Sunday Book Review #73 – Investment Mistakes

Investment Mistakes is a simple compilation of 77 common errors made by investors.  Most of them are obvious and could have been written by any investor with a modicum of experience.  For example:

Mistake #2 – Do You Project Recent Trends Indefinitely into the Future?

Mistake #3 – Do You Believe Events Are More Predictable After the Fact than Before?

Mistake #4 – Do you extrapolate from small samples and trust your intuition?

Mistake #35 – Do you understand the arithmetic of active management?

Mistake #59 – Do you have too many eggs in one basket?

I’m not saying these points are inaccurate, or that being reminded of them isn’t a good thing.  It’s just that they aren’t great insights.    

As I was writing this review, my best friend Mike Callen, investor extraordinaire, called me to discuss various issues on his mind, and we spent a little time talking about investing.  (If you know Mike, you know he doesn’t need much prompting to share his collected wisdom.)  In the span of less than five minutes, Mike revealed that he regularly makes the following mistakes:

            Mistake #11 – Do you let the price paid affect your decision to continue to hold an asset?  (Mike will hold forever to avoid admitting a loss.)

            Mistake #12 – Do you believe you are playing with the house’s money?  (Mike regularly travels to Vegas and Reno, and still has a stash from a large jackpot that he is willing to lose incrementally without feeling any guilt or remorse.  His wife feels strongly that this is a mistake because she can think of some alternative uses for the money.)

            Mistake #15 – Do you let friendships influence your choice of investment advisors?  (Mike still holds a grudge against a friend who steered him wrong.  Live & learn?  Maybe.)

            Mistake #31 – Do you believe hedge fund managers deliver superior performance?  (Mike thinks hedge-fund managers are the gold standard.)

            Mistake #39 – Do you confuse before-the-fact strategy with after-the-fact outcome.  (Based on his experience in watching certain business and the entire market, Mike thinks he can buy high and sell low – a stock, an industry, or the entire market – by exercising some judgment and intuition.

 Out of the 77 mistakes listed in this book, there were a few that contained excellent insights.  Specifically:

            Mistake #11 – Do you let price paid affect your decision to continue to hold an asset?  I share my friend Mike’s weakness for this mistake, especially when dealing with a stock.  For some reason, I don’t feel the same way about my 401k investments.  For many years, I would tell co-workers that I would decide every day whether to have my 401k in stocks, bonds, or cash, and that it was irrelevant what I paid for those assets.  But when it comes to an individual stock, I am loathe to sell it for a loss.  If I need to sell some stocks, I will almost always sell one on which I have made a nice profit and therefore will be subjected to a capital-gains tax.  Go figure.

            Mistake #14 – Do you believe you are playing with the house’s money?  Again, I share this mistake with my friend Mike.  When my Ford or Lifetime Fitness stocks do down, I don’t get stressed because they have already gone up so much that they remain immensely profitable.  Yet when Goldman Sachs goes down, it feels horrible because it causes my loss to balloon. 

Mistake #22 – Do you confuse great companies with high-return investments?  I bought my Ford and Lifetime Fitness stock because they were great companies whose stock price had been a lot higher before the bubble popped in 2007-2009.  But for all I knew, they could have been already priced more than they were worth.  Old saying – I’d rather be lucky than good.

Mistake #36 – Do you understand that bear markets are a necessary evil?  This section was fascinating because it described not only the cyclical nature of business, but also the risk-premium that is created by the cycle.  If business (and the market) was steady, then the risk-premium would go away and stock returns would more closely approximate fixed income investments.     

Mistake #40 – Do you believe that stocks are risky only if your horizon is short?  The authors point out that this mistake is based on the American experience to date, but fails to consider that the American experience has been exceptional.  Other countries have not been so lucky – e.g., Egypt, Argentina, Japan. 

            Mistake #48 – Do you confuse speculating with investing?  “Investors get compensated for taking systematic risks – risks that cannot be diversified away.  The compensation is in the form of greater expected returns.  Bad risk is the type for which there is no such compensation.  Thus, it is called uncompensated or unsystematic risk.  Equity investors face several types of risk:

1. First, there is the systematic risk of investing in stocks.  This risk cannot be diversified away, no matter how many stocks or different asset classes you own….
2. Second, various asset classes carry different levels of risk.  Large-cap stocks are less risky than small-cap stocks, and glamour (growth) stocks are less risky than distressed (value) stocks.  These two risks cannot be diversified away.  Thus, investors must be compensated for carrying them.
3. The third type of equity risk is that of the individual company.  The risks of individual stock ownership can easily be diversified away by owning passive asset class or index funds that basically own all the stocks in an entire asset class or index fund….  Since the risks of single-stock ownership can be diversified, the market does not compensate investors for taking that type of risk.  This is why investing in individual companies is speculating, not investing.  Investing means taking compensated risk.  Speculating is taking uncompensated risk.” 

Fascinating.

            Mistake #49 – Do you try to time the market?  This mistake is the most obvious, but I include it here because it contained two eloquent quotations:

1. “It must be apparent to intelligent investors that if anyone possessed the ability to [time the market] consistently and accurately he would become a billionaire so quickly he would not find it necessary to sell his stock market guesses to the general public.”  David L. Babson, 1951.
2. “Our stay-put behavior reflects our view that the stock market serves as a relocation center at which money is moved from the active to the patient.”  Warren Buffett.

 

 

Buffett’s wisdom – continued

Yesterday I blogged about Warren Buffett’s most recent letter to the Berkshire Hathaway shareholders.  Compared to other editions of the shareholder letter, I thought this edition was relatively skimpy, and in my blog I noted only three significant Buffett insights – (1) a replacement CEO for Berkshire had been selected, (2) the economy in America would rebound vigorously as soon as the housing overstock was sold off, and (3) Berkshire Hathaway would continue buying back its stock because it was underpriced.

But no sooner had I posted the entry to my blog than I had a conversation on investing with an old USAA friend.  This friend has a seven-figure 401k, a beautiful house with no debt, and a sizable inheritance, yet he is concerned that his current cash flow will be stressed as his kids get to college.  Talk about looking far and wide to find something to be unnecessarily worried about.

My friend went on to express concern for preserving his estate for his kids.  Ever since the crash of 2008-2009, he has been too skittish to invest in the stock market.  He has inherited a sizable amount of agricultural real estate, but he is planning to sell that because he suspects that its current pricing is a bubble that is ready to burst.  The only safe investments probably would not keep up with inflation.  He was perplexed because he seemed to have no good choices. 

Following our conversation, I recalled that Warren Buffett’s most recent shareholder letter directly addressed my friend’s concerns.  In the letter, Buffett described three broad categories of investment – (1) currency-based investments, such as bonds and money-market funds (2) non-productive assets, such as gold, and (3) productive assets, such as businesses and real estate.

Buffett’s letter contained devastating critiques of currency-based investments and non-productive assets:

• Currency-based investments.  Most of these currency-based investments are thought of as “safe.” In truth they are among the most dangerous of assets. Their beta may be zero, but their risk is huge. Over the past century these instruments have destroyed the purchasing power of investors in many countries, even as the holders continued to receive timely payments of interest and principal. This ugly result, moreover, will forever recur. Governments determine the ultimate value of money, and systemic forces will sometimes cause them to gravitate to policies that produce inflation. From time to time such policies spin out of control.  Even in the U.S., where the wish for a stable currency is strong, the dollar has fallen a staggering 86% in value since 1965, when I took over management of Berkshire. It takes no less than $7 today to buy what $1 did at that time. Consequently, a tax-free institution would have needed 4.3% interest annually from bond investments over that period to simply maintain its purchasing power. Its managers would have been kidding themselves if they thought of any portion of that interest as “income.”  Today, a wry comment that Wall Streeter Shelby Cullom Davis made long ago seems apt: “Bonds promoted as offering risk-free returns are now priced to deliver return-free risk.”

 

• Non-productive assets.  Today the world’s gold stock is about 170,000 metric tons. If all of this gold were melded together, it would form a cube of about 68 feet per side. (Picture it fitting comfortably within a baseball infield.) At $1,750 per ounce – gold’s price as I write this – its value would be $9.6 trillion. Call this cube pile A. Let’s now create a pile B costing an equal amount. For that, we could buy all U.S. cropland (400 million acres with output of about $200 billion annually), plus 16 Exxon Mobils (the world’s most profitable company, one earning more than $40 billion annually). After these purchases, we would have about $1 trillion left over for walking-around money (no sense feeling strapped after this buying binge). Can you imagine an investor with $9.6 trillion selecting pile A over pile B? Beyond the staggering valuation given the existing stock of gold, current prices make today’s annual production of gold command about $160 billion. Buyers – whether jewelry and industrial users, frightened individuals, or speculators – must continually absorb this additional supply to merely maintain an equilibrium at present prices. A century from now the 400 million acres of farmland will have produced staggering amounts of corn, wheat, cotton, and other crops – and will continue to produce that valuable bounty, whatever the currency may be. Exxon Mobil will probably have delivered trillions of dollars in dividends to its owners and will also hold assets worth many more trillions (and, remember, you get 16 Exxons). The 170,000 tons of gold will be unchanged in size and still incapable of producing anything. You can fondle the cube, but it will not respond. Admittedly, when people a century from now are fearful, it’s likely many will still rush to gold. I’m confident, however, that the $9.6 trillion current valuation of pile A will compound over the century at a rate far inferior to that achieved by pile B.

 

Ultimately, Buffett concludes that the ownership of productive assets is not only the most profitable, but also “by far the safest”:

• Our country’s businesses will continue to efficiently deliver goods and services wanted by our citizens. Metaphorically, these commercial “cows” will live for centuries and give ever greater quantities of “milk” to boot. Their value will be determined not by the medium of exchange but rather by their capacity to deliver milk. Proceeds from the sale of the milk will compound for the owners of the cows, just as they did during the 20th century when the Dow increased from 66 to 11,497 (and paid loads of dividends as well). Berkshire’s goal will be to increase its ownership of first-class businesses. Our first choice will be to own them in their entirety – but we will also be owners by way of holding sizable amounts of marketable stocks. I believe that over any extended period of time this category of investing will prove to be the runaway winner among the three we’ve examined. More important, it will be by far the safest.

Buffett concedes that Berkshire keeps between $10 and $20 billion in currency-based investments for business-purchasing purposes, and my USAA friend obviously has liquidity needs related to his kids’ college education.  But if I were in my friend’s financial position, I would put my assets to work and stop being concerned.

Buffett’s 2011 letter to his shareholders

Although the timing of my retirement (March 2009) was excellent for purposes of investing in the stock market (the market has doubled since then), my timing for investing in Warren Buffett’s Berkshire Hathaway (April 2009) couldn’t have been worse.

In Warren Buffett’s annual letter to his shareholders, he always begins by comparing his company’s performance to the S&P 500.  In the past 48 years, Berkshire Hathaway has averaged a 19.8% gain as compared to 9.2% with the S&P, and Berkshire Hathaway has outperformed the S&P in 40 of those 48 years.  Unfortunately for me, two of those bad-performing years were 2009 and 2010.  According to Buffett’s most recent shareholder letter, Berkshire in 2011 finally returned to supremacy over the S&P, but just barely – 4.6% to 2.1%.  That’s better than nothing.

The big story from the 2011 letter is that Buffett’s successor has been selected, although the successor’s identity was not disclosed:

• Your Board is equally enthusiastic about my successor as CEO, an individual to whom they have had a great deal of exposure and whose managerial and human qualities they admire. (We have two superb back-up candidates as well.) When a transfer of responsibility is required, it will be seamless, and Berkshire’s prospects will remain bright. More than 98% of my net worth is in Berkshire stock, all of which will go to various philanthropies. Being so heavily concentrated in one stock defies conventional wisdom. But I’m fine with this arrangement, knowing both the quality and diversity of the businesses we own and the caliber of the people who manage them. With these assets, my successor will enjoy a running start. Do not, however, infer from this discussion that Charlie and I are going anywhere; we continue to be in excellent health, and we love what we do.

In the letter, Buffett also suggested that (a) the American economy will enjoy a vigorous rebound as soon as the excess supply of houses is inevitably exhausted, and (b) Berkshire will continue to buy back its shares because they are underpriced. 

I think I will hold onto my shares.

The Zuckerberg Tax

A recent op-ed piece in the NY Times recommended that America adopt a “marked to market” tax – something it called the Zuckerberg Tax in honor of Facebook founder Mark Zuckerberg.  Essentially the tax would require the wealthiest Americans to pay taxes on their capital gains every year, regardless of whether they actually sold their assets – i.e., individuals would be taxed on their paper gains. 

That makes sense to me.  Individuals who are getting super-rich should not be able to avoid contributing toward the provision of government services by holding onto their capital assets.  The column reported that Apple’s Steven Jobs never sold any of his Apple stock, and thus never paid capital-gains taxes on his billions of dollars of capital gains.

Even more troubling is the report in the column regarding the tax treatment of capital gains that are never realized before the owner dies and passes them to heirs.  According to the column, neither the estate nor the heir pay capital gains at the time the capital is transferred, and inexplicably instead of requiring the heir to assume the deceased’s cost basis for the assets, the heir’s basis becomes the market value of the assets at the time of the transfer. 

For example, Steve Jobs buys ten million shares of Apple for $10 a share, and then holds them until his death, when they are worth $300 a share.  Thus, he never realized any capital gains and didn’t pay a penny of taxes.  His wife then receives the shares through the Jobs’ will, and she holds them for another year before selling them for either $290 a share or $310 a share.

If she sells them for $290 a share, she will receive $2.9 billion from an initial investment of $100 million, yet she can actually declare a $100 million loss and offset that loss against other capital gains.  If she sells them for $310 a share, she will receive $3.1 billion, but will have to declare capital gains of only $100 million, on which she will pay capital-gains tax of 15% or $15 million.  That’s an incredibly low tax rate (.5%) on the $3 billion in capital gains that she and her husband experienced.

The Zuckerberg Tax seems like a good idea, even though it will have tough sledding.  There is no reason, however, for failing to assess the capital-gains tax when property is transferred by someone’s death.

The Gone Fishin’ Portfolio

Alexander Green is the author “Beyond Wealth, the road map to a rich life,” a book that I plan to review this Sunday.  The book focuses on the acquisition of spiritual wealth as opposed to material wealth.

Green’s claim to fame, however, is the acquisition of material wealth.  He had a successful career as an investment advisor for The Oxford Club, and then capped that career in 2008 by writing a bestselling investing book titled, The Gone Fishin’ Portfolio.

Green named his recommended portfolio “Gone Fishin’” because it enables his clients to allocate their nest eggs into ten designated mutual funds at the beginning of the year and then they can go fishing for the rest of the year.  The only recommended maintenance is an annual re-allocation back to the following recommended amounts:

• Total Stock Market Index (VTSMX) – 15%
• Small-Cap Index (NAESX) – 15%
• European Stock Index (VEURX) – 10%
• Pacific Stock Index (VPACX) – 10%
• Emerging Markets Index (VEIEX) – 10%
• Short-term Bond Index (VFSTX) – 10%
• High-Yield Corporates Fund (VWEHX) – 10%
• Inflation-Protected Securities Fund (VIPSX) – 10%
• REIT Index (VGSIX) – 5%
• Precious Metals Fund (VGPMX) – 5%

I have a close friend who swears by this portfolio, especially since the portfolio has outperformed the S&P 500 every year since 2003.  I conceded to him that the portfolio looked thoughtful and reasonable, but I doubted there was anything magical about it.  Rather, I suspected that it had been developed, after-the-fact, to out-perform the
S&P from 2003 to 2007, and I had no confidence that it would continue to out-perform the S&P going forward.  In fact, I predicted to him that the portfolio would start losing to the S&P as soon as American stocks started out-performing foreign stocks.

Boy, was I wrong.  According to the current Gone Fishin’ Portfolio website, the portfolio outperformed the S&P 500 index in 2010 for the eighth straight year:

• “Admittedly, 2010 year was a bit of a squeaker.   The S&P 500 returned 15.1%.  And, according to official figures released by the Vanguard Group, our Gone Fishin’
  Portfolio returned 16.1%.  This doesn’t begin to tell the tale, however. The Gone Fishin’ Portfolio is far less risky than being fully invested in stocks.  We have 10% invested in high-grade corporate bonds, 10% invested in inflation-adjusted Treasuries and 10% invested in high-yield bonds.  Each of these asset classes underperformed the S&P last year.  But they provided some ballast.  Investors who were fully invested in stocks got a very bumpy ride in 2010.  Our journey was less thrilling.  (You probably slept better as a result.)  And the stellar performance of our small-cap stock fund (up 27.7%), REIT fund (up 28.3%) and gold fund (up 37.5%) allowed us to beat the broad market again.”

By contrast, even though I avoided the 30% in ballast in cash and bonds, I was hammered by 40% in International stocks.  The year 2011 has been even worse because my
25% in small caps is getting hammered, too.

As soon as I win back some of my International losses, I plan to move my entire portfolio to Green’s suggestion, and then go fishin’.

Sunday Book Review #50 – The Most Important Thing – the conclusion

Before posting my Sunday Book Review #50 – The Most Important Thing – I should have included my conclusion.  Better late than never:

Howard Marks seems cut from the same cloth as John Bogle of Vanguard fame and Warren Buffett of Berkshire Hathaway, and I think all three would agree that I need to get out of the business of buying & selling stocks and instead they would gently suggest that I should shift into 100% mutual funds.  Even though I can improve my trading performance by learning from masters like them, I can’t reasonably expect to ever progress to what Marks calls second-level thinking.  If I enjoyed trading stocks, I could rationalize the activity as an entertainment expense (like the 45% chance of winning in Vegas), but I don’t enjoy studying stocks and the market that much.  I would prefer to dump my money in a mutual fund and then watch it work.

One lingering question – Marks said that a successful investor needed to get past a “buy & hold” strategy and get to the point of understanding where in the business cycle we currently are.  Warren Buffett has been described as the ultimate ”buy & hold” guy, and I wonder what he would say about Marks taking it to another level.  I didn’t really understand what Marks was suggesting investors should do when they conclude that the market is in, for example, the irrational exuberance phase since he seemed to conclude that timing the market was impossible.

One other lingering question – Marks said that a successful investor never searches for quality assets, but rather searches for great value.  I would love to hear Marks and Buffett discuss that issue because Buffett’s purchasing career seems to be focused solely on quality assets for great value.  I wonder if Buffett would say to Marks that you can never find a price low enough to justify buying a crappy company.

Sunday Book Review #50 – The Most Important Thing by Howard Marks

In my most recent book review – Islam, a short guide to the faith – I noted that the “little, highly readable” book reminded me of Harvey Penick’s Little Red Book on golf.  That description applies even more to Howard Marks’ book on investing – The Most Important Thing.

Marks describe his little book (180 pages) as a collection of insights (20) about investing that he has made over his 40-year career.  Each insight was initially a stand-alone comment that Marks might have fleshed-out in a memo to clients.  But over the years, as Marks’ insights gained critical mass, he began to realize that, although these insights could stand alone, they were more effective when considered as part of a package.  (Of course this alleged synergy justified consolidating the memos into book form.)  Although I have never heard of Marks, he is apparently famous as a value investor and the cofounder of Oaktree Capital Management, with $80 billion under management.

According to Marks in Chapter One, the most important thing is “second-level thinking,” which he describes as something a little deeper or more nuanced than the conventional wisdom. An investor needs
to focus on achieving second-level thinking because only with this ability can an investor consistently out-perform the market.

According to Marks in Chapter Two, the most important thing is understanding market efficiency and its limits.  The efficient-market hypothesis generally posits that the market absorbs all available information and then generates pricing that reflects that information.  Marks’ position is that the market is incredibly efficient, but he defines efficient as “speedy, quick to incorporate information, not necessarily right.”

By now you should be understanding the format of this book.  It reminds me of MMA fighting.  Every few months, my son tells me about an upcoming fight that he invariably calls the fight of the century.  After a few such fights, I pointed out the ludicrousness of the claim, and he responded that I shouldn’t take everything so literally.  The same rule applies to Marks’ insights.  Each one may be the most important thing, but not really.

According to Marks in Chapter Four, the most important thing is value.  In this chapter, Marks briefly describes fundamental analysis, technical analysis, random-walk hypothesis, and momentum investing, and then focuses on the difference between value investors and growth investors.  He describes value investors as those who buy stocks because their current value is high relative to its current price.  By contrast, growth investors buy stock because its current value is likely to grow enough to cause substantial appreciation in the future price.  Marks endorses value investing because it is easier to consistently make profitable purchases.  Growth investing is more speculative.  According to Marks, “In my book, consistency trumps drama.”

Chapter Four describes the relationship between price and value.  According to Marks, no asset is of such good quality that price is not the dominant consideration.  Stating the obvious, Marks points out that
investment profits can be derived from (1) an increase in the intrinsic value of an asset, (2) selling an asset for more than it is worth, or (3) buying something for less than its value.  The last of these is the most reliable, but even that is not foolproof because “the convergence of price and intrinsic value can take more time than you have; as John Maynard Keynes pointed out, ‘The market can remain irrational longer than you can remain solvent.’”

Chapters Five, Six, and Seven deal with risk – understanding risk, recognizing risk, and controlling risk.  Marks suggests that the conventional thinking equates risk with volatility.  He disagrees.  He equates risk with the possibility of loss, or even more, the risk of permanent loss.  That makes sense.  Personally, I believe the market will inevitably recover before I need to cash-in most of my investment assets, and
therefore I don’t think the current volatility creates an inordinate amount of risk.  If the market is down significantly in 20 years, then I will have make a bad decision, and my estate and me will suffer the consequences.

Chapters Eight and Nine warn investors to be attentive to cycles and pendulums, with cycles referring to economic expansion and contraction and pendulums referring to investor optimism and pessimism.

Chapter Ten advises investors to combat the negative influences of human nature – e.g., greed, fear, a willing suspension of disbelief, a tendency to conform to the view of the herd, envy, ego, and capitulation.

Chapter Eleven endorses contrarianism, which makes sense for anyone trying to beat the conventional wisdom.  The trick is identifying what about the conventional wisdom is likely incorrect.  For example, when the market is crashing, most experts say, “We’re not going to try to catch a falling knife; it’s too dangerous.  We’re going to wait until the dust settles and the uncertainty is resolved.”  Marks
interprets this to mean that they are too frightened and unsure of what to do.  “The one thing I’m sure of is that by the time the knife has stopped falling, the dust has settled, and the uncertainty has resolved, there’ll be no great bargains left.”  If you know what you are doing, this is the time to do it.

Chapter Twelve recommends finding bargains.  These are usually unattractive assets that provide value because of their unreasonably low prices.  Because of their “unusual ratios of return to risk, they represent the Holy Grail for investors.”

Chapter Thirteen prescribes patient opportunism.  Marks credits Warren Buffett for articulating this concept in one of his annual shareholder letters.  Buffett taught the concept by first describing a baseball batter who is punished by baseball rules if he takes a juicy pitch right down the middle.  Pass on three such pitches and the batter is declared out.  By contrast, investors can take as many pitches as they want, even if the pitches are right down the middle.  Because of this unlimited opportunity, wise investors can wait until really good investments come along before pulling the trigger.

Chapter Fourteen warns about knowing what you don’t know.  Marks thinks most investing mistakes are made by persons who don’t know what they don’t know.  In this chapter, he contrasts actions taken
by investors in the “I don’t know” school vs. those in the “I know” school.

Chapter Fifteen compares three ways of dealing with inevitable cycles – (1) refuse to accept that cycles are unpredictable and try to predict them better than the average Joe, (2) ignore cycles and employ a
“buy and hold” strategy, or (3) instead of prediction or ignoring cycle, have a more limited objective of trying to figure out where we stand in the current cycle and what that implies for our actions.  We should be able to discern whether other investors are acting with reckless exuberance or undeserved caution, and that would suggest contrarian moves.  I think Warren Buffett said something like, “When others are fearless, I fear.  When others are frightened, I am emboldened.

Chapter Sixteen talks about appreciating the role of luck.  Although Bill Parcells is famous for saying a team is as good as its record, that is not necessarily true.  Some actions may look brilliant in hindsight, but the result was not pre-ordained.

Chapter Seventeen advises investing defensively.  There are old investors, and there are bold investors, but there are no old bold investors.

Chapter Eighteen says that the most important thing is to avoid pitfalls.  An investor needs to do very few things right as long as he avoids big mistakes – Warren Buffett.

Chapter Nineteen says the most important thing is to add value.  That value can be gaining more than the market when it goes up or losing less than the market when it goes down.  Marks, like Buffett, prides
himself in keeping up with the market in good years and then separating from the market (in a good way) in the bad years.

Chapter Twenty says the most important thing is to pull it all together.  This chapter contains 27 aphorisms that re-state the insights contained in the 19 previous chapters.  Among my favorites:

• The relationship between price and value holds the ultimate key to investment success.  Buying below value is the most dependable route to profit.  Paying above value rarely words out as well.
• The superior investor never forgets that the goal is to find good buys, not good assets.  (I wonder if Buffett agrees with this.)
• Economies and markets cycle up and down.  Whichever direction they’re going at the moment, most people come to believe that they’ll go that way forever.  This thinking is a source of great danger since it poisons the markets, sends valuations to extremes, and ignites bubbles and panics that most investors find hard to resist.
• Underpriced is far from synonymous with going up soon.  Thus, being too far ahead of your time is indistinguishable from being wrong.  It can require patience and fortitude to hold positions long enough to be proved right.
• Never forget the six-foot-tall man who drowned crossing the stream that was five-feet deep on average.

 

The TEA Party downgrade?

The S&P downgrade of America’s credit rating has creating an unstable stock market.  Yesterday was my worst day ever, with the Dow down 635 points, while today was my best day ever, with the Dow up 430 points.

Both political parties are politicizing the downgrade.  On one hand, the Republicans are saying that President Obama is the first president to have a downgrade “on his watch.”  That is undeniable.

On the other hand, the Democrats are calling it the “TEA Party downgrade.”  That is more debatable.

S&P warned that there might be a downgrade unless the federal deficit for the next decade was trimmed by at least $4 trillion.  Thus, the only way to have avoided the downgrade was the adoption of President Obama’s and Speaker Boehner’s Grand Bargain.

The Grand Bargain would have trimmed the deficit by $4 trillion, but President Obama and Speaker Boehner couldn’t agree on how much revenues should increase.  According to news reports, Boehner offered to increase revenues by $800 billion, while Obama insisted on $1.2 trillion.

The significant fact is Boehner offered to increase revenues, which is something that his TEA Party members would never sign-off on.  Thus, the TEA Party wasn’t controlling Boehner or the process.

The Grand Bargain failed because Boehner and Obama couldn’t agree on how much, not whether, revenues should increase.  So instead of calling it the TEA Party downgrade, let’s call it the Obama/Boehner downgrade.

Do defined-benefits pension plans deserve to die?

Earlier this morning, I heard a FOX News opinionator suggest that defined-benefits pension plans (DB plan) have no place in America.  Because his position seemed a bit extreme (I have a DB plan from USAA), I wasn’t entirely focused when he explained that the economic status of virtually everyone is affected by the ups and downs of the economy, so why should retirees be any different.  As the morning went on, however, I kept returning to his explanation and found it persuasive.

For those who don’t recall the difference between the two major types of pension, a defined-contribution pension plan (DC plan) is like a 401k.  A defined amount of money (a percentage of an employee’s salary) is put into the plan, but the amount coming out to a retiree depends on how well the money is invested.  If the money is invested conservatively, it will probably have a small positive return of 2-5% annually.  If it is invested aggressively, it might have a negative return or a positive return of more than 10% annually. 

By contrast, a defined-benefits pension plan (DB plan) pays a pension amount that can be calculated by multiplying an employee’s salary times years of service times a pre-determined multiplier.  For example, an employee with a $100k salary and 40 years of service and a 2% multiplier would receive an annual pension of $80k ($100k x 40 x 2%).  Common variations with the salary calculation include whether only the final year is counted, the highest year, or the highest three or five consecutive years.  Public employers tend toward a shorter term, while private employers tend toward a longer term.  When employers base their calculation on a single year, there is a tendency to load up on overtime pay in that year.  Public employers also tend toward a higher multiplier.  Some employers further limit the years of service to a maximum of 30 years. 

My former employer USAA had a pension plan based on the average of the highest five years of salary, with a 30-year maximum and a 1.5 multiplier.  Thus, using the same example as above, a USAA employee’s pension could be reduced by almost half – i.e. $40,500 ($90k x 30 x 1.5%).      

Perhaps the greatest variation in a DB plan is the age of retirement.  A DB plan can provide full benefits at age 65, like Social Security does.  My previous employer USAA gave full benefits at age 62.  Most government employers give full benefits at a much earlier age – either at age 55 or after 30 years of service.  This variation is so expensive because government employees can easily draw retirement for more years than they worked.

Although employees may contribute some of their salary toward a DB plan, the employer is responsible for putting away enough money to satisfy its pension obligations (unlike the federal government and Social Security).  When the business and investments are going good, an employer is more able to pay into its pension fund; when the economy is bad, those payments are difficult.

Public v. private pensions

The verdict of private employers is in, and they have eliminated their DB plans and shifted to DC plans, including USAA which discontinued its pension several years ago.  Ironically, DB plans have survived in the public sector even though the public-sector plans have traditionally been much more generous.  In fact, I went bike-riding this past weekend with a state employee from Colorado who told me that their multiplier (2.5%) was even more generous than Texas’s (2.3%). 

One could argue that public employees are significantly sheltered from the economic cycle during their employment and thus continuing this shelter during their retirement is appropriate.  I disagree.  As my old boss at USAA used to say during his employee meetings, the company works better when everyone realizes how interdependent we are on each other.  We don’t want public employees thinking, “I got mine, Jack.  What’s your problem?” 

Social Security is the grand-daddy of all defined-benefits plans, and George W. Bush was soundly rebuffed when he tried to convert part of Social Security away from defined benefits and toward defined contribution.  Although that part of Social Security that serves as a safety net should remain a defined benefit, the other part should be converted to a defined contribution.  I remain optimistic that good ideas like that will eventually be accepted by Americans.

Sunday book review #18 – The Little Book of Behavioral Investing by James Montier

The Little Book of Behavioral Investing is directed toward those investors whose investments underperform the market – i.e., just about everyone.  The author, James Montier, believes that investors are unsuccessful, not because they aren’t as smart as Warren Buffett, but because their decision-making process is prone to be based on emotion instead of reason.  Montier even quotes Buffett to support this proposition:

• “Success in investing doesn’t correlate with IQ once you’re above the level of 100.  Once you have ordinary intelligence, what you need is the temperament to control the urges that get other people into trouble investing.”

Initially, I thought The Little Book would have little applicability to me because I am a firm adherent to Buffett’s buy-and-hold philosophy.  Montier warns of studies, however, that show virtually all investors concede that emotional behavior significantly affects investing decisions, but they also believe they are the exception to the rule. 

To persuade his readers that they aren’t an exception to the rule, Montier begins his book with a three-part brain teaser:

1. A bat and a ball cost $1.10 in total.  The bat costs a dollar more than the ball.  How much does the ball cost?
2. If it takes five minutes for five machines to make five widgets, how long would it take 100 machines to make 100 widgets?
3. In a lake there is a patch of lily pads.  Every day the patch doubles in size.  If it takes 48 days for the patch to cover the entire lake, how long will it take to cover half the lake?

This test (Cognitive Reflection Task – CRT) is designed to reveal whether an individual’s brain operates with a lot of emotional thinking or logical reasoning.  Montier uses two characters from Star Trek to contrast this difference, with Dr. McCoy (Bones) epitomizing human emotion and Spock epitomizing dispassionate logic.  McCoy’s is an emotional approach to decision making (effortless, with mental shortcuts), whereas Spock’s is a more logical way of processing information (slow, step-by-step).  (All of which sounds a lot like my previous posting on intuition.)

According to psychologists, individuals tend to act like McCoy when (a) a problem is ill structured and complex, (b) information is incomplete, ambiguous, and changing, (c) the goals are ill-defined, shifting, or competing, (d) the stress is high, because either time constraints or high stakes are involved, or (e) decisions rely on interaction with others.  Montier points out that one of these factors applies to virtually all of our important decisions. 

Montier suggests that even if you correctly answered all three questions on the CRT test, you might still have “general vulnerability to a whole plethora of behavioral biases, such as loss aversion, conservatism, and impatience.  In addition to these biases, everyone has a problem with over-confidence, over-optimism (chapter three), and confirmatory bias (chapter eight).   

Only 17% of respondents correctly answered all three questions; whereas 33% got all three wrong.  I quickly answered the first question and studied the second and third more closely.  Not surprisingly, I got the first wrong and the other two correct.  The first answer is five cents, the second is five minutes, and the third is forty-seven days. 

I love brain teasers like the CRT and there are several others in the book.  The most difficult is in Chapter Eight, and it is intended to show that we are all subject to a “confirmatory bias”:

• “Let’s imagine you have four playing cards laid out in front of you.  Each one has a letter on one side and a number on the other.  The four face-up symbols are E, 4, K, and 7.  I’m going to tell you that if a card has an E, then it should have a 4 on the reverse.  Which cards would you like to turn over to see if I am telling you the truth?”

 This teaser, which 95% of the people fail, shows that we tend to look for information that confirms our existing beliefs and we avoid disconfirming evidence. Most people answer E and 4.  The E is correct because if the face-down is not a 4, you will have learned that I lied.  However, turning over the 4 proves nothing, regardless of what the face-down symbol is.  The same is true of the K.  But you should turn over the 7 because if the face-down is an E, you will have learned that I lied.   Sometimes the best way to test a hypothesis is to look for all information that disagrees with it – “a process known as falsification.”  This is a particularly glaring weakness of mine.  I often look for a good explanation of something that I believe in and then don’t bother to look or study the contrary arguments.

Some of the various behavioral defects discussed in The Little Book include:

• The empathy gap.  The “empathy gap” means that a person says or does one thing during calm and a different thing during the heat of the moment.  Because decision-making is usually better during calm, the author suggests that decisions be made during calm and then use discipline to ensure that you don’t change your mind during the heat of the moment.
• Courage deficit.  The “courage deficit” describes the inability to act when the big bad market is terrifying.  As an example, Montier mentions the bottoming of the stock market in March 2009, at which time he presciently wrote, “Buy when it’s cheap – if not then, when?”  He brags, “Of course valuation isn’t a fail-safe reason for buying equities – cheap stocks can always get cheaper – but in March I was convinced that they offered a great buying opportunity for long-term investors.”  That sounds like Monday Morning Quarterbacking, which Montier lambastes later in the book.  With all of the Buffett quotes in this book, I am surprised that he didn’t use one of Buffett’s best in this chapter – “When others are fearful, be brave; when others are brave, be fearful.”
• Over-optimism.  Montier describes over-optimism as one of the cognitive-ability-resistant biases.  To counter this, we must discipline ourselves to think critically and become more skeptical. 
• Over-confidence.  This is another cognitive-ability-resistant bias that especially afflicts experts, who are even more over-confident than the rest of us.  Stop listening to them.
• Forecasting.  Is almost always wrong.  Use it to help prepare, but don’t rely on it.
• Information overload.  Humans are susceptible to information overload because, unlike computers, we cannot efficiently process limitless information.  At some point, the additional marginal information weakens our ability to make the correct, timely decision.
• The good story.  There is a temptation to ignore facts when they conflict with a good story.  Value stocks usually have bad stories; IPOs usually have good stories.
• Dealing with bubbles.  Normal people have an advantage over pros in dealing with bubbles because normal people don’t have to compete against artificial benchmarks.
• Monday Morning Quarterbacking.  Investors are disposed to think, in hindsight, that everything that happened was obvious and predictable.
• ADHD.  Many investors are afflicted with attention-deficit, hyperactivity disorder (ADHD).  They feel like they always should be doing something.  By way of contrast, Warren Buffett suggests the analogy of a baseball hitter without an umpire.  That batter can wait all day until he gets a fat pitch to swing at.  That’s what an investor should do.
• Lemmings.  Instead of being a lemming, be a contrarian.
• Status-quo bias.  There is a tendency to avoid buying or selling – like a deer caught in headlights.

Montier concludes by warning that we can’t control the outcome, but we can improve our chances by controlling our decision-making process.  Excellent advice; excellent book.