Modern Investing
Page 3
Think about that—money is not “real.” Money is a purely intellectual notion, a complex one, whose rules are entirely derived from one set of relationships: trust and uncertainty among participants in the market. What humans have created complex, imaginative systems that build on each other out of pure nothingness. Investing is one such imaginary system. It is a fiction that is based on the concept of money, a very complex topic in its own right.
Money is just a medium for exchanging goods and services, but it also functions as a storage of wealth. It requires trust and faith that the future will be as good or better than the present, and hence the money you’re handing over—a promise on a piece of paper to give whoever holds it ‘100 dollars’ or whatever—will still have value in the future. Money in this process undergoes a magical transformation from the humble $100 you have in your hand to all those wonderful things you imagine buying. With a savvy investment, that money may turn into yachts, gold watches, and trips to Aruba.
However, what we receive and what we pay are two very different concepts. As we have seen, it favors the party who has an information advantage. Demanding adequate returns are one way to compensate investors for the risks of passing their money to another party. The higher they perceive the risks involved, the higher the returns they need to demand. However, this is just a general guideline and prone to misunderstandings and confusion.
Let’s consider the safest form of investing today—short-term U.S. government notes and bonds of up to 10 years or more. Investors can be assured that they first get their invested principal returned in full, and on top of that, will receive a pre-agreed semi-annual or annual interest payment. These cash flows are guaranteed by the U.S. government and backed by U.S. taxpaying citizens, as well as a vast military arsenal that sees U.S. political and economic interests enforced throughout the world. Investments very similar to U.S. Treasury bonds are bonds issued by the German and Japanese government called Bunds and JGBs (Japanese Government Bonds). Both countries are ranked among the safest investments in the world and are considered “safe havens” for your money, even though they yield even less than U.S. Treasury bonds in 2016.
Nevertheless, the U.S. Treasury’s yield is the benchmark return, or risk-free rate, for all other investments in the world to compare itself with. It represents the opportunity cost of all other possible investments. It’s a core principle in finance known as the “time value of money.” What time value means is cash in your hand is much more valuable than the same amount of cash in an uncertain future. It is understood in the industry that every other competing investment that is considered less safe should pay an appropriate premium over this opportunity cost in order to make it more attractive for investors to open their wallets. Otherwise, we would just buy safe U.S. Treasury bonds for the same returns. But here is the problem. What would be an appropriate premium over risk-free rate? How much more should investors demand, if the risk-free-rate is zero or even negative? Clearly, it must be connected to how we perceive risk in each other investments than safe government bonds. An early start-up investment should require a much higher risk premium than a corporate bond issued by General Electric. But how do you quantify the difference? This is where most investors and academic researchers differ in opinion, ranging from what actually constitutes investment risk and how to measure it. More importantly, how much exactly investors should demand for the additional risk they take on.
The Matter of Risk
So, what exactly is risk? The word “risk” derives from the Early Italian word risicare, which means “to dare.” In investment, risk is the probability that you lose part, or all, of your investment. Whenever you lay out money, you will expose yourself to the risk of not getting the money you initially paid back. It is the same whether you buy stocks, bonds, real estate, or part interest in a private business. There are many different types of risks investors should be aware of and have to deal with, from the academic view theoretical risk to the risk of fraud we could experience on any level of the investment process. But to better understand risk, we need to look at the main reasons how and why investors lose money. For that, we need to look at the types of risk an individual investor has to deal with.
Overpayment Risk
By far the most relevant risk investors face is overpayment risk. This is the risk that paying too much for an asset can lead to financial losses. Let me give you a fairly recent example: Anthony Bolton, former star fund manager at Fidelity, came out of retirement to manage the Chinese Special Situations Fund for Fidelity between 2009 and 2014. He was so excited about the future prospect of China and its upcoming economic boom that he couldn’t resist putting his financial magic on one of Fidelity's leading funds one last time. In hindsight, he might have wished to stay in retirement.
The first two years of the fund saw him performing well. Global stock markets quickly recovered from market lows in 2009, and he felt assured that he still had what it takes to be a leading fund manager. Then, during the disastrous year of 2011, he saw all of his gains melt away with a staggering loss of 34% for the year.
What happened? What had gone so wrong so quickly? One major contributing factor was a 90% loss of a single investment in China Integrated Energy, a company that claimed to be a producer of ethanol. The company was recommended to him by one of his previous investments, a United States-listed fund called Vision Opportunities. Bolton met with CIE’s senior management, a standard procedure for all professional investors, to get a better picture of their business. Impressed by what he had seen, Bolton bought shares and built up a sizeable position for his China fund. “They told a good story,” he later said.
Unfortunately, he didn’t know as much about the company as he should have. At the same time Bolton was putting his money into CIE, someone else had hired investigators who went to one of the company’s plants and stuck a camera outside. What they found astonished everyone. In Bolton’s own words:
“...nothing was going on [at the factory]. But the next day, when another investor tour turned up, everything ramped up and started working again. A day later everything stopped again.”7
In the end, investors realized the company did not have any operations at all. It was pure fiction and fantasy. They bought an empty shell company and lost a lot of money in the process. Bolton cut his losses and bailed on the investment, then canceled his investment with Vision Opportunities Fund for good measure. Bolton’s experience is a simple example of overpayment risk. He didn't get nearly the value he was hoping for. You could argue that Bolton was a victim of fraud. Very often, overpaying for something is connected to a form of deception or even fraud. The point is that Bolton should have known more about the company he was investing in. Caveat emptor still applies to star fund managers.
Let’s take a look at an example from our daily lives. When you go shopping, you could end up with low-quality goods; they could be damaged, fake, or not as nice as you’d thought they’d be. What follows is an instant realization that you overpaid for something. Unfortunately, buyer’s remorse is a little different when it involves financial assets for two reasons. First, the real value of a stock is more difficult to assess than that of an object like a bottle of Coca Cola. Second, the true value of the stock only becomes apparent to the investor long after it’s been purchased. A bad steak is obvious, but a rotten stock can take months to stink. More upsetting, perhaps, is the fact that there are only two things that cause such purchases to go ahead:
Wishful thinking.
Insufficient knowledge.
Naïve tourists buying souvenirs and antiques in a foreign country get regularly scammed for those two reasons. If you don’t know what you’re purchasing, you are just taking an unnecessary risk.
Force Majeure
The second type of risk is called force majeure. To explain this, I am going to tell you the story of a farmer. Takahashi Saito (not his real name) is a farmer in Sendai, Miyagi Prefecture in the northeastern region of Japan. In early 2011, when he bought some fertile l
and from a retiring farmer he’d known for decades, Saito was convinced he had gotten a great piece of land at a fair price. The owner chipped in some farming equipment and a bunch of puppies, happy to see that his land was being managed by a younger, capable farmer who would carry on the local traditions. He signed the papers, local rice wine flowed and toasts were given. It was the beginning of a close relationship between him and his new community. Or so he thought.
Little did Takahashi know that his entire investment would literally sink into the abyss on the afternoon of March 11, 2011. In the aftermath of the biggest recorded earthquake in Japanese history, Saito’s new land was ravaged by tsunamis laden with mud and industrial waste. Any hope Saito may have had of recovering his investment disappeared over the next few days as the Fukushima nuclear disaster unfolded. By the end of the week, his land was off-limits entirely, as it lay within the 40 km (25 miles) exclusion zone around the power station.
All investors in history have had to face the aspect of major unforeseen events such as natural catastrophes or wars. All those random events and unexplainable incidents outside of their control or influence. Events that Nassim Taleb titled as “Black Swan” event, “that comes as a surprise, has a major effect, and is often inappropriately rationalized after the fact with the benefit of hindsight.”8 This is something any investor has to live with: the risk of uncertainty and the aspect of chance in our lives. By their very nature, these incidents are hard to predict, which is why in the world, they’re known as acts of God. There are only two ways to account for the acts of God – constant vigilance and diversifying investments to ensure that the disaster doesn’t destroy all of them.
Risk of Financial Leverage
There are many additional types of risks in investment, but one category of risk that caused so much havoc in the world of finance and investing is the risk of financial leverage. This risk of loss increases exponentially when we add any form of “financial leverage,” which is just a fancy way of saying “borrowing money to play.” If you use any financial leverage, you magnify not only your potential gains but also your potential losses. When investors use excessive financial leverage, the risk of loss increases dramatically, even if mathematical models tell you otherwise. The money borrowed still has to be paid back within an agreed period, and usually ends up with less favorable interest rates.
Also, with borrowed money, investors expose themselves to the potential of being forced out of positions, as lenders usually demand collateral for outstanding loans in challenging market environments. This can sometimes result in the need to close promising investment positions at a loss in order to provide the necessary liquidity. This usually happens at the most inconvenient time for investors, and results in a vicious cycle of falling prices and even more pressure to come up with new collateral. Though leverage might enhance performance dramatically, it also makes investment decisions much more complicated.
Good Financial Leverage
Leverage can be the rocket fuel to enormous riches, as long as none of your own money is involved. In the financial world, this is referred to as “good leverage.” It is when you buy investments entirely with other people's money and get a cut of the winnings. If you win, you get a percentage cut of the gains; if you lose, your pride might get hurt, but in the end, it wasn't your own money that was lost.
Investment banks and professional asset managers use this model with gusto, and they have made fortunes for themselves. Today, some funds still charge 2% management fees up front and 20% performance fees off of all profits. You're lending them money, and you actually pay them for this privilege. I call it a business model made in heaven.
Moronic Leverage
You borrow the maximum amount of money possible with your private wealth as collateral and take excessive risks. The wager either doesn't work, or you underestimate and miscalculate the real risks involved, and you lose it all, including your own wealth. That might seem to be a far-fetched scenario, but let’s look at a real life case of this actually happening: Long-Term Capital Management (LTCM).
LTCM is the leading investment fund (a.k.a. a hedge fund) that blew up in the midst of the Russian financial crisis in 1998. It pushed the entire U.S. financial system to the brink of disaster way before Lehman Brothers finally succeeded ten years later. At times, it was leveraged 28:1 and more, i.e. for every dollar they possessed, they had borrowed $28. So although LTCM had around $1 billion in assets, they were able to buy over $28 billion worth of investments. It was rumored that LTCM had at its peak over $125 billion in assets with a capital base of only $4.7 billion.9 Considering they mostly traded with other people's money, many partners decided to put all of their private wealth on the line as personal collateral to maximize their personal profit potential. LTCM was on the quest to find that perfect investment formula that promised endless riches and easy gains on the assumption that risk can be measured as easily as gravity. The top management at LTCM truly believed that they had found the perfect formula, as shown in their overconfidence in betting their own fortunes in their company.
LTCM simply ignored the fact that markets occasionally behave irrationally. When participants lose faith in academic models and assumptions that build the basis for these formulas and models, fiction deflates to nothingness and only facts and reality are the foundation for a hard landing. When players sell in panic and fear takes hold of markets, no rationally-explained formula or story of a better future will be able to stop the financial onslaught of ever falling prices and increasing losses. LTCM underestimated their greed and were overconfident in their ability to consistently anticipate the future correctly.
To this day, when interviewed, LTCM’s key partners believed that their risk was practically zero in accordance with their financial models. They still believe that they would have made money on their bets had they survived. Their argument is that LTCM was just overwhelmed by the irrationality of markets that their mathematical models just couldn’t account for. Their lenders and investors who’d lost billions in the blow-up and the central bankers who’d done the utmost to avoid a collapse of the entire financial system couldn't disagree more, regardless of irrational market players and unexpected events. In the wake of LTCM’s collapse, many partners literally lost it all—luxurious mansions, yachts, cars, and status.
Key Takeaways
In this part, we learned the background and origins of investing. Its nature and elementary components. We have looked at ways to assure the return of capital through contracts protected by law. But a contract itself doesn’t protect an investor from possible losses. In order to assure “safety of principle,” as Benjamin Graham postulates, you need to have a mechanism to evaluate and value each investment before a decision is made. We learned that in each case in order to protect our capital investment, we always have to make sure to understand the underlying asset we purchase and the rights we receive as property owners. Only then can we assess whether an investment promises safety of principal.
With Graham’s second component of his investment definition, we looked at returns, as adequate compensation for the risks we take. Risk is understood as per definition, the possibility of losing real money. Furthermore, we looked at the importance of the risk-free rate as the reference point to compare all investment opportunities in a possible investment universe. We saw that the ultimate risk investors face is the risk of overpayment relative to the value they have hoped to receive, whether in real assets or future cash flows. We can say that investors need to take risk in order to achieve returns, but to minimize the real risk of loss, its potential to generate future cash flow needs to be assessed relative to the price paid. In Part II we transition from the topic of investing to the more glittery and exhilarating world of gambling and speculation.
PART II
THE METAMORPHOSIS
CHAPTER 4
GAMBLING, INVESTING, AND SPECULATION
“All the evidence shows that God was actually quite a gambler, and the universe is
a great casino, where dice are thrown, and roulette wheels spin on every occasion."
—Stephen Hawking
Risk has always been a part of human life. For early hominids, coming down from the trees and walking across the wide African plains was a huge risk to take, considering the sheer number of much more powerful predators in the open savannah who were waiting for an easy lunch. Gambles have changed the course of history, and Adam Smith, the author of the Wealth of Nations, acknowledged that the tendency for humans to take wagers here and there could foster even more economic progress. However, in excess, it can be catastrophic. Two centuries after Smith, John Maynard Keynes noted, “When the capital development of a country becomes the byproduct of the activities of a casino, the job is likely ill-done.”10 But he also believed that “[i]f human nature felt no temptation to take a chance...there might not be much investment merely as a result of cold calculation.”
You could say that our capitalistic system relies on the “propensity of all its participants to take gambles in order to propel economic progress.” If humans have no incentives to risk capital, scientific and technological progress, economic growth might be seriously hampered. But not even Smith and Keynes could have been 100% correct all the time on the issue of when to take a wager and, more importantly, when to stop. So how is one supposed to know?
A lot of what you read or hear about investing and financial markets is gambling. But that is not to say that the two are identical, or work the same way in practice. In today's markets, you'll, by and large, see two kinds of people: the speculator and the investor. The former is much closer to being a gambler than the latter; their approach is fundamentally that of a professional gambler. These days, many players in financial markets that are considered “investors” are in fact, speculators.