Arnott: 40 Years of Bonds Beating Equities

Bonds: Why Bother?

Rob Arnott’s paper Bonds: Why Bother? sets out to succinctly punch a few holes in accepted market norms. What he finds should be sobering for investors in shares who believe that they can gain excess returns for taking the excess risk of holding equities over reasonable lengths of time.

Now a lot depends on your definition of a “reasonable length of time” but as the paper shows that someone holding and rolling over 20 year Treasury bonds would have beaten an investor in the S&P 500 over any time frame since 1979 you'd have to have a very long term view indeed to regard equity investment as a safe thing. In fact bonds have actually beaten equities on the same measure over the last forty years.

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Risky Bankers Need Swiss Cheese Not VaR

Financial Risk Management is Too Risky

The failures by banking institutions across the world over the last couple of years would have been remarkable in almost any industry. However, when they’re taking place in institutions that are fundamentally all about risk management, closely overseen by phalanxes of regulators, they’re quite extraordinary. Sadly the banking industry was too focused on profits to remember the basic rule of investment.

If pharmaceutical companies or airlines suffered from the same type of risk management failures as the banks we’d all be dying of aspirin overdoses and ducking for cover as airliners crashed in our back gardens. These other industries have more nuanced models of managing risk, relying on combinations of methods. It’s about time the banks learned about the Swiss Cheese Model of Risk.

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Why The Growth of India and China Means Our Kids Should Do Media Studies

Software Isn’t Hi-Tech Any More

Last year I visited China in my role as an IT guy and, as usual, got into a discussion about the additional software services we might sell in addition to our products. The manager I was trying to talk to just smiled and beckoned me to follow him. We wandered down a few corridors and passed through a door that opened up into an aircraft hanger of a room filled, end to end, with serried cubicles staffed by young Chinese writing software.

The point, of course, was that there were no software services I could offer that the Chinese couldn’t support themselves, cheaper. The West has yet to fully appreciate the impact of the transition of China and India to fully industrialised nations. Our children need to start looking for new sorts of jobs, now, or spend the rest of their lives stacking shelves in supermarkets.

Transitioning from Agricultural Societies

Estimates suggest that around 1.2 billion of China and India’s 2.3 billion combined population still works outside the industrial sector. First world economies use approximately 3% of their available labour to till the land so that would imply over a billion people spilling into the globalised industrial economy at some point in the next few decades.

These countries are throwing out engineers, scientists and IT people at a rate far beyond what we in the West can achieve. Meanwhile our media obsessed younger generation shows a marked disinclination to engage in these areas which, as it turns out, may be a pretty intelligent decision. In competition with people at least as well educated as themselves but paid ten times less the opportunities for such skills are likely to be significantly reduced over the next twenty years.

So what’s left for the rest of the world if China, India and other South East Asian economies are going to become the global IT engine room? Where does this leave us as investors?

Global Resources

A second consideration is about the resources needed to fuel this growth. The development of the global media exposes the have-nots of the world to that which the haves, have. A Chinese friend of mine recalls walking out of LA airport in the late eighties and standing, stunned, at the sight of more cars than he’d ever seen in his entire life before: a lifetime of indoctrination was broken in a moment.

Yet the realities of global economic growth dictate that the world can’t support its poor becoming wealthier. For all Indians and Chinese to attain first world wealth we would have to strip the planet of its minerals and energy sources in an unsustainable frenzy of global proportions. In the words of Worldwatch:

…if by 2030 China and India alone were to achieve a per-capita footprint equivalent to that of Japan today, together they would require a full planet Earth to meet their needs.

http://www.worldwatch.org/node/3894

This isn’t going to happen. Yet the invisible hand must work and the redistribution of global wealth will happen. If India and its cohort can’t attain first world wealth then the latter must drop to meet the competition coming up. In short – we in the West, or at least our children, are going to be poorer on average.

Investing for the Future

Leaving aside the issues of planetary destruction and the inevitable decline of western society for a moment, we need to consider what difference this makes for us as rational investors. The obvious answer, investing directly in these economies, isn’t as easy as we’d like.

As we’ve seen before although investors are, as a whole, pretty good at figuring out which areas or stocks will outperform they are, as a whole, uniformly bad in avoiding underpaying for them. Value stocks appear to outperform growth stocks because investors overpay for growth rather than underpaying for value (see Clairvoyant Value). Investing in high growth, but expensive, Eastern stocks is likely to be a losing play, long term.

The Commodity Play?

The growing economies – especially China – are relatively short of commodities to fuel their growth. The search for sources of these will no doubt continue but the potential or actual impact of this saw oil and other commodities spike alarmingly in 2008.

Commodities generally obey the marginal laws of pricing deduced by David Ricardo. Simplistically, if supply of a commodity exceeds demand then the price of the commodity will tend to the cost of production: if it goes lower than this companies will eventually stop production entirely. However, if demand exceeds supply even marginally suddenly the producers are in a position to charge excessive prices.

The OPEC Effect

We saw this happen in the 1970’s when the creation of OPEC suddenly restricted oil supplies causing the price to spike because demand exceeded supply. The consequence, over many years, was that industrialised nations moved to reduce their consumption of the black stuff until OPEC was no longer able to force its members to cut supplies any further and the price collapsed back to its cost of marginal production.

Something similar happened last year when emerging economy growth drove demand up without a significant increase in supply – although whether this was a genuine increase in demand or purely a speculative reaction by hedge funds (as suggested in Hedge Funds Ate My Shorts) and other investors is still not clear. Whatever, the effect was a sudden and dramatic spike in oil and other commodity prices.

If China and India do continue to industrialise at the current rate then commodities are a way of investing in that growth. However, it’s a risky play: price rises will drive the world to look for ways of reducing consumption of oil and minerals. We’ve been given a warning, which is unlikely to be forgotten quickly. Still, these types of effects take years to play out so there’s a trade off between the speed with which industrialisation takes place and the rapidity of the reaction to price rises.

Buying the West

The psychological trap that investors typically fall into is chasing the next growth story. Checking where the investment industry is feverishly offering new funds is as good a sign as any. Guess what they were marketing a couple of years ago? Looking at closed end funds in emerging markets trading at big NAV discounts may not be a bad idea, if you trust the fund managers not to merge the funds out of existence.

However, the best way of investing in these countries may be simply to invest in undervalued Western companies that are using their cheap labour and finding ways of selling into the East. Given a choice between expensive Eastern stocks and cheap Western ones the latter will provide investors with better returns even if the former grow much more rapidly than the latter.

Unfortunately, as far as I can tell, there are no passive funds that allow such an investment. For long-term active investors with a value mindset focusing on such companies should offer very decent returns: almost certainly far better than buying companies on high multiples focusing on the trendy areas of climate change and alternative energy.

Services and Skills

On the local level we’re back to services. Some of this is relatively high-end stuff as well – power generators, infrastructure management (water, airports, etc), doctors and lawyers for instance. Lots of it, though, is simply box shifting. As far as I know you can’t easily get someone in India or China to stack UK shelves.

For our kids there’s no easy escape from the equalisation of the global economy. They need to develop language and design skills, focus on doing things that can’t be transferred abroad and, above all, rely on their parents for handouts while they get established. For us it’s an investing opportunity but for them it’s going to be a crisis.


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The Buffet Munger Paradox

Financial Focus or Latticeworks of Mental Models?

Warren Buffett and Charlie Munger, Chair and Vice-Chair of Berkshire Hathaway, are the most successful investors of all time as measured by monetary value, insight and wit. Don’t underestimate the intrinsic value of those latter two components – to retain senses of proportion and humour in the face of wealth unimaginable to the majority of us should immediately mark out these men as having characters extraordinary.

Yet at the heart of this enduring relationship is a curious paradox. When asked to identify the most important factor in his financial success Buffett replies with a single word: “focus”. Munger, on the other hand, extols the need for investors to develop a broad education in which to ground their investment activities. How can we reconcile these two different approaches?

Buffett’s Focus

Everything about Warren Edward Buffett seems to spring from a hunger, a focus, for making money. An early photograph shows him holding his favourite toy – a coin counter. By age 19 he had amassed the small fortune of $10,000 through various moneymaking schemes from paper rounds to a pinball machine hire business. He went to Columbia in pursuit of Ben Graham, maxed out on his courses and then pestered Graham until he gave in and made him the first non-Jewish employee of his firm.

When Graham retired Buffett packed his New York bags and returned to his home town of Omaha where he set up his own partnership, raking in fees based on profits made on capital from his investors with one single rule: astonishingly he wouldn’t tell them what he was investing in. They weren’t complaining – the young Warren made money hand over fist by taking Ben Graham’s lessons and applying focus – small and concentrated portfolios of value based stocks. The Buffett Partnership made 20%+ per year through the late fifties and sixties until, out of the blue, Buffett announced that he was winding up his investment firm.

Folding His Hand

Buffett had made the calculation that his tried and trusted investment techniques would no longer work in the booming markets of the late sixties: value was dead, as periodically happens. Unwedded to convention and with the clarity of vision that many other so-called gurus can only dream of, he coolly assessed the situation at the table where he’d won so much money, folded his hand and walked away. Within months the markets started crumbling.

In winding up the Buffett Partnership and distributing the funds to his shocked investors there were a couple of stocks left over that he also distributed, remarking that he believed that these would offer above average growth over the coming years. Unremarked amongst them was a failing textiles company called Berkshire Hathaway.

Most people who met the young Buffett were impressed by his focus, his intelligence, his energy and, above all, his honesty. Amongst the many who were wooed was a young lawyer, introduced to Buffett by a mutual friend: a dude by the name of Charles Thomas Munger.

Munger’s Mental Models

Munger stays in the shadow of Buffett, largely because that’s the way he likes it. Whereas Buffett is happy to write for the popular press, is delighted to pick up the phone to talk live to financial commentators on TV and loves nothing more than a big gathering of business people Munger shies away from the limelight. Even at Berkshire Hathaway’s AGM’s legendary question and answer sessions Munger lets Buffett do most of the talking.

So when Charlie Munger does decide to say something it’s usually something worth listening to and something that bears thinking about. And what he mostly talks about is mental models.

The core concept behind Munger’s philosophy is what he calls a “latticework of mental models upon which to array ideas”. He believes that people who approach investing with a limited set of mental models are bound to fail when situations change. Perhaps his greatest scorn is reserved for that part of the academic community which sponsors the Efficient Market Hypothesis – this, he believes, is a perfect example of a group who have a single model which they apply to all situations and all times.

When the evidence shows that they’re wrong rather than changing their model they change the evidence required. Munger calls this “man with a hammer syndrome”.

A Snowball’s Chance in Karnataka

To escape this trap we need to take ideas from all sorts of different areas, many of which have little or nothing to do with investing. Munger’s ideas range over areas as diverse as psychology, physics, biology, history and economics. Yet very often the point he’s trying to make gets lost in the detail as investors try to figure out which models to use from these subjects. That’s not – quite – the point.

Assume you lived in Southern India five hundred years ago and some stranger arrives and starts telling you about a strange phenomenon called “snow”. It’s white, it’s wet, it’s cold, it falls from the sky, lies about for ages and you make men out of it. Would you believe them?

Well, if your only model of the world is that you’ve experienced at home then the likelihood is that you won’t because snow isn’t something that you’re going to have personally witnessed. However, if you’re widely read and a budding philosopher or scientist you may be able to do a little better than simply dissing the idea – for a start you know that there may be things out there that you’ve never experienced, so you don’t dismiss it out of hand. But how can you decide whether this “snow” stuff is imaginary or not?

Arraying Your Knowledge

As you’re a student of physics or psychology you’ll know a few tricks of your own. You can probe for a few simple inconsistencies and to ask for some corroborating evidence – like what kind of clothes do people wear and does it snow all the time? With a few simple ideas you can perform enough of a cross check to conclude that, on the balance of probabilities, this stranger isn’t completely mad.

This is Munger’s concept of mental models. You don’t need to know everything but when that financial advisor arrives with his sheaves of papers showing the unbelievable returns to be gained from the new Ponzi bonds you need to know enough to crosscheck the ideas and the figures. To run a sanity check.

So all “arraying knowledge” on a mental model means is that when you come across new concepts you need to test them against multiple, pre-existing models. If all you have is a single model – it doesn’t snow in India – you won’t be investing in the new fangled refrigeration. Watch that fortune just walk out the door.

Focus or Mental Models?

So on one hand we have the incredibly focused Warren Buffett. On the other we have Charles Munger and his bag of broadly focused mental models. And back in the early seventies they started the process of integrating their investments into the behemoth has become Berkshire Hathaway. Unlike most investors, who suffer from the Law of Big Numbers – the increasing difficult of generating large returns from larger and larger amounts of capital – Buffett and Munger have carried on generating 20% per year.

Despite their apparently widely differing approaches they’re obviously doing something right. So how, exactly, does this partnership work?

To be continued in: Investing Like Berkshire Hathaway


 
 
Related Posts: The Rediscovered Ben Graham, Is Intrinsic Value Real?, Warren Buffett Bias

Technical Analysis, Killed By Popularity

Heisenberg’s Investment Principle

In quantum mechanics the Heisenberg Uncertainty Principle expresses the finding that in attempting to measure anything at the sub-atomic level you inevitably change what you’re measuring. You can determine a particle’s position or its speed but never both at the same time.

In stockmarket investment a similar thing happens whenever someone identifies a sure-fire way of making money. No sooner do they publish their findings then their technique fails. It’s all down to human psychology and it’s the same reason why popular technical analysis techniques can’t reproducibly produce above average market returns. Heisenberg rules, OK?

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Survivorship Bias in Magical Mutual Funds

The Magical Inflation of Mutual Fund Returns

Despite years and years of data showing that, on average, actively managed funds underperform their passive brethren by around the amount charged in fees – a point William Sharpe demonstrated using the most basic math back in 1991 (The Arithmetic of Active Management) – the darned things won’t lie down and be slain. Worse still, they use their excess fees to dream up smart new ways of improving their apparent returns.

Perhaps the cleverest and simplest method is to magically make the worst performers disappear from the record, a clever trick I wish I could perform with my portfolio. However, just like the investors in those disappeared funds, I’m stuck with my returns while the funds benefit through survivorship bias.

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Black Swans, Tsunamis and Cardiac Arrests

Low Probability, High Consequence

On 26th December 2004 an earthquake off Sumatra caused a tsunami that sped across the Indian Ocean and led to the death of nearly 230,000 people. It was one of the deadliest natural disasters in recorded history. Despite the possibility of such an event being long acknowledged and the relatively low cost of putting early warning systems in place no such protection was available.

In the jargon it was a low probability, high consequence event and the failure to plan for it is a consequence of the human psychological focus on the predictable and short term to the exclusion of the unpredictable and long term. More colloquially the world had witnessed a Black Swan.

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The Tragedy of the Financial Commons

The Sumerian Dilemma

Way back in the mists of barely historic times, down in the then fertile crescent of Mesopotamia, the Sumerians ceased their nomadic wandering, started cultivating wheat and barley and settled down to form the world’s first civilisation. The easy availability of food – at least compared to hunting vicious animals with nasty pointy teeth – allowed them to grow their society but also created a deadly dilemma. To maintain the population nearly all the Sumerians – apart from a few priests and so forth – needed to spend all of their time processing grain. A people that can’t generate a surplus of food are destined to spend eternity on the treadmill of maintenance.

Sadly the Sumerians, acting in their own interests, exhausted the resources needed to maintain their society and in so doing destroyed it. In a similar manner our financial industry is exhausting the world’s fiscal resources. Unfortunately it’s unlikely that the individuals responsible will care too much because they’re too busy spending their loot.

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Regression to the Mean: Of Nazis and Investment Analysis

Francis Galton, The Measuring Man

Francis Galton, cousin of Charles Darwin, was utterly uninterested in the both the workings of investment analysts and Hitler’s future plans for world domination. To be fair he died before both really got going. However, he has the dubious distinction of being at least partially to blame for some of the madder excesses of both.

What Galton was interested in was measuring things: mainly people, although he’d turn his hand to anything in the absence of a likely suspect or two. In so doing he uncovered a statistical phenomenon known as Regression to the Mean which lies behind many of the theories which still dominate stockmarket analysis and valuation techniques today and which many people misunderstand totally.

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The Media, Fear and Stockmarket Manias

Breast Cancer

If I were to ask you at what age are women most at risk from breast cancer, what would you answer? Write down what you think. Or, at least remember carefully. We don’t trust our memories around here.

I’ll come back to that later.

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