Ten Commandments for Investors (Application)

Are the Ten Commandments just for the religiously-minded?

That’s a fair question, as is the question as to why a finance guy is spending so much time on a religious text. The short answer is that we can learn investment lessons from any great work of literature, religious or secular. Great literature, after all, is just a reflection on human nature, in all its complexity. Investing is also a reflection on human nature, but written in the language of finance. It’s perfectly sensible that they should have lessons to offer one another.

But there is a deeper reason why the Ten Commandments are especially poignant. Almost 216 years ago George Washington, late in his second presidential term, asserted that a sense of religious and moral obligation is essential to a well-functioning political economy. His Farewell Address is considered to be one of the most important documents in American history, and is still read annually in the Senate.

A sound moral and ethical framework is crucial for all aspects of society to work smoothly, but it is especially true in finance. The bank robber Willie Sutton is said to have robbed banks because “that’s where the money is,” and crooks and criminals are perennially drawn to finance. The swindles and scams that we see so regularly are a discouraging reminder that we need to be careful with our money.

By contrast, The Ten Commandments stand out as a moral and ethical foundation. Their simplicity makes them memorable. It’s been said that if you want to be able to recognize counterfeit currency, you should study the genuine article. And if we want to avoid the next Madoff, being familiar with a fundamental moral text should be helpful.

Douglas R. Tengdin, CFA
Chief Investment Officer
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Ten Commandments for Investors (Part 6)

“Do not murder” seems pretty straightforward. How does this help us invest?

On the face of it, the sixth commandment couldn’t be more simple: murder is a universal human prohibition. But understanding the context is the key to applying the text. At the time of the Exodus—when the Ten Commandments were given—Israel was a tribal confederation. They may have all traced their heredity back to a single ancestor—Jacob, or Israel, Abraham’s grandson—but their real loyalty was to their closest family members. In a pre-literate society, close relatives are often the only people you can trust.

In such a situation, mistakes and misunderstandings can get magnified until one party takes offence and violence breaks out. Then a blood-feud develops between the families, and the nation may be riven by civil war. This simple prohibition keeps people from letting their emotions take them somewhere that’s bad for them and the whole society.

In the same way, investors need to be ruled by their heads, not their hearts. When we make emotional decisions, apart from the analytical support needed to back them up, it’s likely that we’re just following the fashions of the day. And that’s rarely a profitable strategy. At best, it allows you to ride a trend for a while. But usually, once a trend is identifiable, the forces are in place to reverse it, leaving you holding the bag.

Furthermore, the investment world is littered with folks who fell in love with a stock, or have some behavioral bias for or against an approach. But money has no politics, and a stock doesn’t know you own it. It’s a mistake to fall in love with something that can’t love you back.

The sixth Commandment says we should keep our emotions in check. For investors, that’s a discipline that will never go out of style.

Douglas R. Tengdin, CFA
Chief Investment Officer
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Ten Commandments for Investors (Summary)

Many commentators have noted that the second five of the Ten Commandments have a different focus than the first five: while the first group focuses on the believer’s relationship towards God, the second set emphasizes the his or her relationship with others.

This may be the reason why Jesus, in a famous encounter, is said to have summarized the Ten Commandments—and indeed the full corpus of Jewish law—into two principles: love God, and love your neighbor. His “first and greatest” command, to love God, is taken directly from the Jewish “shema,” the Hebrew creed that a faithful Jew would recite daily. The second, while less prominent in the Old Testament, effectively encapsulates commandments six through ten, and indeed much of Jewish law: love your neighbor as yourself.

In applying these principles to managing money, investors need to focus on their attitude first towards the markets, and second towards other investors. The first command tells us to respect the markets, their complexity, integrity, and wisdom. It’s not a small thing to disagree with the market’s assessment of what a stock or a bond may be worth. Jesus’ second command—which is like the first—advises us to respect other investors—their rights and protections—not just under investing law, but also under ethical and moral codes of fiduciary conduct that have been worked out over centuries.

For example, respecting other investors means keeping confidential matters confidential. If someone shares his or her personal information with you, you have no right to tell others about this, unless they give you permission. Confidentiality is crucial. Other fiduciary duties can similarly be derived from this simple principle of respect.

Jesus’ synopsis of the Ten Commandments is a reminder that much investment wisdom is simple, but not easy. Respecting the market means that investing is hard work, and requires significant mental and emotional energy. And respecting other investors is a good way to stay out of trouble.

Douglas R. Tengdin, CFA
Chief Investment Officer
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Banking on Ratings

Moody’s just downgraded a lot of banks. What does it mean?

Yesterday Moody’s Investor Services lowered the credit rating that they assign to 15 global banks. Large banks from the North America and Europe were all dropped one to three notches in Moody’s view. No one was dropped to junk bond status, and for the most part, the relative pecking order among banks was preserved: in the US, JP Morgan is still on top; in Europe it’s HSBC. So what changed?

These are all banks that have large investment banking operations. Banks that just focus on plain-vanilla banking—taking deposits and making loans—weren’t affected. But it’s a truism to say that large banks have significant exposure to the global capital markets. For large companies, the global capital markets is where they need to go to raise the money they need for operations and investment.

Moody’s says that the volatility of the markets has increased, and banks that are exposed to this need larger shock absorbers, either in the form of greater capital, earnings from diverse subsidiaries, or a strong risk-management culture.

Because no one was downgraded to junk and the ordering of the banks hasn’t changed, it’s tempting to say that Moody’s global downgrade is a bureaucratic exercise designed to limit their liability in case something really goes wrong—if, for example, Greece leaves the Euro and a large, global bank gets taken over by the government. Then Moody’s can say, “It wasn’t us! We warned you!”

While that’s true, buried in their 57-page report is this nugget: several banks still have legacy problems from the financial crisis that haven’t gone away—but most have cleaned up their balance sheets. The financial world may still be a volatile place, but some banks are clearly ports in a storm.

As always, with the ratings agencies, ignore the ratings themselves. Those are too political. Instead, focus on the report. That’s where any new news is.

Douglas R. Tengdin, CFA
Chief Investment Officer
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Models Behaving Badly

Physicists are looking for the “God particle.” Could its discovery affect investments?

The scientists at the CERN Institute are huddling over the results of some supercollider experiments. They show a tantalizing bulge in the curves that has a “one-in-a-thousand” chance of being random. That is, there’s a very good chance that the scientists have found evidence of the Higgs Boson, a long-predicted but never-observed key to the Standard Model of physics.

The Standard Model is a set of physical theories that combines the forces of gravity, electromagnetism, weak, and strong nuclear interactions. The Higgs Boson is a key to this theory, because according to the model, it explains why fundamental particles have mass. It’s the only particle predicted by the Standard Model that hasn’t yet been discovered.

In finance there is no standard model, no broadly accepted theory that purports to explain why markets behave the way they do. Instead, we have rational expectations and efficient markets, behavioral finance, Austrian economics, Keynesian and neo-Keynesian models, and a host of micro-applications, like public choice theory and the theory of the firm. But there is no overarching framework that holds them all together, no “one ring” that binds them.

In part, that’s because finance describes people’s economic behavior, and people are funny subjects. They generate feedback effects that can counteract a model’s carefully quantified predictions. But similar problems vexed physicists 100 years ago. It took them 70 years to formulate the Standard Model, and it is now being challenged by the elusive “God particle.”

Someday we may devise a Standard Model of finance. In the meantime, we’ll just have to keep searching.

Douglas R. Tengdin, CFA
Chief Investment Officer
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Chapter and Verse on Greece

Will Greece get a break on its debt?

The Greeks have been cutting public sector wages and increasing taxes in an attempt to reign in their budget deficit. Even so, their level of government debt is around 2 times the size of their economy, and their economy is stalling out in a highly regulated environment.

The austerity measures are designed to bring the government budget into balance, so Greece can pay down enough of its debt by 2020 so that it can go back to the capital markets and borrow on its own. Until then, the other European countries are committed to providing financing so Greece can continue to service its existing debt.

The focus is the time-frame. Anyone who thinks they can predict what a volatile economy is going to look like eight years from now is too clever by half. Nevertheless, the current schedule gives the Greek officials a framework within which to implement their reforms.

But therein lies the rub. That schedule is what the parties need to negotiate, or re-negotiate. In the US we have a bankruptcy system that shares out responsibility for restructuring people’s finances. The key issue is that responsibility is shared. But that’s not what seems to be on tap in Europe. They seem to want to put Greece into debtor’s prison, with a goal of reducing its budget deficit from 9% of GDP last year to 2% by 2014. This isn’t realistic.

Yes, the Greeks borrowed the money; but their creditors lent the money. Both sides have to sacrifice, and no one gets everything they want. At the end of the process, though, bankruptcy gives people a clean slate. That’s what Greece needs now.

Douglas R. Tengdin, CFA
Chief Investment Officer
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European Options

What’s up with government bonds?

On the face of it, global bond yields appear to be at crazy levels. Ten-year government bonds vary from insanely low levels, like Japan and Switzerland at less than 1%, to Italy and Spain near 6% or even 7%. In the middle are the US and the UK, with their ten-year bonds yielding around 1.5%, even as long-term inflation runs around 2-2.5%. It looks like investors are paying their governments for the privilege of parking their money.

So is this a free lunch for the favored governments? Short-term bonds really look like a free lunch: Japanese yields are virtually zero, and Swiss two-year bonds actually have a negative nominal yield of -0.50%.

It’s tempting to just say this is nuts and walk away, but we’ve actually seen this sort of thing before. In the late ‘80s and early ‘90s very short-term yields went wild in Europe because currencies were under attack. Member currencies traded within narrowly defined bands, and when there were expectations that a band would be adjusted, short-term deposit rates would either soar or crash, depending on whether speculators were going short or long that currency.

The same thing is happening now. So if you take the US, UK, and Canada–large, diversified economies that manage their own money supply–as neutral, their five-year bonds yield between 0.5-1%. Below that are Switzerland and Japan, whose currencies are widely expected to go up. And above that are the peripheral European nations—Italy, Spain, and Portugal—which may have to leave the Euro and go back to having their own, depreciating currencies.

An appreciating currency is hard for an economy to swallow, just as depreciating currencies punish investors and savers. There’s still no free lunch.

Douglas R. Tengdin, CFA
Chief Investment Officer
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Greek Drama

It looks like the Greeks just voted to stay in the Euro. What does this mean?

In the short-run, this eases fears of an imminent rupture within the Euro zone, where Greece could be the first of a number of indebted countries departing the common-currency area. The fear is that a Greek exit would trigger financial contagion that might threaten financial institutions around the world.

Those fears have been allayed for the moment. By itself the vote doesn’t solve Greece’s problems, but it does represent a victory for rational finance: in the aggregate voters seem to understand that there is no free lunch—bills need to be paid, debts need to be honored, and you can’t just sprinkle pixie dust over a financial crisis and declare that it’s over.

But after a brief rally, markets have settled back. All eyes are now on Germany, whether they might be willing to accept some concessions in Greece’s fiscal adjustment program, especially in the pace of budget cuts required of the government. All eyes are also on Spain, which had its debt rating cut recently to BBB, the lowest level that is still considered investment-grade. Spanish yields have soared recently to over 7%.

But this is how the world grows: not with a bang but with a series of pops. The US market is near the top of its 12-month range, and most European markets are in the middle of their ranges. Bull markets climb a wall of worry, and Europe has given them plenty to worry about. Let’s hope they can keep climbing.

Douglas R. Tengdin, CFA
Chief Investment Officer
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A World in Crisis?

Having looked at the first five of the Ten Commandments, it’s time to take a break and discuss some other issues. One of the most pressing is the state of the global economy.

With Greek elections coming up this weekend and the leaders of Europe holding an economic summit towards the end of the month, it’s appropriate to ask whether the world’s economy is in crisis. Unemployment in the US is stubbornly high, and it’s worse in Europe. Their finances are in a shambles, with over-indebted countries paying very high interest even as their economies contract. Falling demand in Europe contributes to slowdowns in China, India, and Brazil, affecting US exports as well.

But is this a crisis? Continue reading A World in Crisis?

Ten Commandments for Investors (Part 5)

Often people have difficulty remembering all of the Ten Commandments. But the Fifth Commandment, “Honor your Father and Mother,” is one that many recognize right away.

The wisdom of honoring one’s parents seems self-evident: their experience, their greater knowledge, and the effort they put in to care for and raise their children is naturally worthy of respect. And we even have special days set aside for this purpose: Mother’s Day and Father’s Day. But it’s easy to forget. We seem to have attention deficit disorder when it comes to remembering the work and sacrifice of our parents as we were growing. So it’s a good thing to be reminded.

Because it’s easy to imagine that things are different now, that the trials and pressures that we face are nothing like those our parents experienced, and so their wisdom and insight just don’t apply to our current situation. But history, while not repeating itself, often does rhyme, as Mark Twain once said. The challenges and tests we experience aren’t so different from what our mothers and fathers faced, and we can learn from their success and failure.

In the same way, it’s easy to dismiss the lessons of investment history and say, “It’s different now.” In many ways, it’s always different—there is always new technology, new geopolitical challenges, and new investment opportunities. This is why the market periodically puts its faith in “go-go” young people who aren’t burdened by the wisdom of experience.

But it’s never really different. There’s no new history, only old history happening to new people. Those “go-go” periods in the ‘60s, ‘80s, and ‘90s didn’t end well. The lessons of history shouldn’t be slavishly copied, but they need to be honored and respected. And what are some of those lessons? Valuation matters, risk matters, and what has happened before will happen again—although not right away or the same way.

Honoring our parents is wise. It’s good, and good for us. Respecting the lessons of history is good for our portfolios.

Douglas R. Tengdin, CFA
Chief Investment Officer
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