Rich Like Kings

I have lamented in the past that, to me at least, it often seems I am posting (or E-mailing) to myself. Zach has noted that such is the fate of bloggers (what an ugly word–sort of what you would get if loggers and boogers could have babies–ugly babies).

Anyway, I will get my nose back to the grindstone and hope that once in a while someone gets something worthwhile out of the time that is invested by he and me.

As sciences go, Ecology is relatively new. The term was coined in the mid 1800s and its acceptance and formulation as a science were established in the ensuing century. It is concerned primarily with finding and describing resource relationships and interactions among species, populations and communities. Put simply, ecology is the economics of nature and indeed, many key ecological concepts and models were first formulated by economists.

Human pomp insists that natural (and particularly cyclical) phenomena can and should be managed. Wildlife (mis)management schemes early in the prior century often focused on the “management” of predators (to benefit humans of course). The unintended consequence was an explosion in the populations of primary prey species, followed by population collapse as birth rates exceeded carrying capacities. Malnourished animals succumbed to disease or starvation. A healthy population of predators would have removed diseased individuals, thereby reducing the population and the opportunities for additional infections.

That same pomp drives attempts to manage the economy. The obvious ups and downs tempt the brightest among us to say “I can fix that.” Less obvious is that any efforts to dampen natural oscillations are destined to amplify them if not collapse the system altogether. We have an excellent example in the current housing crisis. As the housing market collapsed, governments rushed to appear to be doing something. After being driven to artificial highs by a monetary policy that inflated numerous bubbles for the better part of a decade, it was inevitable that the market would collapse. In this chart from The Atlantic:

we see that from the 1960s to the late 1990s the rate of home ownership held to a band betwen 63% and 66%. This might be considered the “natural rate” of home ownership as governed by numerous macro and micro economic factors (e.g. interest rates, economic growth, demographic trends). In the late 1990′s the rate blasted out of that natural range, driven by artificially low interest rates and government policies that encouraged mortgage lending to high credit risk consumers.

After the economic collapse that began in 2008 (the housing bubble actually started to pop in 2007) the Federal government offered tax credits to prop up the real estate market. That plan worked while the tax-breaks were in effect but as soon as they expired (in October 2008) the collapse gained momentum. Not only did the Feds fail to stop the collapse, they ultimately made it worse by coaxing purchasers to accelerate their buying plans. The result was that sales that might have taken place in Novermber or later, instead took place in October and earlier. They stole growth from the future and now that the future is here, the housing market remains severely depressed. Eventuallly the home ownership rate will return to its natural range. In the meantime, it will likely “regress to the mean” by falling well below that 63% floor.

Out of ecology grew environmentalism and a concern for the health of the Earth’s ecosystems. In time ecology taught environmentalists that a hands-off approach was the best way to “manage” the natural world. We would do well to apply that lesson to our economic policies–we should not try to manage what we cannot fully understand or quantify.

Why is Warren Buffet’s tax rate lower than that of his secretary?

Because her income is from salary while Mr. Buffet’s is from dividends and capital gains. Income may be taxed at a rate as high as 35% while dividends and capital gains may be taxed at a rate as low as 15%.

There is a reason for this and “coddling billionaires” isn’t it. Aside from the fact that the lower tax rate benefits retirees, whose income often comprises dividends and capital gains, the low rate is intended to encourage investment and entrepreneurial risk taking–both of which are essential for economic growth and job creation.

President Obama would do well to find better economic advisors. And if he and Buffet are so concerned over the secretary’s taxes, President Obama could reduce them and Buffet could write a personal check as a gift to the U.S. Treasury.

Profit is often derided as an inducement to corruption and unethical behavior. Such derision is to blame the motive rather than the perpetrator.

Among some elitists, the pursuit of profit is viewed as a base behavior unworthy of civilized men. But what is profit really?

Profit is residual. It is what is left over after all of the bills have been paid. Describing it as residue doesn’t do much to enhance its image, but the fact is, profit is the motivator that has compelled people to provide goods and services to each other via trade for thousands of years. Think on this–the alternatives to trade are theft or murder.

Profit is the reward for efficiency. And the quest for profit, particularly in a competitive environment, has driven the advancement and refinement of endless waves of human innovation. Profit-inspired efficiency has ensured that we (in the aggregate)* make the most of scarce resources and that they are deployed in the manner most beneficial to the most people.

The pursuit of profit in a competitive (free) market produces three key outcomes (when compared with any alternate system) :

1. more pletiful options
2. lower prices
3. higher quality goods/services

These are all tangible benefits. There is one intangible benefit and that is the increased rate at which innovation takes place when the reward of innovation (profit) flows to the innovator.

*That is to say that given two hypothetical systems, one allowing personal profit, the other not, given equal initial resources, the profit-supporting system will be more productive than the one in which profit is not allowed. The profit-bearing system will not be perfectly efficient, but it will be relatively more efficienct.

An asset class is a group of entities that are similar from an investment point of view. Examples include stocks, bonds, mutual funds, real estate, collectibles and commodities (there are many more).

Each class may be subdivided any number of ways. For example, there are growth stocks, value stocks, domestic stocks, emerging market stocks and preferred stocks (there are others).

Likewise there are many bond subclasses: junk bonds, corporate bonds, government bonds, municipal bonds, savings bonds, etc.

Real estate classes might include commercial, residential, rental, retail and industrial (as well as others).

Collectibles include coins, stamps, beanie babies, magic cards and pinky fingers of vanquished foes.

Each asset class is characterized by its own risk-reward profile. Because the values of different asset classes are not necessarily correlated, it is recommended that investors diversify across a range of classes in order to maximize returns while minimizing risk.

The chart (click the image to enlarge) from Morningstar ranks annual investment returns for several asset classes over the last 10 years (through 2009). Notice that return varies from year to year for each class.

We discussed this at the meeting a couple of weeks ago, but it is worth repeating and formalizing here. As an evangelist for investing, my message will always be to invest somewhere starting as soon as possible. I typically recommend investing until it hurts–and then invest some more.

There is a big difference between saving and investing. Saving is about preserving capital (avoiding risk). Investing is about growing capital and it entails an implicit acceptance of risk.

When choosing an investment, examine your:

Savings goal–To what use will you put the money and how much do you need? Do you need to turn
$1000 into $2000 or do you need to turn $1000 into $10,000?

Time horizon–How long before you need the money, 6-months or 10 years?

Risk tolerance–In general, risk and reward are correlated. When someone puts their money at
greater risk, they demand a greater reward to compensate them for the additional risk.

You invest in order to grow your money. While there is more to life than money, there is no denying that life is better with it than without. So I think we can all agree that growing our money is a desirable goal. Whether you invest with the investment club or somewhere else (actually you should invest elsewhere in addition to the investment club) regular investing should be a personal goal.

Why invest in the stock market? Because historically, the stock market has provided a better return on investment than other asset classes relative to risk, liquidity and accessibility. What does that mean? It means that stocks provide good returns without excessive risk of loss (risk), they are easy to get out of if you need the cash fast (liquid) and easy for the average person to buy (accessibile).

Why invest with the investment club? The investment club has three goals; 1) to earn money, 2) to educate members and 3) to provide cameraderie.

Investing with the investment club gives each of us a chance to learn about investing (and life in general) from each other. We have an opportunity to learn at our own pace from people that respect and care for each us. Besides, hanging out with friends is fun whether you’re discussing yield-curves or goofing off.

Investing with a group means that we are less likely to make catastrophic mistakes. More eyes looking at and brains studying a situation make it more likely that we will catch pitfalls that might be missed otherwise. Pooling resources makes asset diversification easier and lets us spread the risk among more investments. Similarly, by splitting costs, we reduce our own investment-related expenses.

The same goal of reducing risk and expenses can be accomplished with a mutual fund. However, the investment club provides the opportunity to find our own Google, Microsoft or Wal-Mart–all companies that greatly enriched their early investors. You can’t do that with a mutual fund.

I encourage everyone to take advantage of this opportunity, but you must be aware that extended periods with negative returns are possible (you can lose money). But I also would repeat the maxim “No risk, no reward.”

As often as I can remember it I will provide a brief “what is” post on Wednesdays.

So, an appropriate question for today:

“What is a ‘dead-cat’ bounce?”

A dead-cat bounce refers to a temporary upturn in the stock market in the midst of a longer-term correction or bear market. Of course a dead-cat bounce isn’t identifiable as such until enough time has passed to learn whether the market will resume its decline or has turned a corner and begun a new long-term upswing.

Bargain hunting during a downturn is a good strategy but it is essential to do one’s due diligence to ensure you aren’t acquiring a “dead” asset. Sometimes even free isn’t a bargain.

Most of you probably know that in stock market slang, ‘Bulls’ are optimists who believe the market is going higher and ‘Bears’ are pessimists, believing the market will fall. The recent volatility in the market prompted me to share this video regarding bear attacks.

Incidentally, for future reference, a bear market is generally defined as a drop of 20% or more. A smaller decline is generally referred to as a ‘correction’. Because the long-term, general trend of the market is up, there really isn’t a particular percentage increase that qualifies as a bull market. A bull market is essentially a prolonged period of increasing market value that isn’t interrupted by a decline of 20% or more.

Corrections may be associated with “sector rotation” which describes a characteristic change in market leadership. For example, as the economy comes out of recession and investors anticipate an increase in spending, the manufacturers of capital equipment (machines that do work) and durable goods (household items expected to last more than a year) tend to appreciate in value. As the economy continues to improve, attention shifts to the next wave of beneficiaries–such as the makers of luxury goods and leisure and hospitality providers. Toward the end of the cycle, capital intensive industries (such as auto and heavy equipment manufacturers) start to decline and attention turns to more speculative or higher growth industries such as technology and life sciences. As the economy slows, consumer staples, utilities and pharmaceuticals tend to dominate as their products remain in demand even in a slow growth environment.

Sector rotation is driven by the economy on a macro scale but can be influenced by political events (major legislation affecting a single industry for example) or natural events (such as an earthquake disrupting major supply chains).

After the Market’s horrid past week, this one is off to a worse start. No one knows how far it will fall or how long it will stay down. It would not be unprecedented if years were to pass before new highs are reached. It also would not be unprecedented for the market to finish up for the year (it is down a few percentage points from where it opened on January 2nd).

Investing is fraught with pitfalls but not all decisions carry equal risk. Our goal is to find a happy balance between risk and return.

In difficult times, investors tend to seek “safe havens” in the stock market–consumer staples, utilities, pharmaceuticals. Innovative players exist in every industry, even those that are mature, low-tech and boring.

For a list of companies that carry an “innovation premium”, see this article from Forbes. Before you look, try to think of two or three companies that you find innovative. Are they on the list.