Mike Kueber's Blog

July 28, 2012

My new investing strategy

Filed under: Investing,Retirement — Mike Kueber @ 6:05 pm
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As someone who is fascinated by investment strategies, I have read about a variety of techniques to minimize risk and maximize returns – e.g., dollar-cost averaging, ladder purchases, re-balancing of assets, and numerous diversifying techniques, including indexed mutual funds.  Because I believe the ups and downs of the stock market can’t be timed, I generally don’t focus on trying to buy low and sell high.  Instead, I’m a confirmed buy-and-hold guy.  And, as a young guy, I’m 100% in the market.

Last week, however, with the stock market returning to a relatively high level (and with me not being as young as I used to be), I decided to implement a strategy for moving some of my nest egg out of the market.  This strategy, which I invented, takes advantage of market swings, akin to the dollar-cost averaging strategy.  (Although I am claiming to be the inventor, I’m sure thousands or millions of other people have thought the same thing).   

My plan is to take 5% out of my stock-market nest egg and move it to cash.  Then whenever the market recoups that 5% withdrawal (on average, twice a year), I will take out 5% more.  Thus, I will be forever selling stock on an upswing, and my stock-market nest egg will stay at the same level, less inflation.  A $100k nest egg would periodically generate $5k into cash, and a $1 million nest egg (which seems to be the target for many white-collar workers) would periodically generate $50k into cash.     

The only weakness with this strategy that I can detect is if the market drops and doesn’t return to the earlier level for several years.  If such an event occurs, I hope that I will have pocketed enough earlier withdrawals to avoid selling during a downturn.  But if I have to sell during a downturn, I will be especially motivated to keep the withdrawal to the smallest amount necessary (less than 5%).

A lot of investment advice must be tailored to an investor’s comfort level with risk.  In the past, I was comfortable with all of my savings in the stock market.  Whether the market went up or down, I knew that it had almost no effect on my lifestyle.  My co-workers and I called it paper loss (or paper gain).  Now that I have retired and am spending my savings, the ups and downs of the market are real, not abstract. 

When I sell 5% of my stock on Monday and move it to cash, I am going to feel a lot better knowing that I have cash to live on for a long time and won’t have to sell any additional stocks unless the market continues its upward march (in which case, I will have another 5% cash to live on for a long time times two).  The ups-and-downs of the market will once again be relatively abstract.

Because of my skin in the game, I have been rooting for President Obama’s success for the past three and a half years.  That is also one of several reasons why I am rooting for Mitt Romney to win in November.

May 13, 2012

Sunday Book Review #73 – Investment Mistakes

Filed under: Investing — Mike Kueber @ 2:30 am
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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.

 

 

February 28, 2012

Buffett’s wisdom – continued

Filed under: Investing — Mike Kueber @ 6:49 pm
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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.

October 22, 2011

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.