Investing, economics, finance and random thoughts.
Posts tagged risk
William Bernstein is Wild About Harry
Aug 29th
Investment author William Bernstein from Efficient Frontier recently wrote an article about the Permanent Portfolio:
He states:
In many respects, this allocation is a thing of beauty. Not only does it provide some protection against all but the most dire of scenarios, but its correlation grid is one rarely seen in finance: four non-derivative assets populated entirely by near-zeros…
- William Bernstein – Efficient Frontier “Wild About Harry”
He continues:
And therein lies the real problem with the TPP (ed: Theoretical Permanent Portfolio): because of its huge tracking error relative to more conventional portfolios, it attracts assets and adherents during crises, then sheds them in better times. There’s nothing wrong with Harry’s portfolio – nothing at all – but there’s everything wrong with his followers, who seem, on average, to chase performance the way dogs chase cars.
…
Sadly, this [buying assets before they have gone up in price] is the opposite of what the legions of new TPP adherents and PRPFX owners have been doing recently – effectively increasing their allocations to red-hot long Treasuries and gold. Consider: over the long sweep of financial history, the annual real return of long bonds and gold have been 2% and 0%, respectively; over the decade ending 2009, they were 5% and 11%.
- William Bernstein – Efficient Frontier “Wild About Harry”
His point about people not sticking to an investment plan is well taken, but hardly unique to the Permanent Portfolio. As for whether gold or LT bonds are a good buy now: I learned a long time ago that whenever I think I know what the markets are going to do I’m usually surprised later.
I read articles back in 2007 saying how expensive gold was when it was $600 an ounce and would crash any day now (it’s over $1200 now). I read articles over a decade ago about avoiding LT bonds because of the inevitable rise in interest rates (30 year bonds yielded 5.9% in 2000 – today they are 3.5% giving big profits to long bond holders over this time). In fact, I’ve read investment books going back over 20 years saying the exact same thing about the inevitable destruction of the long bond (30 year bonds in 1990 yielded 8.6% BTW).
The above is to say nothing of the copious amounts of doom and gloom stock predictions in 2009 that proved to be horribly incorrect as the market recovered so sharply it could give you whiplash. All of these predictions have been dead wrong and highly unprofitable if followed.
As it were, Harry Browne actually got this type of question about avoiding this or that asset over the years and I made this audio clip of him answering it:
http://crawlingroad.com/blog/wp-content/uploads/2010/01/HarryBrowne-WhichAssetWillDoBest.mp3
This clip was made in 2004 but could have been recorded last week (Browne even mentions about the Dow being 10,000 back then and it’s there again right now in fact – It’s de ja vu all over again). These debates about what to buy and sell are raging constantly in the market and will do so forever. Investors just need to ignore all of them.
The point is not to be a cheerleader for some particular asset because eventually every investment has a bad spell. It’s simply that we can’t predict the future and the reason we own different assets in the portfolio is to provide protection against the unknown.
Diversifying asset classes, as Harry Browne knew well, can benefit a portfolio. The secret is deploying them before those diversifying assets shoot the lights out.
- William Bernstein – Efficient Frontier “Wild About Harry”
I disagree. Investors can’t possibly position their portfolio in a way to take advantage of an asset before it goes up in price. It just doesn’t happen that way.
What’s the real secret? Simple:
Just own everything at once because we have no way of knowing what is going to do best going forward.
It was investors who owned assets like gold and long bonds all the time, regardless of what was being predicted, that were able to reap these rewards the past few years. They may continue to do well, or maybe not. Maybe stocks will finally come out of their funk and go gangbusters again as they did in the 1980s and 1990s. Nobody knows.
We just don’t know when the markets will move one way or another. Investors therefore must diversify, and must stay diversified, all the time regardless of what their opinion is about the future. We simply cannot know what asset is going to do best ahead of time and allocate accordingly.
The correct strategy then is to hold fast to your asset allocation. If something has gone up enough in price to trigger a rebalancing band, then sell it down and use the profits to buy the laggards. But never time the buying or selling of an asset in the portfolio because of how you feel about it. That’s a sure way to run into big problems. The Permanent Portfolio is designed to hold volatile assets together in the form of 25% each stocks, bonds, cash and gold. If you take out any one piece you lose the protection of the portfolio.
Performance chasers will always performance chase and will always show poor results for their efforts. The Permanent Portfolio is not designed to be a hot rod so the performance chasers will eventually be disappointed. What the portfolio provides however is moderate growth with wide diversification and low volatility even in very bad markets. At the same time the strategy has shown reasonable real after-inflation returns for the level of risk involved with no market timing nor close monitoring required. For people looking for those attributes, the strategy may make you wild about Harry, too.
The Five Minute Rule
Aug 4th
Vanguard CEO Bill McNabb gave a speech recently about the financial markets and the need for trust. With the past few years shaking the confidence of investors, the industry has certainly been lacking in the trust department.
In this speech CEO McNabb gives out three important points about investing that are critical:
1) Simplicity – Investments should be simple to understand.
2) Transparency – Investment vehicles should be transparent so all moving parts are understood.
3) Candor – Investors and advisors should be honest with each other about the risks in an investment.
His point on simplicity matches up very closely to one of the 16 Golden Rules of Investing. That is, never invest in something you don’t understand completely:
A great rule in investing is the five-minute rule: If you don’t understand an investment in five minutes or less, take a pass. This should apply to sophisticated investors, novices opening their first accounts, and everyone in between. – Bill McNabb, Vanguard CEO on Restoring Investor’s Trust
Very wise counsel! A complicated investment can conceal many dangers. All investments have risks, but as investors we must be certain we understand each risk as best as possible. Having unknown risks buried in a complicated and opaque investment scheme is bound to cause problems eventually.
Remember this: There is no shame passing on an investment you don’t understand. I have done it myself many times in the past and have never regretted it.
Simplicity is critical to investing success and this can’t be stated often enough. The Five Minute Rule is a great way to weed out bad investments and keep things simple.
California Bonds Banner Ads
Mar 10th
Obviously, my site features some banner ads from Google. These ads bring in enough revenue to cover the costs of the web hosting (if that). Well lately I’ve been seeing ads encouraging people to buy California Bonds at this site:
I’ve never seen a state so aggressively advertising their bonds in banner ads. I can’t say it would put my mind at ease if I owned California Munis to see this.
EDIT: I’m not the only one who noticed this:
EDIT #2: Here’s the ad that just showed up on my site:
Oh! The offer ends March 10th! Better hurry! I’m sure they’re selling like hotcakes so don’t miss out!
Person to Person Deadbeat Lending
Feb 25th
Over at the Diehards forum a conversation came up about the fad of Person to Person (P2P) lending.
When I first saw this idea years ago, the first word to pop into my head was “foolish.”
The first reason I knew it was foolish is because business magazines thought it was a great idea.
The second reason is why in the world would anyone make an anonymous loan over the Internet to someone they know virtually nothing about? I’d rather just donate the money to charity where it could be better used.
What’s funny though is that these sites got started for reasons of undermining The Man (being the banks) that are so mean by requiring, you know, to prove credit worthiness. How archaic! Clearly we live in a world now where deadbeats, I mean “sub-prime borrowers”, are not risky at all. We’ll just do P2P loans and sing Kum-Ba-Ya and it will all work out and we’ll cut out those greedy middlemen.
But maybe The Man had this figured out long ago as the default rate on these peer to peer loans is abysmal. Check out the graph from this blogger:
http://www.prospers.org/blogs/Fred93
Prosper Default Rates Over Three Years
Since loans that are one month late nearly always default at these sites, that’s a 20% default rate after the first year and keeps going up the longer the loan is. Ugly! Now we know why loan sharks need to charge so much to their clients to turn a profit. No real bank could survive on default rates this high.
But it seems that sites like Prosper.com are trying to clean up their image.
But now Prosper is back in action with a relatively low default rate of 5% among borrowers, according to Barron’s. This service and its competitors are now putting people through their paces to weed out the baddies. The company claims 850,000 members and just a little under $200 million in loans underwriting at this date.
Lending Club has a 3% default rate, meanwhile, and turns down 90% of potential borrowers in an effort to cull the herd and find the most credit worthy.
The article follows up with this salient point:
That, of course, begs the question: Why would anyone go the P2P route if you’re credit worthy?
Yeah that’s pretty much what I think, too. If someone needs a loan from P2P they are probably doing it because nobody else trusts them enough.
But what about the returns?
The returns you might get as a lender can be enticing. Prosper claims the average lender earns 7% on their money, net after expenses and charge-offs. But those who are really into this virtual underwriting boast that they can make a 12% return.
The stock market has averaged around 9-10% a year the past 80 years. And now they’re telling me I’m going to beat the market by 20% a year with 12% returns by making loans to anonymous people that can’t get a real low-interest rate loan from a bank? Sounds like BS to me. If someone claims you are getting above market returns you are taking above market risks. There is no free lunch.
If I wanted to risk a 12% return (and let’s not kid ourselves because it would be quite risky) I’d just put the money I was going to use for P2P loans into a volatile emerging market stock index and let it ride. It may be a bumpy ride, but it could pay off. Yet, I may not get 12% over time but I’m not going to lose -100% either like with a large number of P2P loans. And for 7% returns? For that I’d just put it in the Permanent Portfolio allocation and go do something less stressful with my life while earning more money.
What’s most interesting is that these P2P sites started up to give loans to people that evil banks wouldn’t consider because of the credit risk. Now they are turning into weeding out credit risks just as evil banks do because of the deadbeats ruining it for everyone. In other words they’re turning into….evil banks! The hippies must be choking on their granola at this thought.
From all of this there is a lesson to be learned and that is that banks can seem heartless at times, but they have their reasons. Ultimately, as a depositor giving them my money to help fund loans for others, I want them to be picky. When they’re not picky (or told to not be picky by government rules) we end up with things like real estate bubbles where someone earning $20,000 a year is given $500,000 to buy a house. Also, loaning money to someone who can’t pay it back just makes that person’s situation worse by straddling them with more debt. How is that fair to them? It’s an overall bad deal for everyone involved.
Yeah I know there are some people that are not deadbeats in this P2P thing and could be good loan risks. But mostly I think these loans won’t lead to any additional profits vs. just doing something simpler (and safer) with the money. If you are trying to be charitable, then just donate the money to charity.
Overall, this entire idea of P2P loans reminds me of an Onion article I read a while back.
Book Review – Books on Risk (and two podcasts)
Jan 28th
A theme you’ll hear on this blog about investing is the idea that the markets are not predictable. You may believe that I’m referring to the idea that you can’t predict returns on investments ahead of time and that’s partially true. The other part though relates to extreme risks that sweep through the markets in unpredictable ways with unpredictable results.
Aside from standard market risks, when you look at your investments it’s also important to always ask yourself: “What if I’m wrong?” Because, odds are, you will be wrong eventually. It’s just a question of degrees on how wrong it will be: A little or a lot.
The Permanent Portfolio has protection against unpredictable market risks and being wrong. If you’re wrong, you’re not going to be wrong so much that you take a crushing blow to your portfolio (because your asset allocation is widely diversified in relatively small chunks). We should also understand though that all investments have risk. Without risk, you will not get rewards. So risk must be taken to grow a portfolio, but it must be done with specific goals in mind. We need profits, but we also need defenses against an unknown future.
In this light, I’d like to share with you some books and podcasts that I think really hit at this problem of risk, uncertain futures and protecting yourself against being wrong. They may help you understand why diversifying and eliminating unnecessary risks in your portfolio is so important and why being wrong does not have to be fatal if you handle it correctly.
First there is John Allen Paulos and his book A Mathematician Plays The Stock Market. This 2003 title is one of a series of excellent books written about his worldly observations as a mathematician. In this case, the book details his own personal story of losing money in the stock market and how uncertainty rules. It’s an interesting look at many concepts you see in the investing world with respect to stocks vs. bonds, efficient market hypothesis, chaos theory, etc. And, best of all, it’s a very easy and fun read with almost no math but high level explanations of many concepts with real-world examples. He has a number of books written in his “A Mathematician” series exploring everything from innumeracy in society to his experiences investing (and losing) lots of money in Worldcom as he discusses in this book. The bottom line is that risk is real, markets are random, and trying to beat it can be very costly. His dedication reads:
To my father, who never played the market and knew little about probability, yet understood one of the prime lessons of both. “Uncertainty,” he would say, “is the only certainty there is, and knowing how to live with insecurity is the only security.”
John Allen Paulos – A Mathematician Plays the Stock Market Dedication
Now that’s a dedication I can get behind! That is the core philosophy of how the Permanent Portfolio is designed to operate.
Next, there is Nassim Nicholas Taleb and his series of books on chance. First there was Fooled By Randomness followed by The Black Swan. Both of these books explore the idea of unpredictability in the world. While his advice is largely being linked to finance today (he was a former trader), his observations come into play in many areas of life. His book, The Black Swan, pre-dated the 2008 crash involving Fannie Mae but said this in one of his footnotes:…the government-sponsored institution Fannie Mae, when I look at their risks, seems to be sitting on a barrel of dynamite, vulnerable to the slightest hiccup. But not to worry: their large staff of scientists deemed these events “unlikely.”
Nassim Taleb – The Black Swan Pg. 225
I’d say he certainly called that one correctly.
I also think you’ll enjoy these two podcasts from Nassim Taleb. One recorded in 2007 talks about his book The Black Swan. The second was recorded in 2009 after the market meltdown as an after-action report on what he had written and said before:
Taleb on Black Swans – April 30, 2007
Taleb on the Financial Crisis – March 23, 2009
One thing about Taleb is while he has disdain for most fields of economics (and especially the very silly Keynesians), he does have an affinity for the Austrian Economic School and their dislike of the over-application of mathematics in economics for what is, essentially, a human behavioral problem (aka. scientism). Why does this matter? For one, you cannot model risks accurately with standard statistical methods because human behavior is not predictable. Secondly, Harry Browne was a firm believer in Austrian Economics and the Permanent Portfolio design, at its absolute core, is based on the Austrian School’s theory on monetary cycles (a lengthy topic for another day) and embracing unpredictability in the world. In fact, I think that one of the reasons the Permanent Portfolio is good at dealing with market risk is because the Austrian Economics school is right about a great many things. This outlook helps to drive the portfolio down the right path over time avoiding serious pitfalls and dangerous assumptions about the future.
With these three books and two podcasts you will understand more about market risk than most professional investors and economists. Seriously. Combine that with Harry Browne’s podcasts, and his own previous books, and you’ll be well versed in the dangers of the unpredictable in the investing world and how to position yourself to deal with them.
I Don’t Know
Dec 1st
Johnny Carson as the Carnac the Magnificent
I know this blog would be more interesting if I commented on the latest market happenings and posted pretty graphs projecting future returns. Perhaps some latest prediction by an investing guru about the state of the world and what it means going forward. Etc. But I won’t do these things because I don’t believe they are productive. To a diversified investor, these activities are at best a waste of time. At worst, these activities can cause investors to make rushed decisions that could lead to large portfolio losses and market underperformance.
Investing should be dead simple. It should not involve complicated machinations inside your portfolio and relying on a bunch of prognostications about what the markets are going to do. Why? Because the markets are not predictable.
I don’t know what future asset prices are going to do. I don’t know if something is overvalued or undervalued. I don’t know what gold is going to do next week. I don’t know what stocks are going to do in a month. I don’t know if bonds are going to crash tomorrow. Nobody is clairvoyant despite how confident about the future they may sound.
Please do not expect anyone to know what is overvalued, what is undervalued, and whether the Permanent Portfolio will blow up next week because of some unexpected event. No one can possibly know. Harry Browne used to say: “Anything can happen, but nothing has to happen.” That pretty much sums up the issue. Most people don’t go to psychics for life advice so why go to market psychics for investing advice?
The future is unpredictable. You do your best to diversify and that’s all you can do. Invest your money passively, keep costs low, keep turnover low, diversify widely, learn from your mistakes, keep things simple, and expect the unexpected. Doing these things makes it easier for you to say “I don’t know” and be happy with your answer.
Permanent Portfolio Historical Returns
Dec 22nd
Let’s get to the meat of any investment strategy: How well does it actually work?
In a prior post we talked about the Permanent Portfolio allocation which is:
25% – Stocks (in a broad based stock index fund like the S&P 500)
25% – Long Term Treasury Bonds
25% – Gold Bullion
25% – Cash (in a Treasury Money Market Fund)
This allocation will provide protection when the economy shifts through the cycles of prosperity, inflation, deflation and recession.
Now, some may be thinking that this allocation sounds very different than what they’ve seen elsewhere. For instance, the idea of owning gold is scoffed at by some investment advisors because it has no dividends or interest. Long Term Bonds? Many will tell you that they’re too risky due to rising interest rates. How about Cash? Isn’t holding a bunch of cash missing out on the hot stock market action? And, only 25% in stocks? Well everyone knows that stocks always beat every other investment so surely you want more than 25%, right? Right!?
Not exactly.