Crisis Fatigue

When discussing long term investing, I typically go over a list of all of the Bear Markets we have had since World War II, as well as a (fortunately, much shortened) list of some of the crises we have had over the last 50 years. Some were merely figments of the collective markets’ imagination,  some were quite temporary in nature and, yes, there were other crises which were very real and very devastating. But, we survived them all.

The point of this exercise is that, in spite of all of the calamities – wars, inflation, oil embargoes, assassinations, terrorism – the best way to participate in the long term growth of the economy was (and still is) to partner with some of the greatest and strongest corporations in the United States and, indeed, the world, through ownership of shares of stock. Being discouraged, being afraid or even overly cautious was a very bad strategy then, and is a very bad strategy now.

Witness: In January 1973, at the very top of a Bull Market, the Standard and Poor’s 500 Index was 120. From there it declined 45% over the next two years. Pretty terrible, right?

Well, in revisiting Thanksgivings past, here is where that index stood: In 1980 at 140, in 1990 at 315, and now, in 2010, it is close to 1,200. Including dividend income, the rate of return from January 1980 to the present has been approximately 11 per cent.

Yet, in the last two years, the world has seen so many crises that it is difficult to keep track of them – home foreclosures, bank failures, insurance companies in danger of default, the automobile industry in distress, even sovereign nations unable to pay their bills.

Pop quiz! What was the crisis everyone was hyperventilating about early this year? Hint: It was a debt crisis of a country that had had a tremendous building boom. (See the answer at the bottom of this post.)

And the crises keep coming. A while back, I had dinner with a high school friend who asked me if he should be worried about “the Greek Crisis.” I said that he could worry if he wanted to, but that not much was going to change. Now, of course, this year we have had to pay attention to Ireland and possibly Spain and perhaps other places that are nice to visit, but no longer so nice to live or work in.

Am I recommending that you ignore the next crisis? Actually, yes.

Get a Plan

If you already have a plan, you should stick to it, regardless of the Crisis du Jour. If you don’t have a plan, you should get one. Determine your risk tolerance and time horizon, establish an Investment Policy Statement and construct a well diversified portfolio of stocks and bonds.

You could attempt to do this yourself, but you probably should do it with the help of a financial planner who works for you (and not his or her employer).

And then, having carefully designed and implemented a plan that is right for you, do not be influenced by the media coverage of some terrible event which could possibly derail western civilization, as we know it. As before, we will survive it, whatever “it” is.

Stay the course. Stay the course. Stay the course.

For more posts on this subject go to The Education of an Investor.

Answer to the pop quiz: Dubai. Who even remembers that?

For a humorous take on the Dubai hubris, read Dubai Debt Crisis Halts Building of World’s Largest Indoor Mountain Range.

All that Glitters …

Gold – among the most precious of all metals – has been on a tear, having gone up 18% in just the last three months.  Over the last decade, gold prices soared more than 300%.  Should you jump on this gilded bandwagon and attempt to capture possibly even greater returns in the future?

You have heard it said time and time again: There are no sure things in investing.  This year you cannot even count on death and (estate) taxes going together.  But, in general, you cannot win a race looking backwards.  Past returns are, well, in the past. 

Background

There are several reasons why gold is bought.  There is an industrial demand for it, and manufacturers use it to make jewelry.  The recent high interest and demand in gold is because it is perceived as a better store of value and the ultimate insurance for really bad economic times, as in a depression or hyperinflation.  Furthermore, some investors now consider gold as an asset that can help diversify a portfolio comprised of stocks, bonds, and real estate.  (In my opinion, the addition of an asset class usually happens after a sharp rise in its price.)

Looking at not just the recent past but putting gold prices into the historical context of the last 30 years tells a much less favorable story.

The last time we witnessed such high interest in gold was back in November 1979, when the price of gold rose from $400 an ounce to $850 by mid-January 1980.  Investors who poured in – expecting more of the same – were sorely disappointed.  By the end of March 1980, gold was back to selling at less than $500 an ounce, leaving investors who bought at the peak holding a stunning 40% loss for the quarter. Ouch.

Holding onto it didn’t help either.  By the end of the stock market run-up in early 2000, a single ounce of gold was selling for under $300 on the spot markets.

Today, of course, gold is hot; the shiny metal has tested all-time highs almost monthly, leaping from a little over $1,150 an ounce in late July to its latest all-time high, just over $1,365 in the middle of October.  Is it time to jump on this bandwagon and ride the gains up (according to some bullish newsletters) to $2,000 an ounce or higher?  Or is gold an overpriced investment ready to go bust?

Of course no one really knows. Obviously people disagree, as every time someone buys gold, someone else is selling it.

Things to consider

It isn’t real intrinsic demand driving the price of gold higher. Rather, it is investors (or speculators) who are buying at far higher prices than it costs to produce an ounce of gold.

There is no “shortage” of gold, as production over the past five years has been relatively stable at about 2,485 tons per year. In general, new mines are replacing the depleting production of current ones, so there has been little significant expansion in global output.

As prices rise, the market will probably see more recycled or scrap gold – a category which includes people selling gold jewelry. Between 2004 and 2008, recycled gold contributed 28% to annual supply flows.

There is no economic supply/demand imbalance, unless you count thousands of eager investors looking for more price run-ups or a hedge against inflation.

Is gold a reliable hedge against inflation? Since gold’s peak in the early 1980s, the annual inflation rate dropped, but cumulative inflation increased – just as gold was falling in value through the next two decades. According to InflationData.com, gold’s 1980 peak price on the spot market reached $2,250 if it were measured in today’s inflation-adjusted dollars, and the price fell to an inflation-adjusted $370 just two decades later. If gold had been an effective inflation hedge during that 20-year period, the price would have remained the same in inflation-adjusted terms.

So the numbers indicate that for long periods of time (but not always), gold can be a poor inflation hedge.   However, it does appear to be a pretty good “crisis hedge.” When people are concerned about a global liquidity crisis and/or an economic hangover (as they have been for the past couple of years), gold takes off. When the panic subsides, it is reasonable to expect that the price of the precious metal will decline.

Kenneth Rogoff is certainly not a “gold bug”, and he covers both sides of the argument in his article $10,000 Gold?

Pro

“In my view, the most powerful argument to justify today’s high price of gold is the dramatic emergence of Asia, Latin America, and the Middle East into the global economy. As legions of new consumers gain purchasing power, demand inevitably rises, driving up the price of scarce commodities.”

Con

“Gold prices are extremely sensitive to global interest-rate movements. After all, gold pays no interest and even costs something to store. Today, with interest rates near or at record lows in many countries, it is relatively cheap to speculate in gold instead of investing in bonds. But if real interest rates rise significantly, as well they might someday, gold prices could plummet.”

Conclusion

As Martin Feldstein wrote, “ Unlike common stock, bonds, and real estate, the value of gold does not reflect underlying earnings. Gold is a purely speculative investment. Over the next few years, it may fall to $500 an ounce or rise to $2,000 an ounce. There is no way to know which it will be. Caveat emptor.”

I certainly cannot predict whether the current fears will continue to drive gold higher. But history suggests that as soon as people start feeling more secure about the world situation, gold will suddenly lose its luster and leave its investors with significant losses.

If you buy gold now, are you investing or speculating? If you are speculating, is the best time to do it at near-record high prices?

Freedom from the Press

While freedom of the press is crucial to a well-functioning democracy, reading the financial press may be hazardous to your wealth.

One of the worst things investors can do, right now, is to pull out of the stock market because (they think) “the end of the world is upon us.”  The truth is that many people “throw in the towel” at just the wrong time.  And, certainly, the media, all too frequently, plays into (and plays up) that irrational fear, and usually at just the wrong time.

Several articles, had they been taken seriously, might have scared you right out of the stock market.  If you had followed the very typical story line of “now is a very risky time to be investing in stocks” you might have missed out on the best September since 1939.  In that single month, the Standard & Poor’s 500 Index gained 8.8%!

Here are just a few of the recent articles that could have led you astray.  (And note, please, the usage of the word “flee” in the title of the first two articles; I can’t help but relate the word “flee” to those old Godzilla movies, where everyone is haphazardly running for their lives.)

Small Investors Flee Stocks, Changing Market Dynamics, Wall Street Journal, July 12, 2010

“Many individual investors were tiptoeing back into stocks in the spring. Now, they’re running for cover again.”

“Individual investors were important market pillars in the 1990s, but their flight from stocks is changing the market dynamic.”

The article actually pictured a smiling couple who “sold the last of their stock holdings on May 20, moving the money to bonds, certificates of deposit and bond-like annuities.”  What unfortunate timing!  I’d be curious to see if they’re still smiling.

In Striking Shift, Small Investors Flee Stock Market, New York Times, August 21, 2010

Renewed economic uncertainty is testing Americans’ generation-long love affair with the stock market.

Investors withdrew a staggering $33.12 billion from domestic stock market mutual funds in the first seven months of this year, according to the Investment Company Institute, the mutual fund industry trade group. Now many are choosing investments they deem safer, like bonds.

The New York Times and The Wall Street Journal were not alone in trumpeting doom and gloom.  There have been similar articles in USA Today and Fortune.  Even The Atlantic weighed in with a fabulous title: The Great Stock Myth.

For an astute analysis (and a thorough debunking) of the Atlantic’s article, read Larry Swedroe’s August 30^th post, Are Stocks Really Doomed?

Conclusion

What can we learn from reading (and then completely disregarding) such inflammatory articles?  We learn that they are not at all helpful for long-term investing.  Articles of these types almost always appear after periods of low returns and/or increased volatility of stock prices.

What we know is that, yes, stocks are risky.  And, yes, prices fluctuate.  And, (a very emphatic) yes, we are all facing serious economic and political challenges.  And, perhaps some people should have a significant amount of their money invested in fixed income securities. 

But your portfolio should depend on an individual assessment of your goals, your time horizon, and your ability and willingness to accept risk.

Your long-term investment strategy should definitely not depend on – nor should it be influenced by – what you read in the media.

The Stock Market Declined, Now What?

“Don’t let short-run fluctuations, market psychology, false hope, fear, and greed get in the way of good investment judgment.” – John Bogle.

Last week I was contacted by Sarah Morgan, a writer for SmartMoney.com, who had some questions about the recent volatility and decline in the stock market.  Normally, I don’t respond to the press, but her initial question struck me to my core.  Ms. Morgan wanted to know if clients were panicking.  My clients?  Panicking?  She obviously did not know me or my investment philosophy.  My email response to her was this, “I would take it as a tremendous failure of education and preparation if my clients were panicking now.”  

I went on to say that in trying to time the market (which, as I’ve said before, is patently impossible) investors are more likely to hurt themselves by not being invested when the rebound comes.  And, as historical data prove, there is always a rebound, because the long-term trend is up.

I admit that I took pride in being able to tell Ms. Morgan that clients of Key Financial Solutions do not panic.  Rather, they sit and hold tight and ride out the roller coaster.  They’re prepared for short-term fluctuations and declines, simply because they have a long term plan.

Their Investment Policy Statement specifies a well-balanced portfolio that includes a combination of stock mutual funds and bonds (in ratios that we have decided upon, based upon time horizon, risk tolerance, etc.).  So, even a 10% decline in the stock market has little effect on my clients.  And should a market decline be steep enough to affect a portfolio, rebalancing – selling some (appreciated) bonds and buying some (now, underweight) equities – is appropriate to reestablish the portfolio’s target mix.     

That information was enough to spur a half-hour long phone conversation and a follow-up email. 

It was gratifying to read the article, After Market Slide, What’s Your Next Move?, and not just because I was quoted.  No, I was happy to see that Ms. Morgan got it right. She quoted a number of people who said that long-term investing is the key to success.

Having a well thought out Investment Policy Statement is the best chance I know of to stick with a long-term plan.  When markets experience extreme volatility, it sure helps to have a strategy that is based on more than a prediction of what today’s news means to your investment portfolio.

And what are the rewards of long-term investing versus the risk of getting out of the market?  Christopher Davis of Davis Advisors gave a presentation at the NAPFA (National Association of Personal Financial Advisors) National Conference.  Here is what he reported.

Average Annual Returns for 1995 – 2009 for investing in the S&P 500

8.0%		for Staying the Course
3.2%		if you missed the 10 best days
-2.6%		if you missed the 30 best days
-9.2%		if you missed the 60 best days

 

For a fifteen year period, if you missed the 30 best days, you could have managed to lose 2.6% per year, versus earning 8.0% per year.  Thirty days in 15 years!

So let me turn the original question on its head, “Why would anyone risk being out of the stock market?”

Goldman Sachs: Banker or Bookie?

Late last week, the Securities and Exchange Commission charged Goldman Sachs with investor fraud.  It seems that they chose not to disclose all of the terms of one of their own financial products.  After reading the analysis of the events, I have just got to ask:  Are these bankers or bookies?  Goldman Sachs, among other large Wall Street firms, appears to be running a legal bookie operation, catering to clients who wanted to place large bets on the outcome of certain financial events.  You’ve heard the expression, if it walks like a duck and talks like a duck… The real question: was the game rigged?  We’ll have to wait and see.

Last month, in a post about Greed and Delusion on Wall Street, I said

It’s difficult to appreciate the amount of backstabbing, mistrust and cynicism that is endemic at Wall Street firms. “Wall Street doesn’t care what it sells.” Investment banks exploited their institutional customers (pension funds, mutual funds, banks). The same firm that is advising them on what to invest in (the sell side) also has an in-house operation that is trading for its own account. Why is this blatant conflict of interest allowed?

Incredibly, I may have actually understated the problem!  It seems to me that it is patently impossible to be cynical enough, at least about some Wall Street firms.

Why do I say that?  Well, the suit filed by the SEC alleges that Goldman Sachs put together a package of derivatives based on subprime mortgages and did not disclose that the components were selected by the party who wanted to bet against the investment, i.e. sell short.  The claim is that the security was “designed to fail.”  Please take note of the word “alleged,” meaning that they may or may not have done something illegal.  Because it’s a civil lawsuit which may take years to adjudicate, Goldman Sachs will have ample opportunity to present its side of the story.  I have complete confidence that they will hire the best lawyers that megabucks can buy.

Even if Goldman Sachs “wins” that lawsuit, they may have lost something infinitely more valuable – their reputation.  To my mind, this is no small thing, since confidence in your advisor is (or should be) of paramount importance to investment bankers, including Goldman Sachs.  I am compelled to ask one more question, though, did these bankers aim to protect investors’ interests or were they just determined to make a profit at all costs? 

What Is the Public Value of Trading in Synthetic Securities?

But as investors and citizens, it is worth pondering whether all of this trading activity has a social purpose or is it merely gambling in a more refined form.  The topic of synthetic financial derivatives is highly complex and difficult for most ordinary mortals to understand.  But Roger Lowenstein’s column, Gambling With the Economy in the April 20^th edition of The New York Times, offers an excellent summary of the arguments:

Wall Street’s purpose, you will recall, is to raise money for industry: to finance steel mills and technology companies and, yes, even mortgages. But the collateralized debt obligations involved in the Goldman trades, like billions of dollars of similar trades sponsored by most every Wall Street firm, raised nothing for nobody. In essence, they were simply a side bet — like those in a casino — that allowed speculators to increase society’s mortgage wager without financing a single house.

The mortgage investment that is the focus of the S.E.C.’s civil lawsuit against Goldman, Abacus 2007-AC1, didn’t contain any actual mortgage bonds. Rather, it was made up of credit default swaps that “referenced” such bonds. Thus the investors weren’t truly “investing” — they were gambling on the success or failure of the bonds that actually did own mortgages. Some parties bet that the mortgage bonds would pay off; others (notably the hedge fund manager John Paulson) bet that they would fail. But no actual bonds — and no actual mortgages — were created or owned by the parties involved.

The S.E.C. suit charges that the bonds referenced in Goldman’s Abacus deal were hand-picked (by Mr. Paulson) to fail. Goldman says that Abacus merely allowed Mr. Paulson to bet one way and investors to bet the other. But either way, is this the proper function of Wall Street? Is this the sort of activity we want within regulated (and implicitly Federal Reserve-protected) banks like Goldman?

While such investments added nothing of value to the mortgage industry, they weren’t harmless. They were one reason the housing bust turned out to be more destructive than anyone predicted. Initially, remember, the Federal Reserve chairman, Ben Bernanke, and others insisted that the damage would be confined largely to subprime loans, which made up only a small part of the mortgage market. But credit default swaps greatly multiplied the subprime bet. In some cases, a single mortgage bond was referenced in dozens of synthetic securities. The net effect: investments like Abacus raised society’s risk for no productive gain.

Conclusion

I find Lowenstein’s points very convincing, and I totally agree with his recommendations.
“ …the financial bailout has demonstrated that big Wall Street banks … (have) implicit bailout protection. Protected entities should not be using (potentially) public capital to run non-productive gambling tables.
… Congress should take up the question of whether parties with no stake in the underlying instrument should be allowed to buy or sell credit default swaps. If it doesn’t ban the practice, it should at least mandate that regulators set stiff capital requirements on swaps for such parties so that they will not overleverage themselves again to society’s detriment. …”

Proposed reforms by the Obama administration will hopefully rein in the questionable activities of Wall Street bankers, although, Wall Street lobbyists will naturally attempt to defeat any such reform. As I said previously, we’ll have to wait and see, but nearly a week later, no further charges from the SEC have been forthcoming. Of note, however, several European countries have commenced the filing of similar charges against Goldman Sachs.

Apollo 13

“Houston, we have a problem” is one of the great understatements (and oft quoted lines) in movie dialogue. Those words set the stage for the amazing drama of the Apollo 13 moon exploration mission, which took place exactly 40 years ago this month. The great 1995 movie is based on the book, “Lost Moon,” which was co-authored by one of the Apollo 13 astronauts, Jim Lovell, who is played by the ever talented (and understated) Tom Hanks.

No early space mission was ever routine, certainly not in 1970. The astronauts learned their jobs through extensive and thorough training, including hours upon hours of practice in space simulators, reliance on checklists, and their previous experience as (primarily) test pilots. Even so, problems were not unusual.

But the Apollo 13 mission suffered not an ordinary problem but a catastrophic explosion in space, resulting in loss of oxygen, power and a fully functioning guidance system. The 3-man crew faced the possibility of freezing to death, suffocating and being poisoned by their own carbon dioxide exhalation. And that was before they had to manually calculate (on a slide rule, no less) and maneuver their craft into position so that they could get back to earth and land safely, without being incinerated as they passed through the earth’s atmosphere in a module that was damaged to an unknown extent.

At one point, the NASA Flight Director, Gene Kranz, as played by Ed Harris, grandly states that, ”failure is not an option.”  In truth, success was highly improbable.

The movie simultaneously covers NASA’s Mission Control’s race to save the astronauts, what was going on inside Apollo 13, and how the families of the astronauts coped, as the rest of the world watched the events unfold on live television. It is an exhilarating story of calm courage, professionalism, teamwork, perseverance, and ingenuity.

I highly recommend Apollo 13, because it is so realistic, wonderfully acted and tells a gripping story so well. For me, it also doesn’t hurt that it yields a strong dose of optimism about American know-how. Available in DVD, Apollo 13 is skillfully directed by Ron Howard, and has an excellent ensemble cast including Bill Paxton, Kevin Bacon, Gary Sinise and Kathleen Quinlan.

Keeping Your Investment Balance, Part 2

In my last post on the subject, I introduced the idea of monitoring and maintaining a portfolio’s asset allocation. 

Determining when and how to effectively rebalance your portfolio requires careful monitoring of not only portfolio performance, but awareness of your tax status, cash flow, financial goals, and tolerance for risk.  The act of portfolio rebalancing results in transaction fees and has the potential to incur capital gains in taxable accounts. Thus, while there may be good reasons to rebalance, the benefits must outweigh the costs.

Given these challenges, a practical approach to rebalancing takes into consideration the occurrence of “triggering” points, yet provides enough flexibility that costs are effectively managed and minimized.

When to Rebalance

Defining triggering points helps us decide when to rebalance. Most experts recommend rebalancing when asset group weightings move outside a specified range of their target allocations.  This may be widely defined according to either a stock-bond mix or to a percentage drift away from target weightings for categories like small cap stocks, international stocks, and the like.

How to Rebalance

While rebalancing costs are unavoidable, several strategies can help minimize the impact:

• Rebalance with new cash. Rather than selling over-weighted assets that have appreciated, use new cash to buy more under-weighted assets; this reduces transaction costs and the tax consequences of selling assets.
• Whenever possible, rebalance in the tax-deferred or tax-exempt accounts where capital gains are not realized.
• Incorporate tax management within taxable accounts, such as strategic loss harvesting, dividend management, and gain/loss matching.
• Implement an integrated portfolio strategy. In other words, rather than maintaining rigid barriers between component asset classes and accounts, manage the portfolio as a whole.

Conclusion

While there are good reasons to adjust portfolio risk by rebalancing, it does incur real costs that can detract from returns. A good strategy includes determining which investment components can acceptably drift, and adopting tax-saving and cost-saving strategies during rebalancing. In helping our clients rebalance, we strive to develop a structured plan that remains flexible to each individual’s unique blend of goals, risk tolerances, cash flow, and tax status.

No one knows where the capital markets will go—and that’s the point. In an uncertain world, investors should have a well-defined, globally diversified strategy and manage their portfolio to implement it over time. Rebalancing is a crucial tool in this effort.

Moreover, if and when your overall financial goals or risk tolerance change, you have a foundation for making adjustments. In the absence of a plan, adjustments are a matter of guesswork.

Wall Street Greed and Delusion

Derivatives (complex financial instruments) are time bombs and “financial weapons of mass destruction” that could harm not only their buyers and sellers, but the whole economic system.

“Derivatives generate reported earnings that are often wildly overstated and based on estimates whose inaccuracy may not be exposed for many years.”

Warren Buffet (2003)

After seeing Michael Lewis on both 60 Minutes and The Charlie Rose Show last week, I had to read The Big Short: Inside the Doomsday Machine, the just released book by Lewis about the subprime mortgage disaster. Lewis is a fabulous story teller, and I cannot recommend this book enough.

He tells how the subprime mortgage market was created, who benefited, who lost, the cons, the dupes and the dopes and “how some of Wall Street’s finest minds managed to destroy $1.75 trillion of wealth in the subprime mortgage markets” and created the worst financial crisis since the Great Depression.

Essentially billions of dollars were lent to people who had very little chance of ever paying it back. And Wall Street firms earned billions of dollars creating, packaging and betting on complex financial instruments whose raw material was the risky mortgage loans they created. And that was just the beginning.

Tremendous leverage (using borrowed money to magnify possible returns) increased the risk of destroying entire firms.

Lewis follows a few very colorful individuals who gradually figured out just how corrupt the entire risky mortgage system was. These investors made billions by betting against the subprime market by selling short.

Note that “selling short” is an entirely legal transaction, but generally considered a high risk one that involves betting against something, i.e. a stock, bond, or currency, for example, which isn’t “actually” owned by the investor. Selling short requires astuteness, foresight, excellent timing and staying power. Being “right” too soon can be both nerve wracking and very costly, because until the market agrees with your assessment, you are at risk of losing a great deal of money. (Disclosure: I do not sell short.)

In reading Lewis’s gripping story, I alternated between nodding my head in recognition of the self-serving greed that categorized Wall Street to shaking my head in disbelief that Wall Street bankers could have been so deluded that they ended up believing their own lies, I mean “models.” As I read, I found myself laughing out loud more times than I can count – truly, Lewis has a way with words.

To give you some background info, in the “old” days, a bank lent money to a home buyer and they held the mortgage. The bank was very serious about getting repaid, so before they agreed to fund the loan, they did some rather basic things like verify the borrowers’ creditworthiness, check their employment and salary history and retain an appraiser to assess the value of the property being bought. A good credit history, a stable job and a property value that would support the loan were enough incentive for banks, back in the “old” days, to grant a loan request.

But when banks started selling the mortgage to a Wall Street firm who repackaged the loan and then sold the package to investors, the incentives became very different. It was like the Wild West before the Marshall came to town to establish law and order.

The acronym IBGYBG came into being. The brokers who made more money than they ever imagined said, “I’ll be gone, you’ll be gone” so let’s not worry about the suckers who will probably lose their homes or the gullible institutions that bought the crappy investments in the purposely opaque financial instruments. And it was easy to rationalize the sleazy behavior, because, after all, it was possible that this will all work out, if home prices keep rising. That was a big IF.

It was really a mammoth legal Ponzi scheme, or as Lewis called it a “mass delusion.”

The individual characters’ stories are fascinating, but I will not try to summarize them. Instead, here are some observations that emphasize the need for fundamental financial regulation of Wall Street firms.

1. No one goes to Wall Street investment banks to make the world a better place. “Greed on Wall Street is assumed – almost an obligation. The problem was the system of incentives that channeled the greed.”
2. People see what they have an incentive to see. Wall Street employees, managers and CEOs had an incentive (i.e. huge bonuses – surely, you’ve heard about them) not to see the truth.
3. When Wall Street firms were partnerships and the principals had their own money at risk, they had a sane long-term approach to their business operations. When these same firms became publicly traded corporations, risk was transferred to the shareholders. But, of course, huge bonuses were paid to successful traders based on one year’s results. In the short term, traders had every incentive to take large risks. “Heads I win, tails someone else loses, perhaps some time in the future.”
4. The fixed income (bonds) world dwarfs the equity (stocks) world in size. The stock market is transparent and heavily policed. On the other hand, “bond salesmen could say and do anything without worrying that they would be caught. Bond technicians could dream up ever more complicated securities without worrying too much about government regulation – one reason why so many derivatives had been derived, one way or another, from bonds.”
5. The world of mortgage-backed securities (pooled investments backed by mortgages) and derivatives (financial instruments created by Wall Street) were intentionally difficult to understand, so no one even bothered to try. The book describes the nature of asset-backed securities, tranches, collateralized debt obligations, credit default swaps, etc. You, dear reader, can safely skip those portions if you want to. The horse is already out of the barn.
6. It’s difficult to appreciate the amount of backstabbing, mistrust and cynicism that is endemic at Wall Street firms. “Wall Street doesn’t care what it sells.” Investment banks exploited their institutional customers (pension funds, mutual funds, banks). The same firm that is advising them on what to invest in (the sell side) also has an in-house operation that is trading for its own account. Why is this blatant conflict of interest allowed?
7. While there may have been some criminal behavior, in the end, group think, mass delusion and incompetence were more important factors. Wall Street firms did not understand the money-making machine they had created or the risks they had taken.
8. When lenders ran out of customers who would qualify for a normal mortgage, they dreamt up new ways to lend to people who could not afford to pay the old fashioned way. Hence the introduction of “interest-only negative-amortizing adjustable-rate subprime mortgages.” Translation: you don’t have to pay any principal or any interest on your new mortgage; we’ll just keep adding that to the amount you owe.
9. Amazingly enough, Wall Street firms convinced bond ratings agencies (Moody’s, S&P) to give such garbage a Triple A rating. That credit rating agencies are “educated” by and paid by the issuers of the bonds is quite a conflict of interest! And it still exists.
10. Lewis asserts that today “nobody believes that Wall Street knows what it is doing.” He understands why Goldman Sachs and Morgan Stanley, for example, want a say in how they are regulated. He wonders why anyone would listen to them.

Conclusion

The greed and miscalculation of Wall Street firms caused the near collapse of the world economy. Governments around the world felt forced to commit trillions of dollars to resuscitate the banks.

Regulation of firms and people which have fundamentally the wrong incentives will not be easy. Regulatory reform of institutions that are too well connected to fail will not be easy. Change is never easy. But it is absolutely essential or we will all be at risk of a repeat performance of the last financial crisis. Without reform, the investment banking system can crash again, taking with it jobs, savings and U.S. tax payer dollars.

Keeping Your Investment Balance, Part 1

When meeting with new clients, I always discuss risk and return before helping them design a portfolio that will meet their needs.  We live in an uncertain world, so there are no guarantees, and generally, risk and reward go hand in hand. I help my clients arrive at a portfolio that is well diversified and, most importantly, has an acceptable (for them) risk profile.  It allows my clients to “stay the course,” even when market declines occur, as they inevitably will.

While global diversification gives investors a valuable tool for managing risk and volatility in a portfolio, it requires maintenance.  Over time, asset classes have different returns. This is inevitable and, in fact, desirable. A portfolio that holds assets that perform dissimilarly will experience less overall volatility, and that results in a smoother ride over time.

However, dissimilar performance can also change the integrity of your asset mix or allocation – a condition known as “asset drift.” As some assets appreciate in value and others lose relative value, your portfolio’s allocation changes, which affects its risk and return qualities. If you let the allocation drift far enough away from your original target, you end up with a very different portfolio.

If you do nothing, “asset drift” will cause your portfolio to deviate from your long range plan and risk tolerance.  As I said, even a well diversified portfolio requires maintenance.

Rebalancing is the remedy. To rebalance, you sell some assets that have risen in value and buy more of assets that have dropped in value. The purpose of rebalancing is to move a portfolio back to its original target allocation. This restores strategic structure in the portfolio and puts you back on track to pursue long-term goals.

Why rebalance?

At first glance, rebalancing seems counter-intuitive. Why sell a portion of outperforming asset groups and acquire a larger share of underperforming ones? A common reaction is to want to buy what has gone up, because you think it will continue to outperform.  This logic is flawed, however, because past performance may not continue in the future.  In reality, there’s no reliable way to predict future returns.  The old stock broker mantra (slightly modified, simply because you can’t predict the future) holds true, “Buy lower, sell higher.”

Equally important, remember that you chose your original asset allocation to reflect your risk and return preferences. Rebalancing realigns your portfolio to these priorities by using structure, not recent performance, to drive investment decisions. Periodic rebalancing also encourages dispassionate decision making – an essential quality during times of market volatility.

Conclusion

In the real world, portfolio allocations can be complex, incorporating not only fixed income and stocks, but also the multiple asset groups within equity investing. And, of course, tax considerations are very important.

In summary, to ensure that a portfolio’s risk and return characteristics remain consistent over time, a portfolio must be rebalanced.  Rebalancing is a tool to control risk and also an antidote to becoming too optimistic or too pessimistic.  You are, in effect, buying low and selling high, whether you want to or not.

Determining when and how to effectively rebalance is the subject of Part 2.

Consumer Protection: Funny & Serious

 

“This isn’t liberal or conservative.” – Elizabeth Warren.

Why would six former presidents (two of whom are deceased) take the trouble to visit President Obama? And who arranged this “Presidential Reunion”? For the answer, visit Funny or Die, the popular comedy Web site.

Of course, consumer protection is really no laughing matter, especially if you or someone you know is paying 18% interest on credit cards or has seen their mortgage payments balloon to unpayable (i.e. forecloseable) amounts.

For a detailed, intelligent 20 minute discussion of the issue, click on the Charlie Rose interview with Elizabeth Warren, the Chair of the Congressional Oversight Panel.

Here is a summary of some of her points.

According to Professor Warren, of the Harvard Law School, no federal agency is looking out for the consumer when it comes to such matters as credit cards, mortgages, check overdraft fees, and car loans. She has been pushing for the formation of a new consumer agency for much of the last year, and it is currently the subject of Congressional negotiations.

Professor Warren believes that the current regulatory framework is “inefficient, and either ignored and ineffective, or captured by the large financial institutions. A fractured, bloated, overly fat — I just don’t know what else to say — regulatory system is what we’ve got now. It works very well for the large financial institutions because it means no effective regulation.”

Regarding the proposed Consumer Protection Agency, she says “You’ve got to have an agency that’s ultimately independent, whether it’s located within the Fed, within Treasury, the Department of Agriculture, or whether it sits in its own separate place. The key is whether or not it is functionally independent — does it write its own rules, does it enforce those rules, and does it have access to a budget that’s independent of the folks who want to smother it.”

“This is an agency that just makes sense. It’s about readable credit cards, it’s about readable mortgages, it’s about prices that are transparent. This isn’t liberal or conservative. The American Enterprise Institute, very well respected, very conservative, has put model two-page mortgage agreements, two page check overdraft agreements on its Web site. … A consumer agency makes sense to get the market working again. So this isn’t a division of ideology. This is about bank lobbyists. This is about people who are paid professionally to stop this agency, their words, “to kill this agency” so they can protect the revenues for the Wall Street banks.”

By the way, Professor Warren also has some very interesting observations on how the government mishandled the financial crisis and what to do about the “too big to fail” financial institutions. So do watch the entire video, if you have the time.

And for a not-so-serious article on the same subject you can learn how the Presidential Reunion video was made possible by reading the New York Times story.

While not directly involved in the making of the video, Ms. Warren did comment on the video’s premise. “Why wouldn’t our past presidents agree on shrinking government by transforming a bunch of bloated, ineffective and unaccountable consumer-protection bureaucracies into a smaller, streamlined, and effective agency? And why wouldn’t they all support two-page credit card agreements?”

Conclusion

Pardon me for getting political (an arena I try very hard to stay out of), but one indication of whether Congress can pass any meaningful reform on anything is whether it can withstand intense lobbying against consumer finance protection. Today Senator Christopher Dodd of Connecticut is scheduled to release his proposed legislation. We will see if his solution, which covers many more things than just consumer protection, will be acceptable to enough Senators and eventually to the American people.

If this issue is important to you, let your voice be heard. You have the ability to pass this post on to friends; simply click on the title of a post, then “Share This” to forward.

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