Rational Advisor

Merry Christmas and a Happy 2009

In a truly historic market, a cliche best describes it all: What a difference a year makes.

Few people have lived through a market as wrenching as the one we’ve seen in the past year. Prices have fallen, while previously stalwart companies such as Lehman Bros went bankrupt, Bear Stearns was purchased by JP Morgan, companies like Merrill Lynch was forced to sell itself to Bank of America.

2008 was a year of remarkable headlines and events. Market volatility reached new levels, while industries went through dramatic changes. Investors have rightly become concerned about the long standing viability of previously sound companies.

There are lessons to be learnt from the series of events that happened in 2008, not least of which is how smart money (hedge funds, resource based funds, and emerging market funds) got it so wrong, and how supposedly “dumb” investments like Balanced funds, bonds and somewhat dividends funds got it fundamentally right. Even though they were impacted, they still were less affected than smart investors.

Even great investors like Warren Buffett have taken a big beating,Berkshire Hathaway A is down 31.09% for 1 year. Here is the greatest investor of our lifetime, and even he was not able to steer clear of the market issues in 2008.

Let’s begin with the trouble in global finance. The failings of modern Wall Street and Bay street can be summed up in three ideas; crazy leverage, poor credit risk, and not understanding low probability risks.

If there was one lesson to be learned about financial risk from the Great depression, it was this: Leverage in combination with volatile assets is a poisonous brew. Much of these volatile assets were in Hedge funds that previously had stupendous returns, mostly leveraged on the back of commodity prices. Another reason not to look at past great performance funds and managers.

My views are that much of the commodity price increase had to do more with speculation and leverage than real demand and supply issues. And this speculation was fuelled by the entry of the US led by Bush and Cheney into Iraq (the 2nd largest proven reserves of Oil in the world (http://www.brookings.edu/papers/2003/0512globalenvironment_luft.aspx).
Prices of Oil shot up from $60 from March 2003 to $147 on July 11th
2008. This led to concerns around inflation, increases in interest rates in 2006, housing and sub-prime crash following due to higher rates to fight the inflation issue, lack of purchases of Big gas-guzzling auto car sales (mostly US), currency increases in Canada, due to Canada’s higher content of Oil, which led to less jobs in manufacturing, slowdowns which meant that lenders such as banks were less willing to lend - just in case. All trickled down from one major event - is this too simplistic, maybe. But, it’s harder to dispute when you take a look at the timeline of events. Pre-2003 we never had any of these issues, sure there were bubbles etc - but the pin that pricked the balloon wasn’t there yet (that pin that pricked the ballon is meant to reference the outgoing US adminsitration)

Just before July 11th, it was announced that the democratic candidate for the US president would be Obama and not Clinton. Suddenly the end of Bush and Cheney’s Oil love affair began to come in sight. It faded even further when in November McCain, a Bush wanna-be lost the election for the US president. And so, we’ve seen a dramatic decrease in the supply of Oil, which has led to failures in companies that were caught on the wrong end of oil speculation - Bear Stearns, Amaranth, Lehman Bros and others.

The temptation to take ever greater risks rose in the past five years, with interest rates at low levels not seen since the 1960s. People forgot about credit risk, and they decided to forget about diversification and instead concentrate on what was doing well, commodities, Energy, India and China.

Combine leverage and inattention to risk and the third failing, the failure to anticipate low-probability risks and the story was complete.

I’ve had many concerns around the “great” contribution of modern finance, and its assumption that the world is based around statistics and mathematical formulas. The propeller heads. PhDs and math wiz’s followed these new techniques of quantitative investing, correlation, sortinos, betas. standard deviations and better risk management tools. One of the great failings of the smart money was to focus unduly on the central tendency, and ignore the low-chance events (Black Swan events). there may well be a 98% probability that your capital position is secure, but once in a great while, say, in 1929 or 2008 - a 2% event comes along. I am absolutely, not a fan of the propeller heads and computer based models to protect assets. Investing is not as much mathematics as a combination of mathematics, art and a larger amount of psychology. It’s interesting that teh greatest investors in the world the likes of Warren Buffett, David Dreman etc are not Math Wiz’s.

What lesson should we investors draw from the decline of the smart money?

During times of crisis, it’s easy to shut down and avoid asking yourself and your advisor the right questions. But, it’s crucial to take a deep breath, take a step back and assess where you are now. The crisis will pass and you’ll still be faced with planning for your future. Are you committed for the long haul or looking to make short term changes?

The next important question to ask yourself is “How am I doing today?” Are you feeling confident or anxious? have recent events brought up strong emotions such as anger and resentment? If so, talk to your advisor.

The classic response to stress has often be described as “Fight or Flight”.

Fight mode means that you may be displacing your negativity onto others, such as snapping at your spouse and others. If you feel that’s happening, take a break, walk around the block and cut the negative circuit. This is not a Fight you will lose, of you keep a cool head and realize that strong companies will come out smelling like roses,
and that they will continue to increase their revenues and cash flows, as their weaker competitors get decimated and removed.

Flight mode means that you may be trying to escape from the crisis by locking yourself in your office or avoiding talking to your advisor. If you’re going into flight mode, take the initiative. Schedule an appointment with your advisor, and make sure you are staying connected.

We need to look at the millions of North Americans who did the right thing financially: diversify, make sure bonds are part of a portfolio, understand their risk tolerance, understand what they are invested in, not get caught up in the high returns of the past investments, not get deluded by past performance numbers, keep a focus on their longer term.

Successful investors display great emotional intelligence during moments of crisis. They’re forward looking, and rationally optimistic, Crisis like the one in 2008 take almost everyone by surprise, including myself.

2008’s volatility is not new, it’s only that daily and intra-day swings of two, three or four percent

Remember it’s not the event, but your reactions to the event that’s really critical. If you think rational thoughts, you’re going to feel rational. you’re going to have more appropriate judgement and more appropriate feelings, And in the end you’re going to behave more rationally. During times of crisis, emotional intelligence is as
important as financial intelligence.

When the air clears, there will be renewed interest in economic fundamentals. Financial institutions will need to be better capitalized, less leverage on their balance sheets, and better built to withstand low-probability events. This all makes for stronger companies in the future, something that I, looking forward, find
particularly exciting.

One of the unexpected consequences of the financial crisis, I anticipate, with be the rise of stronger dividend paying companies, and better managed funds. The markets will continue to evolve, creating new challenges and opportunities. Downturns don’t last forever

Meanwhile, take a step back and focus on what matters the most. Play with your children, talk to your spouse, reconnect with your friends and identify with what keeps you grounded. Take a deep breath and take fear out of the equation. Stay true to yourself and your values.

I promise to stay true to my values of having portfolios constructed with Bonds and Dividends of strong companies, and managers who have demonstrated the ability to succesfully weather crisis in the past. I have an even greater faith in this process now!

“All financial crises end-and when they end, they end in ways that create spectacular opportunity.”
- Larry Summers, incoming head of the Obama administration’s National Economic Council

With that I leave you with some very special words from Ben Stein

“And let me close with another thought. I am far from glib about the economy. It has a lot of pitfalls facing it. As workers and investors, we know that many dangers lurk in our paths.

But so far, these things have always worked themselves out and this one will, too. In the meantime, they say that falling in love is wonderful, and that the best is falling in love with what you have.”

Please copy and paste the link below as my New Years gift to you

http://www.nytimes.com/2008/07/13/business/13every.html?_r=1&em&ex=1216440000&en=a9a6d3e97f11545f&ei=5087%0A

Remain Rational

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