line is that people eventually win over the dictates of past interventions.
As they say, it takes two to tango. Almost none of the evils were pre-meditated. The problems that have befallen people would not have been possible without both sides agreeing on something. Purchases of homes, cars, securities, and the inherent acceptance of debt (or as we prefer to label it, leverage) would not have been possible without a signature. In almost all instances, the signature was accompanied by a difficult-to-comprehend legal document. In many cases, the obtuse legalese was in documents that were never opened, even to examine their length. What motivated these buyers, some of whom were companies and, in many cases large, publicly-traded corporations, was the desire to own something they could not afford. These loans were packaged in a number of different wrappings and sold to both individual and institutional buyers. Despite the weighty legal documents, the attraction to buyers was a perceived, essentially, riskless, above-average yield (or performance). Many of those who lost their assets in various frauds and Ponzi schemes suffered from the same desire for unrealistic returns.
The very human desire to prevent such tragedies in the future is understandable and even commendable. However, it starts with a fallacy that “they” did it to the unsuspecting public. In the current political environment, “they” is usually a financial intermediary. There is little or no recognition of the culpability of the tango partner, or the sweet music played by the government. I believe that until there is some self-recognition of the initial source of the problem, there will be few solutions achieved.
One of the frightening elements of the Journal’s survey and reporting is that government intervention would make the economy and/or the market “safer.” First of all, it is not the function of government to make all human relations safe. At best a very clever government, continuously monitoring all communications between people, could possibly make disclosure fairer, but that would go up against the legal protections that one or both parties want.
In general there is a lack of appreciation on the part of governments, particularly this one, as to the nature of intervention. Initially, the authors of intervention attempt (almost in a biblical sense) to divide the good from the bad with one quick stoke of His staff. There are lots of problems with this glorious picture. First, the intervener has to gather up all the good people on one side. (Are they always, in every respect going to be the good people?) All the bad guys (no matter how bad), will need to be forced to the other side of this bipolar world. Second, since the beginning of wars and conflicts, some of the participants on each side have traded with the enemy. In turn these trading relationships have blossomed into friendships and even marriages of some type. Third, almost no single intervention, by itself can stand the test of time. Even that most precious of all interventions in the English language, The Declaration of Independence, could not stand alone by itself for long. After much wrangling, the U.S. Constitution, the operating document for our enterprise, was created. Despite that effort, amendments soon became necessary, the first ten resulting in the Bill of Rights. Further, our founding Fathers recognized that the language of the Constitution may not be perfectly understood, and the various states (the political powers of the day), could interpret the document differently. Thus, to bring these concepts into line with their original intent, they created the Supreme Court. The purpose of this very brief history lesson is to show that no single intervention can be, in and of itself, a solution. In biblical terms it could be said the first intervention begat the second intervention which begat the third, etc.
I have two warnings for those who plea for an intervention: First, they will get more than they intended. The second warning is that it will not work as completely intended, no matter who designs it. Why? Get out your Physics book. Sir Isaac Newton’s third Law of Motion states that each action is met with an equal and opposite reaction. With diligence equal to that of the government, clever people will succeed at finding ways around any regulation.
There is even a more important reason why pure intervention won’t work. How many of you, as parents, successfully intervened with your children by just taking away some privilege, which they thought was their absolute right. Did it work? In most cases this pure punishment did not work. What usually worked was to forge some form of behavior modification, so that the child first understood the consequences of an action, and second (and much more importantly), modified their behavior. The solution to preventing future problems is behavior modification, not reliance on intervention.
One of the challenges in working with families of wealth is the desire of the senior member to posthumously intervene in their children’s, grandchildren’s or favorite charity’s lives. There are all sorts of provisos written into wills and trusts that are an attempt to allow the dead to control from the grave. A number of these stipulations withhold funds unless certain things are done, e.g. going to the Alma Mater, getting married, having children, completing a certain task, teaching a particular view, playing only a certain kind of music, etc. There was even one family that we worked with that tied the physical weight loss of the contingent beneficiary with the provision to receive an inheritance. Some of the more difficult situations occur when there is a family business involved, with some members of varying skills working within the business while others are non-working members. In each case, the senior member is desperately trying to make up for failures of the past. My job as the adviser to the senior member is try to get him or her to recognize, like the government, that benefits of intervention may not last, and we need to focus on current behavior modification.
The bottom line is that people eventually win over the dictates of past interventions.
Sunday, July 5, 2009
Can We be Independent?
We have just celebrated Independence Day to commemorate that brave band of Americans who have declared their independence from, at that time, the most powerful nation in the world. On late night cable on July 4th the film “1776” was broadcast. The plot centers on the days of wrangling that went on among the delegates to the Continental Congress. Until the final day, there were not enough votes to pass the bill. What is quite clear is that this remarkable group of men chose to lead rather than merely represent the popular will of the people. As investors do we have the wisdom, courage and fortitude to declare our own independence? Just like those earlier patriots we are facing a tyrant. At that time the tyrant was not just the King of England, but the tyranny of experience. The American Revolution had no historic precedent; no people’s revolt had ever created a new nation.
As investors we have suffered mightily from a sharp decline in market prices. More importantly, the world has gone through an economic devastation. The tyranny that we are now facing is the normal reliance on experience. We are looking at the events of the past as just another cyclical series with the thought that we will rise once again to the former heights. I, for one, doubt it. What was quite clear from the American Revolution, was there would be deaths and other casualties to our lives and to the ways that our society and economy worked.
Before we put too much weight on our ability to order the future, we need to remember, as with all wars, the losing side contributed more mistakes than the winning side. Luck was with us in the sense that the storms off Newport, Rhode Island kept the superior British Fleet bottled up, rather than doing battle with the French Fleet. Thus, Cornwallis could not evacuate his losing army from Yorktown and had to surrender to the forces commanded by the indispensable General George Washington. This was the last major battle of The Revolution, but it took two more years before a peace treaty was signed. What Americans in general (and investors in particular) did not appreciate was that the “peace party” in Parliament at the time was gaining the upper hand, and wanted the war ended, for they had better things to do with their resources.
How should we learn from the American Revolution today as investors? First, do not hold up a mirror to the past cycles. Though we can still learn from sound principles from the past in terms of risk management, they will be broader than in the past. Second, look for changes in structure in both the world economy and in the market place. We have seen the rise of sovereign wealth funds and the expansion of central banks, which could be the tyranny of new attempts at central controls. We have already seen the disappearance of floors of securities exchanges in favor of electronic exchanges, which will operate from the ether, domiciled in the least regulated locations. We are finally close to getting some of the derivatives, (e.g. credit default swaps) clearing through a series of central clearing houses. Finally, within a relatively few years, we will see new leaders arise who will be much better equipped to manage themselves, their own activities and perhaps even governments. Just as the leaders of the American Revolution succeeded through the much more difficult task of writing a Constitution and creating a new form of government, we may see new groupings of people, not based on location but rather their own particular interests.
In looking to a brave new and frightening new world, we may have to get rid of old ways of thinking. For instance, the so-called “prudent man rule” has been the foundation for courts and learned investment opinion since it was handed down by a Massachusetts state court in 1830. The case questioned whether Harvard College was managing its endowment properly. Judge Putnam ruled against Harvard, by defining prudence as what other intelligent people did with their own money. (Seems as if Harvard has a slow learning process.) Despite this definition of prudence, we could be entering a period that new and thoroughly thought-out investment policies should be followed. For example, is the legal form of an investment as important as the predictability and terminal value of a security? Thus, we may find that compartmentalizing a portfolio into stocks, bonds, funds, and various forms of illiquid investments is not as important as the variance of future year-by-year returns, expected or tolerated. Another consideration that may come increasingly important is the evolving body of corporate and civil law, e.g. stipulating the priority position of senior secured bond holders or the imposition of “gates” on hedge fund redemptions, etc. Will changes in estate taxes alter the motivations and valuations of various investments in public and private securities? The list of examples is far from complete. The purpose of these radical, perhaps not revolutionary, ideas is to indicate some of the range of changes that should guide us to seek a new way of thinking.
In the end, tyranny of all forms is self-defeating, as it can never for all times be complete. Eventually the unknowns become known, which some people identify early enough to survive, and in some cases prosper.
Be alert, and share with us what we should be seeing.
As investors we have suffered mightily from a sharp decline in market prices. More importantly, the world has gone through an economic devastation. The tyranny that we are now facing is the normal reliance on experience. We are looking at the events of the past as just another cyclical series with the thought that we will rise once again to the former heights. I, for one, doubt it. What was quite clear from the American Revolution, was there would be deaths and other casualties to our lives and to the ways that our society and economy worked.
Before we put too much weight on our ability to order the future, we need to remember, as with all wars, the losing side contributed more mistakes than the winning side. Luck was with us in the sense that the storms off Newport, Rhode Island kept the superior British Fleet bottled up, rather than doing battle with the French Fleet. Thus, Cornwallis could not evacuate his losing army from Yorktown and had to surrender to the forces commanded by the indispensable General George Washington. This was the last major battle of The Revolution, but it took two more years before a peace treaty was signed. What Americans in general (and investors in particular) did not appreciate was that the “peace party” in Parliament at the time was gaining the upper hand, and wanted the war ended, for they had better things to do with their resources.
How should we learn from the American Revolution today as investors? First, do not hold up a mirror to the past cycles. Though we can still learn from sound principles from the past in terms of risk management, they will be broader than in the past. Second, look for changes in structure in both the world economy and in the market place. We have seen the rise of sovereign wealth funds and the expansion of central banks, which could be the tyranny of new attempts at central controls. We have already seen the disappearance of floors of securities exchanges in favor of electronic exchanges, which will operate from the ether, domiciled in the least regulated locations. We are finally close to getting some of the derivatives, (e.g. credit default swaps) clearing through a series of central clearing houses. Finally, within a relatively few years, we will see new leaders arise who will be much better equipped to manage themselves, their own activities and perhaps even governments. Just as the leaders of the American Revolution succeeded through the much more difficult task of writing a Constitution and creating a new form of government, we may see new groupings of people, not based on location but rather their own particular interests.
In looking to a brave new and frightening new world, we may have to get rid of old ways of thinking. For instance, the so-called “prudent man rule” has been the foundation for courts and learned investment opinion since it was handed down by a Massachusetts state court in 1830. The case questioned whether Harvard College was managing its endowment properly. Judge Putnam ruled against Harvard, by defining prudence as what other intelligent people did with their own money. (Seems as if Harvard has a slow learning process.) Despite this definition of prudence, we could be entering a period that new and thoroughly thought-out investment policies should be followed. For example, is the legal form of an investment as important as the predictability and terminal value of a security? Thus, we may find that compartmentalizing a portfolio into stocks, bonds, funds, and various forms of illiquid investments is not as important as the variance of future year-by-year returns, expected or tolerated. Another consideration that may come increasingly important is the evolving body of corporate and civil law, e.g. stipulating the priority position of senior secured bond holders or the imposition of “gates” on hedge fund redemptions, etc. Will changes in estate taxes alter the motivations and valuations of various investments in public and private securities? The list of examples is far from complete. The purpose of these radical, perhaps not revolutionary, ideas is to indicate some of the range of changes that should guide us to seek a new way of thinking.
In the end, tyranny of all forms is self-defeating, as it can never for all times be complete. Eventually the unknowns become known, which some people identify early enough to survive, and in some cases prosper.
Be alert, and share with us what we should be seeing.
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