COMMENTARY
May 27, 2010, 5:00PM EST
The Sun Also Sets
Investors learned the lessons of the recent recovery a bit too well
By Roben Farzad
Who could blame an investor today for feeling a tad nostalgic for the Panic of 2008? There was a simplicity to the thing. It was such a brutal and impartial rout—slaying just about every asset class—that it made you want to swear off all markets forever. There was comfort to be found in stashing a shoebox full of $50 bills in the freezer. No paperwork. No jabberwocky from your broker. Just the reassuring face of Ulysses S. Grant juxtaposed with your cold, raw fear.
By March 2009, with U.S. stocks at 1996 levels, equities had returned less than Treasuries over the previous 10-, 20-, and 30-year periods—debunking the equity-risk premium so central to Econ 101. Until, of course, the market reversed course and surged 80 percent in 13 months, reminding investors that it was at least theoretically possible to make money in equities. That change of mood edged out fear just in time for the 2010 edition of the credit crisis, an international production that began with Greece's near-collapse and soon spread to Portugal, Ireland, Italy, Spain, and beyond. The Standard & Poor's 500-stock index has now fallen 12 percent in a month, its first official correction since the new bull began last spring.
Corrections are routine and even healthy events; they come along about once every 11 months on average and wring out the excesses and false expectations that rallies inevitably bring. "To the extent that current worries squeeze long positions, extinguish optimism, or even lead policymakers to pursue courses of action that are more supportive—not more punitive—for markets, the selloff may be creating more favorable entry points for investors to buy into a still recovering global economy," writes Stuart Schweitzer, global markets strategist for JPMorgan Private Bank, in a May 24 note to clients. That may all turn out to be true—provided investors don't panic, rush for the exits, and help turn a routine recovery into the second leg of a double-dip recession.
If the lesson of March 2009 is that the sun comes up—the most brutal selloff is just a prelude to the next rally—then the lesson of the recent runup is that the sun can shine too brightly, blinding us to boulders in the road. And then it can set.
With payrolls still slack and credit still tight, the contours of these peculiar economic times are becoming apparent. Last year's snapback is not going to bring a garden-variety, V-shaped recovery. Instead, investors are again having to confront the messy unfolding of a long and overly generous credit cycle, global in nature and marked by a spate of bank and business failures. How the economies of the world digest it is anyone's guess. When the next leg up begins, though, it will mark a critical milestone for a stock market that still needs to rally by almost half to revisit its 2007 high. Getting there despite profound economic challenges is going to take some hard traveling.
"In the U.S., we have no living precedent for this," says Donald Luskin, chief investment officer at strategy firm Trend Macrolytics, whose search for domestic parallels to this credit crisis took him all the way back to 1907. "We have had a living laboratory for it in Japan for the past 15 years. But in the U.S., we're all attuned to the little upticks in metrics that don't necessarily inform much." In other words, we seek auguries where there are none by comparing traditional business cycle statistics such as payrolls and housing starts to once-in-a-lifetime lows from late 2008 and early 2009. Luskin predicts the market will be range-bound for at least five more years as companies and consumers shed debt. "This is not a particularly bearish view," he says. "It's just the expansion-less, low-return world we're now in."
Luskin's unenthusiastic outlook—which contrasts with the prevailing optimism among Wall Street strategists in a May 25 Bloomberg survey—brings to mind the "new normal" paradigm coined last year by Bill Gross and Mohamed El-Erian at Pimco, the bond giant. The idea is that a bitter confluence of deleveraging and reduced consumption and employment will necessarily bring a long period of low growth and low returns. In the absence of a healthy consumer, the neo-normalists point out, there is no other driver to magically propel the economy.
All of which is reasonable—and has largely been ignored amid a recent rush to riskier, less stable sectors at the expense of large-cap companies. This rush was less than rational; if returns are negligible and credit is tight, one would have expected investors to move into big, stable equities that pay dividends. But they didn't, even though the private equity feeding frenzy and promiscuous lending that made small-cap company buyouts all the rage a few years back are long gone. Small companies today are less likely to be self-financed and far more likely to be dependent on volatile-rate bank debt (assuming it is offered to them at all). Even so, the S&P's small-cap index has returned 3.6 percent so far this year—almost 10 points better than the 5.8 percent loss registered by the S&P 100 (the bluest of blue chips, including IBM (IBM) and ExxonMobil (XOM)). Going back to the market's low last spring, the excess return is hardly inconsequential: 90 percent for small stocks, vs. 50 percent for the mega-caps.
The lesson? The financial conflagrations of the past three years did not signal a permanent flight to quality. Appetite for the high-risk/high-reward trade is alive if not well. The resurgence of large-cap equities has, again and again, been exaggerated. According to Leuthold, a Minneapolis fund management firm, small-cap stocks now sell at a "very fat" valuation premium of 20 percent relative to large caps, an all-time record disparity. Nobody seems to care that Johnson & Johnson (JNJ), with a $165 billion market cap and impeccable financials, pays a 3.62 percent dividend—more than 10-year Treasuries. AT&T (T), the country's largest phone company, an inveterate booster of its dividend over 26 years, yields almost twice that, but its shares have badly lagged the broader market this year. All this as banks believe they are doing you a favor by advertising 1 percent for your cash.
To some, any case for U.S. stocks—small, large, whatever—is also exaggerated. Pimco is now lumping the U.S. together with Japan, France, Spain, and Greece in what it calls a sovereign debt risk "ring of fire"—an ignominious league of nations that will increasingly have problems paying their debts. That association would suggest a lot more downside for U.S. shares, whose aggregate 4 percent drop so far in 2010 is but a sliver compared with the S&P Euro Index's 12.5 percent plunge.
Everywhere you look in the U.S. and Europe is another investing dead end. Together, they make the case for aggressive allocation away from developed markets and into emerging markets—yesteryear's financial basket cases turned today's paragons of growth. According to the International Monetary Fund, the developing world has catapulted itself from 18 percent of global GDP in 1994 to 31 percent last year, with its share still gaining at the expense of Japan, Western Europe, and the U.S.
That sort of growth means it is now far too prudish to allocate a mere 10 percent of one's portfolio to developing powers such as Brazil and India. "U.S. investors should move from a U.S.-centric worldview and toward a larger allocation to emerging market economies," says John West of Research Affiliates, an index strategy shop, also of Newport Beach. "They don't face the hurricane-like headwinds of deficit, debt, and demographics that developed markets, including the U.S., do." Since the market's low, the MSCI Emerging Markets index has shot up 77 percent—20 full percentage points better than the S&P 500. Not that no one has noticed: Emerging-market stock funds have consistently taken in multiples of their U.S. counterparts for five years. And while the U.S. and Europe have swooned in the past month, the emerging markets have fallen 15 percent, a resilient showing for a category that has historically been incapable of handling contagion. West thinks that investors in emerging markets amid this global risk realignment will be disproportionately rewarded over the coming decade.
If you don't have the stomach for increasing volatility, you might just take the old advice to sell in May and go away. Or you might park your dollars in gold, which is trading at an all-time high and is certain to go higher, unless it doesn't. Or you might go to cash, which the Federal Reserve is deliberately pegging at all-time low yields, guaranteeing that inflation eats away at what you have.
The sun will rise again, but in the meantime, no one is saying anything about sleeping well tonight.
Bloomberg Businessweek Senior Writer Farzad covers Wall Street and international finance.
http://www.businessweek.com/magazine/content/10_23/b4181064685899.htm
Saturday, 29 May 2010
Chuck Schwab Is Worried About Small Investors. Should We Worry Too?
COVER STORY May 27, 2010, 5:00PM EST
Chuck Schwab Is Worried About Small Investors. Should We Worry Too?
"People are still in a state of fear," says the father of individual investing. "And with good reason." Schwab believes it is crucial for the little guy to stay invested. And his business depends on it
In 12 years as a retail financial consultant for Charles Schwab (SCH), George Pennock thought he had seen every kind of market. Then, on May 6, he and his 250 clients lived through something new. Pennock was in Schwab's office in Englewood, Colo., just outside of Denver, talking by phone with a retiree who moved his money to Schwab last year because he says he felt suckered by his old broker. While they spoke, Pennock kept an eye on his computer screen and saw the Dow drop 250 points, bounce sideways, then go into free fall—300, 400, 900 points down. His client was watching the same thing on CNBC.
"What's going on, George?" the retiree asked. "Do you have any explanation for this?" Pennock didn't. He was thinking he should end the call and contact clients who had pulled out of equities after getting clobbered in 2008 and 2009. Some left at the bottom, then sat on the sidelines while the market raced up 80 percent. Maybe they would see this as a buying opportunity.
He never got the chance. In minutes, the market anomaly was over and the Dow was heading back up. It wasn't until the next day that Pennock, 37, began to appreciate its impact on investor psychology. He arrived at his office the morning after to find 22 phone messages. By day's end he had 50—one-fifth of his client base. "A lot of the calls were nervous," he recalls. "It was, 'George, this is testing my risk tolerance.' They have deep-seated concerns that [the correction] will go on for a while and nobody knows how long or how bad it will be."
It took Pennock two weeks to catch up on all the calls. "These conversations are lengthy," he says. "They take a lot of hand-holding." Some clients wanted to retreat; he reminded them why they had made financial plans in the first place. A retired airline pilot wanted to know if the 30 percent of his assets invested in equities was too high. (Pennock assured him it wasn't.) Another investor, who had waited five months to get back into the market, worried he had missed his chance. Most simply wanted reassurance. The May 6 crash may have been a freak occurrence, but it felt like one more sign that the deck was stacked against the little guy. "They got burned very badly before," Pennock says, "and they don't ever want to be in that situation again."
Many small investors had only begun to tiptoe back into equities when the May 6 crash and the European credit crisis rocked the markets, completing a particularly cruel cycle. In the year prior—while the S&P 500 was rebounding 69 percent from its Mar. 9, 2009, bottom—individual investors withdrew a total of $11.5 billion from U.S. equity mutual funds and poured $506 billion into lower-yielding bond funds, according to TrimTabs Investment Research. By late spring, they had just begun to reverse course, venturing back into equities by channelling $13.9 billion into domestic mutual and ETF funds in March and $6.9 billion in April. By the third week of May, they'd withdrawn $29.3 million from U.S. equity mutual funds and poured an additional $8.2 billion into bonds. An American Association of Individual Investors survey taken the week of the May crash showed investor sentiment jumped to 36 percent "bearish," from 28 percent the week before. As of May 10, according to the Federal Reserve, money on the sidelines in bank and money market accounts had reached $9.36 trillion, compared to $7.44 trillion in May 2007.
The period since early 2008 "is the worst time since I began the company," says Charles Schwab, the father of the modern American individual investor. "These are the most violent markets. Most people are still in a state of fear. I'd say 98 percent are still very concerned. And for a lot of good reasons. Look at the headlines. You've got these scoundrels doing all this stuff. People wonder, 'Who can I trust?' "
Schwab is sitting in his San Francisco office—which has always been spare but these days seems downright spartan—looking out the window at the Bay Bridge and mulling the tortured psychology of the American investor. "Where are they?" he asks, then pauses and lets out a sigh. "This is the most violent period I've ever seen," he says finally. "It was the end of capitalism as we knew it. The whole definition of safety and soundness—what does it really mean any more?"
As chairman of the $4.2 billion company he founded in 1975, Schwab has reason to be worried about his customers. The success of his company depends in some measure on his financial advisers' ability to keep their clients engaged in the markets. Last year, almost a quarter of the company's revenue came from trading commissions; another 45 percent came from asset management fees. That's the tension at the heart of Schwab's enterprise. He has become the de facto therapist to the individual investor, but he is not a disinterested observer. His job—like Pennock and his other 6,868 licensed brokers—is to keep America invested. Schwab says that staying broadly diversified and firmly in the game remains the key to long-term financial security. Given what's going on in the world, should anyone believe him?
Schwab, now 72, and Vanguard Funds founder Jack Bogle are the old lions of the retail investment industry. Both played key roles in launching the golden age of individual investing—the period between August 1982 and March 2000 when the S&P 500 climbed from 102 to 1,527 and buy-and-hold seemed the surest path to security. Bogle was the pioneer of mutual funds and Schwab opened the door to equity trades for small investors. When Congress deregulated brokerage fees in 1975, some brokerage houses responded by raising fees; Schwab slashed his, making investing affordable for the middle class and becoming broker to the masses. His company's revenues grew from $387 million in 1990 to $5.8 billion in 2000. By then, it was offering round-the-clock trading, sophisticated investment analysis, and a mutual fund supermarket. Long before Starbucks (SBUX), Schwab's branches were gathering places for market enthusiasts—office workers, day traders, and loiterers who stopped by to check stock quotes, mull their next move, brag about their big scores, and indulge in a group fantasy about a spectacular new way to get rich.
As individual investing became a way of life, Schwab inevitably drew competitors—rival discount brokers (and, later, discount online brokers) such as Ameritrade (AMTD) and E*Trade (ETFC), and full-service houses such as Fidelity. Schwab's company rode the late-1990s tech boom but was battered by the steep drop in trading following the 2000 crash. Schwab himself moved out of the top job in 2003, only to move back in a year later, renewing the company's commitment to the small investor. (Today the chief executive officer is Walt Bettinger.) During the financial panic of 2008, Schwab attracted investors fleeing Merrill Lynch, Wachovia, E*Trade, and other battered firms. That new business helped boost Schwab's assets under management 25 percent to $1.4 trillion last year from the prior year (compared with $1.5 trillion at Fidelity, $350 billion at TD Ameritrade, and $162 billion at E*Trade) but Schwab's revenue fell 19 percent under pressure from low interest rates. The company's stock was trading around $16 last week, down $3 from one month before.
Since 1986, Schwab has written four books on investing. He is an optimist by nature, one who has always preached asset allocation, diversification, and investing for the long term. By empowering individual investors at the start of the bull market, he and Bogle and Fidelity's marquee investor Peter Lynch inadvertently created a monster. As playing the market became a national pastime, investing turned into a synonym for stockpicking. Equities were thought of as savings. Today, legions of investors are torn between a newfound desire for safety and the allure of old, bad habits.
Worse, as Americans became do-it-yourselfers and sometimes day traders, their success—especially during the inflating of the dot-com and real estate bubbles—masked a profound shift in the balance of power. Wealth was migrating to institutions, hedge funds, and investment banks like Goldman Sachs (GS), which had created proprietary desks to trade ever more esoteric instruments for their own accounts. Institutional investors now own about 70 percent of American corporations, up from 35 percent in 1975, according to Bogle. As trading algorithms grew more complex and computers sped up, every advantage went to the big guys.
The Yale School of Management has conducted a "buy on dips" survey since 1989, a confidence index that measures investors' willingness to buy after market drops of 3 percent or more. Institutional and individual investor sentiment tracked closely until 2007. At the height of the Dow Jones industrial average, in October 2007, 61 percent of each group said they would buy on dips. Since then they have diverged. By March 2010, 71.6 percent of institutional investors were willing to buy on dips compared to only 57.5 percent of individuals.
In other words, small investors need more help than ever. "Before, nobody needed advice—most just called me up to place their trades," says Robinson Martin, a financial consultant in Schwab's Cobb County (Ga.) office, on the outskirts of Atlanta. Now Martin and others are no longer cheerleaders and trade executors; they are psychologists, trauma experts, counselors, empathizers. It's a delicate balance. In pre-crash days, the company's clients were mostly avid investors. Rarely did Schwab have to coax them into the market. But that's what the company has to do now to prop up the assets it oversees. It's what it has to do to juice its own adviser business. It's what Charles Schwab has preached from the beginning—asset allocation over time. And it's what he does, as well. In August 2007, near the very top, he invested the more than $10 million he'd received from the company's sale of its U.S. Trust unit in a portfolio divided between 50 asset classes. Then he left it. After losing about 30 percent of its value at its lowest point, it is now down about 12 percent, he says. "I follow my own advice," he says. "I'm not running for the hills. Yes, those investments might be somewhat down from '07, but they will be at higher values next year or the year after. I don't know exactly when, but I believe it because of my confidence in the American economic system. If you don't have that confidence, then you definitely should not be a client of Schwab."
Atlanta is a buy-and-hold town, loyal to local favorites Coke, (KO) SunTrust Bank (STI), Delta Air Lines (DAL), and Home Depot (HD), says Martin, 38, as he prepares to conduct a client seminar on a sunny weekday at Schwab's Cobb branch. THe old rules don't work any more, he says. You can't buy and hold anything with confidence, and that's rattling even those who didn't follow the rules during the bull market.
Martin's conference room, inside a tall, glass-and-steel building in a suburban office park, feels like a relic of more prosperous times as a dozen strangers unwrap turkey and ham sandwiches and start talking about the markets. Most are retirees; three are doctors, one a former restaurant owner. They have come to get a market outlook that turns out to be cautiously optimistic. No matter. For nearly two hours, the conversation ricochets from one fear to another—mostly about what could blindside them next. Fannie and Freddie? Inflation? Government spending debasing currencies? "I look at what's happening in Greece, and I see us. I think that could happen here," says James Wood, an Atlanta neurosurgeon.
No one at the conference table knows what to believe anymore, and with good reason. "I had absolutely no idea how deeply the subprime mortgages had penetrated into the financial markets." says Dyckman Poland, a retired engineer. How are investors supposed to make informed decisions when they can't trust what's printed on corporate balance sheets, asks Dr. Wood. How much of the market is ruled by computer-generated trading anyway, another asks, "while you and I are just putting in our dribs and drabs? How do we individuals fit into all this?" Bob Bonacci, the vice-president of a business-services firm in nearby Kennesaw, looks around the table. "I think the majority of us are at or near retirement," he says. "We've taken a hit once, and now it looks like we're on the brink of another situation where it could all be taken away from us. For us, these mistakes are really going to count."
As the stock market fell toward the bottom in March 2009, Schwab distributed videos to its clients in which the founder tried to strike a reassuring tone. Just hang on, he urged. "We told them," Schwab says, "the world was not coming to an end." Yet just as they had after every market crash since 1987, investors fled to safety at the wrong moment, trading equities for cash and fixed income. "It is too darned bad," Schwab says. "So many people held on and held on and held on through 2008, and finally, by early 2009, they'd had enough. Then just at the wrong moment, they got to the pitch of emotion and they said, 'I've had enough.' And chucked it in and sold. Fear took over in the most extreme way." To steady their nerves, the company puts out books, seminars, articles, and the famous "Talk to Chuck" ads. "One of our chief roles is to try to help people through this thing," he says. "But we can't help people overcome the power of fear. Or the power of greed. Those are too much a part of human instinct. We are not psychiatrists."
Now, Schwab says, his biggest worry is that investors will miss out again. They have $2.98 trillion stashed in money market funds, according to TrimTabs, and lots more in CDs and savings accounts. "If you're not an investor, you get no return on your savings and you have this very difficult situation coming up in the next three to five years of inflation that will just take away whatever you might get in some kind of yield. My fear is that inflation will come back and people will throw up their hands and say: 'Jeez, I wish I'd done something to protect myself.' "
That may sound self-serving. Except that, barring a return to a raging bull market, Schwab stands to benefit more, at least in the short-term, if its clients stay paralyzed. If interest rates take off, as the company expects they will by next year, its earnings will soar. That's because Schwab began to change its business mix a decade ago. Foreseeing an end to the bull market and with it, a decline in trading volume, it reduced its dependence on trading to 24 percent of total revenue last year from about 40 percent in 2000. It increased its asset management business and added the Charles Schwab Bank, offering retail banking and mortgage services—thus turning itself into more of a discount investor-services firm than a mere brokerage. It derives much more of its revenue from fees for managing and administering assets (45 percent last year, vs. 27 percent in 2000) and net interest revenue from the cash in its bank and money market funds (29 percent last year, vs. 22 percent in 2000).
If Schwab had not waived the fees it charged on money market funds last year—a move Schwab ordered because their interest yield was so low—trading would have accounted for just 20 percent of last year's revenue and interest would have accounted for 32 percent. And if interest rates do head higher, a report by JPMorgan Chase (JPM) analyst Kenneth B. Worthington said this month, Schwab's earnings will react like a "coiled spring." As rates rise from 2010 to 2012, he predicts, Schwab's net income will more than double.
"We make little bits of money on everything, for the most part," says Schwab. "We are completely neutral about what you do. We would probably make more money on money that sits in a money market fund than on a stock you buy and hold. But we don't have an agenda. We really don't."
Yet the Schwab brand is not about making a killing by collecting interest on the money that clients have sitting in their accounts. The brand lives and dies by "Ask Chuck," as a place where befuddled investors go to not get screwed. And Schwab can't continue to be the "Trusted Advisor" if the client assets of its advisory business aren't growing. It's got to show that it's helping investors, and that means guiding them into vehicles that show growth, not stagnation. "Individual investors must understand asset allocation," says Schwab. "With just a few thousand dollars, you can get a little slice of this and a little slice of that—large caps, small caps, emerging markets, and then build on it," he says. The point is not to get in on the ground floor of the next Google (GOOG) and ride a juggernaut. "You're going to get maybe 5 to 10 percent per annum over 5 to 20 years—maybe 30. That's still pretty good."
The day after the Schwab seminar in Atlanta, one of its attendees, Gene Perkins, 66, returned to Robinson Martin's office. Though he has done his own investing since he sold his restaurant business three years ago, Perkins is now enlisting SChwab so he doesn't get burned, as he did in the 2008 crash when his investments lost 28 percent of their value. He and Martin are working on an asset allocation plan, and it's pretty tough going. Perkins' approach to investing is practically bipolar. At first, he presses Martin about the safest assets. "So what if you just buy treasuries and CDs?" Perkins asks. "Would it kill me to lose a little ground [to inflation] if it lets me sleep at night? It's all relative."
Within minutes, Perkins is trying to elicit a little stockpicking from Martin. That hybrid approach was a big winner during the long bull market. Even disciplined investors could dip in now and then, roll the dice and maybe make a windfall. "You're going to be mad at me for bringing this up," Perkins says. "But if the market tanks, there's going to be some good buys....Let's say the market closes down 80...I may be wrong, dead wrong, and I hope I am. But I got eight or nine stocks here...." He gestures to a hand-scrawled list: McDonald's (MCD), BP (BP), Altria (MO), Citi (C). He's got good arguments for each. "McDonald's is at $68—that's my business. If I can get it at $65, that's a good deal. And Citi...I can wait it out. If Citi is still at $4 a share four years from today, well then I deserve to lose money on that account."
Martin listens patiently and then shakes his head. "Gene, that's too much risk," he says. What will Perkins do with the gains? "Keep it in cash?" Perkins ventures. "Or wait till the market tanks again and buy some more deals?" Responds Martin: "Gene, that's head fakes. When the market tanks again, you will pull everything out. You are playing Vegas odds."
Perkins slumps back in his chair. "I just have a lot to make up. I can't afford to take another hit."
Martin continues calmly: "You said McDonald's and Citi, Gene, and that may well be. But what you're missing is a hedge. Asset allocation is your hedge. You started this conversation with capital preservation, and what capital preservation has to be is a balance between risk and growth. Ultimately what we're trying to do is get out of the guessing game."
Martin keeps trying, his bedside manner patient but firm. Once Perkins has a plan in place, his assets will be invested broadly across asset classes to mitigate his risk. What he has to decide is the balance between risk and reward. With a financial plan working for him, "it's all math at that point," explains Martin. The hard part for so many investors is having to constantly recalibrate the portfolio to keep the asset classes in line with each other. That means scaling back on—not rushing into—sectors that are growing fast. To individual investors who came of age in a bull market, it's all painfully counterintuitive.
Perkins has heard it all before. "Asset allocation is the opposite of market timing, I do understand that," he sighs. "You all have made that crystal clear." And then he gets to the heart of the matter, the reason these investing decisions are causing him so much agony. He has no heirs. He will begin drawing on his retirement funds at 70. "If I live to be 90...if I start drawing at 70, will there be enough?" The subprime crash was a huge setback, and now he doesn't know. "I don't need to have anything left over. I'd like to be broke when I'm dead. I don't even need a casket. As long as I have enough. I just don't want to run out before I die."
Morris is a Bloomberg Businessweek contributor.
http://www.businessweek.com/magazine/content/10_23/b4181058561674.htm
Chuck Schwab Is Worried About Small Investors. Should We Worry Too?
"People are still in a state of fear," says the father of individual investing. "And with good reason." Schwab believes it is crucial for the little guy to stay invested. And his business depends on it
In 12 years as a retail financial consultant for Charles Schwab (SCH), George Pennock thought he had seen every kind of market. Then, on May 6, he and his 250 clients lived through something new. Pennock was in Schwab's office in Englewood, Colo., just outside of Denver, talking by phone with a retiree who moved his money to Schwab last year because he says he felt suckered by his old broker. While they spoke, Pennock kept an eye on his computer screen and saw the Dow drop 250 points, bounce sideways, then go into free fall—300, 400, 900 points down. His client was watching the same thing on CNBC.
"What's going on, George?" the retiree asked. "Do you have any explanation for this?" Pennock didn't. He was thinking he should end the call and contact clients who had pulled out of equities after getting clobbered in 2008 and 2009. Some left at the bottom, then sat on the sidelines while the market raced up 80 percent. Maybe they would see this as a buying opportunity.
He never got the chance. In minutes, the market anomaly was over and the Dow was heading back up. It wasn't until the next day that Pennock, 37, began to appreciate its impact on investor psychology. He arrived at his office the morning after to find 22 phone messages. By day's end he had 50—one-fifth of his client base. "A lot of the calls were nervous," he recalls. "It was, 'George, this is testing my risk tolerance.' They have deep-seated concerns that [the correction] will go on for a while and nobody knows how long or how bad it will be."
It took Pennock two weeks to catch up on all the calls. "These conversations are lengthy," he says. "They take a lot of hand-holding." Some clients wanted to retreat; he reminded them why they had made financial plans in the first place. A retired airline pilot wanted to know if the 30 percent of his assets invested in equities was too high. (Pennock assured him it wasn't.) Another investor, who had waited five months to get back into the market, worried he had missed his chance. Most simply wanted reassurance. The May 6 crash may have been a freak occurrence, but it felt like one more sign that the deck was stacked against the little guy. "They got burned very badly before," Pennock says, "and they don't ever want to be in that situation again."
Many small investors had only begun to tiptoe back into equities when the May 6 crash and the European credit crisis rocked the markets, completing a particularly cruel cycle. In the year prior—while the S&P 500 was rebounding 69 percent from its Mar. 9, 2009, bottom—individual investors withdrew a total of $11.5 billion from U.S. equity mutual funds and poured $506 billion into lower-yielding bond funds, according to TrimTabs Investment Research. By late spring, they had just begun to reverse course, venturing back into equities by channelling $13.9 billion into domestic mutual and ETF funds in March and $6.9 billion in April. By the third week of May, they'd withdrawn $29.3 million from U.S. equity mutual funds and poured an additional $8.2 billion into bonds. An American Association of Individual Investors survey taken the week of the May crash showed investor sentiment jumped to 36 percent "bearish," from 28 percent the week before. As of May 10, according to the Federal Reserve, money on the sidelines in bank and money market accounts had reached $9.36 trillion, compared to $7.44 trillion in May 2007.
The period since early 2008 "is the worst time since I began the company," says Charles Schwab, the father of the modern American individual investor. "These are the most violent markets. Most people are still in a state of fear. I'd say 98 percent are still very concerned. And for a lot of good reasons. Look at the headlines. You've got these scoundrels doing all this stuff. People wonder, 'Who can I trust?' "
Schwab is sitting in his San Francisco office—which has always been spare but these days seems downright spartan—looking out the window at the Bay Bridge and mulling the tortured psychology of the American investor. "Where are they?" he asks, then pauses and lets out a sigh. "This is the most violent period I've ever seen," he says finally. "It was the end of capitalism as we knew it. The whole definition of safety and soundness—what does it really mean any more?"
As chairman of the $4.2 billion company he founded in 1975, Schwab has reason to be worried about his customers. The success of his company depends in some measure on his financial advisers' ability to keep their clients engaged in the markets. Last year, almost a quarter of the company's revenue came from trading commissions; another 45 percent came from asset management fees. That's the tension at the heart of Schwab's enterprise. He has become the de facto therapist to the individual investor, but he is not a disinterested observer. His job—like Pennock and his other 6,868 licensed brokers—is to keep America invested. Schwab says that staying broadly diversified and firmly in the game remains the key to long-term financial security. Given what's going on in the world, should anyone believe him?
Schwab, now 72, and Vanguard Funds founder Jack Bogle are the old lions of the retail investment industry. Both played key roles in launching the golden age of individual investing—the period between August 1982 and March 2000 when the S&P 500 climbed from 102 to 1,527 and buy-and-hold seemed the surest path to security. Bogle was the pioneer of mutual funds and Schwab opened the door to equity trades for small investors. When Congress deregulated brokerage fees in 1975, some brokerage houses responded by raising fees; Schwab slashed his, making investing affordable for the middle class and becoming broker to the masses. His company's revenues grew from $387 million in 1990 to $5.8 billion in 2000. By then, it was offering round-the-clock trading, sophisticated investment analysis, and a mutual fund supermarket. Long before Starbucks (SBUX), Schwab's branches were gathering places for market enthusiasts—office workers, day traders, and loiterers who stopped by to check stock quotes, mull their next move, brag about their big scores, and indulge in a group fantasy about a spectacular new way to get rich.
As individual investing became a way of life, Schwab inevitably drew competitors—rival discount brokers (and, later, discount online brokers) such as Ameritrade (AMTD) and E*Trade (ETFC), and full-service houses such as Fidelity. Schwab's company rode the late-1990s tech boom but was battered by the steep drop in trading following the 2000 crash. Schwab himself moved out of the top job in 2003, only to move back in a year later, renewing the company's commitment to the small investor. (Today the chief executive officer is Walt Bettinger.) During the financial panic of 2008, Schwab attracted investors fleeing Merrill Lynch, Wachovia, E*Trade, and other battered firms. That new business helped boost Schwab's assets under management 25 percent to $1.4 trillion last year from the prior year (compared with $1.5 trillion at Fidelity, $350 billion at TD Ameritrade, and $162 billion at E*Trade) but Schwab's revenue fell 19 percent under pressure from low interest rates. The company's stock was trading around $16 last week, down $3 from one month before.
Since 1986, Schwab has written four books on investing. He is an optimist by nature, one who has always preached asset allocation, diversification, and investing for the long term. By empowering individual investors at the start of the bull market, he and Bogle and Fidelity's marquee investor Peter Lynch inadvertently created a monster. As playing the market became a national pastime, investing turned into a synonym for stockpicking. Equities were thought of as savings. Today, legions of investors are torn between a newfound desire for safety and the allure of old, bad habits.
Worse, as Americans became do-it-yourselfers and sometimes day traders, their success—especially during the inflating of the dot-com and real estate bubbles—masked a profound shift in the balance of power. Wealth was migrating to institutions, hedge funds, and investment banks like Goldman Sachs (GS), which had created proprietary desks to trade ever more esoteric instruments for their own accounts. Institutional investors now own about 70 percent of American corporations, up from 35 percent in 1975, according to Bogle. As trading algorithms grew more complex and computers sped up, every advantage went to the big guys.
The Yale School of Management has conducted a "buy on dips" survey since 1989, a confidence index that measures investors' willingness to buy after market drops of 3 percent or more. Institutional and individual investor sentiment tracked closely until 2007. At the height of the Dow Jones industrial average, in October 2007, 61 percent of each group said they would buy on dips. Since then they have diverged. By March 2010, 71.6 percent of institutional investors were willing to buy on dips compared to only 57.5 percent of individuals.
In other words, small investors need more help than ever. "Before, nobody needed advice—most just called me up to place their trades," says Robinson Martin, a financial consultant in Schwab's Cobb County (Ga.) office, on the outskirts of Atlanta. Now Martin and others are no longer cheerleaders and trade executors; they are psychologists, trauma experts, counselors, empathizers. It's a delicate balance. In pre-crash days, the company's clients were mostly avid investors. Rarely did Schwab have to coax them into the market. But that's what the company has to do now to prop up the assets it oversees. It's what it has to do to juice its own adviser business. It's what Charles Schwab has preached from the beginning—asset allocation over time. And it's what he does, as well. In August 2007, near the very top, he invested the more than $10 million he'd received from the company's sale of its U.S. Trust unit in a portfolio divided between 50 asset classes. Then he left it. After losing about 30 percent of its value at its lowest point, it is now down about 12 percent, he says. "I follow my own advice," he says. "I'm not running for the hills. Yes, those investments might be somewhat down from '07, but they will be at higher values next year or the year after. I don't know exactly when, but I believe it because of my confidence in the American economic system. If you don't have that confidence, then you definitely should not be a client of Schwab."
Atlanta is a buy-and-hold town, loyal to local favorites Coke, (KO) SunTrust Bank (STI), Delta Air Lines (DAL), and Home Depot (HD), says Martin, 38, as he prepares to conduct a client seminar on a sunny weekday at Schwab's Cobb branch. THe old rules don't work any more, he says. You can't buy and hold anything with confidence, and that's rattling even those who didn't follow the rules during the bull market.
Martin's conference room, inside a tall, glass-and-steel building in a suburban office park, feels like a relic of more prosperous times as a dozen strangers unwrap turkey and ham sandwiches and start talking about the markets. Most are retirees; three are doctors, one a former restaurant owner. They have come to get a market outlook that turns out to be cautiously optimistic. No matter. For nearly two hours, the conversation ricochets from one fear to another—mostly about what could blindside them next. Fannie and Freddie? Inflation? Government spending debasing currencies? "I look at what's happening in Greece, and I see us. I think that could happen here," says James Wood, an Atlanta neurosurgeon.
No one at the conference table knows what to believe anymore, and with good reason. "I had absolutely no idea how deeply the subprime mortgages had penetrated into the financial markets." says Dyckman Poland, a retired engineer. How are investors supposed to make informed decisions when they can't trust what's printed on corporate balance sheets, asks Dr. Wood. How much of the market is ruled by computer-generated trading anyway, another asks, "while you and I are just putting in our dribs and drabs? How do we individuals fit into all this?" Bob Bonacci, the vice-president of a business-services firm in nearby Kennesaw, looks around the table. "I think the majority of us are at or near retirement," he says. "We've taken a hit once, and now it looks like we're on the brink of another situation where it could all be taken away from us. For us, these mistakes are really going to count."
As the stock market fell toward the bottom in March 2009, Schwab distributed videos to its clients in which the founder tried to strike a reassuring tone. Just hang on, he urged. "We told them," Schwab says, "the world was not coming to an end." Yet just as they had after every market crash since 1987, investors fled to safety at the wrong moment, trading equities for cash and fixed income. "It is too darned bad," Schwab says. "So many people held on and held on and held on through 2008, and finally, by early 2009, they'd had enough. Then just at the wrong moment, they got to the pitch of emotion and they said, 'I've had enough.' And chucked it in and sold. Fear took over in the most extreme way." To steady their nerves, the company puts out books, seminars, articles, and the famous "Talk to Chuck" ads. "One of our chief roles is to try to help people through this thing," he says. "But we can't help people overcome the power of fear. Or the power of greed. Those are too much a part of human instinct. We are not psychiatrists."
Now, Schwab says, his biggest worry is that investors will miss out again. They have $2.98 trillion stashed in money market funds, according to TrimTabs, and lots more in CDs and savings accounts. "If you're not an investor, you get no return on your savings and you have this very difficult situation coming up in the next three to five years of inflation that will just take away whatever you might get in some kind of yield. My fear is that inflation will come back and people will throw up their hands and say: 'Jeez, I wish I'd done something to protect myself.' "
That may sound self-serving. Except that, barring a return to a raging bull market, Schwab stands to benefit more, at least in the short-term, if its clients stay paralyzed. If interest rates take off, as the company expects they will by next year, its earnings will soar. That's because Schwab began to change its business mix a decade ago. Foreseeing an end to the bull market and with it, a decline in trading volume, it reduced its dependence on trading to 24 percent of total revenue last year from about 40 percent in 2000. It increased its asset management business and added the Charles Schwab Bank, offering retail banking and mortgage services—thus turning itself into more of a discount investor-services firm than a mere brokerage. It derives much more of its revenue from fees for managing and administering assets (45 percent last year, vs. 27 percent in 2000) and net interest revenue from the cash in its bank and money market funds (29 percent last year, vs. 22 percent in 2000).
If Schwab had not waived the fees it charged on money market funds last year—a move Schwab ordered because their interest yield was so low—trading would have accounted for just 20 percent of last year's revenue and interest would have accounted for 32 percent. And if interest rates do head higher, a report by JPMorgan Chase (JPM) analyst Kenneth B. Worthington said this month, Schwab's earnings will react like a "coiled spring." As rates rise from 2010 to 2012, he predicts, Schwab's net income will more than double.
"We make little bits of money on everything, for the most part," says Schwab. "We are completely neutral about what you do. We would probably make more money on money that sits in a money market fund than on a stock you buy and hold. But we don't have an agenda. We really don't."
Yet the Schwab brand is not about making a killing by collecting interest on the money that clients have sitting in their accounts. The brand lives and dies by "Ask Chuck," as a place where befuddled investors go to not get screwed. And Schwab can't continue to be the "Trusted Advisor" if the client assets of its advisory business aren't growing. It's got to show that it's helping investors, and that means guiding them into vehicles that show growth, not stagnation. "Individual investors must understand asset allocation," says Schwab. "With just a few thousand dollars, you can get a little slice of this and a little slice of that—large caps, small caps, emerging markets, and then build on it," he says. The point is not to get in on the ground floor of the next Google (GOOG) and ride a juggernaut. "You're going to get maybe 5 to 10 percent per annum over 5 to 20 years—maybe 30. That's still pretty good."
The day after the Schwab seminar in Atlanta, one of its attendees, Gene Perkins, 66, returned to Robinson Martin's office. Though he has done his own investing since he sold his restaurant business three years ago, Perkins is now enlisting SChwab so he doesn't get burned, as he did in the 2008 crash when his investments lost 28 percent of their value. He and Martin are working on an asset allocation plan, and it's pretty tough going. Perkins' approach to investing is practically bipolar. At first, he presses Martin about the safest assets. "So what if you just buy treasuries and CDs?" Perkins asks. "Would it kill me to lose a little ground [to inflation] if it lets me sleep at night? It's all relative."
Within minutes, Perkins is trying to elicit a little stockpicking from Martin. That hybrid approach was a big winner during the long bull market. Even disciplined investors could dip in now and then, roll the dice and maybe make a windfall. "You're going to be mad at me for bringing this up," Perkins says. "But if the market tanks, there's going to be some good buys....Let's say the market closes down 80...I may be wrong, dead wrong, and I hope I am. But I got eight or nine stocks here...." He gestures to a hand-scrawled list: McDonald's (MCD), BP (BP), Altria (MO), Citi (C). He's got good arguments for each. "McDonald's is at $68—that's my business. If I can get it at $65, that's a good deal. And Citi...I can wait it out. If Citi is still at $4 a share four years from today, well then I deserve to lose money on that account."
Martin listens patiently and then shakes his head. "Gene, that's too much risk," he says. What will Perkins do with the gains? "Keep it in cash?" Perkins ventures. "Or wait till the market tanks again and buy some more deals?" Responds Martin: "Gene, that's head fakes. When the market tanks again, you will pull everything out. You are playing Vegas odds."
Perkins slumps back in his chair. "I just have a lot to make up. I can't afford to take another hit."
Martin continues calmly: "You said McDonald's and Citi, Gene, and that may well be. But what you're missing is a hedge. Asset allocation is your hedge. You started this conversation with capital preservation, and what capital preservation has to be is a balance between risk and growth. Ultimately what we're trying to do is get out of the guessing game."
Martin keeps trying, his bedside manner patient but firm. Once Perkins has a plan in place, his assets will be invested broadly across asset classes to mitigate his risk. What he has to decide is the balance between risk and reward. With a financial plan working for him, "it's all math at that point," explains Martin. The hard part for so many investors is having to constantly recalibrate the portfolio to keep the asset classes in line with each other. That means scaling back on—not rushing into—sectors that are growing fast. To individual investors who came of age in a bull market, it's all painfully counterintuitive.
Perkins has heard it all before. "Asset allocation is the opposite of market timing, I do understand that," he sighs. "You all have made that crystal clear." And then he gets to the heart of the matter, the reason these investing decisions are causing him so much agony. He has no heirs. He will begin drawing on his retirement funds at 70. "If I live to be 90...if I start drawing at 70, will there be enough?" The subprime crash was a huge setback, and now he doesn't know. "I don't need to have anything left over. I'd like to be broke when I'm dead. I don't even need a casket. As long as I have enough. I just don't want to run out before I die."
Morris is a Bloomberg Businessweek contributor.
http://www.businessweek.com/magazine/content/10_23/b4181058561674.htm
Why Financial Plans Are Worthless
March 15, 2010, 12:10 PM
Why Financial Plans Are Worthless
By CARL RICHARDS
Carl Richards
I read somewhere that average Americans will spend more time planning their vacation to Disneyland than they will planning their financial future.
I’m not sure that’s correct, but it wouldn’t surprise me. There are a number of reasons why we are hesitant to spend time planning for our financial future, but the biggest one is that we have confused the process of planning with the end product, a plan.
Financial plans are worthless, but the process of planning is vital. Let me explain the difference.
Creating a traditional financial plan starts by making a bunch of assumptions. These assumptions can be about inflation, what the stock market will do, how much you will save, when you will retire, how much you will spend in retirement and even when you’ll die.
If you have been through this process, you know that it’s very uncomfortable. We know that no matter how hard we try, we will definitely be wrong.
This is one of the cruel ironies of any plan: You don’t have the information you need when you start. This is true when you start a restaurant, a business or are planning the rest of your financial life.
If we accept the fact that even the best plan will be wrong, we can focus our energy on the process of planning instead of obsessing over the assumptions.
Sure we need to chart a course where we think we are headed, and this will involve making some assumptions about the future. But they are just guesses; make them and move on.
Think of this as the difference between a flight plan and the actual flight. Flight plans are really just the pilot’s best guess about things like the weather. No matter how much time the pilot spend planning, things don’t always go according to the plan.
In fact, I bet they rarely go just the way the pilot planned. There are just too many variables. So while the plan is important, the key to arriving safely is the pilot’s ability to make the small and consistent course corrections. It is about the course corrections, not the plan.
Once you have a general idea of your own destination, the focus should shift to what you can do over the short term to get there. Focus on the next three years. Thinking in shorter time frames inspires us to act instead of worrying about all of the things that are out of our control.
So set a course quickly. Realize that you will be wrong, and plan on making course corrections often.
http://bucks.blogs.nytimes.com/2010/03/15/why-financial-plans-are-worthless/
Why Financial Plans Are Worthless
By CARL RICHARDS
Carl Richards
I read somewhere that average Americans will spend more time planning their vacation to Disneyland than they will planning their financial future.
I’m not sure that’s correct, but it wouldn’t surprise me. There are a number of reasons why we are hesitant to spend time planning for our financial future, but the biggest one is that we have confused the process of planning with the end product, a plan.
Financial plans are worthless, but the process of planning is vital. Let me explain the difference.
Creating a traditional financial plan starts by making a bunch of assumptions. These assumptions can be about inflation, what the stock market will do, how much you will save, when you will retire, how much you will spend in retirement and even when you’ll die.
If you have been through this process, you know that it’s very uncomfortable. We know that no matter how hard we try, we will definitely be wrong.
This is one of the cruel ironies of any plan: You don’t have the information you need when you start. This is true when you start a restaurant, a business or are planning the rest of your financial life.
If we accept the fact that even the best plan will be wrong, we can focus our energy on the process of planning instead of obsessing over the assumptions.
Sure we need to chart a course where we think we are headed, and this will involve making some assumptions about the future. But they are just guesses; make them and move on.
Think of this as the difference between a flight plan and the actual flight. Flight plans are really just the pilot’s best guess about things like the weather. No matter how much time the pilot spend planning, things don’t always go according to the plan.
In fact, I bet they rarely go just the way the pilot planned. There are just too many variables. So while the plan is important, the key to arriving safely is the pilot’s ability to make the small and consistent course corrections. It is about the course corrections, not the plan.
Once you have a general idea of your own destination, the focus should shift to what you can do over the short term to get there. Focus on the next three years. Thinking in shorter time frames inspires us to act instead of worrying about all of the things that are out of our control.
So set a course quickly. Realize that you will be wrong, and plan on making course corrections often.
http://bucks.blogs.nytimes.com/2010/03/15/why-financial-plans-are-worthless/
Is Europe heading for a meltdown?
Is Europe heading for a meltdown?
This financial crisis is worse than the sub-prime crash of 2008 because the sums are so much bigger and it is governments that are in dire straits. Edmund Conway explains the dangers.
By Edmund Conway
Published: 8:21AM BST 27 May 2010
Comments 201 | Comment on this article
Mervyn King, the Bank of England Governor, summed it up best: "Dealing with a banking crisis was difficult enough," he said the other week, "but at least there were public-sector balance sheets on to which the problems could be moved. Once you move into sovereign debt, there is no answer; there's no backstop."
In other words, were this a computer game, the politicians would be down to their last life. Any mistake now and it really is Game Over. Or to pick a slightly more traditional game, it is rather like a session of pass-the-parcel which is fast approaching the end of the line.
The European financial crisis may look and smell rather different to the American banking crisis of a couple of years ago, but strip away the details – the breakdown of the euro, the crumbling of the Spanish banking system to take just two – and what you are left with is the next leg of a global financial crisis. Politicians temporarily "solved" the sub-prime crisis of 2007 and 2008 by nationalising billions of pounds' worth of bank debt. While this helped reinject a little confidence into markets, the real upshot was merely to transfer that debt on to public-sector balance sheets.
This kind of card-shuffle trick has a long-established pedigree: after the dotcom bust, Alan Greenspan slashed US interest rates to (then) unprecedented lows, which helped dull the pain, but only at the cost of generating the housing bubble that fed sub-prime. It is not so different to the Ponzi scheme carried out by Bernard Madoff, except that unlike his hedge fund fraud, this one is being carried out in full public view.
The problem is that this has to stop somewhere, and that gasping noise over the past couple of weeks is the sound of millions of investors realising, all at once, that the music might have stopped. Having leapt back into the market in 2009 and fuelled the biggest stock-market leap since the recovery from the Wall Street Crash in the early 1930s, investors have suddenly deserted. London's FTSE 100 has lost 15 per cent of its value in little more than a month. The mayhem on European bourses is even worse, while on Wall Street the Dow Jones teeters on the brink of the talismanic 10,000 level.
Whatever yardstick you care to choose – share-price moves, the rates at which banks lend to each other, measures of volatility – we are now in a similar position to 2008.
Europe's problem is that the unfortunate game of pass-the-parcel came at just the wrong moment. It resulted in a hefty extra amount of debt being lumped on to its member states' balance sheets when they were least-equipped to deal with it.
Europe was always heading for a crunch. For years, the German and Dutch economies pulled in one direction (high saving, low spending) while the Club Med bloc – Greece, Portugal, Spain, Italy (and their Celtic outpost Ireland) – pulled in the other. At some point, there was always going to be a problem, given that these two economic blocs were yoked together in the same currency, controlled by the same central bank. By triggering the global recession and shovelling an unexpected load of debt on to Greece's balance sheet, the financial crisis has effectively smoked out the European folly.
The Club Med nations – and in many senses Britain – were not so different to sub-prime households: they borrowed cheap in order to raise their standards of living, ignoring the question of whether they could afford to take on so much debt. But, as King points out, sub-prime households – and the banks that lent to them – can usually be bailed out. The International Monetary Fund simply does not have enough cash to bail out a major economy like Spain, Italy or, heaven forfend, Britain. So, again, we find ourselves in unknown territory.
There are plenty of episodes in history when countries have been as indebted as they are now, but they are all associated with periods of war. History shows that when nations reach as high a level of indebtedness as Greece, and have as few prospects of growth, they will almost certainly default. Indeed, the IMF, which has pretty good experience of fiscal crises, privately recommended that Greece restructure its debt (a kind of soft default, renegotiating payment terms). It was refused point-blank by the European authorities.
To understand why, step back for a moment. It is fashionable to compare the current situation to the Lehman Brothers collapse, but that understates its severity. The sub-prime property market in the US, together with its slightly less toxic relatives, represented a $2 trillion mound of debt. The combined public and private debt of the most troubled European countries – Greece, Portugal, Spain and so on – is closer to $9 trillion.
Moreover, whereas the pain from sub-prime was spread out relatively widely, with investors hailing from both sides of the Atlantic, the owners of the suspect European debt tend almost exclusively to be, gulp, Europeans. No one is suggesting all of this debt will go bad, but the European policymakers fear that the merest hint that Greece might default would spark a chain reaction that would cause a more profound crisis than in 2008.
The problem is not merely that holders of Greek government debt would dump their investments, or even that they would ditch their Spanish and Portuguese bonds while they were at it. It is that government debt is the very bedrock of the financial system: should Greek government bonds collapse, the country's banking system would become insolvent overnight. In fact, banks throughout the euro area would be at risk, given that they tend to hold so much of their neighbours' government debt. That, at least, is the theory, but as was the case in the aftermath of Lehman's collapse, no one really knows how great their exposure is.
The other, more cynical, explanation for Brussels' refusal to countenance default is that it fears that this would fatally destabilise the euro project itself – which of course it would. But as the politicians are discovering, organising a European sovereign bail-out is far, far more difficult than rescuing a bank. It took barely more than a few days in September 2008 for the Government to push through the semi-nationalisation of Royal Bank of Scotland and HBOS.
Earlier this month, when the French President Nicolas Sarkozy announced that the continent would be saved by a "shock and awe" $1 trillion bail-out package, markets convinced themselves for a moment that the politicians might be able to manage it. But the challenge of having to co-ordinate an unprecedented rescue across a 16-nation region without a common language or central Treasury is proving too much for Europe's leaders. Add to this the fact that most citizens (particularly in Germany) resent the idea of bailing each other out at all, and are willing to vote out their governments to prove it, and you get the idea of the challenge at hand.
Despite his rather aloof appearance, European president Herman Van Rompuy put it pretty well this week, saying: "Today, people are discovering what a 'common destiny' in monetary matters means. They are discovering that the euro affects their pensions, savings, and jobs, their very daily life. It hurts. In my view, this growing public awareness is a major political development. It forces the governments to act."
That action, so far as Van Rompuy is concerned, means more integration and some eye-watering spending cuts across the continent. Unfortunately, both are being carried out in haphazard fashion. The bail-out package may pave the way for a central EU Treasury, but it is still being muddled through the legislative process, and could well fall foul of voters in France or Germany. Spain and Italy are, rightly, inflicting severe cuts on their budgets, but so is Germany, which ought, according to a host of economists including Mervyn King, to be spending more, not less.
In the meantime, European politicians, torn in one way by their voters, in another by Brussels, emit even more confusing signals which only destabilise markets further. Angela Merkel's ban on investors short-selling German bank shares, and the collapse of a swathe of Spanish savings banks have hardly helped, either. And all the while, the euro continues to fall as investors mull its fate. The single currency can survive – but only if its members agree to more political union, and the prospect of that would be about as palatable to the people of Europe this summer as an ouzo and retsina cocktail.
http://www.telegraph.co.uk/finance/comment/edmundconway/7770265/Is-Europe-heading-for-a-meltdown.html
This financial crisis is worse than the sub-prime crash of 2008 because the sums are so much bigger and it is governments that are in dire straits. Edmund Conway explains the dangers.
By Edmund Conway
Published: 8:21AM BST 27 May 2010
Comments 201 | Comment on this article
Mervyn King, the Bank of England Governor, summed it up best: "Dealing with a banking crisis was difficult enough," he said the other week, "but at least there were public-sector balance sheets on to which the problems could be moved. Once you move into sovereign debt, there is no answer; there's no backstop."
In other words, were this a computer game, the politicians would be down to their last life. Any mistake now and it really is Game Over. Or to pick a slightly more traditional game, it is rather like a session of pass-the-parcel which is fast approaching the end of the line.
The European financial crisis may look and smell rather different to the American banking crisis of a couple of years ago, but strip away the details – the breakdown of the euro, the crumbling of the Spanish banking system to take just two – and what you are left with is the next leg of a global financial crisis. Politicians temporarily "solved" the sub-prime crisis of 2007 and 2008 by nationalising billions of pounds' worth of bank debt. While this helped reinject a little confidence into markets, the real upshot was merely to transfer that debt on to public-sector balance sheets.
This kind of card-shuffle trick has a long-established pedigree: after the dotcom bust, Alan Greenspan slashed US interest rates to (then) unprecedented lows, which helped dull the pain, but only at the cost of generating the housing bubble that fed sub-prime. It is not so different to the Ponzi scheme carried out by Bernard Madoff, except that unlike his hedge fund fraud, this one is being carried out in full public view.
The problem is that this has to stop somewhere, and that gasping noise over the past couple of weeks is the sound of millions of investors realising, all at once, that the music might have stopped. Having leapt back into the market in 2009 and fuelled the biggest stock-market leap since the recovery from the Wall Street Crash in the early 1930s, investors have suddenly deserted. London's FTSE 100 has lost 15 per cent of its value in little more than a month. The mayhem on European bourses is even worse, while on Wall Street the Dow Jones teeters on the brink of the talismanic 10,000 level.
Whatever yardstick you care to choose – share-price moves, the rates at which banks lend to each other, measures of volatility – we are now in a similar position to 2008.
Europe's problem is that the unfortunate game of pass-the-parcel came at just the wrong moment. It resulted in a hefty extra amount of debt being lumped on to its member states' balance sheets when they were least-equipped to deal with it.
Europe was always heading for a crunch. For years, the German and Dutch economies pulled in one direction (high saving, low spending) while the Club Med bloc – Greece, Portugal, Spain, Italy (and their Celtic outpost Ireland) – pulled in the other. At some point, there was always going to be a problem, given that these two economic blocs were yoked together in the same currency, controlled by the same central bank. By triggering the global recession and shovelling an unexpected load of debt on to Greece's balance sheet, the financial crisis has effectively smoked out the European folly.
The Club Med nations – and in many senses Britain – were not so different to sub-prime households: they borrowed cheap in order to raise their standards of living, ignoring the question of whether they could afford to take on so much debt. But, as King points out, sub-prime households – and the banks that lent to them – can usually be bailed out. The International Monetary Fund simply does not have enough cash to bail out a major economy like Spain, Italy or, heaven forfend, Britain. So, again, we find ourselves in unknown territory.
There are plenty of episodes in history when countries have been as indebted as they are now, but they are all associated with periods of war. History shows that when nations reach as high a level of indebtedness as Greece, and have as few prospects of growth, they will almost certainly default. Indeed, the IMF, which has pretty good experience of fiscal crises, privately recommended that Greece restructure its debt (a kind of soft default, renegotiating payment terms). It was refused point-blank by the European authorities.
To understand why, step back for a moment. It is fashionable to compare the current situation to the Lehman Brothers collapse, but that understates its severity. The sub-prime property market in the US, together with its slightly less toxic relatives, represented a $2 trillion mound of debt. The combined public and private debt of the most troubled European countries – Greece, Portugal, Spain and so on – is closer to $9 trillion.
Moreover, whereas the pain from sub-prime was spread out relatively widely, with investors hailing from both sides of the Atlantic, the owners of the suspect European debt tend almost exclusively to be, gulp, Europeans. No one is suggesting all of this debt will go bad, but the European policymakers fear that the merest hint that Greece might default would spark a chain reaction that would cause a more profound crisis than in 2008.
The problem is not merely that holders of Greek government debt would dump their investments, or even that they would ditch their Spanish and Portuguese bonds while they were at it. It is that government debt is the very bedrock of the financial system: should Greek government bonds collapse, the country's banking system would become insolvent overnight. In fact, banks throughout the euro area would be at risk, given that they tend to hold so much of their neighbours' government debt. That, at least, is the theory, but as was the case in the aftermath of Lehman's collapse, no one really knows how great their exposure is.
The other, more cynical, explanation for Brussels' refusal to countenance default is that it fears that this would fatally destabilise the euro project itself – which of course it would. But as the politicians are discovering, organising a European sovereign bail-out is far, far more difficult than rescuing a bank. It took barely more than a few days in September 2008 for the Government to push through the semi-nationalisation of Royal Bank of Scotland and HBOS.
Earlier this month, when the French President Nicolas Sarkozy announced that the continent would be saved by a "shock and awe" $1 trillion bail-out package, markets convinced themselves for a moment that the politicians might be able to manage it. But the challenge of having to co-ordinate an unprecedented rescue across a 16-nation region without a common language or central Treasury is proving too much for Europe's leaders. Add to this the fact that most citizens (particularly in Germany) resent the idea of bailing each other out at all, and are willing to vote out their governments to prove it, and you get the idea of the challenge at hand.
Despite his rather aloof appearance, European president Herman Van Rompuy put it pretty well this week, saying: "Today, people are discovering what a 'common destiny' in monetary matters means. They are discovering that the euro affects their pensions, savings, and jobs, their very daily life. It hurts. In my view, this growing public awareness is a major political development. It forces the governments to act."
That action, so far as Van Rompuy is concerned, means more integration and some eye-watering spending cuts across the continent. Unfortunately, both are being carried out in haphazard fashion. The bail-out package may pave the way for a central EU Treasury, but it is still being muddled through the legislative process, and could well fall foul of voters in France or Germany. Spain and Italy are, rightly, inflicting severe cuts on their budgets, but so is Germany, which ought, according to a host of economists including Mervyn King, to be spending more, not less.
In the meantime, European politicians, torn in one way by their voters, in another by Brussels, emit even more confusing signals which only destabilise markets further. Angela Merkel's ban on investors short-selling German bank shares, and the collapse of a swathe of Spanish savings banks have hardly helped, either. And all the while, the euro continues to fall as investors mull its fate. The single currency can survive – but only if its members agree to more political union, and the prospect of that would be about as palatable to the people of Europe this summer as an ouzo and retsina cocktail.
http://www.telegraph.co.uk/finance/comment/edmundconway/7770265/Is-Europe-heading-for-a-meltdown.html
Diary of a Private Investor: how the pros make money from turbulence
Diary of a Private Investor: how the pros make money from turbulence
Unfortunately there is no foolproof system to deal with these sort of situations. When a panic occurs, it is usually right to buy.
By James Bartholomew
Published: 9:49AM BST 27 May 2010
What a daunting few weeks this has been in the stock market. In normal times, one or two worries present themselves. Recently they have had to form a queue.
It was bad enough when we were just worrying about Greece and its budget deficit. One of the scary numbers I came across was that German financial institutions hold $37bn in Greek bonds. That, I presume, is not counting money lent in forms other than bonds. If Greece defaulted, some major German banks would take a big hit. Think through all the consequences of that and you get to higher lending costs around Europe and renewed recession.
My shares quoted in Hong Kong were probably not too worried about that but they spiralled down for a different reason. China has tightened lending to quieten down property prices. And what are my biggest holdings in that area? Why, property companies of course.
Back home, growing anguish about the coalition government's apparent aim to tax capital gains more heavily in future is encouraging people to sell sooner rather than later. On Friday last week, I myself sold some Healthcare Locums (at 223p) held by one of my children to use up the tax free allowance under the current rules. The fear must be that many people will decide not to reinvest after selling if the new regime is harsh.
Then came news that the North Korean dictator has taken it into his head to prepare for war. Next came a crisis among Spanish banks. For those of us who are pretty fully invested, the bad news has been relentless. It has been like the charge of the light brigade: "Cannon to the right of them, cannon to the left of them, cannon in front of them … into the mouth of hell rode the six hundred"
Unfortunately there is no foolproof system to deal with these sort of situations. When a panic occurs, it is usually right to buy. But sometimes it is better to get out because the fears will turn out to be justified. As concerns about an uprising in Russia increased in 1917, I expect prices of Tsarist bonds fell back. It probably looked clever to buy on the dip. Unfortunately, as it turned out, when the communists took over, the bonds lost all their value except as wallpaper. So it all depends on how things actually turn out. Right now, if Greece and Spain do not default and if North Korea thinks better of starting a war, shares are cheap. On the other hand …
Investment obliges you to take a view on how things will turn out in politics and all sorts of other things. That is one of the things that makes it so interesting. Another aspect of investment is the influence of personality. I tend to be optimistic and that is probably key to why I think that we will probably muddle along. In any case, it occurs to me that even if North Korea attacks, this will probably not stop people going to have a drink at the pubs owned by one of my companies, Enterprise Inns. Some things you can rely on.
Last week I was even sanguine enough to buy more shares in Paragon, a mortgage lender, which came out with good results and made hopeful noises about restarting active lending. The purchase turned out to be horribly timed. I bought at 151p and, after the market falls, they are licking their wounds, as I write, at 133p. On Monday, my fears about Greece increased, and I wanted to reduce my exposure to further market weakness without selling any of my favoured companies. So I tried something I have never done before. I bought a few shares in an Exchange Traded Fund (ETF) designed to go up if the stock market goes down. It has the strange name, DB X-trackers FTSE 100 Short, and I bought at 938p.
Incidentally, I was astonished to see how big this fund is. The market capitalisation is an amazing £1.4bn. I had not realised just how big the business of being bearish on shares has become. This is just one of a number of such funds. But on Tuesday, the market fell so far and so fast – with Enterprise Inns down 10pc for example – that I decided the bearish trend had gone too far. I sold my bearish ETF for a little profit at 981p.
Unfortunately this bit of good timing was with only a tiny amount of money. Overall, I have been nearly fully invested and my portfolio had taken a bit of a battering.
-----
Some comments:
Thank you Jo.
Padraig, I am sorry but you are wrong in so many ways. Long term 'investing' is just as risky as short term trading. It's all a 'gamble' as you put it, I prefer the term 'bet' as it is all about calculated risk. You're right in that gambling loses in the long run but proper trading is not gambling. You are also right that it is impossible to pick market movements correctly all the time. One does not need to and I am often wrong, but I manage my risk effectively and ensure I capitalise on the times when I am right so that I make money. I do this over and over and over. The stock market is not the only thing to money on and markets do not go up all the time. How can you say that the only way to make money is in a strong bull market,just sell futures!
And yes as you have all pointed out Warren Buffet is succesful, but he not the only one in the world. Please measure your success your own way. Mr Buffett is not the only succesful investor in the world. There are thousands. Mr Buffet has done extrememely well but I could not replicate his success with his style as my personality is not suited for the long term approach. In reality I will not be as rich as him because the volumes in the market will not accommodate my short term approach and that is fine by me. I make money and so do many others.
---
Don't see your point, Paul. Stock or currency, bull or bear, you can make money. Day trading is fine if you're after 5% gains here and there, but most of us are here for 5 years or so, therefore long positions on shares are a much better idea.
I too am mostly all-in, James. It’s been a pretty stressful year or two, hasn't it? I've gone from 50% up to 35% down since Xmas, crazy times.
I agree entirely with you on the topic of your post, probably one of the most important lessons for any new PI for that matter.
Confident in Sarkozy talking tosh, I managed to pull out a blinding FTSE short (a proper CFD short, not an ETF) following the brief rally last week. It's shooting up today, but that was a lot of resistance on the 5k line it broke through on Tuesday, so I'm not too confident s/term - any any ideas for next week??!
http://www.telegraph.co.uk/finance/personalfinance/investing/shares-and-stock-tips/7767939/Diary-of-a-Private-Investor-how-the-pros-make-money-from-turbulence.html
Unfortunately there is no foolproof system to deal with these sort of situations. When a panic occurs, it is usually right to buy.
By James Bartholomew
Published: 9:49AM BST 27 May 2010
What a daunting few weeks this has been in the stock market. In normal times, one or two worries present themselves. Recently they have had to form a queue.
It was bad enough when we were just worrying about Greece and its budget deficit. One of the scary numbers I came across was that German financial institutions hold $37bn in Greek bonds. That, I presume, is not counting money lent in forms other than bonds. If Greece defaulted, some major German banks would take a big hit. Think through all the consequences of that and you get to higher lending costs around Europe and renewed recession.
My shares quoted in Hong Kong were probably not too worried about that but they spiralled down for a different reason. China has tightened lending to quieten down property prices. And what are my biggest holdings in that area? Why, property companies of course.
Back home, growing anguish about the coalition government's apparent aim to tax capital gains more heavily in future is encouraging people to sell sooner rather than later. On Friday last week, I myself sold some Healthcare Locums (at 223p) held by one of my children to use up the tax free allowance under the current rules. The fear must be that many people will decide not to reinvest after selling if the new regime is harsh.
Then came news that the North Korean dictator has taken it into his head to prepare for war. Next came a crisis among Spanish banks. For those of us who are pretty fully invested, the bad news has been relentless. It has been like the charge of the light brigade: "Cannon to the right of them, cannon to the left of them, cannon in front of them … into the mouth of hell rode the six hundred"
Unfortunately there is no foolproof system to deal with these sort of situations. When a panic occurs, it is usually right to buy. But sometimes it is better to get out because the fears will turn out to be justified. As concerns about an uprising in Russia increased in 1917, I expect prices of Tsarist bonds fell back. It probably looked clever to buy on the dip. Unfortunately, as it turned out, when the communists took over, the bonds lost all their value except as wallpaper. So it all depends on how things actually turn out. Right now, if Greece and Spain do not default and if North Korea thinks better of starting a war, shares are cheap. On the other hand …
Investment obliges you to take a view on how things will turn out in politics and all sorts of other things. That is one of the things that makes it so interesting. Another aspect of investment is the influence of personality. I tend to be optimistic and that is probably key to why I think that we will probably muddle along. In any case, it occurs to me that even if North Korea attacks, this will probably not stop people going to have a drink at the pubs owned by one of my companies, Enterprise Inns. Some things you can rely on.
Last week I was even sanguine enough to buy more shares in Paragon, a mortgage lender, which came out with good results and made hopeful noises about restarting active lending. The purchase turned out to be horribly timed. I bought at 151p and, after the market falls, they are licking their wounds, as I write, at 133p. On Monday, my fears about Greece increased, and I wanted to reduce my exposure to further market weakness without selling any of my favoured companies. So I tried something I have never done before. I bought a few shares in an Exchange Traded Fund (ETF) designed to go up if the stock market goes down. It has the strange name, DB X-trackers FTSE 100 Short, and I bought at 938p.
Incidentally, I was astonished to see how big this fund is. The market capitalisation is an amazing £1.4bn. I had not realised just how big the business of being bearish on shares has become. This is just one of a number of such funds. But on Tuesday, the market fell so far and so fast – with Enterprise Inns down 10pc for example – that I decided the bearish trend had gone too far. I sold my bearish ETF for a little profit at 981p.
Unfortunately this bit of good timing was with only a tiny amount of money. Overall, I have been nearly fully invested and my portfolio had taken a bit of a battering.
-----
Some comments:
Thank you Jo.
Padraig, I am sorry but you are wrong in so many ways. Long term 'investing' is just as risky as short term trading. It's all a 'gamble' as you put it, I prefer the term 'bet' as it is all about calculated risk. You're right in that gambling loses in the long run but proper trading is not gambling. You are also right that it is impossible to pick market movements correctly all the time. One does not need to and I am often wrong, but I manage my risk effectively and ensure I capitalise on the times when I am right so that I make money. I do this over and over and over. The stock market is not the only thing to money on and markets do not go up all the time. How can you say that the only way to make money is in a strong bull market,just sell futures!
And yes as you have all pointed out Warren Buffet is succesful, but he not the only one in the world. Please measure your success your own way. Mr Buffett is not the only succesful investor in the world. There are thousands. Mr Buffet has done extrememely well but I could not replicate his success with his style as my personality is not suited for the long term approach. In reality I will not be as rich as him because the volumes in the market will not accommodate my short term approach and that is fine by me. I make money and so do many others.
---
Don't see your point, Paul. Stock or currency, bull or bear, you can make money. Day trading is fine if you're after 5% gains here and there, but most of us are here for 5 years or so, therefore long positions on shares are a much better idea.
I too am mostly all-in, James. It’s been a pretty stressful year or two, hasn't it? I've gone from 50% up to 35% down since Xmas, crazy times.
I agree entirely with you on the topic of your post, probably one of the most important lessons for any new PI for that matter.
Confident in Sarkozy talking tosh, I managed to pull out a blinding FTSE short (a proper CFD short, not an ETF) following the brief rally last week. It's shooting up today, but that was a lot of resistance on the 5k line it broke through on Tuesday, so I'm not too confident s/term - any any ideas for next week??!
http://www.telegraph.co.uk/finance/personalfinance/investing/shares-and-stock-tips/7767939/Diary-of-a-Private-Investor-how-the-pros-make-money-from-turbulence.html
The Time Value of Money
"A bird in hand (today) is worth two in the bush (tomorrow)."
Everyone would rather have a dollar in his or her pocket today than to receive a dollar far into the future. Today's dollar is worth more - that it has more value - than a dollar received tomorrow.
The three main reasons for this difference in value are:
1. Inflation.
Inflation does reduce purchasing power (value) over time. With a 5% per year inflation, a dollar received a year from today will only buy 95c worth of goods.
2. Risk
There is always the chance that the promise of a dollar in the future will not be met and you will be out of luck. The risk could be low with a CD at an FDIC insured bank; or the risk could be high if it is your brother-in-law who is promising to repay a personal loan.
3. Opportunity Cost.
If you loan your dollar to someone else, you have lost the opportunity to use it yourself. That opportunity has a value to you today that makes today's dollar worth more than tomorrow's.
These three concepts - inflation, risk, and opportunity cost - are the drivers of present value (PV) and future value (FV) calculations used in capital budgeting and investing.
Present value (PV) calculations are used in business to compare cash flows (cash spent and received) at different times in the future. Converting cash flows into present values puts these different investments and returns onto a common basis and makes capital budgeting analysis more meaningful and useful in decision-making.
Nominal dollars are just the actual amount spent in dollars taken out of your wallet. Real dollars are adjusted for inflation. When you take out inflation (i.e. convert from 'nominal dollars' into 'real dollars') the price difference becomes much more comparable and easy to explain.
Capital Budgeting
In capital budgeting, different projects require different investment and will have different returns over time. In order to compare projects "apples to apples" and "oranges to oranges" on a financial basis, we will need to convert their cash flows into a common and comparable form. That common form is present value.
Simply put, a little bit of cash that is invested today followed by lots of cash returned in the near future would be a REALLY GOOD financial investment.
However, lots of cash invested today followed by a little bit of cash returned in a long time would be a REALLY BAD investment.
Capital budgeting analysis is as simple as that.
Everyone would rather have a dollar in his or her pocket today than to receive a dollar far into the future. Today's dollar is worth more - that it has more value - than a dollar received tomorrow.
The three main reasons for this difference in value are:
1. Inflation.
Inflation does reduce purchasing power (value) over time. With a 5% per year inflation, a dollar received a year from today will only buy 95c worth of goods.
2. Risk
There is always the chance that the promise of a dollar in the future will not be met and you will be out of luck. The risk could be low with a CD at an FDIC insured bank; or the risk could be high if it is your brother-in-law who is promising to repay a personal loan.
3. Opportunity Cost.
If you loan your dollar to someone else, you have lost the opportunity to use it yourself. That opportunity has a value to you today that makes today's dollar worth more than tomorrow's.
These three concepts - inflation, risk, and opportunity cost - are the drivers of present value (PV) and future value (FV) calculations used in capital budgeting and investing.
Present value (PV) calculations are used in business to compare cash flows (cash spent and received) at different times in the future. Converting cash flows into present values puts these different investments and returns onto a common basis and makes capital budgeting analysis more meaningful and useful in decision-making.
Nominal dollars are just the actual amount spent in dollars taken out of your wallet. Real dollars are adjusted for inflation. When you take out inflation (i.e. convert from 'nominal dollars' into 'real dollars') the price difference becomes much more comparable and easy to explain.
Capital Budgeting
In capital budgeting, different projects require different investment and will have different returns over time. In order to compare projects "apples to apples" and "oranges to oranges" on a financial basis, we will need to convert their cash flows into a common and comparable form. That common form is present value.
Simply put, a little bit of cash that is invested today followed by lots of cash returned in the near future would be a REALLY GOOD financial investment.
However, lots of cash invested today followed by a little bit of cash returned in a long time would be a REALLY BAD investment.
Capital budgeting analysis is as simple as that.
Think Like Warren Buffett
Think Like Warren Buffett
by Glenn Curtis (Contact Author | Biography)
Back in 1999, Robert G. Hagstrom wrote a book about the legendary investor Warren Buffett, entitled "The Warren Buffett Portfolio". What's so great about the book, and what makes it different from the countless other books and articles written about the "Oracle of Omaha" is that it offers the reader valuable insight into how Buffett actually thinks about investments. In other words, the book delves into the psychological mindset that has made Buffett so fabulously wealthy.
Although investors could benefit from reading the entire book, we've selected a bite-sized sampling of the tips and suggestions regarding the investor mindset and ways that an investor can improve their stock selection that will help you get inside Buffett's head.
1. Think of Stocks as a Business
Many investors think of stocks and the stock market in general as nothing more than little pieces of paper being traded back and forth among investors, which might help prevent investors from becoming too emotional over a given position but it doesn't necessarily allow them to make the best possible investment decisions.
That's why Buffett has stated he believes stockholders should think of themselves as "part owners" of the business in which they are investing. By thinking that way, both Hagstrom and Buffett argue that investors will tend to avoid making off-the-cuff investment decisions, and become more focused on the longer term. Furthermore, longer-term "owners" also tend to analyze situations in greater detail and then put a great eal of thought into buy and sell decisions. Hagstrom says this increased thought and analysis tends to lead to improved investment returns. (To read more about Buffett's ideologies, check out Warren Buffett: How He Does It and What Is Warren Buffett's Investing Style?)
2. Increase the Size of Your Investment
While it rarely - if ever - makes sense for investors to "put all of their eggs in one basket," putting all your eggs in too many baskets may not be a good thing either. Buffett contends that over-diversification can hamper returns as much as a lack of diversification. That's why he doesn't invest in mutual funds. It's also why he prefers to make significant investments in just a handful of companies. (To learn more about diversification, read Introduction To Diversification, The Importance Of Diversification and The Dangers Of Over-Diversification.)
Buffett is a firm believer that an investor must first do his or her homework before investing in any security. But after that due diligence process is completed, an investor should feel comfortable enough to dedicate a sizable portion of assets to that stock. They should also feel comfortable in winnowing down their overall investment portfolio to a handful of good companies with excellent growth prospects.
Buffett's stance on taking time to properly allocate your funds is furthered with his comment that it's not just about the best company, but how you feel about the company. If the best business you own presents the least financial risk and has the most favorable long-term prospects, why would you put money into your 20th favorite business rather than add money to the top choices?
3. Reduce Portfolio Turnover
Rapidly trading in and out of stocks can potentially make an individual a lot of money, but according to Buffett this trader is actually hampering his or her investment returns. That's because portfolio turnover increases the amount of taxes that must be paid on capital gains and boosts the total amount of commission dollars that must be paid in a given year.
The "Oracle" contends that what makes sense in business also makes sense in stocks: An investor should ordinarily hold a small piece of an outstanding business with the same tenacity that an owner would exhibit if he owned all of that business.
Investors must think long term. By having that mindset, they can avoid paying huge commission fees and lofty short-term capital gains taxes. They'll also be more apt to ride out any short-term fluctuations in the business, and to ultimately reap the rewards of increased earnings and/or dividends over time.
4. Develop Alternative Benchmarks
While stock prices may be the ultimate barometer of the success or failure of a given investment choice, Buffett does not focus on this metric. Instead, he analyzes and pores over the underlying economics of a given business or group of businesses. If a company is doing what it takes to grow itself on a profitable basis, then the share price will ultimately take care of itself.
Successful investors must look at the companies they own and study their true earnings potential. If the fundamentals are solid and the company is enhancing shareholder value by generating consistent bottom-line growth, the share price, in the long term, should reflect that. (To learn how to judge fundamentals on your own, see What Are Fundamentals?)
5. Learn to Think in Probabilities
Bridge is a card game in which the most successful players are able to judge mathematical probabilities to beat their opponents. Perhaps not surprisingly, Buffett loves and actively plays the game, and he takes the strategies beyond the game into the investing world.
Buffett suggests that investors focus on the economics of the companies they own (in other words the underlying businesses), and then try to weigh the probability that certain events will or will not transpire, much like a Bridge player checking the probabilities of his opponents' hands. He adds that by focusing on the economic aspect of the equation and not the stock price, an investor will be more accurate in his or her ability to judge probability.
Thinking in probabilities has its advantages. For example, an investor that ponders the probability that a company will report a certain rate of earnings growth over a period of five or 10 years is much more apt to ride out short-term fluctuations in the share price. By extension, this means that his investment returns are likely to be superior and that he will also realize fewer transaction and/or capital gains costs.
6. Recognize the Psychological Aspects of Investing
Very simply, this means that individuals must understand that there is a psychological mindset that the successful investor tends to have. More specifically, the successful investor will focus on probabilities and economic issues and let decisions be ruled by rational, as opposed to emotional, thinking.
More than anything, investors' own emotions can be their worst enemy. Buffett contends that the key to overcoming emotions is being able to "retain your belief in the real fundamentals of the business and to not get too concerned about the stock market."
Investors should realize that there is a certain psychological mindset that they should have if they want to be successful and try to implement that mindset. (To learn more about investor behaviors, read Understanding Investor Behavior, When Fear And Greed Take Over and Master Your Trading Mindtraps.)
7. Ignore Market Forecasts
There is an old saying that the Dow "climbs a wall of worry". In other words, in spite of the negativity in the marketplace, and those who perpetually contend that a recession is "just around the corner", the markets have fared quite well over time. Therefore, doomsayers should be ignored.
On the other side of the coin, there are just as many eternal optimists who argue that the stock market is headed perpetually higher. These should be ignored as well.
In all this confusion, Buffett suggests that investors should focus their efforts of isolating and investing in shares that are not currently being accurately valued by the market. The logic here is that as the stock market begins to realize the company's intrinsic value (through higher prices and greater demand), the investor will stand to make a lot of money.
8. Wait for the Fat Pitch
Hagstrom's book uses the model of legendary baseball player Ted Williams as an example of a wise investor. Williams would wait for a specific pitch (in an area of the plate where he knew he had a high probability of making contact with the ball) before swinging. It is said that this discipline enabled Williams to have a higher lifetime batting average than the average player.
Buffett, in the same way, suggests that all investors act as if they owned a lifetime decision card with only 20 investment choice punches in it. The logic is that this should prevent them from making mediocre investment choices and hopefully, by extension, enhance the overall returns of their respective portfolios.
Bottom Line
"The Warren Buffett Portfolio" is a timeless book that offers valuable insight into the psychological mindset of the legendary investor Warren Buffett. Of course, if learning how to invest like Warren Buffett were as easy as reading a book, everyone would be rich! But if you take that time and effort to implement some of Buffett's proven strategies, you could be on your way to better stock selection and greater returns.
by Glenn Curtis (Contact Author | Biography)
Glenn Curtis started his career as an equity analyst at Cantone Research, a New Jersey-based regional brokerage firm. He has since worked as an equity analyst and a financial writer at a number of print/web publications and brokerage firms including Registered Representative Magazine, Advanced Trading Magazine, Worldlyinvestor.com, RealMoney.com, TheStreet.com and Prudential Securities. Curtis has also held Series 6,7,24 and 63 securities licenses.
http://www.investopedia.com/articles/stocks/08/Buffett-style.asp
by Glenn Curtis (Contact Author | Biography)
Back in 1999, Robert G. Hagstrom wrote a book about the legendary investor Warren Buffett, entitled "The Warren Buffett Portfolio". What's so great about the book, and what makes it different from the countless other books and articles written about the "Oracle of Omaha" is that it offers the reader valuable insight into how Buffett actually thinks about investments. In other words, the book delves into the psychological mindset that has made Buffett so fabulously wealthy.
Although investors could benefit from reading the entire book, we've selected a bite-sized sampling of the tips and suggestions regarding the investor mindset and ways that an investor can improve their stock selection that will help you get inside Buffett's head.
1. Think of Stocks as a Business
Many investors think of stocks and the stock market in general as nothing more than little pieces of paper being traded back and forth among investors, which might help prevent investors from becoming too emotional over a given position but it doesn't necessarily allow them to make the best possible investment decisions.
That's why Buffett has stated he believes stockholders should think of themselves as "part owners" of the business in which they are investing. By thinking that way, both Hagstrom and Buffett argue that investors will tend to avoid making off-the-cuff investment decisions, and become more focused on the longer term. Furthermore, longer-term "owners" also tend to analyze situations in greater detail and then put a great eal of thought into buy and sell decisions. Hagstrom says this increased thought and analysis tends to lead to improved investment returns. (To read more about Buffett's ideologies, check out Warren Buffett: How He Does It and What Is Warren Buffett's Investing Style?)
2. Increase the Size of Your Investment
While it rarely - if ever - makes sense for investors to "put all of their eggs in one basket," putting all your eggs in too many baskets may not be a good thing either. Buffett contends that over-diversification can hamper returns as much as a lack of diversification. That's why he doesn't invest in mutual funds. It's also why he prefers to make significant investments in just a handful of companies. (To learn more about diversification, read Introduction To Diversification, The Importance Of Diversification and The Dangers Of Over-Diversification.)
Buffett is a firm believer that an investor must first do his or her homework before investing in any security. But after that due diligence process is completed, an investor should feel comfortable enough to dedicate a sizable portion of assets to that stock. They should also feel comfortable in winnowing down their overall investment portfolio to a handful of good companies with excellent growth prospects.
Buffett's stance on taking time to properly allocate your funds is furthered with his comment that it's not just about the best company, but how you feel about the company. If the best business you own presents the least financial risk and has the most favorable long-term prospects, why would you put money into your 20th favorite business rather than add money to the top choices?
3. Reduce Portfolio Turnover
Rapidly trading in and out of stocks can potentially make an individual a lot of money, but according to Buffett this trader is actually hampering his or her investment returns. That's because portfolio turnover increases the amount of taxes that must be paid on capital gains and boosts the total amount of commission dollars that must be paid in a given year.
The "Oracle" contends that what makes sense in business also makes sense in stocks: An investor should ordinarily hold a small piece of an outstanding business with the same tenacity that an owner would exhibit if he owned all of that business.
Investors must think long term. By having that mindset, they can avoid paying huge commission fees and lofty short-term capital gains taxes. They'll also be more apt to ride out any short-term fluctuations in the business, and to ultimately reap the rewards of increased earnings and/or dividends over time.
4. Develop Alternative Benchmarks
While stock prices may be the ultimate barometer of the success or failure of a given investment choice, Buffett does not focus on this metric. Instead, he analyzes and pores over the underlying economics of a given business or group of businesses. If a company is doing what it takes to grow itself on a profitable basis, then the share price will ultimately take care of itself.
Successful investors must look at the companies they own and study their true earnings potential. If the fundamentals are solid and the company is enhancing shareholder value by generating consistent bottom-line growth, the share price, in the long term, should reflect that. (To learn how to judge fundamentals on your own, see What Are Fundamentals?)
5. Learn to Think in Probabilities
Bridge is a card game in which the most successful players are able to judge mathematical probabilities to beat their opponents. Perhaps not surprisingly, Buffett loves and actively plays the game, and he takes the strategies beyond the game into the investing world.
Buffett suggests that investors focus on the economics of the companies they own (in other words the underlying businesses), and then try to weigh the probability that certain events will or will not transpire, much like a Bridge player checking the probabilities of his opponents' hands. He adds that by focusing on the economic aspect of the equation and not the stock price, an investor will be more accurate in his or her ability to judge probability.
Thinking in probabilities has its advantages. For example, an investor that ponders the probability that a company will report a certain rate of earnings growth over a period of five or 10 years is much more apt to ride out short-term fluctuations in the share price. By extension, this means that his investment returns are likely to be superior and that he will also realize fewer transaction and/or capital gains costs.
6. Recognize the Psychological Aspects of Investing
Very simply, this means that individuals must understand that there is a psychological mindset that the successful investor tends to have. More specifically, the successful investor will focus on probabilities and economic issues and let decisions be ruled by rational, as opposed to emotional, thinking.
More than anything, investors' own emotions can be their worst enemy. Buffett contends that the key to overcoming emotions is being able to "retain your belief in the real fundamentals of the business and to not get too concerned about the stock market."
Investors should realize that there is a certain psychological mindset that they should have if they want to be successful and try to implement that mindset. (To learn more about investor behaviors, read Understanding Investor Behavior, When Fear And Greed Take Over and Master Your Trading Mindtraps.)
7. Ignore Market Forecasts
There is an old saying that the Dow "climbs a wall of worry". In other words, in spite of the negativity in the marketplace, and those who perpetually contend that a recession is "just around the corner", the markets have fared quite well over time. Therefore, doomsayers should be ignored.
On the other side of the coin, there are just as many eternal optimists who argue that the stock market is headed perpetually higher. These should be ignored as well.
In all this confusion, Buffett suggests that investors should focus their efforts of isolating and investing in shares that are not currently being accurately valued by the market. The logic here is that as the stock market begins to realize the company's intrinsic value (through higher prices and greater demand), the investor will stand to make a lot of money.
8. Wait for the Fat Pitch
Hagstrom's book uses the model of legendary baseball player Ted Williams as an example of a wise investor. Williams would wait for a specific pitch (in an area of the plate where he knew he had a high probability of making contact with the ball) before swinging. It is said that this discipline enabled Williams to have a higher lifetime batting average than the average player.
Buffett, in the same way, suggests that all investors act as if they owned a lifetime decision card with only 20 investment choice punches in it. The logic is that this should prevent them from making mediocre investment choices and hopefully, by extension, enhance the overall returns of their respective portfolios.
Bottom Line
"The Warren Buffett Portfolio" is a timeless book that offers valuable insight into the psychological mindset of the legendary investor Warren Buffett. Of course, if learning how to invest like Warren Buffett were as easy as reading a book, everyone would be rich! But if you take that time and effort to implement some of Buffett's proven strategies, you could be on your way to better stock selection and greater returns.
by Glenn Curtis (Contact Author | Biography)
Glenn Curtis started his career as an equity analyst at Cantone Research, a New Jersey-based regional brokerage firm. He has since worked as an equity analyst and a financial writer at a number of print/web publications and brokerage firms including Registered Representative Magazine, Advanced Trading Magazine, Worldlyinvestor.com, RealMoney.com, TheStreet.com and Prudential Securities. Curtis has also held Series 6,7,24 and 63 securities licenses.
http://www.investopedia.com/articles/stocks/08/Buffett-style.asp
The Fundamental Mechanics Of Investing
The Fundamental Mechanics Of Investing
by Andrew Beattie (Contact Author | Biography)
In this article, we tell a simple story that demonstrates why stocks and bonds are created.
A Business Is Created
Jack is a farmer, and he is interested in starting up an apple stand for the tourists who pass his place. Since Jack has fairly good credit, he got a business loan to cover the costs of set up, and he now has the ideal land for apple growing. Unfortunately Jack only set aside enough money for getting his land in shape. He forgot all about buying seeds. By a stroke of luck, Jack finds a store that will sell him a magic high-growth, high-yield seed for $100, but Jack only has $50 left.
The Initial Public Offering to Raise Capital for Growth
Our clever farmer goes to five of his closest friends (you're included) and asks if they'll each give him $10 to help his business. However, Jack doesn't know if he can take it in the form of a loan because he may not be able to pay it back if the seed doesn't turn a profit. No worries: Jack promises everyone they'll receive a percentage of the tree's apples that is equal to the percentage they gave. In other words, Jack has given his friends a share in his tree. They agree and the seed is in the ground before you can sing "Johnny Appleseed".
The Distinction Between Being a Partner and Being a Shareholder
This tree, being magic and all, grows rapidly. In the first month, it is five feet tall and there are two apples. Jack keeps one apple because he owns 50% of the business's product, which he paid for with the $50 dollars he put in for the seed. He cuts the other one into five pieces, each of which goes to each of his investors, who can sell or eat it. The investors have a quick meeting and decide they'd rather have Jack sell their portion of the product and give them a percentage of the profit. So Jack makes up little papers saying, "Jack's Apple Company: you have one share guaranteeing you 10% (10/100) of the profits."
Trading Occurs in Jack's Undervalued Stock
So this tree really takes off now - the magic is coursing through the wood and it grows to 10 feet tall! There are 20 apples and Jack sells them all for $10 a piece, keeping $100 for himself and giving his friends $20 each. Jack uses his $100 to buy another seed and plants it. Pretty soon, Jack has two trees producing 40 apples and earning $400 a month.
Some of his neighbors want in on the deal Jack gave his friends, and Tim, Jack's first investor, is interested in selling his 10% of Jack's Apple Company. Judy, Jack's neighbor, wants to buy it and she offers Tim the $10 that he originally paid. However, Tim is not stupid: he realizes that this share is producing $40 a month and Jack is about to buy another seed. So Tim asks for $40 dollars and Judy snaps up the share, which pays for itself immediately.
A Bit of a Bubble Forms
The other original shareholders see how much Tim got and want to sell too, and the other neighbors notice how quickly Judy's investment paid off so they really want to buy in. The offers steadily climb until Jack's shares are being bought for over $100 a piece - more than Jack's trees are producing in a month. Only one original shareholder, Betty, is still in there and holding out on offers like $120 because she is still getting a regular payment that is pure profit for her. Suddenly, Jack's trees (four in total) are ravaged by aphids. The entire month's production is ruined and several shareholders are wondering if they can pay rent since they used their savings to buy shares.
The Bubble Bursts
The shareholders that need the money sell to Betty at a discount ($40), and then the other shareholders notice, all of a sudden, that their $100 shares are worth $40. This is very disconcerting. The remaining shareholders offer their shares to Betty, but she says she's quite content with three shares. The other shareholders are desperate now, so when the town sheriff offers them $20 a piece for the shares, they take their losses and get out.
Meanwhile, the main drive of Jack's business hasn't changed: people still want apples. Jack needs to get rid of these pesky aphids and he needs the money to buy insecticide.
Jack Issues a Bond
Jack's not too keen on issuing more stock after the fiasco with his neighbors, so he decides to go for a loan instead. Unfortunately, Jack used up his credit with the land preparation so he is once again looking for divine inspiration. He's looking at his equipment to see what he can sell and what he can't, and then it hits him: he'll try to sell his apple crates without actually selling them. The crates are useless without aphid-free product to fill them, but as soon as the aphids are gone he'll need them back.
So Jack calls up Judy (in hopes of making amends) and offers her a deal, "Judy, my good friend, I have an offer for you. I'll sell you my apple crates, which are worth $100 total, for a mere $60 and then buy them back next week for the full $100." Judy thinks about this and sees that in the worst case scenario, she can just sell the crates… sounds good. And a deal is made.
"But Judy," Jack adds, "I don't want to run my crates down there and pick them up again. Can I just write up a piece of paper? It'll save my back."
"I don't know - can we call it a promissory note?" Judy asks enthusiastically.
"Sure can, but I was thinking more of calling it a bond or a certificate," says Jack.
And lo and behold, Jack eliminates the aphids, pays Judy back, and turns a healthy profit that month and every month thereafter.
What Did We Learn?
This story will not explain everything about investing in stocks, but it does highlight one very important point: the price of Jack's stock followed investors' opinion of the stock's value rather than just the performance of Jack's company. Because the stock market is an auction, there is no set price for a certain stock, there is a concept that derails most people's trains of thought: the price paid for a stock is what it's "worth" until a lower or higher price is offered.
This fluctuation of worth is good and bad for investors because it allows for profit (when you buy an undervalued stock) but also makes losses possible (when you pay too much for a stock). If you would like to advance your understanding of stocks, please check out this Stock Basics.
For more on bonds, see the Bond Basics.
by Andrew Beattie (Contact Author | Biography)
http://www.investopedia.com/articles/basics/03/062703.asp?partner=basics5
by Andrew Beattie (Contact Author | Biography)
In this article, we tell a simple story that demonstrates why stocks and bonds are created.
A Business Is Created
Jack is a farmer, and he is interested in starting up an apple stand for the tourists who pass his place. Since Jack has fairly good credit, he got a business loan to cover the costs of set up, and he now has the ideal land for apple growing. Unfortunately Jack only set aside enough money for getting his land in shape. He forgot all about buying seeds. By a stroke of luck, Jack finds a store that will sell him a magic high-growth, high-yield seed for $100, but Jack only has $50 left.
The Initial Public Offering to Raise Capital for Growth
Our clever farmer goes to five of his closest friends (you're included) and asks if they'll each give him $10 to help his business. However, Jack doesn't know if he can take it in the form of a loan because he may not be able to pay it back if the seed doesn't turn a profit. No worries: Jack promises everyone they'll receive a percentage of the tree's apples that is equal to the percentage they gave. In other words, Jack has given his friends a share in his tree. They agree and the seed is in the ground before you can sing "Johnny Appleseed".
The Distinction Between Being a Partner and Being a Shareholder
This tree, being magic and all, grows rapidly. In the first month, it is five feet tall and there are two apples. Jack keeps one apple because he owns 50% of the business's product, which he paid for with the $50 dollars he put in for the seed. He cuts the other one into five pieces, each of which goes to each of his investors, who can sell or eat it. The investors have a quick meeting and decide they'd rather have Jack sell their portion of the product and give them a percentage of the profit. So Jack makes up little papers saying, "Jack's Apple Company: you have one share guaranteeing you 10% (10/100) of the profits."
Trading Occurs in Jack's Undervalued Stock
So this tree really takes off now - the magic is coursing through the wood and it grows to 10 feet tall! There are 20 apples and Jack sells them all for $10 a piece, keeping $100 for himself and giving his friends $20 each. Jack uses his $100 to buy another seed and plants it. Pretty soon, Jack has two trees producing 40 apples and earning $400 a month.
Some of his neighbors want in on the deal Jack gave his friends, and Tim, Jack's first investor, is interested in selling his 10% of Jack's Apple Company. Judy, Jack's neighbor, wants to buy it and she offers Tim the $10 that he originally paid. However, Tim is not stupid: he realizes that this share is producing $40 a month and Jack is about to buy another seed. So Tim asks for $40 dollars and Judy snaps up the share, which pays for itself immediately.
A Bit of a Bubble Forms
The other original shareholders see how much Tim got and want to sell too, and the other neighbors notice how quickly Judy's investment paid off so they really want to buy in. The offers steadily climb until Jack's shares are being bought for over $100 a piece - more than Jack's trees are producing in a month. Only one original shareholder, Betty, is still in there and holding out on offers like $120 because she is still getting a regular payment that is pure profit for her. Suddenly, Jack's trees (four in total) are ravaged by aphids. The entire month's production is ruined and several shareholders are wondering if they can pay rent since they used their savings to buy shares.
The Bubble Bursts
The shareholders that need the money sell to Betty at a discount ($40), and then the other shareholders notice, all of a sudden, that their $100 shares are worth $40. This is very disconcerting. The remaining shareholders offer their shares to Betty, but she says she's quite content with three shares. The other shareholders are desperate now, so when the town sheriff offers them $20 a piece for the shares, they take their losses and get out.
Meanwhile, the main drive of Jack's business hasn't changed: people still want apples. Jack needs to get rid of these pesky aphids and he needs the money to buy insecticide.
Jack Issues a Bond
Jack's not too keen on issuing more stock after the fiasco with his neighbors, so he decides to go for a loan instead. Unfortunately, Jack used up his credit with the land preparation so he is once again looking for divine inspiration. He's looking at his equipment to see what he can sell and what he can't, and then it hits him: he'll try to sell his apple crates without actually selling them. The crates are useless without aphid-free product to fill them, but as soon as the aphids are gone he'll need them back.
So Jack calls up Judy (in hopes of making amends) and offers her a deal, "Judy, my good friend, I have an offer for you. I'll sell you my apple crates, which are worth $100 total, for a mere $60 and then buy them back next week for the full $100." Judy thinks about this and sees that in the worst case scenario, she can just sell the crates… sounds good. And a deal is made.
"But Judy," Jack adds, "I don't want to run my crates down there and pick them up again. Can I just write up a piece of paper? It'll save my back."
"I don't know - can we call it a promissory note?" Judy asks enthusiastically.
"Sure can, but I was thinking more of calling it a bond or a certificate," says Jack.
And lo and behold, Jack eliminates the aphids, pays Judy back, and turns a healthy profit that month and every month thereafter.
What Did We Learn?
This story will not explain everything about investing in stocks, but it does highlight one very important point: the price of Jack's stock followed investors' opinion of the stock's value rather than just the performance of Jack's company. Because the stock market is an auction, there is no set price for a certain stock, there is a concept that derails most people's trains of thought: the price paid for a stock is what it's "worth" until a lower or higher price is offered.
This fluctuation of worth is good and bad for investors because it allows for profit (when you buy an undervalued stock) but also makes losses possible (when you pay too much for a stock). If you would like to advance your understanding of stocks, please check out this Stock Basics.
For more on bonds, see the Bond Basics.
by Andrew Beattie (Contact Author | Biography)
http://www.investopedia.com/articles/basics/03/062703.asp?partner=basics5
Friday, 28 May 2010
A quick look at Genting Malaysia GENM (27.5.2010)
A quick look at Genting Malaysia GENM (27.5.2010)
http://spreadsheets.google.com/pub?key=t6p93zBmPtzub4oIFBVLGCg&output=html
Benjamin Graham's Checklist for GENM (28.5.2010)
http://spreadsheets.google.com/pub?key=tAN3tcyRLcCj8SFLWNuMeCA&output=html
Thursday, 27 May 2010
A quick look at Padini (27.5.2010)
A quick look at Padini (27.5.2010)
http://spreadsheets.google.com/pub?key=tFNtOWNR4IJxYz7y76WL9NA&output=html
Benjamin Graham's Checklist for Padini (28.5.2010)
http://spreadsheets.google.com/pub?key=tKYB6E7Pp3YKh83Wnl7rc4w&output=html
A quick look at Kelington KGB (27.5.2010)
A quick look at Kelington KGB (27.5.2010)
http://spreadsheets.google.com/pub?key=tSG1Twj4DrIi5BPn29MoK5Q&output=html
AVOID
http://spreadsheets.google.com/pub?key=tSG1Twj4DrIi5BPn29MoK5Q&output=html
AVOID
Who Creates the Wealth in Society? (Part 3 of 3)
MAY 21, 2010, 6:00 AM
Who Creates the Wealth in Society?
By UWE E. REINHARDT
Uwe E. Reinhardt is an economics professor at Princeton.
This is the third post in my trilogy on the creation of a nation’s wealth.
In the first I explored what is meant by wealth. The second looked at companies as creators of wealth, with a digression on the social and economic purpose of business corporations. In this concluding post in the trilogy, I explore who are society’s main creators of wealth.
In so doing, I shall draw heavily on a lecture entitled “What Is the Wealth of a Nation?” that I delivered in 2002, at the end of a freshman economics course. Earlier posts in the trilogy drew on that lecture as well.
The lecture was inspired by the cover of a well-known business magazine that celebrated “America’s Great Wealth Creators,” with photos of dot-com heroes of the day and Jack Welch, the chief executive of General Electric until 2001. The magazine was celebrating, of course, the market capitalization of the companies led by these “wealth creators.”
This occurred toward the end of what we now call the dot.com bubble, as the price-to-earnings ratio — the market price of stocks relative to earnings — soared far above historical values, while silly books like “Dow 36,000: The New Strategy for Profiting from the Coming Rise in Stock” by James K. Glassman and Kevin A. Hassett were greeted with the utmost respect on Wall Street and in the media.
As it turned out, much of the what these “wealth creators” were said to have created was ephemeral (see the graph below and also my post “Jack Welch and the Lone Ranger Theory“), just as the subsequent fabulous wealth created by the financial sector during 2004-8 has been ephemeral.
The point of my lecture was not that businesses and their leaders do not contribute to creating the nation’s wealth. Far from it (see my paper “On the Not So Simple Steps Involved in Starting a Business Venture“). By organizing and focusing a variety of resources in a way that produces products and services designed to please someone, businesses make a significant contribution to the creation of value and wealth.
Yahoo General Electric stock performance over time, compared with major indexes. Black triangles indicate stock splits.
My point in the lecture was merely that the precise magnitude of the contribution a company makes to wealth is not easily measured, and certainly not by its market capitalization. Furthermore, I pointed out, the value and wealth contributed by companies and their leaders come only at the end of a long chain of wealth creation on which businesses capitalize, starting with the basic unit in society: the family.
It is now well recognized that the wealth of modern societies is dictated not so much by the natural resources at their disposal, but by their human capital — the knowledge and skill of human beings and their ability to learn and apply new knowledge on their own.
Anyone who has raised children to maturity appreciates the magnificent contribution conscientious parents can make to this human-capital formation, because much of the education of youngsters takes place in the home. Conscientious parents — and especially mothers — rank as the major wealth creators in modern societies, as, of course, do the offspring whose own effort is crucial in assembling that capital.
Next come educators, especially the visionary and dedicated elementary and high school teachers who succeed in getting their students interested in learning and motivated to amass human capital. The role of such teachers in the wealth-creation process is not sufficiently appreciated in our latitudes.
We at the level of higher education also contribute, of course, to the process of human-capital formation, but we have the privilege of preselecting our students and probably deserve less credit in the wealth-creation chain than do parents and high school teachers.
None of the forgoing is to say that being highly educated and skilled is either a necessary or a sufficient condition for contributing value and wealth to society. Anyone who works, be it for pay or as a volunteer, does so.
Finally, what about government? A common mantra in the United States is that “government does not create wealth, people do.” We shall hear it again and again in the Congressional campaigns this fall. What are we to make of that assertion?
In some sense, of course, the mantra is true. Government per se is just an inert set of legal contracts, as is any business. Thus one should really say: “Government and business do not create wealth. The people working in them do.”
If anyone doubts that the people working in government do not create wealth, let them imagine a society without a well-functioning government. Afghanistan immediately comes to mind.
Governments everywhere in modern societies provide the legal and much of the physical infrastructure on which private production and commerce thrive. Imagine a world in which private contracts can be adjudicated and enforced only by private thugs rather than in the civil courts.
Just as sports contests could not be fairly conducted without a strict set of rules and referees with power, so private markets could not thrive without regulations and regulators with power. A truly laissez-faire market economy would be apt to be a mess, as what Wall Street made of its own business in recent years reminds us.
In my lecture on wealth, I went to some length to provide other examples in which government contributes directly to the nation’s wealth and is, indeed, a holder of much concrete wealth on our behalf.
A nation’s wealth is truly a joint creation in which individuals, families, business and government all play crucial parts. Finding just that mix of efforts and regulations that will maximize society’s well-being is a tricky and never-ending quest.
http://economix.blogs.nytimes.com/2010/05/21/who-creates-the-wealth-in-society/
Who Creates the Wealth in Society?
By UWE E. REINHARDT
Uwe E. Reinhardt is an economics professor at Princeton.
This is the third post in my trilogy on the creation of a nation’s wealth.
In the first I explored what is meant by wealth. The second looked at companies as creators of wealth, with a digression on the social and economic purpose of business corporations. In this concluding post in the trilogy, I explore who are society’s main creators of wealth.
In so doing, I shall draw heavily on a lecture entitled “What Is the Wealth of a Nation?” that I delivered in 2002, at the end of a freshman economics course. Earlier posts in the trilogy drew on that lecture as well.
The lecture was inspired by the cover of a well-known business magazine that celebrated “America’s Great Wealth Creators,” with photos of dot-com heroes of the day and Jack Welch, the chief executive of General Electric until 2001. The magazine was celebrating, of course, the market capitalization of the companies led by these “wealth creators.”
This occurred toward the end of what we now call the dot.com bubble, as the price-to-earnings ratio — the market price of stocks relative to earnings — soared far above historical values, while silly books like “Dow 36,000: The New Strategy for Profiting from the Coming Rise in Stock” by James K. Glassman and Kevin A. Hassett were greeted with the utmost respect on Wall Street and in the media.
As it turned out, much of the what these “wealth creators” were said to have created was ephemeral (see the graph below and also my post “Jack Welch and the Lone Ranger Theory“), just as the subsequent fabulous wealth created by the financial sector during 2004-8 has been ephemeral.
The point of my lecture was not that businesses and their leaders do not contribute to creating the nation’s wealth. Far from it (see my paper “On the Not So Simple Steps Involved in Starting a Business Venture“). By organizing and focusing a variety of resources in a way that produces products and services designed to please someone, businesses make a significant contribution to the creation of value and wealth.
Yahoo General Electric stock performance over time, compared with major indexes. Black triangles indicate stock splits.
My point in the lecture was merely that the precise magnitude of the contribution a company makes to wealth is not easily measured, and certainly not by its market capitalization. Furthermore, I pointed out, the value and wealth contributed by companies and their leaders come only at the end of a long chain of wealth creation on which businesses capitalize, starting with the basic unit in society: the family.
It is now well recognized that the wealth of modern societies is dictated not so much by the natural resources at their disposal, but by their human capital — the knowledge and skill of human beings and their ability to learn and apply new knowledge on their own.
Anyone who has raised children to maturity appreciates the magnificent contribution conscientious parents can make to this human-capital formation, because much of the education of youngsters takes place in the home. Conscientious parents — and especially mothers — rank as the major wealth creators in modern societies, as, of course, do the offspring whose own effort is crucial in assembling that capital.
Next come educators, especially the visionary and dedicated elementary and high school teachers who succeed in getting their students interested in learning and motivated to amass human capital. The role of such teachers in the wealth-creation process is not sufficiently appreciated in our latitudes.
We at the level of higher education also contribute, of course, to the process of human-capital formation, but we have the privilege of preselecting our students and probably deserve less credit in the wealth-creation chain than do parents and high school teachers.
None of the forgoing is to say that being highly educated and skilled is either a necessary or a sufficient condition for contributing value and wealth to society. Anyone who works, be it for pay or as a volunteer, does so.
Finally, what about government? A common mantra in the United States is that “government does not create wealth, people do.” We shall hear it again and again in the Congressional campaigns this fall. What are we to make of that assertion?
In some sense, of course, the mantra is true. Government per se is just an inert set of legal contracts, as is any business. Thus one should really say: “Government and business do not create wealth. The people working in them do.”
If anyone doubts that the people working in government do not create wealth, let them imagine a society without a well-functioning government. Afghanistan immediately comes to mind.
Governments everywhere in modern societies provide the legal and much of the physical infrastructure on which private production and commerce thrive. Imagine a world in which private contracts can be adjudicated and enforced only by private thugs rather than in the civil courts.
Just as sports contests could not be fairly conducted without a strict set of rules and referees with power, so private markets could not thrive without regulations and regulators with power. A truly laissez-faire market economy would be apt to be a mess, as what Wall Street made of its own business in recent years reminds us.
In my lecture on wealth, I went to some length to provide other examples in which government contributes directly to the nation’s wealth and is, indeed, a holder of much concrete wealth on our behalf.
A nation’s wealth is truly a joint creation in which individuals, families, business and government all play crucial parts. Finding just that mix of efforts and regulations that will maximize society’s well-being is a tricky and never-ending quest.
http://economix.blogs.nytimes.com/2010/05/21/who-creates-the-wealth-in-society/
How Businesses Create Wealth (Part 2 of 3)
MAY 7, 2010, 6:00 AM
How Businesses Create Wealth
By UWE E. REINHARDT
Uwe E. Reinhardt is an economics professor at Princeton.
In last week’s post I offered a near metaphysical definition of wealth that set off a lively round of commentaries.
This week I explore how companies create “value” and distribute it among various stakeholders.
That value can be consumed on the spot to produce other goods and services or to create a consumer’s well-being. Alternatively, it can be saved and stored in the form of some asset. Freshman economics texts define an economic unit’s wealth as the market value of all of its assets minus its liabilities. Value creation and wealth are thus related.
Let’s imagine a company called ABC Inc., which produces a standard, ordinary commodity, by which I mean that society does not hold particular ethical strictures on its distribution (as we, for example, do for health care and education). The chart below sketches the value flow caused by the production of some volume of output. (The pipes going in and out of the company are not drawn to scale.)
Uwe E. Reinhardt
The large pipe in the upper left corner labeled “Gross Value Created” represents the maximum revenue ABC Inc. could have extracted from its customers if each unit of output could have been auctioned off, one after the other, to the highest bidder — an arrangement economists call “perfect price discrimination.” This hypothetical, maximum extractable revenue is the economist’s measure of the “social value” of ABC Inc.’s output.
Evidently, by thus defining social value, economists tacitly assume that rich people, who can bid a higher price for a thing, “value” the thing more than do poor people, even though rich people may not crave it any more than do poor people and possibly even less. It often surprises students that modern economics is solidly based on that legerdemain, which I admit to them in a memo entitled: “How We Economists Bastardized Benthamite Utilitarianism and Became Shills for the Wealthy.”
Leaving aside this important fine point, the sketch is drawn to show that ABC is not able to capture in the form of “sales revenue” all of the gross value it creates.
This is because in most markets, output is sold at a single, common price to all customers, which allows many of them to obtain units of the output at market prices below the maximum bid prices they would have offered in our hypothetical auction. The difference between the two prices is called “buyers’ surplus.” It is a kind of intangible profit that sellers must cede to buyers.
ABC Inc. now distributes the value it captures as “sales revenue” to sundry stakeholders as follows.
Usually the largest fraction is allocated to employees in the form of “employee compensation.” For most employees, the gross value they extract from the corporation as compensation exceeds their so-called “reservation wage.” The latter is the minimum compensation they would have to be paid to attract them to and retain them in the corporation.
This “reservation wage,” of course, is strongly influenced by what the employee could earn in the next best employ — the employee’s “opportunity costs” of working for ABC Inc. — but it also is influenced by how much employees like working there.
The difference between an employee’s actual compensation and his or her reservation wage is the net value employees extract from the corporation. Economists view it as a form of profit, too.
Indeed, it may astound union leaders that many companies bestow more profits of this type on their employees than they bestow profits on their shareholders. It almost surely is so in heavily unionized industries — e.g., the automobile or transportation industries. But it can easily be true even in non-unionized industries.
Brushing lightly over the fraction of ABC’s sales revenue (which is captured gross value) that flows to creditors in the form of interest, to suppliers of non-labor inputs, and to government in the form of taxes, we arrive at a residual that accrues to the owners as “profit available for distribution to shareholders.”
Management and the company’s directors may decide to distribute some of that residual to shareholders in the form of cash dividends. But usually the bulk or even all of it is plowed back into the company in the form of “retained earnings.” Few shareholders take out much of the gross value their companies create in the form of cash.
Wall Street bases its estimate of the company’s “market capitalization” solely on the residual “profit available for shareholders” pipe, eclipsing from view the entire value-flow that accrues to other stakeholders. Unfortunately, many journalists and pundits in the financial press then mistake that “market capitalization” as the sole measure of the “wealth” the company creates, not realizing that this metric can rise or fall for reasons other then genuine value creation by the company.
Suppose, for example, that a company’s volume of output has not changed, but that it somehow manages to raise prices paid by some or all buyers, capturing more of an unchanged gross value created by the company’s output. The company’s market capitalization would be likely to rise as a result of the price increase. But would that add to the nation’s stock of wealth? Or would it merely be a redistribution of wealth from buyers to shareholders?
Similarly, suppose new management takes over and changes nothing other than reducing or eliminating retiree health benefits promised to already retired workers during their working years, albeit in a contract that can be broken (as many such contracts can be broken). If those savings in expenses then flow through to the owners’ profits, the company’s market capitalization would be likely to increase. But is that an increase in national wealth?
I would argue that a corporation contributes to national wealth only if it does something to increase the “total gross value” of what it produces. Someone will then get that added gross value — the buyers in the form of buyers’ surplus or employees in the form of added compensation (perhaps mainly executive bonuses) or the shareholders, and so on.
Regardless of its distribution among stakeholders, and even if none of it flows to the company’s owners, that added gross value can be viewed an addition to national wealth, at least at that moment, before it may be burned up in production elsewhere or on consumption.
http://economix.blogs.nytimes.com/2010/05/07/how-businesses-create-wealth/
How Businesses Create Wealth
By UWE E. REINHARDT
Uwe E. Reinhardt is an economics professor at Princeton.
In last week’s post I offered a near metaphysical definition of wealth that set off a lively round of commentaries.
This week I explore how companies create “value” and distribute it among various stakeholders.
That value can be consumed on the spot to produce other goods and services or to create a consumer’s well-being. Alternatively, it can be saved and stored in the form of some asset. Freshman economics texts define an economic unit’s wealth as the market value of all of its assets minus its liabilities. Value creation and wealth are thus related.
Let’s imagine a company called ABC Inc., which produces a standard, ordinary commodity, by which I mean that society does not hold particular ethical strictures on its distribution (as we, for example, do for health care and education). The chart below sketches the value flow caused by the production of some volume of output. (The pipes going in and out of the company are not drawn to scale.)
Uwe E. Reinhardt
The large pipe in the upper left corner labeled “Gross Value Created” represents the maximum revenue ABC Inc. could have extracted from its customers if each unit of output could have been auctioned off, one after the other, to the highest bidder — an arrangement economists call “perfect price discrimination.” This hypothetical, maximum extractable revenue is the economist’s measure of the “social value” of ABC Inc.’s output.
Evidently, by thus defining social value, economists tacitly assume that rich people, who can bid a higher price for a thing, “value” the thing more than do poor people, even though rich people may not crave it any more than do poor people and possibly even less. It often surprises students that modern economics is solidly based on that legerdemain, which I admit to them in a memo entitled: “How We Economists Bastardized Benthamite Utilitarianism and Became Shills for the Wealthy.”
Leaving aside this important fine point, the sketch is drawn to show that ABC is not able to capture in the form of “sales revenue” all of the gross value it creates.
This is because in most markets, output is sold at a single, common price to all customers, which allows many of them to obtain units of the output at market prices below the maximum bid prices they would have offered in our hypothetical auction. The difference between the two prices is called “buyers’ surplus.” It is a kind of intangible profit that sellers must cede to buyers.
ABC Inc. now distributes the value it captures as “sales revenue” to sundry stakeholders as follows.
Usually the largest fraction is allocated to employees in the form of “employee compensation.” For most employees, the gross value they extract from the corporation as compensation exceeds their so-called “reservation wage.” The latter is the minimum compensation they would have to be paid to attract them to and retain them in the corporation.
This “reservation wage,” of course, is strongly influenced by what the employee could earn in the next best employ — the employee’s “opportunity costs” of working for ABC Inc. — but it also is influenced by how much employees like working there.
The difference between an employee’s actual compensation and his or her reservation wage is the net value employees extract from the corporation. Economists view it as a form of profit, too.
Indeed, it may astound union leaders that many companies bestow more profits of this type on their employees than they bestow profits on their shareholders. It almost surely is so in heavily unionized industries — e.g., the automobile or transportation industries. But it can easily be true even in non-unionized industries.
Brushing lightly over the fraction of ABC’s sales revenue (which is captured gross value) that flows to creditors in the form of interest, to suppliers of non-labor inputs, and to government in the form of taxes, we arrive at a residual that accrues to the owners as “profit available for distribution to shareholders.”
Management and the company’s directors may decide to distribute some of that residual to shareholders in the form of cash dividends. But usually the bulk or even all of it is plowed back into the company in the form of “retained earnings.” Few shareholders take out much of the gross value their companies create in the form of cash.
Wall Street bases its estimate of the company’s “market capitalization” solely on the residual “profit available for shareholders” pipe, eclipsing from view the entire value-flow that accrues to other stakeholders. Unfortunately, many journalists and pundits in the financial press then mistake that “market capitalization” as the sole measure of the “wealth” the company creates, not realizing that this metric can rise or fall for reasons other then genuine value creation by the company.
Suppose, for example, that a company’s volume of output has not changed, but that it somehow manages to raise prices paid by some or all buyers, capturing more of an unchanged gross value created by the company’s output. The company’s market capitalization would be likely to rise as a result of the price increase. But would that add to the nation’s stock of wealth? Or would it merely be a redistribution of wealth from buyers to shareholders?
Similarly, suppose new management takes over and changes nothing other than reducing or eliminating retiree health benefits promised to already retired workers during their working years, albeit in a contract that can be broken (as many such contracts can be broken). If those savings in expenses then flow through to the owners’ profits, the company’s market capitalization would be likely to increase. But is that an increase in national wealth?
I would argue that a corporation contributes to national wealth only if it does something to increase the “total gross value” of what it produces. Someone will then get that added gross value — the buyers in the form of buyers’ surplus or employees in the form of added compensation (perhaps mainly executive bonuses) or the shareholders, and so on.
Regardless of its distribution among stakeholders, and even if none of it flows to the company’s owners, that added gross value can be viewed an addition to national wealth, at least at that moment, before it may be burned up in production elsewhere or on consumption.
http://economix.blogs.nytimes.com/2010/05/07/how-businesses-create-wealth/
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