The Young and the Reckless

Is it smart to be stupid?

Are the incentives in trading and financial markets so skewed that it’s profitable to be foolish and reckless? It sure seems so. One of the frequent targets of financial reformers is proprietary trading—the infamous “prop desk.” At this work-station, young men and women stare at multi-screen monitors all day, divining relationships between volatility, forward rates, overseas markets, and other traders. The goal is to get 15 seconds to 15 days ahead of the next trend, and ride it to a profit.

The pay-structure at the big banks and hedge funds creates a moral quagmire. Traders earn a base salary, enough to live comfortably in a big city. But they also receive an annual bonus, typically 10-15% of their trading profits. Have a good year, and that bonus can total tens of millions of dollars. Have a bad year, and you may not get a bonus. You may even get fired. But you never have to pay back your prior earnings.

The problem is the asymmetry: win big and you can get fabulously wealthy; lose big and go home and look for a new job. And it’s a pretty simple system to “game”: start small, build credibility, and get your trading limits expanded. Then bet big–really, really big. If you win, you may just have earned enough to fund a lavish retirement, your children’s and grandchildren’s college education, and a new hospital wing in your name. Lose, and—perversely—you may have gained enough credibility to start your own hedge fund.

Wall Street is littered with traders who have blown up their employers, their clients, and much of the financial landscape. As long as traders can just walk away from huge losses, they’ll just keep blowing things up.

Douglas R. Tengdin, CFA

Chief Investment Officer

An Italian Job?

In the 1969 British caper film The Italian Job, Michael Caine assembles a team of criminals to steal a load of gold bullion from Fiat headquarters in Torino. In a series of mad-dash chase scenes and high-wire stunts, the crooks pull off the heist and head off to Switzerland, leaving the city in chaos

In a remarkable parallel, Bunga-Bunga master Silvio Berlusconi has engineered his own high-wire electoral comeback, pushing Italian politics into gridlock and threatening the stability of the European common currency.

Italy’s economy is the third-largest in Europe and the third-most indebted in the world. But much of their debt was incurred over 20 years ago. For most of the past decade, they have run a primary budget surplus, only in deficit by interest payments. And most of their debt is long-term. They do not face an immediate funding crisis.

Nevertheless, the austerity measures of technocratic leader Mario Monti have not set well with the electorate. The economy is in recession and his party finished fourth, behind that of a former communist, a former television clown, and Berlusconi. With Italy’s lower house and upper chamber in flux, it’s hard to tell who’s in charge.

Given their weak economy, Italy needs financial support. The European creditor nations have been willing to help, but they want someone responsible to negotiate with—and that’s just what they don’t have. Like the movie, the outcome is a cliffhanger.

In the movie’s ending, the escape vehicle teeters on the brink of a precipice, the stolen gold pulling it over the edge. In the same way, Italy’s hard-money could be pulling its economy over the edge. And just like the movie, we don’t know how this will end.

Douglas R. Tengdin, CFA

Chief Investment Officer

Building For The Future (Part 7)

Home maintenance isn’t on most people’s list of favorite things to do, but without scheduled upkeep, bad things happen. Hot water tanks rust, roofs leak, painted walls start peeling, and your shiny new home begins to look tired and frayed around the edges. In the same way, an investment portfolio needs to be maintained if it is to continue to meet your needs.

There are two major forms of adjustment to an investment portfolio: strategic and tactical. Strategic adjustment has to do with you–you do a strategic reevaluation when your circumstances change. Tactical adjustment has to do with the securities in the portfolio—usually when an asset class does a lot better or worse than the overall market.

Rebalancing at these times encourages investors to buy assets that have done poorly, and to trim holdings that have done well. While this is psychologically hard, it’s a good way to add value over time. It helps people to sell stocks when they’re hot, and to buy them when they’re not. But be careful. A stock that sold at 50 isn’t necessarily cheap at 25, if their business model is broken. At such times it pays to be cautious.

When the whole market becomes irrationally exuberant or gloomy, though, it makes sense to rebalance. If you had a balanced portfolio in 1985 and rebalanced it whenever it got to 60/40, you would have added 25% to your portfolio over the next two decades, purchasing equities in 1993 and buying bonds in 2000.

Portfolio maintenance isn’t terribly exciting, but it’s necessary. Sometimes the most mundane tasks that turn out to be the most valuable.

Douglas R. Tengdin, CFA

Chief Investment Officer

Building For The Future (Part 6)

Finishing out your home is a big part of the building process. Setting up electrical outlets, plumbing, heating, flooring and other details will, in many ways, determine how enjoyable it is to live there. Your structure may be sound; your plans perfect; your layout exactly suited to your needs; but if there aren’t enough outlets in the kitchen, or the cable connections are in the wrong place, you’re not going to be happy.

In the same way, investment reporting establishes the way that you interact with your portfolio. Some people want as much detail as possible—individual asset data, updated monthly. Others just want to see a broad overview, perhaps annually or quarterly. Most people want something in between. But everyone wants some type of presentation of where they are and what has happened.

There are essentially three types of reports: position reports, activity reports, and performance reports. Position reports tell you where you are. There is usually some kind of asset-allocation overview, along with a listing of individual assets. The way assets are listed is important—how items are presented frequently will determine what we see. The best layout is by economic sector, with some consideration of you position’s size. That way you can quickly see how diversified or concentrated your portfolio is.

Next is activity—buys and sells, and payments or stock splits. It’s important to know what’s happening with your investments. Unfortunately, this is where many systems get bogged down. There’s too much detail and users get overwhelmed. A simple overview usually suffices. Finally, there is performance reporting. Again, there are many choices, but a simple time-weighted presentation of portfolio performance—with perhaps a breakout for stocks, bonds, and cash—is usually enough. It’s often the case that less is more—simple well-designed reports are better than lengthy tomes filled with mind-numbing detail.

Reporting may seem like a minor detail, until you have to deal with a poorly designed and executed system. But details matter. Getting them right can make all the difference.

Douglas R. Tengdin, CFA

Chief Investment Officer

Building For The Future (Part 4)

Once you have blueprints and a foundation, what do you do? The next issue builders face is choosing materials—balancing cost and quality. And the next choice for structuring a portfolio is asset allocation.

Asset allocation balances risk and return. Different investment vehicles represent different forms of ownership, stand in different places in the capital structure, and so bear different levels of risk. In general, the more junior the claim your asset has on the cash flow of an entity, the more the risk that you don’t get paid, but the more upside you have if things work out, or if the business grows.

For example, bonds represent a senior claim on operating cash flow. For a business not to pay its bonds, it has to go through bankruptcy—a laborious and disruptive process, in which managers often lose their jobs. So people usually avoid this, and bonds usually get paid. Stocks, on the other hand, represent the most junior claim, and dividends get cut all the time. Shareholders can face losses for all sorts of reasons. But they also benefit the most if the business grows.

Other assets represent different sorts of claims. Short-term treasury bonds are the least risky asset out there. It’s almost inconceivable that a government won’t pay its debts in its own currency. After all, it can always print more! This could lead to inflation, but short-term bonds can be reinvested at the higher rates, so they’re less risky than long-term bonds, which bear inflation risk. Government bonds from states and municipalities—that don’t issue their own currency, but that do collect taxes—are a little more risky, but if the economy is growing and the local government is credible, they’re safer than almost everything else.

And then there are other sorts of securities—real estate trusts and master-limited partnerships. These instruments use various legal structures to reduce taxes. They’re not appropriate for all investors, though, so you need to do your homework!

Asset allocation is a critical step—but it flows from having a plan and policy specific to your needs. It balances the risk/return trade-off, and helps keep your portfolio on-track.

Douglas R. Tengdin, CFA

Chief Investment Officer

Building For The Future (Part 3)

What’s the foundation for good investing?

It’s a good question. Because foundations are—well—foundational. They support everything else. If a building’s foundation isn’t sound, the structure itself won’t be stable. Joinings will fail, and eventually the entire building will come down. A good foundation goes below any disruptive influences—like frost—and keeps things true. It allows you to build a much more interesting structure.

In the same way, an investment portfolio needs to have a sound foundation. And the foundation of any portfolio is the investment policy—the document that specifies the required return, the risk tolerance, and various constraints: time-horizon, liquidity needs, tax considerations, the legal and regulatory framework, and any other considerations.

The required return is simple: money needed divided by money available over time. Yes, compound interest makes the required return smaller, but only over long periods—ten years or more. So, if you have $50,000 and need it to double over 20 years, that implies a 5% return. But the actual required return is 4% due to compounding. A simple spreadsheet can calculate this

Once you have your needed return, you should determine how much risk you can deal with. Risk is on most people’s mind these days. Stocks underwent a 50% decline in 2008, just as they did in 2001 and in 1974. If you can’t live with this sort of volatility, you need to pare it down by owning a proportional amount of bonds and cash.

Other constraints need to be specified as well. These things don’t change with the investing climate, and can serve as touchstones when market conditions become unsettling. The policy isn’t disrupted, because it doesn’t depend on market conditions.

A good foundation makes for a good structure. And a well though-out investment policy is more likely to lead to investment success than all the bull markets in the world.

Douglas R. Tengdin, CFA

Chief Investment Officer

Building For The Future (Part 2)

How do you craft a portfolio?

Assembling a financial portfolio is a lot like building a house. Everyone has a basic need for shelter, but once you get beyond the basics there are all kinds of decisions to make—where to locate, how big to make it, what kind of materials to use, and so on. Building a home can be stressful—but it can be exhilarating, too.

In the same way, putting an investment portfolio together can be stressful but also can be exciting. The projects are similar, especially because they both start with the owner’s needs, desires, and resources. By taking stock of yourself, you end up with a much more satisfying product.

The first question to ask is what do you want your portfolio to accomplish. Some people are looking for supplemental income, others are saving for their children’s college tuition, and other people have other goals. Whatever the objective is, write it down.

Then try to make a rough estimate as to what this will cost. For example, many private colleges cost about $200,000 over four years. If you can only set aside $400 / month, that will accumulate $72 thousand over fifteen years. If you want to have half the cost of college saved up, this goal implies that you will need about a 5% return over this period. If you can save more, your required return is lower.

Your required return will indicate what kinds of assets you need to invest in. Everyone wants safety—but most people also need growth. By specifying your objectives, you can sketch out a plan that is more likely to meet your needs, without keeping you up at night.

Douglas R. Tengdin, CFA

Chief Investment Officer

Building For The Future (Part 1)

In many ways, assembling an investment portfolio is like building a house.

Both tasks are public and intensely personal. Both require diligence and expertise. And both have general principles that everyone needs to follow, if they want to be satisfied with the result.

In both building a house and a portfolio you don’t begin by buying nails, you start by going over a set of plans—the blueprints. These make it clear how your home will be sited, what the layout will be, and the general framework. In the same way, an investment plan will tell you what your money is supposed to accomplish—whether it’s supplementing your income, saving for retirement, or establishing a personal rainy-day fund. In both cases the plan starts with your desires and limitations.

From planning, you move on to laying a foundation. And the foundation of any successful investment process is the investment policy. The policy will specify what the required return is, how much risk you can handle, and other restrictions, such as tax considerations, liquidity needs, your time-horizon, and so on. In any building project, the foundation is what supports the structure. When you’re investing, the investment policy supports every subsequent decision.

From the foundation, we go on to choosing materials. In investing, that’s your asset-allocation decision. When you build, you have to decide between quality and price; with investing, the trade-off is between risk and return. Assets with higher return potential have greater risk to them—it’s inherent to the asset. This is because what allows them to grow—either faster or slower—makes them more risky. It’s usually their position in the legal or economic capital structure that creates the risk.

Framing up the structure is like purchasing the stocks, bonds, and other instruments. And like putting up a frame, execution is everything. A great plan poorly executed won’t make anyone happy. Finishing out the home is akin to setting up proper reporting and access rules. You may have a superior structure, but if the details bother you, you won’t be happy. And home maintenance is like portfolio maintenance: evaluating and adjusting as time goes on.

The parallels are striking—and encouraging. Because building a home isn’t a mystery, it’s a rational process that takes discipline and planning. And everyone has one sort of home or another. It’s just a question of what kind of home we want.

Douglas R. Tengdin, CFA

Chief Investment Officer

The End of Economics?

Did economists “get it all wrong” during the Great Recession?

Certainly a lot of economists have made a lot of mistakes. Ben Bernanke, former Professor of Economics at Princeton, thought the problems in the sub-prime mortgage market were limited and contained in March of 2007. Greg Mankiw, Professor at Harvard, predicted that housing prices would stop rising so fast back in 1995, because most baby-boomers now owned a home. When you analyze something as complex and multifaceted as an economy with billions of prices and trillions of interactions every day, you’re bound to get some things wrong.

But what is the point of economics? Is it supposed to predict the future, or analyze the present? The economics profession has debated this point since the mid-19th century, with the rise of the German Historical School. These scholars objected to the analytical approach of the Classical economists like Alfred Marshall and Adam Smith. Smith’s claimed that his principles were universal, applying to all people in all nations. The Historical School thought that economics should result from careful historical analysis rather than logic and mathematics. Max Plank, the famous German scientist, once considered studying economics but found the combination of historiography, sociology, and psychology too difficult, so he went on to win a Nobel Prize in Physics instead!

At its heart, this debate over method contained a broader question: is the economist a student, or a savior? Karl Marx demonstrated his impatience with analysis when he wrote, “The philosophers have only interpreted the world in various ways; the point, however, is to change it.” His economic works certainly did change the world, although his analytical errors led to tragic outcomes for hundreds of millions of people.

Many economists have taken up the challenge, however, advocating for or against various public policies. And when it comes to government taxes, spending, and regulation, we want laws that are logical and provide the right incentives and constraints. But economics is a social science, not a physical science. Its principles are general and provisional—although some are more provisional than others. And economic predictions are—or should be—always tentative and subject to revision.

In the end, I believe that an economist should be a student of history and should seek to understand the world, not change it. Because if they get it wrong, the consequences can be dire. And, as another Nobel prize winner, the physicist Niels Bohr once said, predictions are hard, especially about the future.

Douglas R. Tengdin, CFA

Chief Investment Officer

The Wealthy Mindset

What does it take to build wealth?

Like many in my generation, I grew up watching Gilligan’s Island. My idea of a rich person was shaped by the behavior of Thurston Howell III and his wife “Lovey.” Week after week, they washed and dried their green-backs and did other silly things. What they wanted the currency for while stranded on a desert island was never clear.

But the world is full of lots of non-fictional millionaires. Their lifestyles can be instructive. In his book The Millionaire Next Door Thomas Stanley examined how they live and, more importantly, what their attitude is about money. What he learned is instructive.

First, they tend to live modest lifestyles. The average home price of someone with $2-5 million was about $350 thousand—comfortable, but not opulent. They rarely buy new, late model cars, preferring older models or even used cars. And they rarely financed their purchases, preferring to avoid the interest expense.

On the other hand, they were willing to borrow—for business opportunities. When the situation presented itself, they weren’t afraid to borrow to invest in their business. For the most part, they love what they do, and are usually more interested in building a business than in making a bundle.

Above all, they lived within their means, spending less than they made. Sometimes that meant detailed budgets; other times it was a savings plan that set aside the money before they saw it. In most cases they understood that the best things in life aren’t things, and that what really counts in life can’t be counted.

What’s really striking about this study is the fact that if people focus on status and what they can buy, they usually can’t afford it. But it’s the patient saver who maxes out his 401(k) and re-soles his shoes who often ends up owning the business.

Douglas R. Tengdin, CFA

Chief Investment Officer