Harry Newton's In Search of The Perfect Investment
Technology Investor. Harry Newton
9:00 AM EST, Thursday, March 12, 2009. "Wall
Street" are firms that sell you something and make a fee on the sale.
You need to understand:
1. Wall Street
creates products for the sole purpose of selling them to you. Examples include
derivatives, auction rate securities, collateralized debt obligations (CDOs)
and credit default swaps (CDSs).
2. Wall Street
has zero interest in, or responsibility for the long-term worth of the product
it sells you. Once you've bought, it's yours. Good or bad. Recently, mostly
3. Wall Street
creates "sales stories" -- reasons you should buy. Those "stories"
have as much truth as diet foods that say you'll lose weight, (cosmetics that
will remove your wrinkles, or (my recent favorite) Arm & Hammer's Age
Wall Street's "sales stories" can be very creative -- like the price
of housing will go up forever and ever, or alternative energy stocks are great
because the new administration loves the industry. But the most creative was
the idea that you can quantify risk and price it into a security, thus making
the security (i.e. what Wall Street was selling you) risk-free. Once you quantify
risk, you make selling the product easy. Hence you no longer need rocket scientists
to sell your stuff. Anyone can sell it. And, in recent years, anyone and everyone
did. Hence the explosion of weird securities.
Which is why
I want you to read Wired Magazine's cover story, Recipe
for Disaster: The Formula That Killed Wall Street. The story starts
with a photo:
caption reads, "In the mid-'80s, Wall Street turned to the quantsbrainy
financial engineersto invent new ways to boost profits. Their methods
for minting money worked brilliantly... until one of them devastated the global
For five years,
(David X.) Li's formula, known as a Gaussian copula function, looked like
an unambiguously positive breakthrough, a piece of financial technology
that allowed hugely complex risks to be modeled with more ease and accuracy
than ever before. With his brilliant spark of mathematical legerdemain,
Li made it possible for traders to sell vast quantities of new securities,
expanding financial markets to unimaginable levels.
was adopted by everybody from bond investors and Wall Street banks to ratings
agencies and regulators. And it became so deeply entrenchedand was
making people so much moneythat warnings about its limitations were
Then the model
fell apart. Cracks started appearing early on, when financial markets began
behaving in ways that users of Li's formula hadn't expected. The cracks
became full-fledged canyons in 2008when ruptures in the financial
system's foundation swallowed up trillions of dollars and put the survival
of the global banking system in serious peril.
Li tried to
mathematically define risk and hence remove it from the investment decision,
i.e. to get you the buyer not to think how risky what you were buying really
risk is the probability that an investment's actual return will be different
than expected. This includes the possibility of losing some or all of your
The BIG problem
is you can't mathematically define risk, because, to do it, you have
to use past events and project them into the future. But nothing like 2008-2009
has ever happened before. (It was different in the Great Depression. )
So how do you
measure probability? You don't. You can't. Risk is gut feel. Some of us are
better at figuring it than others. Warren Buffett is the best. I'm not the
worst, but only because I've hammered into my tiny brain some rules. The key
one is "When in doubt, stay out." That one can be expanded to, "When
I know nothing, stay out."
Stephen Yu has
been reading Ben Grahams investment classis Security Analysis
recently when he came upon this paragraph:
It may be
pointed out further that the supposed actuarial computation of investment
risks is out of the question theoretically as well as in practice.There
are no experience tables available by which the expected mortality
of various types of issues can be determined. Even if such tables were prepared,
based on long and exhaustive studies of past records, it is doubtful whether
they would have any real utility for the future. In life insurance the relation
between age and mortality rate is well defined and changes only gradually.
The same is true, to a much less extent, of the relation between the various
types of structures and the fire hazard attaching to them. But the relation
between different kinds of investments and the risk of loss is entirely
too indefinite and too variable with changing conditions, to permit of sound
mathematical formulation. This is particularly true because investment losses
are not distributed fairly evenly in point of time, but tend to be concentrated
at intervals, i.e., during periods of general depression. Hence the typical
investment hazard is roughly similar to the conflagration or epidemic hazard,
which is the exceptional and incalculable factor in fire or life insurance.
It is a shame,
writes Yu, that Ben Graham is not taught in business schools more often. Had
the rating agencies had Ben Grahams wisdom, there would have been fewer
triple A-rated MBS and CDOs in the past few years. Had hedge funds and banks
understood the limitation of mathematics in the field of finance, they would
not have plunged so willingly into sub-prime mortgages and CDS; and we would
not be in the pickle that we find ourselves today. Had foundations realized
that the Modern Portfolio Theory is founded on narrow mathematical
assumptions, they would have known that broad diversification does not guarantee
safety; and their portfolios would be better endowed to fund their commitments
As Charlie Munger
(Buffett's partner) has said, People calculate too much and think
Citigroup continue to lift the stock market? In
as many words, the Wall Street Journal said that Citigroup's CEO, Vikram Pandit,
was lying. It wrote:
Tuesday after Citi Chief Executive Vikram Pandit said the bank was profitable
in the first two months of this year.
Citi is arguably
the nation's sickest large bank, so any sign it can produce real earnings
in this economic climate bolsters confidence. What's more, if Citi is on
the road to profitability, there is a greater chance the government's bank-sector
revival plan -- involving stress tests and possible equity injections --
will get financial firms through the downturn.
So it is worth
parsing Mr. Pandit's comments. "We are profitable through the first
two months of 2009 and are having our best quarter-to-date performance since
the third quarter of 2007," he said in a memo to employees Monday.
A Citi spokeswoman said Mr. Pandit's measure of profits was net income,
according to generally accepted accounting principles. In other words, Citi
was profitable even after all its expenses, including write-downs and provisions
for credit losses in the period, which are expected to be large.
however, should treat the profit announcement carefully. First, Citi has
assessed profitability for an arbitrary time period. Often banks don't know
their true expenses until the end of a quarter. And the two-month profit
is hard to square with analyst expectations that Citi will lose 32 cents
a share in the first quarter, according to Thomson Financial.
It is possible
that Citi's two-month net income got a boost from a low-quality source --
gains from marking up the value of its own debt as credit-default
swaps on the bank reflected heightened fear.
timing of Mr. Pandit's comments looks opportune. His memo came the day after
Sen. Richard Shelby of Alabama, the ranking Republican on the Senate banking
committee, called Citi a "problem child." With the promise of
profits, it might start to look less problematic on Capitol Hill and damp
calls for more drastic (regulatory) approaches to the banks. ...
reason to be in the Coachella Valley:
Wells Tennis TV Schedule -- PST times (I think)
PM - 2 AM
PM - 12 AM
PM - 7 PM
10:30 PM - 2:30 AM
PM - 7 PM
10:30 PM - 2:30 AM
PM - 7 PM
10:30 PM - 2:30 AM
PM - 7 PM
10:30 PM -12:30 AM
PM - 7 PM
10:30 PM - 12:30 AM
PM - 8 PM
PM -5 PM
just deserts? From Bloomberg this morning:
scheduled to plead guilty today to masterminding the largest Ponzi scheme
in history, may have to fight off prison inmates who want to squeeze him
for money or blame him for the Wall Street crash.
do I think this is funny?
Madoff's Ponzi scheme is now up to $65 billion. A billion here, a billion
there. It's beginning to add up to some real money.
financial crisis explained in simple terms. Part 1.
Heidi is the proprietor of a bar in Berlin. In order to increase sales, she
decides to allow her loyal customers - most of whom are unemployed alcoholics
- to drink now but pay later. She keeps track of the drinks consumed on a
ledger (thereby granting the customers loans).
Word gets around
and as a result increasing numbers of customers flood into Heidi's bar.
of her customers' freedom from immediate payment constraints, Heidi increases
her prices for wine and beer, the most-consumed beverages. Her sales volume
A young and
dynamic customer service consultant at the local bank recognizes these customer
debts as valuable future assets and increases Heidi's borrowing limit.
He sees no reason
for undue concern because he has the promissory notes of Heidi's customers
At the bank's
corporate headquarters, expert bankers transform these customer assets into
DRINKBONDS, ALKBONDS and PUKEBONDS. These securities are then sold and traded
on markets worldwide. No one really understands what these abbreviations mean
and how the securities are guaranteed. Nevertheless, as their prices continuously
climb, the securities become top-selling items.
One day, although
the prices are still climbing, a risk manager of the bank, (subsequently fired
due his negativity), decided that the time has come to start demanding payment
from Heidi for the debts incurred by the drinkers at Heidi's bar.
Heidi's customers cannot pay back any of their debts to Heidi.
fulfill her loan obligations to the bank and claims bankruptcy.
ALKBOND drop in price by 95 %. PUKEBOND performs better, stabilizing in price
after dropping by only 80%.
of Heidi's bar, having granted her generous payment terms and also having
invested in the securities are faced with a new and desperate situation. Her
wine supplier claims bankruptcy and her beer supplier is taken over by a competitor.
The bank is
saved by the Government following dramatic round-the-clock consultations by
leaders from the governing political parties. They came up with a miraculous
rescue plan that saved the bank.
The funds required
for this massive rescue are obtained by levying a new tax on all the non-drinkers.
financial crisis explained in simple terms. Part 2.
Gone with the Wind fans observed the seventy-fifth anniversary of the
Margaret Mitchell novel last week. Some people have never heard of it. Today
people see Gone with the Wind in the bookstore and assume it's an investment
back and smell the roses -- update 1:
Thus came the email: "You're an idiot, Harry. They're not hibiscus.
stand corrected. The history: In 1768 when Admiral Louis de Bougainvillea
began his long journey to the Pacific Ocean and discovered the vine that now
bears his name, it was a botanical highlight of the voyage.
23%? Forbes annual list of the worlds richest got shorter
and the average net worth of those on it fell 23 percent.
Egypt Syndrome: Owners putting their houses
up for sale in the Coachella Valley, California (where I am at present) are
listing their homes at 2006 prices, i.e. 30% to 40% above where they should
be. Real estate agents here say the owners suffer The Egypt Syndrome, namely
the owners are in denial.
This column is about my personal search for the perfect
investment. I don't give investment advice. For that you have to be registered
with regulatory authorities, which I am not. I am a reporter and an investor.
I make my daily column -- Monday through Friday -- freely available for three
reasons: Writing is good for sorting things out in my brain. Second, the column
is research for a book I'm writing called "In Search of the Perfect
Investment." Third, I encourage my readers to send me their ideas,
concerns and experiences. That way we can all learn together. My email address
is . You can't
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