Admitting to speculation in the financial markets, be it in bonds, equities, derivatives, mutual funds or even real estate, is akin to labelling one-self a gambler; highly unlikely and not something you’d like your family to know about. And yet, for most individual (and numerous institutional) market participants this is what they truly are, like it or not.
Investors, on the other hand, are few and far between. These folk stand out from their apparent peers in a number of ways. As the father of value investing, Benjamin Graham so wisely put it in his seminal 1934 work “Security Analysis”:
"An investment operation is one which, upon thorough analysis,
promises safety of principal and a satisfactory return.
Operations not meeting these requirements are speculative."
Taking the time to reflect on these words and evaluating our “investment” process against this benchmark will likely yield rather surprising results. After all, do you perform thorough analysis prior to making your asset allocation decisions?. Or are you more likely to fall into one the following usual patterns?.
1. Buying fads – e.g. Getting into internet stocks in the summer of 1999 for fear of missing out on the next Cisco?
2. Acquiring real estate on the premise that houses are the safest asset and “never lose value”
3. Letting your local bank branch manager talk you into the flavour-of-the-month fund
4. Trading in and out of stocks rapidly on the basis of CNBC sound-bites
5. Equating price with value and therefore allowing the mood of the market to determine your purchase and selling decisions
I, for one, admit to having been on at least 3 counts of the list of 5 above. Fortunately for me, the last 10 years have served to transform a once clueless speculator into a reflective investor. If nothing else, at least the relentless haemorrhaging of hard earned savings that were the hallmark of my early efforts in the markets, has now stopped and in fact been it has replaced with modest positive returns.
So, what essentially does it take to join the ranks of the few true investors, so to speak?. How does one evolve from mindless gambler to “thoughtful investor”?; to paraphrase the title of yet another classic investing book (1949) by the ubiquitous Mr. Graham. Well, as is the case with most addictions, it starts with admitting the error of our ways. As we established on the very first lines of this post, no one likes to be labelled a speculator for it has almost immoral connotations. Nonetheless, failing to take this first step will stand in the way of the learning process that is required to reach the investing holy grail.
Assuming, that pride has been swallowed and the cold realisation of our dreaded speculative persona has set in, we are now ready to get on the investing track!. Here’s how I’ve approached it (and continue to do so to this day):
A. Read what the masters have to say (anything by W. Buffet, S. Klarman, P. Lynch, P. Fisher, B. Greenwald, J. Greenblatt, M. Whitman)
B. Ignore the crowd. Easier said than done but it can be accomplished once you realise that 95% of market commentators really have nothing of interest to say
C. Think of securities as part-ownership claims on real businesses, and act in a business-like manner in your investment decisions
D. Do your homework. Research your likely targets as you would any other decision entailing material financial risk
E. Frame your goals around risk and not returns. Minimise loss potential before concerning yourself with upside.
I hope these reflections prove useful over time and help you make the transition.
Saturday, January 30, 2010
Sunday, January 17, 2010
Listening to academics could be hazardous to your wealth
Just this week I came across a remarkably perceptive study performed by a rare sub-group of investing professionals who dare to deviate from the norm and in fact question some established mantras such as the untold benefits of diversification.
http://www.advisorperspectives.com/newsletters09/pdfs/Why_Diversification_is_Failing.pdf)
Messrs. Page, Chao and Kritzman provided empirical evidence to confirm something I had long suspected but had never “proved”. Diversification across asset classes, geographies or even investing styles (think growth vs. value) is least useful when it is most required. Indeed correlation is highest on the way down rather than on the way up “depression is more contagious than euphoria". To cap it all historical evidence dating some 30 years (more than enough to encompass secular trends and a number of boom-and bust cycles) indicates that such a policy actually stands in the way when times are good, providing a metaphorical umbrella just as the sun comes out.
Once again, as was the case with Efficient Market Hypothesis and its (dire) implications for its most ardent followers financial academia provides us with just the sort of advice you don’t need.
(see previous post on the irrelevance of beta in measuring risk - http://www.juliovildosola.com/2009/11/are-investing-odds-stacked-against-us.html-)
Putting together a rational investment portfolio seeking to minimise standard deviation and yet maximise risk, (in what scholars refer to as the “efficient frontier”), would likely require a number of securities that no one investor could reasonably oversee, not to mention the fact that standard deviation has little to do with actual risk!.
With the exception of the legendary Peter Lynch who managed to deliver stellar returns whilst overseeing a fund with many hundreds of names, I know of no successful investor whose fund comprises more than 50 positions. Given that profitable investing is to be performed in business-like fashion and stock holdings are but partial ownership claims on operating concerns, it should be apparent to all why managing a large number of positions is anything but manageable!. Most notable value investors have been known to hold between 5 and 10% of their fund on a single security. None other than Warren Buffet made news from his remarkably lucrative foray into Amex in 1964 which at the time represented some 40% of his partnership’s funds!.
Having said that, what do most professionals prefer? You guessed right!, large baskets of stocks in an attempt to diversify risk or more subtly, to approach the average-return seeking of index-replicating ETFs or mutual funds. It’s terribly ironic however though that these “professional” investors charge up to 2% of annual fees for the “privilege” of spreading your money across a number of under-researched and yet mostly over-bought securities. When you consider that surely better returns can be obtained at a fraction of the price (around 20 basis points of annual fee for index funds)… I think you get my point.
Whose interests are being served in this manner? Numerous positions more than likely entail portfolio rotation, trading costs, and large teams of analysts; in short, they serve to perpetuate an industry that feeds on itself!. There’s not much marketing spin that can be put out to hype low stock turnover and patient value searching. Furthermore, an additional unacceptable consequence can be pointed out for blame in this seldom enforced concentrated investing approach, as being fully invested is not an obligation.
When the real costs of a fully invested position are tallied up, eg. Liquidity shortfalls to meet redemptions or reduced capacity to invest at short notice on brief windows of opportunity caused by temporary market dislocations, the shortcomings of an over-diversified or fully invested position are there for all (who may want to) see.
As Mark Twain once said,
Put all your eggs in the one basket and --- WATCH THAT BASKET
http://www.advisorperspectives.com/newsletters09/pdfs/Why_Diversification_is_Failing.pdf)
Messrs. Page, Chao and Kritzman provided empirical evidence to confirm something I had long suspected but had never “proved”. Diversification across asset classes, geographies or even investing styles (think growth vs. value) is least useful when it is most required. Indeed correlation is highest on the way down rather than on the way up “depression is more contagious than euphoria". To cap it all historical evidence dating some 30 years (more than enough to encompass secular trends and a number of boom-and bust cycles) indicates that such a policy actually stands in the way when times are good, providing a metaphorical umbrella just as the sun comes out.
Once again, as was the case with Efficient Market Hypothesis and its (dire) implications for its most ardent followers financial academia provides us with just the sort of advice you don’t need.
(see previous post on the irrelevance of beta in measuring risk - http://www.juliovildosola.com/2009/11/are-investing-odds-stacked-against-us.html-)
Putting together a rational investment portfolio seeking to minimise standard deviation and yet maximise risk, (in what scholars refer to as the “efficient frontier”), would likely require a number of securities that no one investor could reasonably oversee, not to mention the fact that standard deviation has little to do with actual risk!.
With the exception of the legendary Peter Lynch who managed to deliver stellar returns whilst overseeing a fund with many hundreds of names, I know of no successful investor whose fund comprises more than 50 positions. Given that profitable investing is to be performed in business-like fashion and stock holdings are but partial ownership claims on operating concerns, it should be apparent to all why managing a large number of positions is anything but manageable!. Most notable value investors have been known to hold between 5 and 10% of their fund on a single security. None other than Warren Buffet made news from his remarkably lucrative foray into Amex in 1964 which at the time represented some 40% of his partnership’s funds!.
Having said that, what do most professionals prefer? You guessed right!, large baskets of stocks in an attempt to diversify risk or more subtly, to approach the average-return seeking of index-replicating ETFs or mutual funds. It’s terribly ironic however though that these “professional” investors charge up to 2% of annual fees for the “privilege” of spreading your money across a number of under-researched and yet mostly over-bought securities. When you consider that surely better returns can be obtained at a fraction of the price (around 20 basis points of annual fee for index funds)… I think you get my point.
Whose interests are being served in this manner? Numerous positions more than likely entail portfolio rotation, trading costs, and large teams of analysts; in short, they serve to perpetuate an industry that feeds on itself!. There’s not much marketing spin that can be put out to hype low stock turnover and patient value searching. Furthermore, an additional unacceptable consequence can be pointed out for blame in this seldom enforced concentrated investing approach, as being fully invested is not an obligation.
When the real costs of a fully invested position are tallied up, eg. Liquidity shortfalls to meet redemptions or reduced capacity to invest at short notice on brief windows of opportunity caused by temporary market dislocations, the shortcomings of an over-diversified or fully invested position are there for all (who may want to) see.
As Mark Twain once said,
Put all your eggs in the one basket and --- WATCH THAT BASKET
Sunday, January 3, 2010
Old habits die hard in Spanish real-estate market
This may be the umpteenth write-up on Spain's real-estate bubble’s burst, but let me assure the reader that my intentions are not to dissect its causes, (which should be evident by now), but rather to reflect on how to act in the face of the facts some two years later.
In all honesty, as I thought about the content for this post, I felt short of ideas and reticent to convey a conformist message.
However, reading yet another of those “buy-real estate-now-before-the-inevitable-rise-as it’s-the-best-asset-ever!... has given me both the content and the motivation to put my thoughts down on paper.
How can it be that “supposedly” informed people in academia and in business still convey the message that was passed on for generations before, pointing to residential real estate as a fail-safe investment? Are these people immune to the laws of supply and demand? Or have they not heard about the “mean-reverting” nature of asset prices?
Allow me to explain the reason for my indignation. Spain has by all accounts over 1.5 million homes built and yet unsold, which if you assume an average annual demand of 200,000 homes per year will take over 7 years to work through. Add to this the fact that this demand will most likely drop in the near future due to:
1. Extremely high unemployment rates resulting in very low disposable income
2. Interest rates that are at historic lows and hence bound to rise at the first sign of inflation in the Euro-zone (a true time
bomb if we take into account that over 90% of mortgages in Spain are variable rate.
If this were not enough, historical data states the ratio of home prices to average family income at somewhere between 3 and 3,5 to 1. Given that wages in Spain are notoriously low compared with most of our neighbours and a family unit comprised of 2 salaried adults, (an increasing rarity with unemployment teetering 20%), results in a grand annual total of 50 k €, average home prices ought to be in the range of 150 to 180 k €. As of December 2009, the average home price in Spain for a single family home is around 300k €.
One does not need to be a genius to conclude that in order to just return to the historical average (and there is no real rationale to divert from it), home prices have to adjust downwards some 40% to 50% from their current prices!.
Returning to my original intention, that is, to reflect on how to act in this market (where by the way real prices, not nominal ones have only come down some 8-10 % since their peaks in the summer of ’07), I venture a few suggestions.
1. Do not assume that things will be as before (it will not take 2 years of minor price reductions to correct over 15 years of
excesses in the real estate market).
2. Remain vigilant of inflationary threats. Although nominal house prices will, (at some point in the future anyway)
appreciate, said increase will likely be marginal after inflation erodes the gain.
3. Plan for the worst and look to safer assets such as long-term, diversified equity investments in order to hedge inflation
risk.
4. Return to the real-estate market only after prices stop defying economic logic (remember the mean-reversion feature we
talked about…)
Happy 2010!
In all honesty, as I thought about the content for this post, I felt short of ideas and reticent to convey a conformist message.
However, reading yet another of those “buy-real estate-now-before-the-inevitable-rise-as it’s-the-best-asset-ever!... has given me both the content and the motivation to put my thoughts down on paper.
How can it be that “supposedly” informed people in academia and in business still convey the message that was passed on for generations before, pointing to residential real estate as a fail-safe investment? Are these people immune to the laws of supply and demand? Or have they not heard about the “mean-reverting” nature of asset prices?
Allow me to explain the reason for my indignation. Spain has by all accounts over 1.5 million homes built and yet unsold, which if you assume an average annual demand of 200,000 homes per year will take over 7 years to work through. Add to this the fact that this demand will most likely drop in the near future due to:
1. Extremely high unemployment rates resulting in very low disposable income
2. Interest rates that are at historic lows and hence bound to rise at the first sign of inflation in the Euro-zone (a true time
bomb if we take into account that over 90% of mortgages in Spain are variable rate.
If this were not enough, historical data states the ratio of home prices to average family income at somewhere between 3 and 3,5 to 1. Given that wages in Spain are notoriously low compared with most of our neighbours and a family unit comprised of 2 salaried adults, (an increasing rarity with unemployment teetering 20%), results in a grand annual total of 50 k €, average home prices ought to be in the range of 150 to 180 k €. As of December 2009, the average home price in Spain for a single family home is around 300k €.
One does not need to be a genius to conclude that in order to just return to the historical average (and there is no real rationale to divert from it), home prices have to adjust downwards some 40% to 50% from their current prices!.
Returning to my original intention, that is, to reflect on how to act in this market (where by the way real prices, not nominal ones have only come down some 8-10 % since their peaks in the summer of ’07), I venture a few suggestions.
1. Do not assume that things will be as before (it will not take 2 years of minor price reductions to correct over 15 years of
excesses in the real estate market).
2. Remain vigilant of inflationary threats. Although nominal house prices will, (at some point in the future anyway)
appreciate, said increase will likely be marginal after inflation erodes the gain.
3. Plan for the worst and look to safer assets such as long-term, diversified equity investments in order to hedge inflation
risk.
4. Return to the real-estate market only after prices stop defying economic logic (remember the mean-reversion feature we
talked about…)
Happy 2010!
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