Quote for the Week

One of the pieces of advice that I’ve had in my books, going back ten years now, is that investors in bonds should invest only in “full faith and credit” securities. Bonds that have call options or bonds that have credit risks or bonds that are highly structured, like the asset-backed securities and CDOs, just don’t belong in the portfolios of sensible investors.

There’s just systematic mis-pricing of credit and options and complexity. Now it’s obvious when I say that. It wasn’t so obvious when I wrote it ten years ago, and then again in Unconventional Success, and now again in the new version of Pioneering Portfolio Management.

People on Wall Street who are structuring these securities are more sophisticated than the people to whom they are selling them. With that kind of dynamic, when really smart, highly compensated, very clever people are on one side of the trade, and less highly compensated, less clever people are on the other side, you know who’s going to end up in the soup. — David Swensen (source)

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Quote for the Week

It’s important to recognize what I call the twin impostors. They are short-term gain or outperformance, and short-term underperformance. Both are impostors, because neither one says anything about real investment skill. Investing performance is what happens when events collide with an existing portfolio. Maybe a portfolio has been assembled very wisely, very prudently, and with a lot of analytical talent, and the events that occur just were unforeseeable. That doesn’t mean the performance that results tells you anything about the wisdom of the portfolio or the ability of the investor.

I refer a lot to The Black Swan, which is an excellent book by Nassim Nicholas Taleb. Here are a couple of points, or my characterization of points that he makes. Investors are right and wrong all the time for the wrong reasons. We all know people who got famous in our business for being right once in row. The correctness of a decision cannot be judged merely from the outcome. Good decisions fail all the time. Bad decisions work all the time. Randomness alone can produce just about any outcome in the short run. It is for reasons like these that we must be leery about attaching great importance to short-term performance. — Howard Marks (source)

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The market can be an expensive teacher. For a brief moment you think you have everything figured out, then the market shoves that mistake in your face. It happens to everyone. Beginners, veterans, nobody gets a pass from the market’s classroom.

The best investors understand this all too well. They’ve experienced it first-hand…more than once. 

Learning is part of the investment process whether you like it or not. You’re better off, of course, expediting the process by learning on your own. It’s cheaper. But if not, investing forces you to learn, sometimes at the most inopportune times. And the lessons include learning about yourself.

The concept of circle of competence gets tossed around often. It’s a fancy way to say you’re good at some things but not everything. It’s about knowing what you’re good at, where you have an advantage, but, more important, not straying into areas that put you at a disadvantage. 

Studying finance, market history, companies past and present, and outside your discipline, expands your circle of competence, hones the edges, and improves decision making.  That’s the goal, at least. Learning improves your chance of (investment) success.

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Quote for the Week

What is that frenzied activity that we see in financial markets all about? Financial markets are the grease in our economy that keeps the wheels of enterprise turning. Financial markets are in the first instance a vehicle for financing governments and enterprises that need money. But why is it that financial markets are so important in this process? Financial markets are a place where owners of outstanding assets can convert those assets into cash, or where owners of cash can find longer-term uses for their money. Financial markets thus give holders of assets with future cash flows the option of realizing the discounted value of those future cash flows in the present. Financial markets are a kind of time machine that allows selling investors to compress the future into the present and buying investors to stretch the present into the future. Without financial markets, all assets would be buy-and-hold and the cost of capital would be orders of magnitude higher than it is today. In panic conditions, as Alan Greenspan so often reminds us (he uses the expression “fear-induced disengagement”), financial markets come to a screeching halt because buyers evaporate and even supposedly liquid assets are transformed into buy-and-hold. — Peter Bernstein (source)

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John Kenneth Galbraith, in A Short History of Financial Euphoria, condensed a speculative mania into three parts.

1. New innovation. Something new, financial or technological, captures people’s attention. It’s not new innovation alone. It’s that, gradually, more and more money concentrates into the assets behind that new thing.
2. Debt. The returns on those assets are so good that people want to accelerate their wealth. They turn to leverage, margin loans, derivatives, anything that could enhance returns further.
3. The Crash. Liquidity dries up. Asset prices freefall. Margin calls are made. Forced selling occurs. The new innovation assets are scrutinized too late for many. Painful losses are widespread.

Galbraith’s speculative mania also describes how investors blow up their portfolio. A paper titled, How to Lose Money in Derivatives, studied previous hedge fund blow ups and backs that up.

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