In Search of the Perfect Investment

Claire lives in Beacon Hill, arguably the prettiest part of Boston. Yesterday they had a tornado. No one can remember the last one — if there ever was one.

Which brings me to the new investing world — populated by Black Swans, tornados and freak weather patterns. You clearly have to allocate your portfolio to accommodate the new weirdness.  Gold and cash are key. This piece from Sunday’s New York Times is pertinent:

Spillonomics: Underestimating Risk
By David Leonhardt, who is the economics columnist for The New York Times

In retrospect, the pattern seems clear. Years before the Deepwater Horizon rig blew, BP was developing a reputation as an oil company that took safety risks to save money. An explosion at a Texas refinery killed 15 workers in 2005, and federal regulators and a panel led by James A. Baker III, the former secretary of state, said that cost cutting was partly to blame. The next year, a corroded pipeline in Alaska poured oil into Prudhoe Bay. None other than Joe Barton, a Republican congressman from Texas and a global-warming skeptic, upbraided BP managers for their “seeming indifference to safety and environmental issues.”

Much of this indifference stemmed from an obsession with profits, come what may. But there also appears to have been another factor, one more universally human, at work. The people running BP did a dreadful job of estimating the true chances of events that seemed unlikely — and may even have been unlikely — but that would bring enormous costs.

Perhaps the easiest way to see this is to consider what BP executives must be thinking today. Surely, given the expense of the clean-up and the hit to BP’s reputation, the executives wish they could go back and spend the extra money to make Deepwater Horizon safer. That they did not suggests that they figured the rig would be fine as it was.

For all the criticism BP executives may deserve, they are far from the only people to struggle with such low-probability, high-cost events. Nearly everyone does. “These are precisely the kinds of events that are hard for us as humans to get our hands around and react to rationally,” Robert N. Stavins, an environmental economist at Harvard, says. We make two basic — and opposite — types of mistakes. When an event is difficult to imagine, we tend to underestimate its likelihood. This is the proverbial black swan. Most of the people running Deepwater Horizon probably never had a rig explode on them. So they assumed it would not happen, at least not to them.

Similarly, Ben Bernanke and Alan Greenspan liked to argue, not so long ago, that the national real estate market was not in a bubble because it had never been in one before. Wall Street traders took the same view and built mathematical models that did not allow for the possibility that house prices would decline. And many home buyers signed up for unaffordable mortgages, believing they could refinance or sell the house once its price rose. That’s what house prices did, it seemed.

On the other hand, when an unlikely event is all too easy to imagine, we often go in the opposite direction and overestimate the odds. After the 9/11 attacks, Americans canceled plane trips and took to the road. There were no terrorist attacks in this country in 2002, yet the additional driving apparently led to an increase in traffic fatalities.

When the stakes are high enough, it falls to government to help its citizens avoid these entirely human errors. The market, left to its own devices, often cannot do so. Yet in the case of Deepwater Horizon, government policy actually went the other way. It encouraged BP to underestimate the odds of a catastrophe.

In a little-noticed provision in a 1990 law passed after the Exxon Valdez spill, Congress capped a spiller’s liability over and above cleanup costs at $75 million for a rig spill. Even if the economic damages — to tourism, fishing and the like — stretch into the billions, the responsible party is on the hook for only $75 million. (In this instance, BP has agreed to waive the cap for claims it deems legitimate.) Michael Greenstone, an M.I.T. economist who runs the Hamilton Project in Washington, says the law fundamentally distorts a company’s decision making. Without the cap, executives would have to weigh the possible revenue from a well against the cost of drilling there and the risk of damage. With the cap, they can largely ignore the potential damage beyond cleanup costs. So they end up drilling wells even in places where the damage can be horrific, like close to a shoreline. To put it another way, human frailty helped BP’s executives underestimate the chance of a low-probability, high-cost event. Federal law helped them underestimate the costs.

In the wake of Deepwater Horizon, Congress and the Obama administration will no doubt be tempted to pass laws meant to reduce the risks of another deep-water disaster. Certainly there are some sensible steps they can take, like lifting the liability cap and freeing regulators from the sway of industry. But it would be foolish to think that the only risks we are still underestimating are the ones that have suddenly become salient.

The big financial risk is no longer a housing bubble. Instead, it may be the huge deficits that the growth of Medicare, Medicaid and Social Security will cause in coming years — and the possibility that lenders will eventually become nervous about extending credit to Washington. True, some economists and policy makers insist the country should not get worked up about this possibility, because lenders have never soured on the United States government before and show no signs of doing so now. But isn’t that reminiscent of the old Bernanke-Greenspan tune about the housing market?

Then, of course, there are the greenhouse gases that oil wells (among other things) send into the atmosphere even when the wells function properly. Scientists say the buildup of these gases is already likely to warm the planet by at least three degrees over the next century and cause droughts, storms and more ice-cap melting. The researchers’ estimates have risen recently, too, and it is also possible the planet could get around 12 degrees hotter. That kind of warming could flood major cities and cause parts of Antarctica to collapse.

Nothing like that has ever happened before. Even imagining it is difficult. It is much easier to hope that the odds of such an outcome are vanishingly small. In fact, it’s only natural to have this hope. But that doesn’t make it wise.

Stocks could bottom soon, says The Street.com. The article consists of seven charts, the first of which is:

Another chart that caught my eye:

The writer’s conclusion:

In short, money continues to flow into the safe havens of gold and the dollar. The major indices are showing extreme panic selling and look ready to bottom in the next few days. However, there is a possibility that the market could break down and start another major leg down, which is a big concern for me. I will be glued to the market internals and support levels for the major commodities and equity sectors, hoping either to catch the bottom or to avoid another meltdown.

You can see all the charts. Click here.

The Scariest Job Chart Ever. Says Business Insider,

We’ve dubbed this chart the “Scariest Job Chart Ever,” as it shows how the decline in employment is WAY uglier than in past recessions.

Calculated Risk has updated it with the latest numbers from this morning, and now it looks even scarier.

Why?

Check out the two red lines at the bottom. The solid one includes Census hiring, while the dotted line doesn’t include it.

What’s clear is that while we still have a rebound including Census hiring, we’re already flattening out on the dotted line. This is a shape not seen on the other lines. suggesting that the fall is extremely deep, and the recovery is shallow.

From the Bureau of Labor Statistics on Friday: Total nonfarm payroll employment grew by 431,000 in May, reflecting the hiring of 411,000 temporary employees to work on Census 2010, the U.S. Bureau of Labor Statistics reported today. do the maths. It’s frightening. The government accounted for 95.4% of all the new jobs in May.  The 2010 census will cost an estimated $14.5 billion. That’s an average of $47 for every person living in the U.S.  — babies and all.

How capitalism works. Investigators suspect that private Afghan security firms are using U.S. funds to bribe the Taliban and fake attacks to make their services more sought after.

Still investigating covered calls. Drop your experiences with them into a Comment below, please. Or email me.

Never cheat on a country woman.

A country wife came home just in time to find her husband in bed with another woman. With super-human strength, borne of fury, and cutting firewood, lifting sacks of feed, and bales of hay, she dragged him down the stairs, out the back door, and into the barn.

She put his manhood in a vice and then secured it tightly and removed the handle. Next she picked up an old carpenter’s saw.

The banged-up-cheater was terrified and hollered, “Stop! Stop! You’re not gonna cut it off with that rusty saw, are you?”

The wife, with a gleam of revenge in her eye, put the saw in her husband’s hand and said ..

“Nope….You are!

I’m gonna burn down the barn!”

Harry Newton,who played the best tennis of his life on Sunday. Tennis is like investing. Keep the ball in play until you get that one big opportunity — typically a short ball — to seize the moment and go for it. Claire is OK. But many of her neighbors’ cars were destroyed by falling trees. The tornado only hit her street.