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Weekend reading: It’s always calmest before the crash

Weekend reading

Good reads from around the Web.

I couldn’t agree more with an article I read this week on BeyondProxy talking about how the world is chaotic, so you might as well deal with it.

Stability in markets begets instability. Always has and always will.

This is one reason I think financial regulation has its limits, incidentally, and why savers and consumers should sometimes take one on the chin for the common good. That way we’re all encouraged to be more prudent and self-reliant, rather than everyone being cushioned, compensated, and bailed-out to the point of abdication.

The more people believe that something can’t fail, the more of it they will take on, eventually including leveraging up to get more – if not explicitly through debt then through some shadow agent or the dumping of diversification or in some other way getting too much of the good thing.

Nothing can be pushed beyond its limit, not even supposedly risk-free assets.

Consider the negative yields on the average German government bond. One of the safest assets in the world is now guaranteeing a loss to its holders, and stoking the potential for myriad different outcomes (which is what ‘risk’ really means) that are not all pleasant (though some are – because risk doesn’t mean that only bad things can happen).

I’ve no more idea than anyone else how or when this slow death of yield ends.

But I suspect it will be with a bang, not a whimper.

Learning to fear stability

BeyondProxy author Michael McGaughy writes:

Twenty-five years ago as a young analyst I loved analyzing companies that had steadily increasing sales, constant profit margins and growing profits. This made my financial projections easy.

However experience has taught me not to trust steady returns and stability.

The business world is competitive and anything but stable. I now believe that ‘stable’, ‘no risk’, and ‘guaranteed return’ are some of the most frightening words in business and investment.

Consider the following:

  • Bernie Madoff’s funds got big by seemingly delivering steady monthly returns in both up and down markets. As we know now, it was all a fraud.
  • Before it went bankrupt, Enron was well-liked by sell-side analysts and investors for meeting analyst estimates. It steadily met expectations and was considered a stable and safe company. But it was mostly smoke and mirrors before it became America’s largest bankruptcy.
  • The desire for, and fallacy of, steady growth is nothing new. Adam Smith (aka George Goodman) wrote about the illusion of steady growth in his 1972 book SuperMoney. “Everywhere you looked, there was a company with a neat stepladder of growing earnings. Some kept the stepladder right up to the day they filed for bankruptcy”
  • In his commentary on Dell being fined by the SEC for fraudulent accounting designed to smooth earnings, author and Darden School of Business professor Edward Hess notes that, “companies that grow for more than four consecutive years without resorting to earnings games are the exception, not the rule”

McGaughy goes on to to sing the praises of instability for giving us all the wonderful change we see in the world – at the price of the occasional wobble.

Remember every investment can fail you. Don’t put all your eggs in one basket – and ideally have a few chickens about the place, too!

Beyond that, I say embrace the world like a buccaneer, not as a sailor who thinks the world is flat.

There be dragons!

From the blogs

Making good use of the things that we find…

Passive investing

Active investing

  • A step-by-step guide to investment analysis [PDFs]ShareScope
  • 12 things learned from Stanley Druckenmiller about investing – 25iq
  • Howard Marks interviews Joel Greenblatt [Video]YouTube
  • Investing in Woodford’s Patient Capital trust – Richard Beddard
  • How to think like a trader – The Kirk Report
  • Uh oh! US Equity investors are optimistic again – The Reformed Broker

Other articles

Product of the week: Barclays current account customers will be offered up to £144 a year through a new cashback scheme from Monday, but The Telegraph says there are better offers elsewhere, not least a decent interest rate with Santander’s 1-2-3 account.

Mainstream media money

Some links are Google search results – in PC/desktop view these enable you to click through to read the piece without being a paid subscriber of that site.1

Passive investing

  • A solution for the passive bond investor [Search result]FT
  • Swedroe: The case for indexing – MutualFunds.com
  • The balanced 60/40 fund is a classic – NY Times

Active investing

  • The best investors just love investing – Forbes
  • The case for active management weakens [Search result]FT
  • Swedroe: The mystery of hedge fund survival – ETF.com
  • Why Goldman Sachs downgraded the miners – Interactive Investor
  • Should you be reading Ben Bernanke’s blog? – Bloomberg

Other stuff worth reading

  • Even a Telegraph writer thinks extending right-to-buy wrong – Telegraph
  • Don’t expect a repeat of buy-to-let’s stellar gains – ThisIsMoney
  • Chart showing there are effectively 12 rates of income tax – Telegraph
  • Fighting the bubble in bubbles – Bloomberg
  • Understanding the help-to-buy schemes – Guardian
  • How couples can resolve fights over money – WSJ
  • Housel: It’s all so obvious (in hindsight) – Motley Fool US

Book of the week: I didn’t notice that Robert Shiller of CAPE and Nobel prize winning fame has a new version of Irrational Exuberance out. A must-read for bubble watchers, the new edition has been updated to take into account the financial crisis and what Shiller sees as its speculative aftermath.

Like these links? Subscribe to get them every week!

  1. Note some FT articles can only be accessed through the search results if you’re using PC/desktop view (from mobile/tablet view they bring up the firewall/subscription page). To circumvent, switch your mobile browser to use the desktop view. On Chrome for Android: press the menu button followed by “Request Desktop Site”. []

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{ 9 comments… add one }
  • 1 Gregory April 18, 2015, 10:13 am

    Did You know Jeol Greenblatt wrote a very good book about passive investing? Value of course:) http://valueweightedindex.com/TheBigSecret/

  • 2 EdgeOfCultivation April 18, 2015, 11:45 am

    Negative yield on Bunds is an interesting one. German government bond yields are negative out to 9 years, and towards the end of last week even the 10y was just 1bp over par. But there are good reasons for certain market participants to still buy even at a small guaranteed nominal loss.

    Deflation stalks the Eurozone so even a nominal loss could translate into a real gain if your inflation expectations are low enough.

    Banks and other financial institutions require high quality securities to act as collateral for trades (government bonds are preferred even to cash for ease of transfer, and banks will take a 20-30bps hit over cash just for that preference). There’s only a limited pool of these sorts of security, and most market participants will acknowledge that some euro bonds are more equal than others (compare yields of German, Dutch, Luxemberg bonds to for example, Greece). Banks and insurers also have a preference for government securities as they get a better capital treatment (laughably considered to be ‘risk-free’ when calculating Risk Weighted Assets).

    Furthermore, expectations of Draghi’s even bigger bazooka being deployed means that price pressures are upward, so a negative running yield could be worth paying if the market value of the bond is driven up.

    Bunds are a natural safe-haven asset too, so not a bad place to park your cash if you’re expecting a correction in other riskier asset classes and you’re happy to assume that others will want to buy when you’re trying to be contrarian and sell.

    Finally, there’s also demand from those wanting to match nominal liability cash flows – no worries for pension schemes and insurers if the asset price falls if your corresponding liability also falls.

    For disclosure though, I’m not a pension scheme, bank or insurer so I’m happily making a tactical decision to avoid nominal gilts with an allocation of zero for now. All my credit allocation is in corporate bonds and linkers. I don’t want risk witthout the expectation of reward and my time horizon is measured in decades, not to the next quarterly accounting statement.

  • 3 Gregory April 18, 2015, 11:49 am

    “The result is predictable: most don’t beat the market. In fact, because of management fees, most don’t even match the market averages. On average and over time, actively managed funds lose to passive index funds by approximately the amount of their higher management fees” from Joel Greenblatt’s book: The Big Secret for the Small Investor

  • 4 Mathmo April 18, 2015, 12:29 pm

    Ahhh. Enron. Those were the days. I worked there briefly before the house of cards came down. It rarely gets credit for the innovation and value creation for which it actually was responsible — just mentioned for the over-reaching and failure end result.

    Bond yields. Good grief. It’s enough to make one twitch over ones passive portfolio and take decisions about asset allocation.

  • 5 Lee April 18, 2015, 1:02 pm

    Thanks for highlighting the Ritholtz podcast. Great find.

  • 6 Neverland April 18, 2015, 1:21 pm

    I don’t think there is any point bitching about the poor current value of bond and equity markets if you have a long term investment horizon – you just have to keep investing every year and hope that the return you get at the end will be close to historic averages because probably it will be

    You have play the cards you are dealt not the cards you would like to hold

    However if you’re maybe 5 years from retirement I think it’s a different story on the risk return balance now

  • 7 magneto April 18, 2015, 7:28 pm

    Always find Wade Pfau interesting (see Retirement Researcher), and still trying to get head around :-

    4) It’s an illusion that volatility means risk. This is absolutely true. It’s a fundamental reason why Modern Portfolio Theory isn’t really meant to apply to personal finance situations. The standard deviation of returns isn’t risk. Risk is the possibility that market events force a permanent reduction to one’s standard of living.
    Unquote

    The bit in particular that seemed perplexing :-
    “Modern Portfolio Theory isn’t really meant to apply to personal finance situations”

  • 8 dearieme April 18, 2015, 8:18 pm

    “Negative yield on Bunds is an interesting one.” Perhaps some people expect the Eurozone to break up, and the German currency (whatever it might be) to respond with an effective upward revaluation versus something (US dollar, Swiss Franc, …), carrying Bunds with it? Though personally I haven’t the faintest idea of what would happen in the immediate aftermath of Eurogeddon.

  • 9 Gregory April 19, 2015, 10:29 am

    There are some good but a bit misleading atricles about the classic US 60/40 portolio in the US media. Misleading because it contains 60% US stocks and 40% US bonds. After 6 years of the bull market of the S&P and 30 years of the bond bull market the future result of the classic US 60/40 portfolio isn’t promising. Of course the philosophy behind it is good if you take advantage of the diversification internationally too.

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