Falstaff’s Purse

Does it pay to be cynical?

When you study markets and finance it’s easy to become pessimistic about human nature. Audited financials get manipulated to maximize management bonuses. Market oversight officials are lenient when they examine big brokerage firms, hoping to secure their next job. And investment managers themselves use their clients’ business to reward or punish various brokers—to say nothing of the Ponzi-scheme Madoffs who make off with the money.

The rational response to such behavior would seem to be cynicism: suspect everyone. It’s easy to echo Lily Tomlin: “No matter how cynical you become, it’s never enough to keep up.” And the daily news always provides fresh examples of fraud and malfeasance.

But you can’t live—and invest—that way forever. Cash stuffed in a mattress loses real purchasing power at the rate of 2% per year; gold is cold comfort when you need to buy anything; bank deposits pay almost nothing. A risk-free life is a return-free life. Peaks and valleys are hard to traverse, but they provide a beautiful landscape.

Shakespeare’s Sir John Falstaff is one of his most appealing characters. Fat, vain, boastful, and cowardly, his worldly-wise counsel leads the Prince of Wales astray. He embodies a kind of lusty distrust—repudiating honor on the eve of battle as nothing but an empty word. But he is ultimately repudiated when Prince Hal becomes King Henry V.

A cynic knows the price of everything and the value of nothing. He may want to be nobody’s fool, but that fools no one. The world really works through trust. Trust reduces financial friction and makes growth possible. If we sense dissembling among our financial partners, a better approach is captured by the old Russian proverb: trust, but verify.

Douglas R. Tengdin, CFA

Chief Investment Officer

The Making of Dreams

Are market changes real?

There’s a common understanding that market gains or losses aren’t real gains or losses—they’re only “on paper” until the investor sells the stock, making them “real.” But that’s a cognitive error—a kind of egocentric bias that says that something is only real if it affects me. In fact, price changes are real changes. When IBM goes from $100 to $200 per share, that gain is real. And when it drops to $170, that loss is real. The portfolio’s total value has changed. When we calculate total return we incorporate these temporary changes.

But there’s a sense in which the common sentiment is accurate. Our gains and losses are realized when we sell, and we have to report them on our taxes. Those tax consequences are quite real: money paid to the IRS isn’t coming back. That’s why tax-losses become an “asset” in the topsy-turvy world of tax accounting.

But there’s another sense in which the common sentiment is true: when we alter our asset allocation in response to the market’s gyrations, we take temporary changes in valuation and make them more-or-less permanent. That doesn’t happen when we sell one stock and buy another. We’re not taking money off the table, we’re just changing where we place our bets. But when we shift from stocks to cash (or short-term bonds), we go from a higher-risk asset to a lower-risk asset. That can be for good reasons—say, trimming a position to stay inside of policy limits—or bad ones—like selling out when the market’s volatility scares us. But our behavior can turn temporary gains and losses into permanent changes in a portfolio’s value, depending where we put the proceeds.

In Shakespeare’s The Tempest the main character Prospero tells his daughter and her fiancé that “We are such stuff as dreams are made on, and our little life is rounded with a sleep,” (Act IV, Scene 1). Life is fragile, and what’s here today may be gone tomorrow. It’s true with our money, and it’s true in other things: much of what we experience is “but a dream.”

Douglas R. Tengdin, CFA

Chief Investment Officer

Burned Out By The List

Are you burned out?

When the to-do list is filled with urgent items that are underlined and have stars and exclamation points next to them, it’s tempting to throw up our hands and curl into a ball. The to-do list is an inescapable part of modern life. Sometimes we make lists of our lists just to keep them straight.

And these lists are usually filled with things that we do to avoid criticism, that we have to do to avoid some negative consequence, but that will have to be accomplished again in just a couple weeks or months. When every day is filled with such soul-crushing tedium, burn-out isn’t far away. The Japanese even have a word for death from overwork: karoshi.

A company filled with management reports and meetings that document failures and undone items has an unhealthy culture. That business isn’t moving forward, it’s just trying to keep from falling back. But this kind of monotony won’t attract and encourage talented staff to break out and create the next iPhone. At best it will be filled with folks who can tolerate the day-to-day drudgery of list-checking.

Shakespeare’s King Henry V understands this when he makes his St. Crispin’s Day speech in Act IV of the play. Outnumbered five-to-one, the king had spent the night before the battle among his troops, anonymously, gauging their morale. He knows he needs to stir their hearts. And that’s what he does. He promises his soldiers honor, remembrance, and even brotherhood. He concludes that “all things are ready if our minds be so.”

Some things on your daily list need to inspire you—not just keep you out of trouble. Don’t succumb to the “tyranny of the urgent.” Sometimes the most important task is the one that’s the least pressing.

Douglas R. Tengdin, CFA

Chief Investment Officer

Fortune Favors Who?

Is it safe to go slow?

That’s what our instincts tell us. Whether we see a market running away, or an accident on the highway, our first instinct usually is to slow down, look around, and see what else is going on. “Haste makes waste,” goes the saying.

But slower isn’t always safer. When something truly new has been introduced, it’s important to take advantage of the changes. Watching and waiting may seem prudent, but often it’s just an excuse for procrastination and indecision. Opportunity costs are real, even if they are hard to quantify.

The Roman poet Virgil understood this when he wrote The Aeneid. In the story, the hero Aeneas leads a group of Trojan refugees to a new home after the Greek army destroys their home. When they land in Italy at the site of the future Roman capital, they are opposed by a native tribe. “Fortune favors the bold!” cries their leader Turnus, as he leads a charge against the invaders.

Leadership sometimes requires boldness–not undisciplined, rash decisions, but bold, decisive moves. The business book Good To Great describes several examples of companies that introduced transformative practices or products into their markets. They achieved sustained market leadership through their bold initiatives.

It’s important to be thorough and do your homework. But don’t get consumed by the paralysis of analysis. Sometimes a little audacity is a good thing.

Douglas R. Tengdin, CFA

Chief Investment Officer

Of Morals and Markets

Are markets ethical?

The short answer would seem to be no. After all, money doesn’t care who owns it. Money is a tool, like a knife. It can be used to heal or to harm. The effect of any instrument depends of the plans and intentions of the person who uses it.

But there are folks who would say that the market is deeply immoral. By focusing on shareholder returns, markets would seem to incent people to do bad things, to load costs onto someone else, to take advantage of people or manipulate them so that they are instruments of the all-important bottom line.

But truly free markets allow people to choose where they want to work and who they do business with. People often confuse a corporate economy with free markets. When businesses lobby the government for special favors that allow them to keep competitors out, that’s not capitalism. When big banks receive big bailouts because their bad loans now imperil the entire economy, that’s not capitalism, that’s cronyism. Especially when a Director of the bank is a former Secretary of the United States Treasury.

Markets are predicated on the freedom to choose—a deeply moral concept. If a business wants to grow revenues by touting its sustainable practices or community engagement or workplace equity or charitable contributions, it can do so. Value is created through free and open trade. Free choice requires market participants to respect one another, because customers or workers can always go somewhere else.

Markets aren’t moral, but they require morality to work. When we find failures, they’re usually not in our markets, but in ourselves.

Douglas R. Tengdin, CFA

Chief Investment Officer

Building Finance?

What is investing like?

Many people believe that modern finance began in 1952 when Harry Markowitz published his paper, “Portfolio Selection,” for which he was later awarded the Nobel Prize. His work lays out the mathematical basis for diversification. By combining uncorrelated securities, investors can reduce the riskiness of their portfolios without lowering returns.

But Markowitz had a problem. When he sat before his dissertation committee to defend his thesis, they didn’t know how to classify his work. “It’s not economics,” they objected. “It’s not mathematics. It’s not business. It’s not literature.” Eventually, the committee agreed that Markowitz had earned his doctorate. And the world is a richer place.

But what is portfolio management? It uses all these disciplines, but isn’t really part of them. In my assessment, it’s most like engineering. Portfolio managers need to find the most best way to reach a goal, given a set of constraints, working in a world of uncertain, partial information. Managers build portfolios using various components. Different elements have different functions: some lay the foundation, others raise the profile, still others provide protection. Individual securities are valuable to the extent that they improve the structure of the portfolio as a whole.

Shakespeare understood the engineer’s problem. At the outset of Henry IV Part 2, the rebels are assessing their strength. One them likens their task to that of a builder, who must survey the land, draw a model, and if it’s too costly, revise it. Otherwise he’ll end up with a half-built house and no money, “a naked subject to the weeping clouds, and waste for churlish winter’s tyranny.”

In the same way, investors must assess their assets and continually evaluate their plans, given the changing circumstances of the times. Investing is engineering—we’re designing and building our own futures.

Douglas R. Tengdin, CFA

Chief Investment Officer

The Very Model of a Tax Deal

What is tax inversion?

A tax inversion happens when a corporation relocates its headquarters from a high-tax country to a low-tax country. The company doesn’t change where it makes and sells its products, just where the head office sits. It’s a way for companies to reduce their tax bill. The practice has gotten into the news lately because some prominent US firms have acquired foreign firms, and one financial incentive has been reducing their taxes through corporate restructuring.

Recent examples include Chiquita bananas moving to Ireland, Walgreens moving to Switzerland, and drug-maker Mylan moving to the Netherlands. One major impetus for these deals is the US corporate tax code, which has both a higher rate than every other county, and is a worldwide system, rather than a territorial system. Under current law, if California-based Apple builds iPhones in China and sells them in Japan, the Federal government claims 35% of the profit. But Apple only has to pay these taxes if they bring this cash home to pay US-based expenses. So Apple’s cash-hoard remains domiciled overseas. Only the US and Eritria have worldwide systems.

Taxes motivate all kinds of un-economic behavior. In the opening scene of Henry V, two church prelates agree between themselves that the best way to discourage a proposed levy on the church is to urge the king to undertake a foreign war. Closer to home, tax systems affect corporate investment, marketing, and production decisions, usually reducing earnings and efficiency. Our high corporate tax rates combined with targeted exemptions penalizes efficient companies and subsidizes politically favored firms.

Death and taxes are certain. But since companies don’t die, they just have to worry about the IRS. If the government doesn’t reform its code, more tax-driven deals—and lower tax revenue—are inevitable.

Douglas R. Tengdin, CFA

Chief Investment Officer

Future Shocks?

What’s next for the economy?

One of the most important inputs into any investing process is an understanding of where the economy is going. After all, bonds are a contractual claim on future cashflows. If inflation picks up, their value depreciates. Stocks are a residual claim. They benefit from growth. An improving economy should help the stock market, while an increase in inflation hurts bonds.

So market analysts spend lots of time and effort trying to understand the future. But predicting the economy is challenging. There are leading indicators, lagging indicators, false flags, trends, and turnarounds. Our language reflects our uncertainty: we “examine the tea leaves,” or “look into the stars,” or try to sense “which way the wind is blowing.” And we never see data objectively. Our own expectations color what we see and how we react.

Macbeth was a man obsessed with the future. Early in the play he and his friend Banquo come upon three witches who foretell that Macbeth will be king. Banquo asks them to “look into the seeds of time, and say which grain will grow and which will not.” They answer in riddles, which are only made clear as the play progresses. Later in the play Macbeth goes back to them to find out what they foresee. Their cryptic predictions mislead him—because he hears what he wants to hear.

It’s important not to mislead ourselves when we look at leading indicators. In the past, a reliable leading statistic has been housing. After all, people don’t buy a new home unless they feel confident about their finances. The housing bubble disrupted that indicator, but five years on we seem to be reaching a kind of equilibrium, where trends in sales and prices have some predictive value again. And what do we see? Home prices in most of the world are rising. The US ranks 10th among 52 countries studied by the IMF. Europe is mixed, but generally positive. China and the Pacific rim are also growing, although Japan is falling slightly. Following a period of post-crisis stagnation, global home prices have risen for seven consecutive quarters.

The picture is encouraging. Global growth continues. But like Macbeth, we need to be careful not to see just what we want to see, or our fates will be filled with “double, double, toil and trouble.”

Douglas R. Tengdin, CFA

Chief Investment Officer

King Lear: The Importance of Settlement

Who do you trust?

When people make an estate plan, they need to decide what to do with their money. One of the most important decisions is choosing a trustee. Because a trustee will control the assets—usually for a long time—making the right choice will have far-reaching consequences.

Shakespeare writes about just such a choice in King Lear. At the beginning of the play, Lear states his intention to retire and divide his possessions among his three daughters. The elder two flatter him, while the youngest is disgusted by her sisters’ cloying speeches and says nothing. “Nothing will come of nothing,” Lear rages, and settles her portion on the other two.

As the play goes on, the character of the two older children becomes clear—manipulative, deceitful, grasping—they cut the level of Lear’s support; they even lock him outside during a violent storm. They conspire against him and later against each other.

People planning to name children as trustees should ask themselves if the children are suited for the role—how well they get along, what skills they have, if they are prepared. Sibling rivalry can be an issue, and even if the kids get along, putting one child in charge of the other’s money will create a lot of tension. Having multiple co-trustees may not help, as decision-making can be difficult. A neutral third party is often better equipped to referee disputes and say “no” when necessary.

Lear comes to grief because of his rash choices. Never underestimate the power of an estate.

Douglas R. Tengdin, CFA

Chief Investment Officer

Finding Financial Fraud

How do you smell a rat?

Detecting financial fraud can be challenging. We know there are lots of people who want our money. It’s taken us decades, sometimes a lifetime, to build a nest egg. It’s important to safeguard it. But in the real world people lie, cheat, and steal. Financial products are especially prone to distortion and deception, with complex legal provisions and mind-bending mathematical formulas. How can we protect ourselves?

First, be suspicious. Ask questions. Double-check the answers. If it’s taken years to grow your wealth, spending a few weeks or months checking out someone’s references and reputation is reasonable. Second, don’t lose sight of your money. Regular statements—or online access—should be available. And question anything you don’t understand. Third, remember that risk is part of the game. We live in an uncertain world, where unexpected things happen. If someone offers you a risk-free product with guaranteed returns, they’re probably lying. Don’t walk away, run. Finally, follow the money. It may seem rude, but ask any financial professional how he or she is paid. Incentives matter. You shouldn’t feel that your savings are supporting someone else’s lavish lifestyle.

In Act 2 of Henry V, Shakespeare shows how Henry uncovers a plot to assassinate him just before he leaves for France—by asking his advisors questions, keeping them close, and following the money. It’s a key scene that shows how Henry has matured. In the same way, we need to protect ourselves and stay on top of our finances.

Because if something sounds too good to be true, it probably is.

Douglas R. Tengdin, CFA

Chief Investment Officer