Good Reading -- September 2011

September 10, 2011

Links

  1. "The 14 Biggest Ideas of the Year" -- The Atlantic's annual "guide to the intellectual trends that, for better or worse, are shaping America right now." 

  2. "Do You Suffer from Decision Fatigue?" -- interesting essay adapted from a new book by the same author, "Willpower: Rediscovering the Greatest Human Strength."

    • "Decision fatigue helps explain why ordinarily sensible people get angry at colleagues and families, splurge on clothes, buy junk food at the supermarket and can’t resist the dealer’s offer to rustproof their new car. No matter how rational and high-minded you try to be, you can’t make decision after decision without paying a biological price."

  3. "Is the SEC Covering Up Wall Street Crimes?" -- the latest from now infamous hair-puller Matt Taibbi, of vampire-squid fame. This is full of the usual hysteria and half truths (Steve Cohen is a billionaire; some people might think he's reptilian; but he's not really a short-seller), but I'm including it because there are real facts behind the story -- namely, the SEC, in all of its incompetent glory, has apparently been shredding thousands and thousands of documents of cases that never made it to a formal investigation. Included prominently among those lost documents are many pertaining to Madoff,  AIG, Lehman, Goldman, et al. If you'd like a shorter, less hysterical version, gohere. 

  4. "Current Account Dilemma" -- here Michael Pettis frames monetary policy and international trade flows in a useful way as pertaining to Germany-E.U. and U.S.-China current accounts. (Thanks to James R. for finding this and passing it along.)

  5. "The God Clause and the Reinsurance Industry" -- a good primer on reinsurance and a deeper look at "unknown unknowns," with examples such as 9-11 and U.S. hurricanes. "Between catastrophes, the new capacity drives premiums back down and reinsurers are forced to undervalue risks to stay in the market. Vincent J. Dowling of Dowling & Partners refers to this as the 'cheating phase' of the cycle. That is, even though catastrophes present an existential threat to insurers, and the sober assessment of risk is a firm-defining competency, insurers, like people, can get complacent. 'The psychology piece dominates, even in boardrooms,' says David Bresch. 'People measure against the perceived reality around them and not against possible futures.'”

  6. Interview with Stephen Penman --  a good conversation with the author of "Accounting for Value" (which I recommend), conducted by Jacob Wolinsky. I also agree that FV accounting is very dangerous and creates more problems than it solves.

  7. "Rich Pickings: Profiting on Principle" and "Corporate Governance and National Prosperity" -- as a follow-up to the article a while back on Richard Chandler, and in light of his recent investment in Sino-Forest, here's a couple of interesting things. 

  8. "How AT&T Conquered the 20th Century" -- an interesting history of the company broken into separate eras from 1879 to the present day and the (now questionable) proposed merger with T-Mobile.

Attached

  1. "Interview with Edward O. Thorp" -- interesting discussion of gambling, math, and investing. 

  2. "Grant's Interest Rate Observer" -- a free summer edition including a some interesting articles from old issues. The article on Henry Singleton beginning on page 8 is highly recommended. In 1980, Buffett said he "considers that Henry Singleton of Teledyne has the best operating and capital deployment record in American business." Distant Force, a book about Teledyne and Singleton, is highly recommended as well. For a great profile on Singleton seethis article in Forbes in 1979, which I've attached and sent around before.

    • The "Bonanza" article on p. 20 also dovetails with the Lowenstein article on the gold standard from last time. 

  3. "The Second Coming of Steve Jobs" -- following the sad news of Steve Jobs's resignation for health reasons, I thought I'd follow up on that fascinating Playboy interview from 1985 (email me if you need a copy) with a very good profile of Jobs in Esquire in 1986. "'I think I have five more great products in me,' Jobs says, and then goes off on a long, rambling discourse on the travails of working on computers at this particular moment in history. He compares it to what it must have been like to work for Henry Ford when the automobile was still in its infancy and the technological boundaries were there to be broken. 'It must have been the most incredible feeling to know that this was going to change America. And it did! If we can create the kind of company I think we can, it will give me an extreme amount of pleasure.'"

    • A Fortune article earlier this year also looks at Apple's culture and Jobs's managerial style. (subscription required)

    • More interesting Jobs stuff is here and here.

  4. "The Inevitable Superpower -- Why China's Dominance is a Sure Thing" -- I get really, really nervous when "inevitable," "dominance" and "sure thing" are throw together in the same sentence...especially when that declaration is based on "fairly conservative assumptions" that produce a 7% annual, compounded economic growth rate over the next 20 years. (That would mean China's economy is set to double twice in that span, despite a population that will go from growth to stagnation -- at best -- in that period. Could a country with 4x the people grown enough to achieve one-third the wealth of Americans and thus be a much larger economy in absolute terms? Of course it could. But that is far from a slam dunk given the political system, economic constraints, and demographic problems that China faces in the next decade or two. That said, there are some interesting thoughts in here. I also have a copy of the Sept. '11 issue of "China Economic Quarterly" -- email me for a copy (it's a huge pdf).

  5. "They're in No Hurry" -- a good profile on Tweedy, Browne (and others) focusing on low-turnover investors.

Copied Below

  1. "The Mutual Fund Merry-Go-Round" -- a very good and very important article from the eminent investor David Swensen. Anyone who invests in mutual funds should make this required reading. Unfortunately, I don't think his recommendations are going to make much of a difference. Greedy brokers/advisors, performance-chasing and investors' other illogical behaviors can't be regulated away, although they obviously can and should take more personal control of their investments. And the low-cost approach is almost always the best bet.  

  2. "Advice from a 105-Year-Old Banker" -- ignore the idiot who wrote the (title of the) article. Irving Kahn is a great investor (and a living legend), not an investment banker. "I stopped wasting time on what [other] people claimed a stock was worth and started looking at the numbers. This may surprise you, but there were a large number of valuable buys during the Depression." Another profile from 2009 is here. 

  3. "Asking the Right and Wrong Questions" -- good insights and advice from Dan Ariely regarding financial advisors/consultants for anyone who might be so inclined as to use their services. 


 

The Mutual Fund Merry-Go-Round

By DAVID F. SWENSEN

David F. Swensen is the chief investment officer at Yale University and the author of “Unconventional Success: A Fundamental Approach to Personal Investment.”

New Haven

AS stock prices have gyrated wildly, many investors have behaved in a perverse fashion, selling low after having bought high. Individual investors bear some responsibility for ill-advised responses to the ups and downs in the market, but they are not the only ones to blame. For decades, the mutual fund industry, which manages more than $13 trillion for 90 million Americans, has employed market volatility to produce profits for itself far more reliably than it has produced returns for its investors.

Too often, investors believe that mutual funds provide a safe haven, placing a misguided trust in brokers, advisers and fund managers. In fact, the industry has a history of delivering inferior results to investors, and its regulators do not provide effective oversight.

The companies that manage for-profit mutual funds face a fundamental conflict between producing profits for their owners and generating superior returns for their investors. In general, these companies spend lavishly on marketing campaigns, gather copious amounts of assets — and invest poorly. For decades, investors suffered below-market returns even as mutual fund management company owners enjoyed market-beating results. Profits trumped the duty to serve investors.

Mutual fund companies, retail brokers and financial advisers aggressively market funds awarded four stars and five stars by Morningstar, the Chicago-based arbiter of investment performance. But the rating system merely identifies funds that performed well in the past; it provides no help in finding future winners. Nevertheless, investors respond to industry come-ons and load up on the most “stellar” offerings.

In 2010, investors redeemed $152 billion from one-star, two-star and three-star funds and placed $304 billion in four-star and five-star funds. In the crisis-scarred year of 2008, even as investors withdrew $174 billion from one-star, two-star and three-star funds, they added $47 billion to four-star and five-star funds. Year in and year out, flows to four-star and five-star funds prove remarkably resilient and overshadow flows to the three bottom categories.

This churning of investor portfolios hurts investor returns. First, brokers and advisers use the pointless buying and selling to increase and to justify their all-too-rich compensation.  Second, the mutual fund industry uses the star-rating system to encourage performance-chasing (selling funds that performed poorly and buying funds that performed well).  In other words, investors sell low and buy high.

Ill-advised buying and selling of funds costs the investing public a substantial sum. In 2010, Morningstar found that if mutual fund investors in 2000, as a whole, had simply bought and held their funds for 10 years, their investment outcomes would have improved by an average of 1.6 percentage points per year. That 1.6 percent may not sound like much, but it adds up to tens of billions of dollars per year. Another Morningstar study, in 2005, examined 10 years of returns for 17 categories of stock funds. In each category, the actual returns — after taking into account the ill-timed buying and selling — fell short of the returns that were advertised to the public. More stable funds performed better; more volatile funds performed worse.

Highly volatile technology funds, for example, generated annual returns that were a stunning 13.4 percent below the reported results, as a direct result of monumentally mistimed buying and selling. Holders of less volatile conservative allocation funds suffered only a 0.3 percent annual deficit. 

Even while the investing public suffers from exposure to funds with volatile performance, the mutual fund industry benefits. With a volatile set of offerings, the fund companies will always have some (temporarily) strong performers that rise to the top and earn the four or five stars needed for marketing to a gullible public. Of course, the volatility cuts both ways, ensuring that erstwhile top performers fall to the bottom and end up with one star or two stars. From a business perspective, however, all is not lost, as a number of one-star and two-star funds, with sufficiently volatile strategies, will rise phoenix-like from the ashes and join the exalted ranks of four- and five-star funds.

Why isn’t there more of an outcry? Investors naïvely trust their brokers and advisers. Most understand too little about financial markets to make informed decisions, intervene too frequently in counterproductive ways and gather too little information about portfolio holdings to evaluate results. Investors like to believe they are doing well, even when they are not.

Meanwhile, the mutual fund industry shouts through a megaphone, making campaign contributions to influence politicians and lobbying to avoid regulation. Without any offsetting pressure from the investing public, Wall Street crushes Main Street.

What should be done? First, individual investors should take control of their financial destinies, educate themselves, avoid sales pitches and invest in a well-diversified portfolio of low-cost index funds, like those offered by Vanguard, which operates on a not-for-profit basis. (Even Morningstar concludes, in a remarkably frank study, that low costs do a better job of predicting superior performance than do the firm’s own five-star ratings.) Such a strategy reduces the fees paid to the parasitic mutual fund industry, leaving more money in the hands of the investing public.

Second, the Securities and Exchange Commission should employ its considerable regulatory and enforcement powers to encourage individual investors to embrace low-cost index funds and shun the broker-driven churning of high-cost, actively managed funds.

The S.E.C. should think outside the box in policing the behavior of the mutual fund industry. What about a requirement that every mutual fund offering be accompanied by an index-fund alternative, with the burden of proof on the vendor to justify the sale of a high-cost product? Fund companies, brokers and advisers would have to list all fees associated with the fund offering, along with a description of the impact on expected returns. Over time, mutual fund purveyors would have to provide a head-to-head comparison of the recommended fund and the index fund alternative (including the impact of taxes), demonstrating as clearly as possible the long-term superiority of low-cost, tax-efficient index funds.

 Third, the S.E.C. should hold the mutual fund industry to a “fiduciary standard,” one that puts clients’ interests first. Currently, retail brokers operate under a weaker standard. As it carries out the Dodd-Frank reform act that became law last year, the S.E.C. must insist that brokers act as fiduciaries, not merely as agents who offer “suitable” investments. For all players in the mutual fund industry — brokers, advisers and fund managers — strong fiduciary standards and investor-oriented regulatory oversight would subordinate the pecuniary interests of the fund purveyors to the interests of the individual investors that the industry purports to serve.

For two decades, laissez-faire attitudes toward financial markets allowed the rich and powerful to take advantage of those less well-off. In the mutual fund world, the hands-off approach must be abandoned in favor of aggressive, intelligent regulation.

This is serious business. The financial security of millions of Americans hangs in the balance. 

 

 

Advice From a 105-Year-Old Banker

As markets gyrate wildly, Irving Kahn, who at 105 is perhaps the world's oldest investment banker, says not to worry—the economic downturn is just a blip.

by David Dudley | August 15, 2011 12:59 PM EDT

The stock market is imploding, Europe is on the brink, and, if the doomsayers are to be believed, we could be headed for a double-dip recession.

None of that worries Irving Kahn, perhaps the world’s oldest working investment banker. “There are a lot of opportunities out there, and one shouldn’t complain, unless you don’t have good health,” says Kahn. At 105, he might well be the last man on earth who can speak authoritatively on both longevity and making money amid a historic market meltdown. In 1928, at the age of 23, he went to work on Wall Street as a stock analyst and brokerage clerk. By the tail end of the Great Depression, in 1939, he’d made enough money in the market to move his wife and two children out of public housing and into their own house in the suburbs.

Kahn is still in the game, waking every morning at 7 and going to work as chairman of Kahn Brothers, the small family investment firm he founded in 1978. Until a few years ago, he took the bus or walked the 20 blocks from his Upper East Side home to his midtown office. “For a 105-year-old guy, it’s pretty remarkable,” says Thomas Kahn, Irving’s 68-year-old son and the company’s president. “I get tired just thinking about it.”

Perhaps his closest rival for the title of oldest person working in the securities industry was the financier Roy Neuberger, who passed away in 2010 at the age of 107. But Neuberger had retired at 99. Two of Kahn’s older sons, both in their mid-70s, have likewise retired.

Small and gnomish, Kahn counsels patience in hard times as he holds forth on market distortions and the roots of economic unrest, which he pins on “a bunch of gamblers going crazy on the floor of the exchange.” “Wall Street,” he adds, “has always been a very poor judge of value.”

“This may surprise you, but there were a large number of valuable buys during the Depression.”

The depths of the Depression turned out to be a useful time to learn that lesson. At Columbia Business School, Kahn served as an assistant to economist Benjamin Graham, the value-investing guru whose principles of caution and defensive investing inspired a cadre of disciples that includes Warren Buffett. It’s an investment strategy born of the beating Graham had taken in '29, and Kahn adopted it as his own. “I stopped wasting time on what people claimed a stock was worth and started looking at the numbers,” he says. “This may surprise you, but there were a large number of valuable buys during the Depression.”

 

Then and now, he says, the smart money was on companies with sound fundamentals. “You always had a long list of what I’d call legitimate businesses,” he says—the ones that produced food, clothing, and other essentials. “Everybody still wanted a clean shirt. They wanted to buy Procter & Gamble.” A science buff, Kahn also grew adept at spotting the long-term potential of emerging technologies and new industries. In the 1930s, that meant radio and movies, both of which boomed despite the downturn. Today he’s apt to talk up environmental and energy startups. “You have to have a certain amount of cultural interest in technology to be early in the field,” he says.

Life for a Depression-era Wall Streeter was markedly frugal by current standards: Kahn and his wife, Ruth, enjoyed a penthouse apartment in public housing—the Knickerbocker Village complex on Manhattan’s Lower East Side. “My kids were brought up as if they had a wealthy father, which they didn’t.” He’d walk home for lunch, to save money on restaurants. Kahn’s fortunes improved as the Depression wore on: by 1939 he was doing well enough to buy a house in Belle Harbor, Queens, and he later prospered as the director of several companies, including the Grand Union supermarket chain.

But his habits have remained exceedingly modest. “Irving’s a funny guy,” Thomas Kahn says. “He doesn’t play golf, there’s no weekend house, no country-club membership.” For years he ate the same dish—chopped steak, rare—at the same time-worn French restaurant, Le Veau d’Or, on the Upper East Side. He traveled only reluctantly, at the urging of his wife, and would haul stacks of annual reports to read on Caribbean vacations. Ruth died in 1996, after 65 years of marriage, and Wall Street became his main companion. “I couldn’t find another person or occupation that had as much interest for me as economics,” he says.

For the past several years, Kahn’s longevity has been the subject of scientific inquiry: he’s participating in a study of centenarians at the Albert Einstein College of Medicine in the Bronx, by geneticist Nir Barzilai. Barzilai hypothesizes that Kahn’s extraordinarily high amounts of “good” HDL cholesterol are exerting some protective effect, warding off age-related infirmities. It just might be luck, a genetic gift that he shares with two centenarian siblings, including an older sister of 109 and a younger brother of 101.

Thomas Kahn seems convinced that the market itself is keeping his father alive. Indeed, watching indexes gyrate offers the elder Kahn endless diversion. “I get a kick out of seeing who’s going to come out ahead in this race,” he says.

This is one of the gifts of age, scientists say—the ability to focus on the bright side of things, a talent that Kahn displays in abundance. If you can believe him, happy days will be here again.

“I’m a great bull on American democracy,” he says. “If you give me a long leash on this dog, I can hold him at bay.”

If this downturn culminates in an actual depression, says Kahn, it will end more quickly than the one he endured as a young man, because technology will somehow turn the economy around. “Sometimes favorable surprises come out of the blue.”

 

Asking the right and wrong questions

From a behavioral economics point of view, the field of financial advice is quite strange and not very useful. For the most part, professional financial services rely on clients’ answers to two questions:

  1. How much of your current salary will you need in retirement?

  2. What is your risk attitude on a seven-point scale?

From my perspective, these are remarkably useless questions — but we’ll get to that in a minute. First, let’s think about the financial advisor’s business model. An advisor will optimize your portfolio based on the answers to these two questions. For this service, the advisor typically will take one percent of assets under management – and he will get this every year!

Not to be offensive, but I think that a simple algorithm can do this, and probably with fewer errors. Moving money around from stocks to bonds or vice versa is just not something for which we should pay one percent of assets under management.

Actually, strike that. It’s not something we should do anyway, because making any decisions based on answers to those two questions don’t yield the right answers in the first place.

To this point, we’ve run a number of experiments. In one study, we asked people the same question that financial advisors ask: How much of your final salary will you need in retirement? The common answer was 75 percent. But when we asked how they came up with this figure, the most common refrain turned out to be that that’s what they thought they should answer. And when we probed further and asked where they got this advice, we found that most people heard this from the financial industry. Sort of like two months salary for an engagement ring and one-third of your income for housing, 75 percent was the rule of thumb that they had heard from financial advisors. You see the circularity and the inanity: Financial advisors are asking a question that their customers rely on them for the answer. So what’s the point of the question?!

In our study, we then took a different approach and instead asked people: How do you want to live in retirement? Where do you want to live? What activities you want to engage in? And similar questions geared to assess the quality of life that people expected in retirement. We then took these answers and itemized them, pricing out their retirement based on the things that people said they’d want to do and have in their retirement. Using these calculations, we found that these people (who told us that they will need 75% of their salary) would actually need 135 percent of their final income to live in the way that they want to in retirement. If you think about it, this should not be very surprising: If you add 8 hours (or more) of free time to someone’s day, they will probably not want to spend this extra time by going for long walks on the beach and watching TV – instead they may want to engage in activities that cost money.

You can see why I’m confused about the one-percent-of-assets-under-management business model: Why pay someone to create a portfolio that’s 60 percent too low in its estimation?

And 60% is if you get the risk calculation right. But it turns out the second question is equally problematic. To show this, we also asked people to tell us how much risk they were willing to take with their money, on a ten-point scale.  For some people we gave a scale that ranges from 100% in cash on the low end of the risk scale and 85% in stocks and 15% in bonds on the high end of the risk scale. For other people we gave a scale that ranges from 100% in bonds on the low end of the risk scale and buying only derivatives on the high end of the risk scale.  And what did we find?  People basically looked at the scale and said to themselves “I am a slightly above the mean risk-taker, so let me mark the scale at 6 or 7.” Or they said to themselves “I am a slightly below the mean risk-taker, so let me mark the scale at 4 or 5.” In essence, people have no idea what their risk attitude is, and if they are given different types of scales they end up reporting their risk attitude to be very different.

So we have an industry that asks one question it’s giving the answer to, and a second question that assumes that people can accurately describe their risk attitude (which they can’t). This saddens me because, while I think that financial advisors are overpaid for the service they provide, in principle they could contribute much more, and they could even deserve their salary. But only if they start offering a more useful service, one that they are in the perfect position to provide. Money, it turns out, is incredibly hard to reason about in a systematic and rational way (even for highly educated individuals). Risk is even harder.

Financial advisors should be helping their clients with these tough decisions! Money is about opportunity cost. Every time we think about buying a car or going on vacation we should be asking ourselves what we won’t be able to afford in the future if we go ahead and make this purchase. And that’s where the financial advisor should come in.

It’s possible that the best financial advisors already do help in this way, but the industry as a whole does not. It’s still centered on the rather facile service of balancing portfolios, probably because that’s a lot easier to do than to help someone understand what’s worthwhile and how to use their money to maximize their current and long-term happiness.

The fact is that money is hard to think about and we do need help with making financial decisions. The financial consulting profession has an opportunity to reinvent itself to service this need. And if they do, it will be beneficial for both financial advisors and their clients.

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