Sep

5

I consider myself lucky that my studies of the markets began with Investments by Bodie, Kane, and Marcus. Then before I could be corrupted, I started reading Vic and Laurel's books. The study of "Investments" begins by reading the difference between "real assets" and "financial assets". Then it explains their relationship to each other. How financial assets are used to transfer real wealth. This foundational underpinning often will clarify the fallacy in the arguments of the prophets of doom.

When the doomdayist is the photographer, one of the most common deceptions is to magnify the problem, then focus on only one side of the picture completely blurring the other side. He artistically crafts this clear snapshot of one side of the current state. Then he imagines a future world with both sides, but doomed to failure because of its imbalance.

Being interested in demographics, I often will read articles about the impending boomers retirement. This also is one of the doomsdayist most fertile grounds. The USA's boomers, the most productive generation in history will go from being a net producer of wealth to a net consumer. Transfers of this wealth will occur, either through boomers life or at their death. Because many in this generation have amassed a fortune, framing such pictures to imply your prophetic ability is a rich field. Also boomers want to know how this transfer will occur, to determine how to position their wealth. Do you hold "real assets" or "financial IOU's"?

Because of this great wealth, it is the rare author that will take a balanced look at how this transfer of wealth will occur. Often I find articles that will use the actuarial approach to the boomer's problem, that is taking the present value of future benefits then look at the current US debt and add it on to this social security present value and perhaps throw in a the present value of other future government debts.

All of this is put in fiscal terms, with mind numbingly large numbers even the most numerically literate has trouble understanding. The real wealth currently held by the US and the boomers is an ignorable blur. The conclusion is that the only solution is to devalue this debt by inflating your way out of it. Therefore you hold "real assets" such as gold, a doomsdayist favorite. This is of course what every generation X, Y, and Z'er will want; gold, hard assets.

This perhaps shows the brilliance of Mr. Gross's recent article No Cuts, No Butts, No Coconuts. He, like a good doomsdayist photographer, magnifies the problem. But unlike the fiscal doomsdayist, he focuses on the real imbalance. That is that the boomers have the real wealth, and the demand for that wealth will decrease. He uses housing as the basis for every real assets. He insist there will be a slowing of demand for housing therefore implies a slowing of demand for everything real. He implies that you especially do not want to hold a real company producing real wealth. He implies you certainly do not want to bet on the US, the current largest holder of the world's real wealth.

The intended message of this deflation is of course you want to hold bonds, or fiscal assets. Remember he is the biggest bond salesman around.

I would suggest that the truth lies somewhere in between. Boomers will have to transfer that wealth to someone. Generation X, Y and Z'ers clearly will not have to work as hard to obtain that wealth as the boomers did.

However, much of this ease in effort to meet needs will be due to increases in productivity, not totally inflation. There will be a slowing of demand for some assets, and a growth in demand for others. The more we look to the emerging markets to make up the shortfall in human capital, the more basis goods will be in demand. The more we look inward the more scientific discovery, quality and artistic expression, the human element, will be valued.

The younger generation will not lose an interest in obtaining wealth once their survival needs are meet. The US will not suddenly lose its real wealth advantage to motivate others. Neither will it loses its foundational ability to through creative destruction and nurturing of the individual spirit to produce wealth.

There will always be problems to solve and people reaching for the stars. In fact I would argue that, in a world where the fundamental shortage is human capital, in this world the wealthiest nations will be those that give the individual spirit the most freedom, not just the nations with the most humans.

Scott Brooks adds:

I have said this before, and I will say it again (even thought I am resoundingly ridiculed for saying it); losses hurt you more than gains help you.

If the premise of the long term positive drift of the market is true (which I believe it is), then getting good returns is simply a function of "showing up at the party". All one has to do is be there to get good returns. Unfortunately, getting good returns is not good enough.

Human beings are ruled by a two sided coin: greed and fear. When things are going well, we and forget the adage that "things are not as good as they seem", or worse yet, we think we are smarter than we really are. So we get greedy. "Hey, look at my returns, I'm pretty smart…so If I'm smart enough to get these returns, then why not go on margin, leverage the money and double, triple, quadruple my returns!"

And of course, you remain a genius, and/or your intelligence increases in direct proportionality to the acceleration or momentum of the "positive drift of the market" until the momentum or positive drift stops. Then you find out, in a very painful manner, what a margin call is.

Maybe you are not leveraged, maybe you just bought into the "safe stocks", argument, or the "new economy" stocks argument, or the "positive earnings" argument. And your newly acquired personal genius told you to hold onto to Cisco at 50 because it was recently up at 80 and it should be worth at least that much. Or Coca Cola, because it had positive earnings growth all thru '00, '01, '02. Or because the long term positive drift of the S&P 500 said keep being "long" even though the 1550 high ('00) is where it should be and not at 755 ('02) it got down to or even the approximately 1300 it is at now.

You see, it is during these times that the other side of the human nature coin rears it ugly head. Fear! Fear leads to rationalization. It leads some to be afraid to sell for fear of missing out on a big run … and thus they ride Cisco down to 12, or Enron to pennies, or Global Crossing to zero! Or maybe you sell after losing half your stake, and you become fearful and indecisive as to when to buy ever again, and the first time the market hiccups, you panic and have sleepless nights, and ulcers.

It does not matter how well you do when times are good. It does not matter how much you make during the market that has such a "positive drift" that tow truck drivers can buy an island, or dot com companies can advertise a monkey playing around in a suburban home garage for 30 seconds during the Super bowl and not even mention their name or what they do (or when tulip bulbs go from $1 to $600 and someone named Newton who missed out on the rise from 1 - 600 finally decided to jump on the tulip bandwagon). It does not matter during those times. What matters is how good you are during the bad times!

It does not matter what you make, it matters what you keep. It doesn't matter if you get 10,000% return, if you lose it all during a market hurricane.

The beaches of Florida may have long term positive effects on human beings (sunny days, warm weather, refreshing water), but you better get your butt off that beach when a hurricane is coming. Why? Because its hard to enjoy the beach if you are dead.

It is hard to enjoy the long term positive drift of the market if you have lost your nest egg, seed money, portfolio, clients, etc. Therefore, I submit to the site that the most important activity for any of us, is to become absolute experts at determining what is the likelihood that the markets are likely to decline. Therefore we should discuss what are appropriate courses of actions to take during those times. How do we recognize them? How do we know that the risk levels in the market are elevated?

What I am saying has nothing to do with being a bear, or discussing fear. It has to do with reality. How do we achieve good solid returns during the good times, and then preserve those gains during the bad times so that when the bad times are over, we have our portfolio intact and we can ride the new long term positive drift (the next wave) of the market again.

Why do I suggest this? Because losses hurt you more than gains help you!

Steve Leslie comments:

Nietzsche said that which does not destroy you makes you stronger. I say that depends on a person's evaluation of the experience. It hurts more when it is personalized.

Behavioral psychologists tell me that people avoid pain more than they seek pleasure. Or more importantly perceived pain. I am not a behavioral psychologist so I will allow some others to chime in.

After a plane crash people are reluctant to fly in a plane even though they stand a far greater chance of being killed driving to the airport. From personal experience I know that losses stay longer in your memory than wins. I can tell you every bad hand that has knocked me out of a major tournament. Or the putt I missed that cost me the club championship.

Everyone says they want the ball at crunch time but only a few of them really mean it. The rest hope that they are not called upon to face Mariano Rivera with the game on the line. Or having to make a knee knocker to go into a playoff with tiger Woods. (See Chris Dimarco at the Masters).

How about this one. Get a 50 percent return for 2005 receive your industries highest award CTA of the year, and then have a few months of drawdowns. Now you are a heel. It goes with the territory. Schadenfreude is ubiquitous.

It is a lot easier to be average or above average than it is to be exceptional or superior. It takes different wiring. Most analysts and all Re-elected politicians understand this, at least those who have long careers.

Dr. Kim Zussman contributes:

One hypothesis is that bull and bear markets have some correlation with the investment lifetimes of generations living through various markets.

For example my parents, who lived through the depression, did not own stocks when they were young because (besides not having much money) they had directly witnessed ruin. It was not until a close family friend did well in the bull of the early 1960's that they bought in the late 60's, and held down through the mid-70's. Thus from then on they eschewed stocks, pronouncing the mantra "Lost $20,000 in the stock market".

Undoubtedly there were many families burned like ours who got and stayed out by the end of the 1970's. By then, boomers only vicariously touched by the bad market of the 70's were becoming flush enough to buy stocks and help fuel the great bull that ensued.

So if painful memory of investment losses has lifetime effects in many people, this could explain some of the decade-length duration of bull and bear markets. And what effect, if any, the 2000-03 decline will have on the current cohort would seem to be a vital question.

Scott Brooks replies:

All good insights, but I am not talking about just having some losses, I am talking about having a methodology to measure risk and the likelihood of downturns. How does one survive 1968 - 1982, or 1939 - 1946.

It seems to me that long term secular bear markets can be devastating to the long term drift theory. Just as a hurricane can damper the Florida beach experience. Markets seem to go thru long term secular trends. The last great bull basically lasted from 1982 - 1999, the one before that from 1950 - 1967.

If one looks at a chart of the long term market one will see that the long term bull cycles are punctuated by basically smooth sailing with the wind blowing pleasantly in the direction that we want to go. All one has to do in those markets is basically index and let the markets blow you to prosperity.

But if one looks at the long term bear cycles (for the sake of this discussion, a long term bear cycle is one where the market goes down and then takes many years to get back to its past high levels…i.e. it hit a high in 1968, proceeded to go down, and then did not get back to that high until 1982), one will notice that they last a long time (usually longer than a long term secular bull cycle) and one will notice that, unlike the smooth sailing of the long term bull markets, they are punctuated with extreme volatility.

Now I know that there are/were big downturns in the last bull market (1987, 1990, 1994, 1998 just to name a few) but they were quick. They went down, and within a short period of time (less than 18 months in the case of 1987) they were back to new highs. All I am saying is that there has to be a way to preserve capital during these downturns. There has to be a way of measuring the likelihood of their occurrence.

Make no mistake about it. I am a bull. But it is my job to be realistic about the markets, asses them and figure out a way to make my clients money. I do not care if the market is going up or down. It is my job to:

  1. Preserve my clients capital
  2. Grow my clients capital
  3. Perform actions 1 & 2 with the least amount of risk necessary

So, my questions to the are simply:

How do we reliably measure risk? How do we manage the portfolio's during higher risk times? How do we make a profit when conventional methodologies (i.e. long term drift) is out of favor, or when our personal pet systems, markets, sectors, regions, investment types, are out of favor, because they are experiencing a long term secular bear market?

Abe Dunkelheit contributes:

Marcel Duchamp, the famous French artist, was sharply criticized for his attitude towards the French Resistance in WWII. Instead of fighting against the Nazis he emigrated to the United States. In an interview he explained his attitude. He said to him it appeared that in any conflict there is a third alternative besides fighting for or against a perceived evil, which is withdrawal! Of course 'withdrawal' is a highly individual response to conflict; it cannot be the strategy of a whole nation. No wonder that such an attitude must seem to be anti-patriotic from the group's point of view.

The idea of long term investment is an illusion because investors as a group cannot survive the bear market periods. (The individual can but not the investors as a group.) The paradoxical situation is that the illusion of long term investment is necessary to keep the economy going. If we look at the wealth of the nation as an aggregate we see it growing; but if we look at individual lives we see much misery. Why is that? Because the wealth of the nation comes at a price! The price is the sacrifice of personal happiness. The welfare of the group depends on behavior that is not good for the individual! For the whole nation the investment meme is good but for the individual it is not!

What can one do? One can develop extremely individual solutions. I think one must become extremely individual in order to survive bad things which tend to hit whole nations. One must totally stay away from the crowd and eradicate anything which is crowd-like in one's own bosom. A lot of unconventional thought must go into the question of 'investment' but nothing definite can be said in an email.

There are many unpleasant truths and one must look at them. "When killers stop killing they get killed." (A wise gangster in a movie.) I do not know if I can make myself understood. What I am basically saying is that 'investment' cannot work for the many, not in the way it is advocated; it works only for the few, but in order to work for the few it needs the many. The whole thing, from a humanistic point of view, is perverse. Trading is not 'human', neither is 'life'. Yet, paradoxically, the long term effect of this 'inhumanity' is economical growth and prosperity, which is good for the group, at least in theory, but comes at a price, which is the sacrifice of the individual, because the individual member of the group ('the many') must be tempted to act in ways which are, from the individual point of view, not good.

As an example for unconventional ways of thinking/acting I studied how to lose money. It is said, people hold on to losers and cut winners. Some time ago I opened an FX account and traded such a strategy: buy low, sell high, based on hunches, otherwise hold (no stops). I did 100s of trades - and broke even! I had a dozen big losers which offset the 95% small winners. Now that was a basis to work from; I gained some highly precious insights from this experience. I learned, for example, that it is not wrong by default to hold on to losers and cut winners; what is wrong is doing this without regard to the liquidity process.

Among many other things, I noticed the unhealthy tendency to increase exposure after a particular market had gone up! In my opinion that is the real reason why people lose money. They tend to do the right thing after experiencing it was the right thing - only that it is now the wrong thing.

I also noticed that trading in and out of stocks is not increasing profits; but dramatically reduces drawdowns. I further noticed that profits tend to come 'like thieves in the night' - rather unexpected. I learned I cannot predict and do not predict. 90% of what I am doing is exposure (or inventory) management. No single decision holds meaning to me; I look and think in terms of the 'whole'. My trading tended to be highly fragmented and I had to stay focused all the time which was draining. Now I am still trading very actively but with a detached attitude, rather disinterested in any particular move. I hardly ever react. Almost all of my trades (entry/exit) are placed before the markets open. I also noticed that when the markets turn busy that this does not necessarily mean I will trade more; it means I will think more!

Finally, I was surprised how small but good decisions can add up to quite substantial profits. There is more to it, like a positive attitude; also useful is following news in conjunction with particular moves. I noticed that moves in individual stocks are often explained by news that are already known to the market for a week or more (like DELL); also that stocks can go up with hardly any comments (like EBAY). I also realized that it seems to be a good time to buy a stock now and not later when people recommend to buy it not now but later (like AMD).

Tom Ryan mentions:

In reply to Scott, it seems to this rather sunbaked speculator that there is an inherent conflict in logic here in the sense that having a long term goal, in this case growing capital, but an operational plan that is geared to minimizing a negative event in the very short term (preserve capital), well this will always produce a sub-optimal solution. if a client comes to me and says five years from now I want to look back and have made a 15% CAGR (doubled my money) but I don't want to suffer more than a 25% loss in any one year, then the reply has to be that really, they do not have a five year plan, they have a one year plan for each of the next five years. In other words the short term operating constraint always overrides the long term plan. Always.

As for risk, there is absolutely no reason for anyone to hire a money manager in order to pursue below average market risk as anyone can do that by calling 1-800 VANGUARD and apportioning the appropriate %s to stock and short term bond index funds to get whatever risk level they want. The only reason to hire a money manager is, to use Tim's phrase, to "pursue alpha". Now all strategies to pursue alpha boil down to one of two things, either selective/focus of positions (hopefully into things that will do better than the market average), or increased turnover of positions (trading). Theoretically, therefore, it is not possible to pursue alpha without above average risk. And yes, before I get 15 replies to this email (including from Melvin) it is possible to show in retrospection how someone or some strategy achieved higher returns with below average volatility or risk in the past, but theoretically, from day(0), all alpha pursuing non-indexed strategies have higher than average risk.

So at the end of the day the issue of how to grow and preserve capital at the same time, or grow capital whilst minimizing risk, can not be solved without proper definitions of risk, such as target CAGR, the significant time horizon, maximum leverage allowed, and what constitutes impairment of capital. Even with these factors mathematically defined, the solution will always have to be probabilistic rather than deterministic because we can only use the past behavior to construct general distributions which can guide us as to future expected behavior. Hence we have come full circle to my first assertion that there is a logical conflict between growth and preservation of capital i.e. your items one and two.

As a postscript: I suppose the one other reason for a layperson to hire a money manager even if they are not pursuing alpha would be to avoid fraud risk as brokers are subject to fraud from time to time. but fraud risk is hard to detect beforehand even for professionals as the past 10 years has repeatedly demonstrated. You can probably achieve the same effect much easier simply by some diversification.

Russell Sears adds:

I would disagree, short term draw downs do not always out weigh the long term goals, just usually. To paraphrase a recent conversation I had with Gordon H. "Principle protection is currently the biggest scam on Wall Street." Anybody that understands indexed options could design a plan that maximizes your exposure to a market, but limits your yearly loss.

The problem is two fold. One, doing so causes you to give up tremendous potential earnings, opportunity cost is high, as you suggest. Second, most advisers on Wall Street upon hearing this their mouths will salivate, they spotted the chump at the table.

How, do you get the client to understand you cannot make money without taking risk? And how do you explain that such a "no losses allowed" strategy, is a chump strategy that those without any integrity will gladly execute at your expense?

I wish I knew the answers, to that last one especially. My current strategy is to assume that most people with money are comfortable acknowledging "business risk", and you have to take business risk to make money. So I try to present "investment" risk as diversification of their current risk… it just has solid $ figures attached to it.


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