Quote for the Week

One of the studies that I did for my first book, Pioneering Portfolio Management, looked at the behavior of endowments and foundations around the crash in October 1987. I used to talk about the crash in October 1987 without explaining what it was and I do still teach a seminar in the economics department in the Fall. I started talking about what happened in October 1987 and I looked around the room and I realized that I think the students were three or four years old in 1987 and weren’t yet reading The Wall Street Journal.

So, just to give you a little bit of context, the crash was really an extraordinary event. According to my calculations it was a twenty-five standard deviation event. One standard deviation happens one draw out of three, two standard deviations one out of twenty, three standard deviations is one out of one hundred. An eight standard deviation event happens once out of every six trillion trials. You can’t come up with a number to describe the twenty-five standard deviation event; it’s just too large a number, I think, for any of us to really comprehend. In essence, this collapse in stock prices — the one-day collapse in stock prices — I think in the U.S. the price was, depending on which index you were looking at, were down 21-22% in a single day. Interestingly, most major markets around the world were off by a similar magnitude. This one-day collapse in stock prices was a virtual impossibility. Of course, this was just a change in stock prices; it wasn’t related to any fundamental change in the economy or any fundamental change in corporate prospects. It was just a financial event. — David Swensen (source)

Here’s what I’ve been reading for the past three months:

• Medici Money — The Medici Bank lasted five generations but less than a century. The book details the founding, rise, and decline of the Medici Bank. The power, influence, and complexity that came with building a bank that spanned most of Europe is explained.
• A Brief History of Panics — This old book covers financial panics in the U.S., starting with 1814 and ending with 1913. Brief accurately describes the writeup on each panic. The author breaks the panics into four causes banking, credit, capital, and tariff changes. It’s data heavy on money in circulation, loans issued, deposits, etc. The lesson is that financial panics have been a recurring theme in the U.S. for over 200 years.
• Tales of National Indemnity Company — Jack Ringwalt founded National Indemnity and wrote this book to commemorate its 50th anniversary. He covers his early insurance career, founding the company, the challenges, growth, and eventual sale to Berkshire Hathaway and Warren Buffett. The book spans a total of 50 pages. PDF copies can be found online.
• The Pleasure Was All Mine — I bought this book several years ago, forgot about it, and just rediscovered it on my shelf. Fred Schwed Jr’s autobiography comes with a catch. It’s more about the people in his life, and their influence on him, then his life itself. It’s filled with humor, a bit of wisdom, and not much finance.

Quote for the Week

The really hard part about investment policy is not figuring out the best feasible combination. While it takes some time and analytical discipline, this part of the problem-solving is far from advanced science.

The really hard part is managing ourselves: our expectations and our interim behavior. Walt Kelly’s Pogo puts it as “we have met the enemy and he is us.” Most investors are too optimistic about the long run and much too optimistic about how well they will do compared to the averages, so they set themselves up for disappointment.

Even worse, most investors do harm to their longer-term investment results by trying and trying again to do better: changing managers and changing asset mix at the wrong time and in the wrong way. — Charley Ellis (source)

International and emerging market stocks underperformed U.S. stocks over the past 15 years. It wasn’t consistent every year. In fact, international led in three of those 15 years while emerging markets led in four. Still, it wasn’t enough to outpace the U.S.

So far, this year has been another exception. Through nine months, both international and emerging markets have outperformed both U.S. large and small caps by a wide margin.

The obvious question is: is this another one-off year or the start of a longer trend much like the one experienced during the early 2000s?

Which brings us to the first of several lessons from the returns so far this year:

Quote for the Week

The first thing you need to understand is that bubbles can only come when all the stars align: The economy’s got to be good; the outlook has got to be good. New technological changes are going on. As far as the eye can see, there’s only prosperity. Only in that kind of an environment are you going to get everybody to just throw caution to the wind and say, “I want to be part of it.”

What can we learn from that? First of all, when you have an era of total participation — an era in which people suspend all logic, become part of the crowd and buy things just because they’re going up — you’ve got a bubble. And there’s only one way a bubble goes down — the only way you let air out of a balloon — it either pops, or you just slowly let it out. However, one way or another, the air has to come out of the bubble…

The dictionary definition of a bubble: “Something insubstantial, groundless, or an impractical idea or belief” — in short, an illusion. In other words, stock market bubbles create illusions. But Sigmund Freud had about the best definition of an illusion as to how it affects the stock market… “Illusions commend themselves to us because they save us the pain and allow us to enjoy pleasure instead. We must therefore accept it without complaint when they sometimes collide with a bit of reality, against which they are dashed to pieces.” In other words, bull markets create bubbles, and bubbles create illusions, and illusions eventually lead you astray. — Arnold Van Den Berg (source)