Lessons from the investment bank disaster

I saw last week that Merrill Lynch and Citigroup were in the news again for the exotic mortgage-backed investments that have helped to screw up the credit markets.  Merrill sold off nearly $31 billion of the investments for just 22 cents on the dollar. Citigroup is expected to write down $8 billion because of its involvement in these crazy investments.

Lots of analysts and reporters are talking about how these losses reflect the trickiness of the financial markets and how these collateralized debt obligations were risky ventures from the start. But I don't think that's really the lesson to take from these announcements.

It didn't take a genius to see what was happening. The big investment banks created a bubble, not unlike the tech bubble of a few years back. Everybody knew that eventually the bubble would burst and that things would get ugly. Everybody knew these investments were risky. But the investment banks ran into them head-on. Why? Because of their compensation system. There was the potential to make huge sums of money in commissions, so they were incentivized to take on huge amounts of risk. 

The investment banks also felt bullet-proof. They figured that they were too big to fail, and that the government would bail them out if they got into trouble. In other words, you and I would be on the hook if things went south.

A money manager at one of these investment banks has an incentive to take as much risk as he can with other people's money. He gets paid for gathering assets, and the more assets he brings in, the more he gets paid. The way to bring in more assets is to show outstanding performance over a short period of time and get publicity in the major financial magazines. The way to show outstanding performance in the short term is generally to take on excessive amounts of risk.

By taking that extra risk, the money manager puts his clients in position to lose a lot more down the road -- but the manager doesn't care. Why should he? He doesn't get penalized as a manager for the losses his clients get; he gets paid for the assets he brings in.   

This shows the systemic problem behind Wall Street's compensation structure. Whether you're talking about these exotic investments such as CDO's or the way that fund managers handle your funds, it doesn't matter. Wall Street types are incentivized to put their interest ahead of yours, and they do not suffer the same consequences as you do when you lose money.

These managers are paid handsomely and are widely regarded as the best in the business. They're supposedly geniuses. But if they can screw up their own companies so bad, do you really want them managing You, Inc.? 

The moral is clear. When Wall Street appears in genius mode, raking in huge profits on mysterious products and complex trades, the secret isn't genius at all. It's that hubris is running wild, and so is risk. And whether it's tomorrow or five years hence, risk will jump from the shadows, knife in hand, to cut genius down to size.

-- Shawn Tully, editor-at-large, Fortune Magazine

If you've been reading my blog or newsletter for a while, you probably know that I have six principles underlying my investment philosophy. Number One is "Most investments are designed to make Wall Street rich, not you," and everything else just cascades down from that.

I think the credit and liquidity problems we're seeing now is a fallout from the greed on Wall Street, and it's a prime example of why I advocate managing your own money. You are uniquely qualified to do it, assuming that you are properly educated. The good news is that it's not hard to learn. It's not a big mystery that takes years and years to decipher.

Even if you choose to have someone else manage your money, you still need to be educated. A properly educated investor is subject to the least amount of conflict-of-interest and can better distinguish between a good investment and a clever sales pitch.

Educating investors is what I do, and helping people succeed is what I love. If you're ready to take the reins of your own portfolio, or if you just want to be a more educated investor so you can make better, more informed decisions, let's chat. Give me a call at 214-245-5236, 1-888-6SNIDER, or send me an email.

SOURCES:
1. Story, Louise, "Write-Down Is Planned at Merrill," The New York Times, 29 July 2008. [accessed 30 July 2008]
2. Dowell, Andrew and Ed Welsch, "Merrill Deal May Cause Banks to Revalue Debt," The Wall Street Journal, 30 July 2008. [accessed 04 August 2008]
3. Tully, Shawn, "Wall Street's Money Machine Breaks Down," Fortune, 12 November 2007. [accessed 01 August 2008]

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Kim Snider is the President and Founder of Snider Advisors, an investment adviser registered with the SEC, focused on teaching individual investors a sensible, long-term investment approach focused on maximizing cash flow. For more information on Snider Advisors or the Snider Investment Method, please visit snideradvisors.com. Her book, How to Be the Family CFO: Four Simple Steps To Put Your Financial House in Order, will be in bookstores October 1, 2008.

Snider Advisors makes no representation that the information and opinions expressed are accurate, complete or current. The opinions expressed should not be construed as financial, legal, tax, or other advice and are provided for informational purposes only. Call 888-6SNIDER to request the Snider Investment Method® Owner's Manual, which includes a description of the Snider Investment Method, investment objectives, risks, suitability and other information. Please read and consider carefully before investing. All investments, including the Snider Investment Method™ are subject to risk, including possible loss of principal.

Optimism vs. Pessimism

“When asked about the country's economy, schools, health care or community spirit, Americans tell pollsters the situation is dreadful. But when asked about their own jobs, schools, doctors and communities, people tell pollsters the situation is good. Our impressions of ourselves and our neighbors come from personal experience. Our impressions of the nation as a whole come from the media and from political blather, which both exaggerate the negative. The latter has never been thicker.”
-- Gregg Easterbrook

SOURCE:
1. Easterbrook, Gregg. “Life is Good, So Why Do We Feel So Bad?” The Wall Street Journal, 13 June 2008. http://www.wsj.com/public/article_print/SB121331500809069989.html (accessed 08 July 2008).

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Kim Snider is the President and Founder of Snider Advisors, an SEC Registered Investment Advisor, focused on teaching individual investors a sensible, long-term investment approach focused on maximizing cash flow. For more information on Snider Advisors or the Snider Investment Method and how to stop enriching your investment advisors at your expense, please visit snideradvisors.com. Her book, How to Be the Family CFO: Four Simple Steps To Put Your Financial House in Order, will be in bookstores October 1, 2008.

Snider Advisors makes no representation that the information and opinions expressed are accurate, complete or current. The opinions expressed should not be construed as financial, legal, tax, or other advice and are provided for informational purposes only. Call 888-6SNIDER to request the Snider Investment Method® Owner's Manual, which includes a description of the Snider Investment Method, investment objectives, risks, suitability and other information. Please read and consider carefully before investing. All investments, including the Snider Investment Method™ are subject to risk, including possible loss of principal.

Know Your Greatest Risk

What is your most valuable asset? Your business? Your house? Your investment portfolio? The pile of gold buried in your backyard? What would you guess?

 

If you guessed anything tangible, you guessed wrong. Your most valuable asset is what economists call your human capital. This is the sum total of the skills knowledge and wisdom you possess which you then trade with your employer or your customers for money.

 

When you are young, human capital represents the lion share of your total wealth. As you age and begin to accumulate other assets, human capital becomes a smaller proportion but still is your largest asset.

 

If that is so, and economists tell us it is, then your biggest risk is not being sued if someone slips and falls in your driveway, a protracted bear market or the cost of long-term healthcare. Your biggest risk is disability or obsolescence. Both have the potential to seriously disrupt your income.

 

Think of it. As long as my income stream keeps flowing, I can get through almost everything else. Suppose someone does slip and fall in my driveway. They sue me and the court awards them millions of dollars. I may file for bankruptcy but the court will allow me to keep enough of my income to keep a roof over my head and feed and clothe my family.

 

Imagine we experience a depression which takes thirty years for stock prices to recover from. As long as I don’t lose my job and I can still work, I can still eat. Imagine I work in a family business that continues to pay me long after I have become old and feeble. Long term healthcare is not a problem.

 

I am not saying life would be champagne and caviar. I am just saying it would be better than the alternative. A steady income solves many problems. Loss of one can wreak havoc.

 

Disability

 

We have two choices when it comes to risk. We can either hedge it or insure it. Insuring a risk is almost always more costly than hedging it because the intermediaries, namely insurance companies, have to make a profit over and above the cost of the hedge.

 

We can insure the risk of disability by purchasing disability insurance. Some employers offer disability insurance as an employee benefit. Disability policies can be either short term or long term.

 

Short term disability policies pay you a percentage of your salary if you are temporarily unable to work because of injury or illness. A typical policy will you anywhere from 50% to 65% of your pay for anywhere from two weeks to two years, depending on the policy you purchase. A period of 13 to 26 weeks is more common and then long-term disability kicks in if you have it.

 

Long-term disability replaces income for a much longer period of time. Policies usually limit benefits to five years or age 65, whichever comes first.

 

Of course, being the optimists that we are, no one likes to think about what happens if disaster strikes. But the question asked by a Family CFO most often has to be, “What if?”

 

Data from the American Council of Life Insurers tells us one in seven will experience a disability lasting more than five years. The odds increase to one in five for those of us between the ages of 35 and 65.28 It turns out the leading cause of disabilities is not freak accidents, as many people think, but instead is caused by devastating illnesses such as cancer or heart disease. The long-term loss of income is so disruptive that 46% of home foreclosures are due to medical disability.

 

Obsolescence

 

You cannot insure against obsolescence but you can hedge against the risk. How? By making constant upgrades to the software between your ears. The best hedge against being replaced by a 23 year old whiz kid is lifelong learning.

 

	Those who do not read are no better off than those who cannot.€ ~Proverb

 

Lifelong learning need not be formal to be effective. I had the pleasure of interviewing Dr. Benoit Mandlebrot for my radio show several years ago. Dr. Mandlebrot is a mathematician who is best known as the father of fractal geometry. Fractal geometry is what makes the stunning reality of modern day computer animation possible.

 

Dr. Mandlebrot'€™s accomplishments are unique in that he has been awarded major prizes not just in mathematics but also in physics, medicine, science and technology. His concepts have also been applied to economics, earth sciences and linguistics.

 

Dr. Mandlebrot credits his ability to think outside the traditional confines of a single branch of science to his unconventional education. He said in one interview, "€œTo tell the truth, and not to sound pretentious, but circumstances prevented me from acquiring a real college or university education in the traditional sense, so I am primarily self taught."

 

Passive income

 

Disability and obsolescence can both be hedged by building a portfolio which produces enough passive income to pay all the bills, as described in chapter 14. When passive income equals or exceeds day-to-day living expenses, work is no longer a necessity, it is a choice.

 

For my husband Jim and I, we use a combination of passive income and disability insurance to hedge our risk. Because I am the public face of our company, if I were to become disabled, our business would be seriously impacted. But we still have employees and bills to pay.

 

We have a disability policy on me which specifically covers the overhead of the business in the event I am disabled. We rely on the passive income from our investments to replace our income from the business.

 

Longevity

 

Americans' increasing longevity can be an economic blessing or a curse. Provided we remain healthy, increased longevity increases our human capital. If our mental and physical health declines as we age, our human capital is diminished.

 

Thus, there is one other thing you can do to increase your odds of financial success and it has nothing to do with saving or investing. Take care of your body and your mind. Quit smoking, eat right and exercise. These are as much a part of achieving lasting financial success as a sound investment strategy.

 

The preceding is an excerpt from Kim Snider's yet-to-be published - but getting closer book, "The Family CFO's Guide to Financial Success." This book should be available in bookstores everywhere (don't you agree?), but isn't - until Kim stops procrastinating on the second draft!

 

Kim Snider, Kim Snider Financial Communications and/or Snider Advisors make no representation that the information and opinions expressed are accurate, complete or current. The opinions expressed should not be construed as financial, legal, tax, or other advice and are provided for informational purposes only. Call 866-952-0100 to request the Snider Investment Method™ Owner's Manual, which includes a description of the Snider Investment Method, investment objectives, risks, suitability and other information. Please read and consider carefully before investing. All investments are subject to risk including possible loss of principal.

The Courageous Investor

Mike was a caller on my radio show Saturday afternoon. Four or five years ago, he had gotten very aggressive in his allocations in his 401(k). Now that the market had been going up for awhile, he was nervous and wanted to know should he change his allocations to something more conservative?

 

What Mike was suggesting is called market timing and it is doomed to failure. Stock picking and market timing are by-products of an obsession with day-to-day performance which is a sure way to get the opposite result.

 

One of the lessons I teach is that most of us are getting the cart before the horse. We pick our investments based on their performance and hope they will meet our objectives.

 

The path to successful investing lies in doing it the other way around. First, you must decide what your objectives are. What is your money's higher purpose? Why are you putting it to work? What do you want it to help you achieve?

 

This is not about numbers. Your objective isn't an 8% return or $1 million dollars in the bank. This is about what you are able to do. This is about being able to do what you want, when you want, without worrying how you are going to pay for it. And most likely, it isn't just one thing. It may be several.

 

I have one client in his mid-50's, his peak earning years, who took two years off to do missionary work in Africa. I have another client who left his job to take care of his two sons full time. Now he is getting his teaching certificate so he can be on the same schedule as his boys as they grow older.

 

Maybe your goals are a little bit more mundane. You just want to have enough money to be able to quit working some time before you die. That's OK. But I would encourage you to allow yourself to get creative and think big. What really lights your fire? What is the one thing you secretly want to do if you had enough money and enough courage? That one thing is your money's higher purpose.

 

	"In the long run, you only hit what you aim at." - Henry David Thoreau   "Aim at heaven and you will get earth thrown in. Aim at earth and you get neither." - C.S. Lewis

 

The cool thing about approaching money this way - even if you don't hit what you aim at - if you aim high enough, even a miss will put you in a pretty good position. So why not aim high?

 

Once you understand your money's higher purpose, then you have two other factors to consider before you can even begin to think about which investments to put your money to work in. You must also consider where you fall on the risk/reward continuum and your temperament.

 

Investments stretch along a risk-reward continuum, from those that produce a guaranteed return to those that offer the chance, but not the promise, of a return. Generally, the higher the return, the higher the risk, although it should be noted that risk can take many different forms. It is not always the loss of capital. That is where your temperament comes in.

 

What sort of investor are you? Are you patient or impatient? Do you stick with an idea that makes sense or do you change philosophy every time what you are doing begins to feel the slightest bit uncomfortable? How hands on are you? How much time do you want to spend managing your investments? These are all questions of temperament.

 

Only when you are crystal clear on these three things can you begin to choose the investment philosophy that is best suited to your specific needs. And yet, when I ask a room full of investors how many can tell me what their money's higher purpose is, only 1 in 10 typically raise their hand.

 

When you get clear about these things before choosing an investment, questions like Mike's go away. Investment strategies and specific investment vehicles are chosen based on their ability to achieve your objectives with the appropriate amount of risk and no more, while be mindful of the fact that your investment strategy must fit your temperament.

 

When you take this top-down approach, your investments - in other words, your money's place of employment - should only change when your money's higher purpose changes. And that, I shouldn't need to tell you, should occur very infrequently.

 

	"Courage is never to let your actions be influenced by your fears." - Arthur Koestler

 

An investor who takes this approach is a courageous investor. A courageous investor never changes course based on fits of fear or greed. The beauty is, the level of commitment to the investment approach matches the level of commitment to the objective. Provided you are committed to your money's highest purpose, the rest becomes a moot point.

 

In the new movie release, Georgia Rule, Lindsay Lohan's character, Rachel, has an exchange with Simon (Dermot Mulroney) about the difference between right and wrong and a lie and the truth. She turns to him and asks sarcastically, "How does it feel to be so sure of yourself?" Without missing a beat, he shrugs his shoulder and replies with complete sincerity, "Yeah, it's pretty good."

 

That is the feeling you get when your investments are based on a higher purpose instead of something facile like growth, income or capital preservation or base like a millions of dollars or 50% return. Wouldn't you like to feel that sure of yourself on a topic that makes some of the smartest people feel so uncertain?

 

Learn more about how to put your money to work consistent with its highest purpose in my upcoming class, "The Family CFO's Guide to Investing." I am offering this class in June only - once in Frisco, once in Fort Worth and once in Dallas. The best part is, like this article, it is free. Check the dates and get registered at kimsnider.com.

 

And as always, feel free to leave your thoughts and comments below.

 

Kim Snider, Kim Snider Financial Communications, Chronim Investments and/or Snider Advisors make no representation that the information and opinions expressed are accurate, complete or current. The opinions expressed should not be construed as financial, legal, tax, or other advice and are provided for informational purposes only. Call 866-952-0100 to request the Snider Investment Method™ Owner's Manual, which includes a description of the Snider Investment Method, investment objectives, risks, suitability and other information. Please read and consider carefully before investing. All investments are subject to risk including possible loss of principal.

Investor or speculator?

Many of Wall Street's most colorful metaphors and fables come, unwittingly for most, from a book originally published in 1940 by Fred Schwed, Jr. (yes, that was his real name) called "Where Are the Customers' Yachts?" Schwed went to work on Wall Street in 1920 and wrote one of the enduring investment classics about his time there.

 

The book is simultaneously eye-opening and hilariously funny. More amazing is that many of its truisms seem prophetic given the passage of almost 70 years. It just goes to show, that for all the changes we have experienced in the investment business, not much has changed at all. Everything old becomes new again.

 

One of the passages in this book which caught my attention was the following description of investing in comparison to speculation:

 

Speculation is an effort, probably unsuccessful, to turn a little money into a lot.

 

Investment is an effort, which should be successful, to prevent a lot of money from becoming a little.

 

If you take a thousand dollars down to Wall Street and attempt to run it up to $25,000 in the course of a year, you are speculating. If you take $25,000 down there and attempt to earn a thousand dollars a year with it (by buying twenty-five four-percent bonds) you are investing. The odds against your being successful in the first venture are roughly 25 - 1. The odds against the success of the second venture are "odds on", or something like 1 -25.

 

Jason Zweig correctly points out in the foreword, "Today, as in Schwed's time, people who try to get rich quick still insist on calling themselves 'investors' - even though they are clearly speculators."

 

I believe in investing, not speculation. I believe this because my goal is to make money, not lose it. But the difference between investing and speculation is, as Schwed himself points out, only a matter of degree. So where do you draw the line? How do you define which is which? What criteria do you use?

 

I would love to know your thoughts on the topic. Do you see a difference? Which are you? Did you set out to consciously do one or the other? Let us know by posting your comments below.

 

Kim Snider, Kim Snider Financial Communications, Chronim Investments and/or Snider Advisors make no representation that the information and opinions expressed are accurate, complete or current. The opinions expressed should not be construed as financial, legal, tax, or other advice and are provided for informational purposes only. Call 866-952-0100 to request the Snider Investment Method™ Owner's Manual, which includes a description of the Snider Investment Method, investment objectives, risks, suitability and other information. Please read and consider carefully before investing. All investments are subject to risk including possible loss of principal.

Commit

Until one is committed, there is hesitancy,

The chance to draw back,

Always ineffectiveness.

Concerning all acts of initiative and creation,

There is one elementary truth

The ignorance of which kills countless ideas

And endless plans:

That the moment one definitely commits oneself, then

providence moves too.

All sorts of things occur to help one that would never otherwise have occured.

A whole stream of events issues from the decision,

Raising in one's favor all manner of unforseen

incidents and meetings and material assistance.

Which no one could have dreamed would come their way.

Whatever you can do or dream you can,

Begin.

Boldness has genius, power, and magic in it.

Begin now.

 

-Johann Goethe

 

Tip of the hat to EM at No Limits Ladies for this wonderful quotation.

 

Kim Snider, Kim Snider Financial Communications, Chronim Investments and/or Snider Advisors make no representation that the information and opinions expressed are accurate, complete or current. The opinions expressed should not be construed as financial, legal, tax, or other advice and are provided for informational purposes only. Call 866-952-0100 to request the Snider Investment Method™ Owner's Manual, which includes a description of the Snider Investment Method, investment objectives, risks, suitability and other information. Please read and consider carefully before investing. All investments are subject to risk including possible loss of principal.

Volatilty vs. Loss

"Once again, this illustrates people’s inability to distinguish between volatility – which I might define as temporary declines in price – and loss, which I would characterize as a permanent reduction in value."

 

Pasted from <http://nickmurrayinteractive.com/secure/articles/jul2006_thank.html>

 

Kim Snider, Kim Snider Financial Communications, Chronim Investments and/or Snider Advisors make no representation that the information and opinions expressed are accurate, complete or current. The opinions expressed should not be construed as financial, legal, tax, or other advice and are provided for informational purposes only. Call 866-952-0100 to request the Snider Investment Method™ Owner's Manual, which includes a description of the Snider Investment Method, investment objectives, risks, suitability and other information. Please read and consider carefully before investing. All investments are subject to risk including possible loss of principal.

 

What's Rational?

"We have a high moral responsibility to be rational."

-- Charles T. Munger, Vice- Chairman, Berkshire hathaway, at the 2006 Annual Meeting

Tip of the hat to Nick Murray Interactive for this quote. I, of course, like this quote because one of the six fundamental tenets of my investment philosophy is, "Investors are their own worst enemy."

I believe emotions cause us to do the opposite of what we should be doing and it is my job to try to keep my tribe acting in a rational manner rather than responding to fear and greed.

For more on this topic, see the posts in the Investors Are Not Rational category.

 

Kim Snider, Kim Snider Financial Communications, Chronim Investments and/or Snider Advisors make no representation that the information and opinions expressed are accurate, complete or current. The opinions expressed should not be construed as financial, legal, tax, or other advice and are provided for informational purposes only. Call 866-952-0100 to request the Snider Investment Method™ Owner's Manual, which includes a description of the Snider Investment Method, investment objectives, risks, suitability and other information. Please read and consider carefully before investing. All investments are subject to risk including possible loss of principal.

Buy when others are selling and sell when others are buying

In order to really make money in the markets, you have to be both right and different from everyone else. If you buy Google because you believe they are going to be the next Microsoft, you may be right, but you won’t get much return on your investment because everyone else thinks the same thing and it has already been priced into the stock. In order to make money, you have to be right and different.

 

If you look at the very few people who have ever made their fortunes in the financial markets - men like George Soros, Jimmy Rodgers or Sir John Templeton - this is exactly how they did it. They bought when everyone else was selling and sold when everyone else was buying. They did not follow the herd. They followed their own path. But what made them successful was not only being contrarian but also being right.

 

Sir John Templeton, for example, correctly figured out when Hong Kong reverted to Chinese control that it wouldn’t be the economic disaster everyone else was predicting. As all the big multi-nationals sold off their holdings in Hong Kong, at fire sale prices, he bought them up. When everyone else came to the same realization he had much earlier, he sold them back at highly inflated prices.

 

What does this example teach us? Those that succeed - financially and in life - are those that have the confidence to think for themselves and act independently. Success is almost always found in that hidden area where most people do not have the courage to go.

 

Few are those who see with their own eyes and feel with their own hearts. ~Albert Einstein

 

As always, you thoughts and comments are not only welcome but appreciated. You can share them below.

 

SOURCES:

 

1. BrainyQuote. "Albert Einstein Quotes,"

http://www.brainyquote.com/quotes/authors/a/albert_einstein.html

 

Kim Snider, Kim Snider Financial Communications, Chronim Investments and/or Snider Advisors make no representation that the information and opinions expressed are accurate, complete or current. The opinions expressed should not be construed as financial, legal, tax, or other advice and are provided for informational purposes only. Call 866-952-0100 to request the Snider Investment Method™ Owner's Manual, which includes a description of the Snider Investment Method, investment objectives, risks, suitability and other information. Please read and consider carefully before investing. All investments are subject to risk including possible loss of principal.

 

On Risk Management

"Loss of opportunity is better than loss of capital."

-- Joe DiNapoli, veteran futures trader

 

Kim Snider, Kim Snider Financial Communications, Chronim Investments and/or Snider Advisors make no representation that the information and opinions expressed are accurate, complete or current. The opinions expressed should not be construed as financial, legal, tax, or other advice and are provided for informational purposes only. Call 866-952-0100 to request the Snider Investment Method™ Owner's Manual, which includes a description of the Snider Investment Method, investment objectives, risks, suitability and other information. Please read and consider carefully before investing. All investments are subject to risk including possible loss of principal.