The next step in dissecting bank involves something called securitization. Securitization is a method of turning an asset (e.g. a bunch of loans) into securities. Let’s say ACME Bank has 5 home loans with a balance of $200K each — or $1M in mortgage assets. It can divvy this $1M bundle of loans into 100 pieces each with a nominal value of $10K each. Companies or people can buy these mortgage backed securities (MBS). This is the basic idea, anyhow.
Basically banks can make loans and repackage them into various MBSs. The simplest kind is a pass-through MBS. In the example for ACME each “share” of the MBS would get 1 percent of the mortgage pool payment stream (less fees).
There are other methods of slicing and dicing MBSs such as collateralized mortgage obligations or CMOs. CMOs repartion the mortgage pool into different flavors or tranches. For example there may be a principal-only tranche that pays only the principal stream and an interest-only tranche that pays out from the interest portion of mortgage payments.
One thing MBSs allow banks to do is to take assets off their balance sheet. They can turn a pile of loans into a bunch of securities they can sell at the market for cash. The other thing banks and investment companies can do is buy MBOs.
Now the basic idea is a pretty good one. The securitization process worked pretty well for many years. And it still does work even today (check out Bill Gross’s excellent PIMCO Total return fund for example). But things can and did go wrong when companies quit buying certain MBOs due to legitimate concerns. No buyer equals no market. And no market spells trouble for companies with too many unpopular MBOs on their books.
I’ve only scratched the surface of this more complicated portion of the bank mess. This is partially to keep the discussion interesting (or at least less boring) and partially because I don’t have more specific data at this time.
I would like to look at the question from the ground up. I propose why we invest is based on what we value. For myself I think the primary reason I invest is for financial security. More security to weather person economic changes. This includes job loss and/or (stock) market loss. I invested in a house because it is nice place to live and was a good value. I keep some money in cash for unexpected costs. I buy insurance, not just because it is required, but because it helps against a large financial loss.
While I value security, I sometimes make poor choices. For example I have not been exercising much this winter. I have also not been very consistent eating healthily. This is foolish because it increases my chance of heart disease and even stroke. Though I am still under 35, I am beginning to enter an age where I can really benefit from a healthier lifestyle. Not to mention the fringe benefits… looking better and feeling better.
At least this is what I am trying to tell myself. 
So far it’s been working for about 8 weeks.
I also hope exercise and healthy eating will offer an antidote to the sting of my financial losses of the last 9-12 months. It would be nice to say my portfolio may be down since summer 2008, but so are my waste line and my weight.
In essence, I hope I’m investing to give myself and my loved ones the best chances for happiness over a lifetime. I hope that I’m investing wisely in life. Money and finance are part of that effort. Investing time with friends and family is too. So is taking care of one’s health and fitness.
I’ve been short-sighted in the past about some of these things. I’ve managed my money, I believe, very well. I like to think that mostly I’ve been a good friend and family member — but I can certainly think of some lapses. I’ve been really hit and miss about diet and exercise. There have been stretches up to about 2 years where I’ve been in good to excellent physical condition. There have also have been stretches of up to 2 years where I have let fitness lapse. I hope I’ll continue digging my self out of the most recent lapse.
My point is that investing isn’t just about money. Ideally investing is one tool among many to help improve the way we live. Not to suggest that this is easy. I think that while there is a danger in neglecting financial investment, there is also a danger in forgetting to examine why we invest in the first place.
I hope this blog helps stimulate some new perspective. It has been interesting to write. I look forward to your thoughts on this little investing/life excursion.
Since I love to read investing books, I somehow got the idea in my head to write one. So far I wrote an outline and a couple working titles and even a promo for the book jacket. Now just to fill in the contents — piece of cake I figure that with a hour here and hour there on nights and weekends I might just be able to have a rough draft in a year or two. I thought I’d share some of my working titles for comment and criticism:
Risk
Charting the volatile seas of bounty and bust.
—or—
The Balhiser Principle
Integrating the financial alchemy of gurus and scholars into your personal risk profile.
Obvious, risk is a key theme. I believe risk is one of the most challenging concepts to intuitively grasp. Benjamin Graham tackled risk with a “margin of safety” approach. Warren Buffet modified Graham’s value approach to achieve phenomenal results. Scholars developed the capital asset pricing model (CAPM) for stocks. Scholes, Black, and Merton took CAPM further applying extending it to stock option pricing and winning Nobel prizes. Thinking they had tamed the financial oceans they made big gains until a financial maelstrom sunk their financial Titanic called Long Term Capital Management. Finally, Nicholas Nassim Taleb rewrote the rules of finance in ways that are just bringing to change the modern financial landscape.
I would like to explain these concepts such that the busy Joe or Jane investor can easily understand and use them. After all what is the point of financial ideas to the personal investor if they are not readily usable by the personal investor?
Well there it is – My intention to write an investing book over the next couple years. Announced on Super Bowl Sunday, 2009. Go Steelers!
While I’m reading and hearing a lot of pessimism in the media, I am increasingly optimistic about the buying opportunities that are currently available. In fact when I hear the recession being called a possible financial depression, I think about buying more shares of SPY and VTI. In doing some research on the term depression I have seen several definitions:
- A prolonged, severe recession.
- A drop in GDP of more than 10 percent.
- A drop in GDP of more than 20 percent.
#2, a drop in GDP of at least 10% (absolute year-over-year), is my working definition. (For reference the Great Depression represented a fall of about 35%)
What we’ve seen in the first 9 months of 2008 is nothing compared a depression. There have been 2 down quarters in the 12 month period, but overall net GDP growth. Sure Q4 is likely to be bad. I’ll stick my neck out and guess it’ll come in at minus 18% annualized (about -4.5% absolute Q3 to Q4).
The popular press (or unpopular press) has covered this financial “crisis” with a stunning mix of balderdash, rubbish, and misapprehension. There, that’s off my chest. Now on to what’s making me optimistic.
- Reasonable, even occasionally cheap, stock valuations. (e.g. good, even great buys)
- My neighborhood. I’m seeing houses priced between $160K through $215K get snapped up within days; sometimes as soon as they are listed. Further I’m seeing continuing, targeted investments in real estate by folks I consider savvy. I’m seeing low mortgage rates that allow buying rental properties that immediately generate positive cash flow.
- A dose of reality. Finally some borrowers are getting the message that “debt, for the lack of a better word, is BAD”. While this insight will have a negative impact on the economy in the short term, it is likely to have an overall positive impact in the long term.
- Technology. It’s baa-aack! I’m talking about computers and the internet. I’m also talking about materials, advanced transportation (rail, aircraft, hybrid autos). I believe that technological innovation will propel the world economy forward over the next 5-10 years. And, the US economy will benefit disproportionately due to it’s innovative, entrepreneurial, and dynamic heritage.
Feel free to call me Polyanna; I’m buying stocks!
I’ve been following the Madoff money scandal with interest, but with limited surprise. The only real surprise for me is the scale: $50 billion is big. I am much less surprised that the regulators missed it. For example, they missed Enron too. It is also not surprising that big money investors were taken in. The “keeping up with the Jones” competition is also a real phenomenon some members of the super rich.
History is replete with examples of wealthy individual who succumb to financial scams. Look at John Law in 1700s France, for example. He was an adroit visionary and scammer. Check out Ponzi himself whose name is now synonymous with such cons. It is with some satisfaction that I wrote about him and the dangers of unwary trust in this August schemes and scams blog. Another, less corrupt, but still costly debacle that snagged experienced and wealth investors and companies was that of Long Term Capital Management.
What I feel compelled to mention is a simple and wise maxim: Diversify! No matter how good an investment is (or seems to be) don’t risk putting your eggs in one basket. Not one company’s stock, not one management company. Secondly, it is simply unwise to invest a massive percentage of one’s portfolio in something so opaque as a hedge fund.
Let me clarify somewhat. I don’t think it necessarily unwise to, say, invest 50% of entire investment portfolio with Vanguard index funds. Why? Because 1) index funds (such as the Vanguard Total Stock Market Index) are diversified — at least in terms of U.S. Stocks. 2) They are transparent… they are clearly invested in market-weighted proportions of the U.S. Stock market. (Fine print: mostly, with some representative sampling of smaller issues).
The saddest thing I hear about folks who “invested” with Madoff. Those who invested all, or most of their money. Some of those sorry folks are likely to go from multi-millionaire to the poor house practically overnight.
The moral of this sad tale can be summed up in two words: “Caveat emptor”.
- Understand your investments. (Be like Buffet… don’t buy what you don’t know.)
- Part II: If you insist on buying something you don’t know, only invest a small amount (5% or less of your net worth).
- Diversify: Spread your funds to a reasonable degree. This includes not putting all your money with one money-manager or fund.
- Diversify. There is arguably no substitute for some money in the bank. E.g. FDIC insured deposits (subject to $100K, $250K limits per institution).
It’s December and a good time to start tax planning. For example now is a pretty good time to realize investment losses by selling some stocks or mutual funds that have lost money (which haven’t). Last I checked the amount of tax loss deductible from ordinary income was $3000. Just be careful of the wash sale rule which effectively prohibits buying back a stock/etc for 30 days: wash sale.
Another thing to consider is mutual fund capital gain distributions. There’s nothing fun about paying taxes on a distribution from a fund that has lost money. It is often helpful to consider funds that have good tax management (index funds are often excellent at keeping capital gains distributions to a minimum.) If a fund is about to dump an unwanted distribution on you consider selling it before the distribution date.
Finally 401(k), IRA, 403b, and similar accounts. If you are not maxed out, consider upping your 2009 401(k) contribution. You might also consider making a 2008 IRA contribution if your are not subject to income limits.
I spent a semester studying bonds, and I was just scratching the surface of the subject. However, rather than regurgitating a bunch of facts and boring data, lets keep it simple and start with Bond Funds. I recommend a few:
1) PIMCO Total Return
2) Vanguard Total Bond Funds VBMFX, VIPSX, and others: Vanguard Bond Link
The question used to be “why buy bonds?” Lately the question is “why didn’t I own *more* bonds?”
Either way, I seldom recommend sudden large changes to portfolios. Assuming you’ve been beaten up by stocks (I have) and have lost some of the risk tolerance you thought you had, maybe its time to consider looking at bonds. Rather than moving funds around, why not just change your allocation of new funds. If you have a 401(k) consider changing your new investment elections.
Bonds and bond funds can help you sleep better at night. Especially Treasury Bonds and TIPs.
Another bond-like investment is a CD (certificate of deposit). The FDIC insurance (now up to $250K) helps peaceful slumber. The wrinkle is getting them into your retirement account.
Bottom line: Any portfolio should contain bonds (or bond-like) investments to be considered balanced.
P.S.: Today’s Fun money update: $21,066. Decreases in my SPY call are approximately offsetting decreases in my SPY underlying. (Yes, that sentence is correct.)
Congratulations to my favorite finance writer: Nassim Taleb. Not only is his portfolio up big time, but he appeared on CNBC Power Lunch. It was fun to see him in person… a man who I only knew by his writing.
After that I found an even better, more in-depth, talk by Nassim Taleb. Sadly the videos were not persistent.
Enjoy!
I’ve had several folks ask me if we are at the market bottom… both in person and by email. I’ll do my best to answer these questions.
I’ll start with disclaimer and an opinion. The disclaimer is that I’m only about 50-60% confident in the following prediction. The opinion is YES, we we at or very near the bottom on Friday with an inter-day S&P 500 level of about 844.
Here’s what I’ve done so far this week. I bought 100 shares of SPY (SP500 ETF) Monday on the market open for $94.47 per share. [BTW, this was a poor price for a market order place on the open... I think it should have cost me closer to $94.10 per share. I'll have to talk to my online broker about the poor order execution.] As of tonight I am up 5.57% on that purchase. Secondly I wrote a covered Nov 102 SPY call Monday afternoon for $465. These trades in my “play-money” account show me suddenly being a bit bullish, with the call write showing a bit of light hedging.
I might as well get specific about my play money account. It started at about ~$17K in early 2005. My oldest exact data shows was it was worth $21,077 on Jan 1,2007. As of today it is valued at $22,148. Since I don’t add or subtract money from this IRA account it will be interesting to see how it fares in the months and years ahead
I feel compelled to note the VIX which hit a historic high on Friday of over 75. Commonly called the fear index, the VIX measures the implied volatility inherent in the prices of S&P500 options. The VIX was about 60 when I wrote my SPY call Monday afternoon. The high VIX value meant I was getting pretty good “time-value” premium for my option. The fact that I held SPY and wrote a slightly out-of-the-money call implied that I was slightly bullish on the S&P 500 for the next month.
So, yes, I believe that we are near a bottom. Getting into the S&P500 for around 1000 (SPY for around 100) seems reasonable. I’m doing so with my risk capital, but I’m hardly altering my larger accounts… neither doing much re-balancing nor changing my contribution elections. I continue to max out my 401(k) contribution for the year (no change for the last 10 years… I always try to max) and I’ll max out my IRA contribution for 2008 (in 2009) before April 15 as I do my taxes next year.
Happy hunting!
I like to write, except when I must. I didn’t post last week because the muse was not with me. But now she is back, filling my head with questions about the line that tries to divide sound investments from downright scams. Often that line is quite clear to many of us. We can often spot an unsophisticated scam from a mile away.
Sometimes those who should know better get taken. When a wise investor get had she is only taken for a small percentage. For example, the collapse of Enron directly impacted my investments… to such a small degree it possibly lost in the round-off error. VTI for example, because it is a market-weighted index, exposed me to a little bit of Enron.
In principle, regulation exists to combat Enron-style malfeasance. And it works to a large degree. However, for individuals and corporations alike, prudence is a perhaps more important factor. It occurs to to me that it is in my own best interest to periodically remind myself of this fact.
It for this reason that I looked up the classic Ponzi scheme to check my facts:
Then there is the legally grey red/black roulette scheme. A financial adviser collects 10% return on all investment profits. He takes the investors money and bets it on black. If the roll looses he tells the client “sorry”. If the roll wins he collects his 10 percent and does the same again at a later date… and demonstrates a 90% after expense return. Now in real life the investment vehicle isn’t literally a spin at the roulette wheel, but a similarly functioning derivatives play or plays.
There is also the advising scam. Start with 1024 target email addresses. Predict, say, the outcome of an NFL football game. Email the Colts prediction to 512 addresses and Panthers to the other 512. Send the next prediction in a similar manner to the 512 folks who were send the correct answer (ignore the others to whom the wrong prediction went). After, say 5 times, you have 32 folks who have all seen your prediction come true. Hit them up for $99 to hear your next insightful pick. If half these folks bite, there’s almost $1600 of ill-gotten gains at your disposal. Until the cops come knocking. [Note repeat again with the 8 folks who took your advice and you advised correctly, however this time the fee is $495. Repeat again with the four remaining folks, then new fee is $995. You get the idea.]
Prudence
It is smart and generally easy for most people to avoid big scams and cons. It is sad to hear about folks losing money at Indymac bank. Deposits over $100,000 ($250,000 IRA) will likely lose most of the excess. However, may I pointedly say “Duh!” It is helpful to get your FDIC facts straight folks. Yes, banks are safe, generally. But, come on, spread it around $100K at a time ($250K IRA). That’s pretty easy… and wise to do.
Personally, I’m asking myself “What are the risks”. Some are market-risk. Some are company-risk. There are many flavors. The US stock market is pretty well regulated. It is among the best managed markets in the world. However, stock brokers, they vary. My number 1 pet peeve is excessive fees including high expense ratios and (any!) loads. Other key peeves are lack of diversification, bad annuities (not that I know much, but someday I will do more research), and setting up or failing to adjust investor expectation.
Sadly, I’ve barely broached the topic and ideas that are coming to mind. Suffice it to say that it behooves an investor to aware of and wary of scams and schemes. A good place to start is with big, classic ones like the Ponzi. There is, I believe, a continuum of such investing parasites (parasitics?) that can drag down investment return. High fees and loads are the most obvious example. These are legal, but should be avoided.
Parting words for now… loads are just that– a big load of *%$#! Best investment wishes, and to all a good night.
BAC and BCS (Bank of America and Barclays ADR) have been good to me in the 2.5 days I have owned them. They are up 28% and 15% since I bought them. This kind of sudden paper gain is pretty rare. All sorts of thoughts and emotions enter my mind:
- I’m a financial mastermind.
- I’m just lucky.
- I should have bought more.
- Maybe I should hedge… BAC is announcing Monday.
(Actually the last idea, about hedging, is a bit impulsive; I may yet do it Monday morning. These stocks are in my smaller IRA which functions as my tax-deferred mad money account. Playing and being impulsive is OK with these funds.)
All of these thoughts, I realize, are silly and fleeting. I don’t take them too seriously. However, part of me thinks I should be beyond such unprofessional emotions and thoughts. I’ve been investing since I was about 10 years old… to one degree or another. I have over 20 years of investing experience. I’ve studied finance in college and discuss finance all the time with a variety of successful people. I’ve read and absorbed book after book after book about money and investing. And still I have reactions that I consider a touch foolish.
Gambling: Keeping it at the Casino and away from the Brokerage Accounts.
My occasional risk-seeking tenancies are one reason I took up poker (and other gambling) about nine years ago. I figured it would be a good way to familiarize myself with my potentially unhelpful emotions. Mathematically, gambling is a bad deal. Arguably there are only two games that potentially make mathematical sense: poker and blackjack. Assuming one is skilled and patient enough.
So I started with blackjack. I bought a book and practiced counting cards at home. I developed a passing proficiency. I then played for real. I more or less broke even. But I found it very boring.
I moved on to poker. Primarily seven-card stud and Texas hold ‘em. I found some good poker books (Boy are there some bad ones! However, I recommend anything authored by Sklansky.) Over years I developed some skill. I found that I did best with tight play — staying out of most hands. When I consistent play tight and with focus, I do reasonably well. I also found that I can be my own worst enemy. Two emotions can cause me particular harm at the poker table. Anger and boredom.
Boredom eventually causes me to take marginal bets that I shouldn’t to avoid the tedium of sitting out hands. Anger clouds my judgment and leads me to careless, impulsive decisions. Over the years at the poker table I’ve learned a variety of skills and techniques to mitigate and manage the impact of anger on my game. I have been generally unsuccessful so far at finding techniques to mitigate my boredom at the table. The only thing that I have found helpful to target boredom is taking myself away from the poker table for a break — usually at the craps table.
Craps
Craps is a stupid game. It can also be a ton of fun. There are simply no workable systems to make money playing craps. One could put twenty dollar bills into a shredder, but craps is simply a more fun way to waste money. Playing craps lets me address my temporary poker boredom, and have fun. When I return to the poker table down 20 or 30 bucks, I play better poker because I am no longer bored. This can sometimes save me 100 or more and sometimes helps me make back my craps losses and more.
It was some pretty circuitous logic that took me from investing to blackjack to poker to craps. There are some decent reasons I bring up these things:
- Investing can easily spill over into gambling and speculating. Trying to take the gambling aspect out of investing is a worthwhile goal which should be sought but is never fully achieved.
- Any gambling is dangerous. Especially if one cannot differentiate between luck and skill. A player can be eaten alive at the poker table if he incorrectly assumes he is more skilled than the others. Same thing can happen with stocks and especially with more exotic things like options, futures, and commodities.
- Investing in stocks, index funds, and quality bonds is like playing poker or blackjack.
- Trading options (and futures, etc) is more like playing craps.
- Moderation and caution are paramount. Without these virtues one risks losing everything.
Loose Ends
I’ve only scratched the surface of my eclectic perspective on investing vs. gambling. I’ve temporarily made some nice bling on my BAC and BCS buys. I strive to be a rational investor, but acknowledge that I am not yet a Vulcan. I’ve briefly explored some ways I channel and manage my emotional, impulsive energies. Hopefully, the paydirt I hit this week is not simply making some money on these two stocks. It is perhaps in finding different ways to explore the money/emotion connection. Hopefully soon I’ll get this blog open and running such that I get reader comments. I look forward to hearing from you.
I was watching an exciting episode of Millionaire this morning (Ogi/Meridith) and realized that this game has elements in common with investing (psychology & decisions). The other game that came to mind is Deal or No Deal. I started to ponder which is most like investing.
The main difference between Millionaire and Deal is knowledge. The right knowledge is critical to Millionaire while knowledge is essentially irrelevant to Deal. What they have in common is large sums of money, decision making, and uncertainty, risk, and reward.
Investing is somewhere in-between. Knowledge is helpful, but not THAT helpful.
Millionaire is progressive and often abrupt. Deal is a volatile up and down ride.
Emotionally I think Deal is easier. I’d have less fear of making a fool of myself on Deal. However, if i missed a question I should know on Millionaire I’d fear that it would haunt me long after the show.
Maybe my initial query is not the most interesting part of this discussion. Each show is a way to see a wide range of human behavior compressed into an entertaining package. Literally millions of such financial decisions, quandaries, and sometimes struggles happen on a daily basis without such TV coverage. Most of us make such decisions at least a few times a year. That is perhaps why so many of us can relate to game shows. They can be a window into the more dramatic aspects of money.
Yesterday I myself was in the hot seat. I heard about BAC and BCS (Bank of America and Barclays ADR) yields given their precipitous drop. A classic value play. I decided to buy some right away with my “play money” account. But I didn’t get to it Tues. I bought today, but not after they were up 15% and 6% respectively in less than a day.
Q: Did I feel foolish? A: Not really.
Q: Did I feel anything? A: Yes, right… but a touch slow Laughing
Q: Am I right? A: Yes, until proven wrong.
So a little bit of Millionaire (possible knowledge about value) and a bit of Deal (do I feel lucky?). And emotion. It was exhilarating to buy stock after a one year hiatus. Sure I’ve been writing covered calls against index ETFs, but that is not the same rush as getting into new stocks. It felt good. Such emotion, ideally, would not enter into my decision making and response. Generally I have less emotional reaction to re-balancing my primary portfolio. It should be careful and generally boring and infrequent work. My play money account is an outlet into which to channel my more impulsive financial energies and help keep my primary money-management decisions calm, deliberate, and sober.
I haven’t really answered my initial question. I have, however, had a fun romp into an investing tangent. Perhaps soon I will stroll into gambling and investing (poker vs. craps). I hope you had fun going on this short journey. I did. Until next time, dear intrepid reader.
Today one of my friends and coworkers is retired after 20 years in the tech industry. Not such an unusual thing, except that he’s only 44 years old. He’s doing so about one year after another friend and co-worker, also way, way under 50 retired as well.
At his going away party it was interesting to see and hear the folks wishing him well. For some there came a verbal statement of envy; for others there was a look of, perhaps, longing for a similar fortune.
For myself… I feel a bit of longing for such a possibility. I’m 33 years old. I have enough assets to live relatively comfortably for 7-10 years without working. But what good would that do? I guess I could take a year or two off, learn a third language (probably Spanish) and tour the globe. Then I could go back to school and finish my graduate work in finance with a Financial Engineering and Risk Management Master’s. Depending on where I went to school tuition could set me back about $12,000-60,000 (state vs. private). At which point I’d probably go back to work, either back to work as an Engineer or entering a new job in Finance. Either way any retirement at this point would be temporary. I have not yet achieved escape velocity from planet Work. I can achieve low-Work orbit, but any such launch would decay after 10 years or so.
Looking forward I see my median work escape window (or WEW) as likely to wax and wane depending on time at work and my investment performance. My current WEW, which I guesstimate at 7-10 years, currently has a median expected value of 8.5. In a high-return year my median WEW can grow about 3 years. In a strongly negative-return year my WEW stays about constant or can even retract (say by 0.5). On average my WEW has grown about 0.77 years per working year over the last 11 years. 11 years ago, when I started my engineering career, my WEW was about 0 (perhaps closer to -0.2).
So for now my financial immune system is fending off the (early) retirement bug. For others, in their forties and fifties, [and with bigger WEWs] early retirement may indeed be contagious. As with many other future looking statements, only time will tell.
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