The stock market is filled with individuals who know the price of everything, but the value of nothing.
Philip Arthur Fisher
Iron Capital’s quarterly investment newsletter through which we share our views on investing your assets in the current market environment.
The team broke huddle and came to the line of scrimmage. Their star quarterback, Osborne, took the snap and dropped back to pass.
“You should never be proud of doing the right thing. You should just do the right thing.”
“We live in a connected world.”
“When it comes to retirement, the old saying is true – there is more to life than money.”
“The investment world has a language all its own, and it gets used and abused..”
The team broke huddle and came to the line of scrimmage. Their star quarterback, Osborne, took the snap and dropped back to pass. The pocket broke down and he scrambled to his right. Seeing no one open for a pass Osborne tucked the ball for safety and decided to run for what yardage he could get. Then out of the corner of his eye he saw his fullback break open. He tried to get the ball back up in a throwing position but the defense was on him, so at the last second he attempted what could only be described as a basketball-style chest pass vaguely in the direction of his fullback. The ball floated right into the hands of the other team’s cornerback, who ran it back for a touchdown.
The rest of the Osborne family sat in the stands, somewhat in disbelief as to what they had just witnessed. An avid fan sitting directly behind them stood up and started shouting, “Stupid! Stupid!” Osborne’s loving and protective older sister had heard enough. She stood up, turned around and announced to the avid fan, “That’s my brother!” At this time, the senior Mr. Osborne put his arm around his daughter, tried to calm her down and said, “Well, you do have to admit, that wasn’t the smartest thing your brother has ever done.”
No, it wasn’t me. This true story was about my brother, who is a successful attorney in South Florida and, this one embarrassing episode aside, a very intelligent guy. But even the smartest among us occasionally does something that can only be described as, well, stupid. For most of my life I have assumed that everyone recognizes this as a fact of life. Then one day I was trying to put together one of those “some assembly required” toys for my son and I made a mistake. I looked at my son as I was fixing it and said, “That was stupid of me.” My son looked at me in horror and informed me that stupid is a bad word.
Until that moment I thought I knew all the bad words that I did not want my children to learn from their father (most of which have four letters, not six.) I tried to explain to him, as was taught to me in a different era, that calling some- one stupid is bad, but stupid itself is not a bad word. Smart people do stupid things all the time, usually when in a hurry or distracted and not fully thinking. I gave up and now try to use the word silly when describing stupidity.
I understand why a teacher would tell children that stupid is a bad word, especially at a young age, as one of the greatest ironies of childhood innocence is that children can often be cruel to one another. Of course, in the real world stupid happens all the time. We’ve all seen it and most of us have done it – I know I have. It happens in sports, when many games are determined by an opponent making a mistake in judgement. It happens in politics, when a promising politician says something carelessly and all of a sudden his career meets its end. The one place it may happen the most often is in my world: the world of economics and finance.
Traditional economics and finance assumes rational behavior. Of course humans are capable of being rational, but this often requires energy and focus. Many times in our busy lives we feel like that quarterback who is being rushed out of the pocket. Our modern lives do not usually lead to actually being chased down and tackled, but between work, family, and our “smart” phones that keep beeping and vibrating at us, constantly reminding of us of the twenty things we were supposed to do today that still are not done, we may feel just as overwhelmed.
It is no surprise then that experts have found that the first thing most people feel when presented with an investment opportunity is reluctance. How are we supposed to slow down enough to use our powers of rationality and make smart decisions? We feel like that is just too hard, so we are reluctant. We don’t want to make a mistake, and although at some level we may recognize that doing nothing might actually be the worst thing, we just feel more comfortable not having to move.
We are like that quarterback in the pocket protected by all those big linemen, but eventually that pocket of protection will start to break. Co-workers, friends, neighbors, or even family members who were not reluctant for whatever reason start pointing out how well they are doing. Our reluctance slowly turns to optimism.
Then we go online. Our modern world gives us the ability like never before to conduct what passes as research: “Google it.” We can post questions for our friends on social media. But there is a dark side. All of that connectivity can lead to seeking confirmation more than true enlighten- ment. One of my friends recently put it best when discussing social media: no one is out there seeking to under- stand; they are out there to have their views amplified, and if anyone dares question them then to shout them down. So people go out there seeking confirmation of their optimism, not seeking truth.
One of the quirks of the Internet is that it will give you what you seek. In this case that causes optimism to turn into excitement. As one stays in his echo chamber getting more and more positive feedback his excitement eventually turns to exuberance, and it is a this moment that the inaction ceases and the investor makes the investment.
All around in the busy world he will see glimpses of positive feedback. He will believe that he has done the right thing, the intelligent thing. Then reality hits home. Bad news, previously ignored, comes to light. Perhaps sub- prime mortgages start to default, or maybe a hedge fund run by a smaller Wall Street bank folds. The reaction will usually be to rationalize, “It’s just sub-prime and that is a small part of the market,” or “It is just one hedge fund.” In other words he is in denial. After all he is intelligent, he did his homework, there is no way he is wrong, there is no way he did something stupid.
Well the hits keep coming. That small firm that ran the failed hedge fund? Now the whole firm is in trouble. This is getting a little scary. Fear sets in, but fortunately regulators come to the rescue and arrange for that troubled firm to be bought by one of its stronger competitors. But, now an even larger firm is in trouble. So are two others. This is getting desperate, what does the investor do? He now has a loss and he doesn’t like taking losses, which is like admitting a mistake.
Then it happens: the larger firm goes down, and another is on the brink. The pocket has completely broken down and big scary defensive linemen are on your tail. Panic sets in, he runs for it, and as all seems lost he finally capitulates, just throwing the ball up for grabs. The other team catches it and runs it back for a touchdown. The Monday morning quarterback in the stands starts shouting, “Stupid, Stupid!”
Sound familiar? It should, because it happened just a few years ago. That small firm was known as Bear Sterns, the larger one Lehman Brothers, the two others, Countrywide and Washington Mutual. This is what happened. I could do the same thing with the tech bubble, and we may be seeing something similar with Greece and China today.
Where do we go wrong? First of all we have too many Monday morning quarterbacks. I sometimes joke with friends that our national pastime used to be playing baseball, and now it is watching football. Technology has led us more and more to be spectators in life instead of participants. We have told that story about the fan calling my brother stupid so many times in my family that it seems like yesterday, but fortunately for my brother it happened in the mid-1970s. I can’t imagine what the reaction would be like today with social media. One thing that always helped with our family was that we understood that the fan really had no idea what it is like to actually be a quarterback.
Spectators sit back and offer criticism after the fact, which doesn’t take any courage, knowledge or understanding – it is easy. Let’s face it, the players usually cannot hear what the spectators are saying anyway. It’s just noise. This happens to the investor as well: Financial advisers who don’t practice what they preach, lecturing clients about this or that. Financial reporters, who know far more about journalism than investing, give advice that always sounds good in hindsight, even if it contradicts what they said last week. It’s all noise.
The reality of today’s world makes it increasingly difficult to overcome reluctance; at the same time, it makes it increasingly easier to fall into denial. All of the big mistakes investors make are driven by these two emotional states. I have long considered it our most important job to help our clients avoid these two things. This is why we emphasize prudent investing. It is much easier to avoid reluctance if one knows what one owns.
Investing from the bottom-up helps one gain an understanding of what is really happening; it gives us a tool to separate news from noise. Analyzing individual investment opportunities automatically drowns out the noise and helps guard against feedback bias. A company’s financial results are what they are regardless of what might be going around on social media.
Absolute return-orientation helps avoid the excitement trap. We don’t need to beat anyone or anything to get where we are trying to go. In this way investing is more like running a marathon than competing in a football game: for the vast majority of marathon runners, to finish is to win. If they beat their personal best, their personal goal that is victory regardless of what other runners are doing.
Risk aversion means never being in denial. Lots of things that shouldn’t have any impact on the markets end up causing havoc. Small things can have a big impact, and big things sometimes have little impact – one never knows how people will react. This is when it is important to know what one owns and understand that even if short-term trading turns negative, patience will be rewarded because what she owns still has value. This is also when it is impor- tant to have disciplined risk controls, realizing that it is better to sometimes be defensive and miss out on upside market reversals than it is to be in denial and end up capitulating.
How do intelligent people avoid doing stupid things? We take our time. We don’t get rushed or scared or distracted. We make prudent decisions. Is our
way of investing the only way? No. But it works for us and our like-minded clients. There are other strategies, alternatives, indexing, sector rotation, market timing, etc. But all of those run the risk that one day a Monday morning quarterback might look at what they’ve done, jump up and yell, “Stupid, Stupid!” I like our way better.
Charles E. Osborne, CFA, Managing Director
~Stupid Is as Stupid Does
Growing up in North Carolina in the 1970s there were two kinds of kids: those who worshiped the ground Dean Smith, legendary basketball coach of the North Carolina Tar Heels, walked on; and those who thought he was the devil himself. I was in the former camp right up until the day my beloved late Uncle Dag convinced me that I should get my education at Wake Forest and not that school on the other end of Tobacco Road.
For all of his success it is easy to forget that Smith was not hired because anyone thought he could win. He was a young assistant who had never been a head coach. He was asked to step up when Frank McGuire was forced to resign because of NCAA violations. Smith was hired the same day McGuire was fired and told that wins and losses didn’t matter as long as he ran a clean program and represented the university well. He went on to win more than 77 percent of the games he coached and 879 games total. He also lived up to his original mandate.
Smith was a man who was not afraid to stand up for what he thought was right. When he was still a young assistant coach he helped desegregate Chapel Hill. His minister had asked Smith if he would accompany him and a black member of their church to dinner at a white-only restaurant, and Smith agreed without hesitation. The restaurant they chose was one where the basketball team often had team meals. The owners knew Smith, who was not famous yet, and did not wish to risk losing the team’s business, so they served the trio and the desegregation of Chapel Hill was begun. That story remained largely unknown until author John Feinstein found out about it while researching a book on Smith. When Feinstein asked him to verify the story, Smith asked who had told him about it. Feinstein revealed his source and Smith said, “I wish he hadn’t done that.” Surprised, Feinstein said, “Dean, you should be proud of doing something like that.” Smith looked him in the eye and said, “John, you should never be proud of doing the right thing. You should just do the right thing.”
A few years ago I decided to volunteer to coach my son’s basketball team. I was telling a client about the decision and he said, “I bet you’ll be really good at it.”
I thanked him, then asked why he had that opinion. He told me that coaching is mostly about teaching and that is a lot of what we do as advisers. He is right – there are indeed many similarities between coaching and being an adviser. The skills needed to convince someone to save more money can be very helpful when convincing a young player that he needs to pass the ball every once and a while. One could argue that risk control in investing is a little like defense in sports: It may not be as exciting as offense, but it is often what wins championships.
Unfortunately for both sports and investing, the strongest link between the two may be the skewed incentives of those involved. Today the traditional financial adviser is really a salesperson whose world revolves around bringing in assets. This role evolved over time. Originally the term adviser was reserved for money managers, who were hired and paid a fee to make investment decisions on behalf of their clients. The clients who could afford such service were either institutions, such as corporate pension plans, or very wealthy individuals. Most investors went without the help of an adviser.
These investors purchased various investments through salespeople known as stock brokers. The role of the traditional stock broker has been eliminated by technology, however the salespeople have survived by re-branding themselves into financial consultants and eventually financial advisers. When we bring on a new client we ask them who manages their money now. Our older clients will answer, “I do, and John is my broker at Merrill Lynch.” Younger clients will say, “Merrill Lynch manages my money.”
In basketball, coaches like Dean Smith used to run summer camps, and elite young players spent their summers going to such camps. Many of these have been eliminated or greatly reduced. In their place we now have leagues, the largest of which is the Amateur Athletic Union (AAU). The issue with this transition is that the incentives of those who coach in camps and those who coach teams in a league are very different. The goal of a camp is to develop players, while the goal of a league team is to win games. If a young player with a lot of raw talent but poor footwork goes to a camp, the coaches will want to focus on that footwork and get him moving more efficiently. If that same player joins a summer team, that coach has other priorities. They must compete so the coach has to teach the players his offensive plays, which takes a lot of practice time away from fundamentals like footwork. Coach wants to help his kids, but the last thing he needs is his star player worrying about footwork in the middle of a tournament where they play two or three games a day. If he tries to fix the skill issue he is likely to see his star not play as well as the new footwork has not become natural yet, and therefore they will lose games and the coach will lose his job. As a result, college basketball is full of very talented players that have very little skill. The NBA has been forced to create a minor league system and employ “skills coaches.” The solution that gets talked about for this problem is rule changes to make it easier to score. Those may or may not be good ideas, but they do not address the real issue.
Similarly, in the investment world investment advisers who are paid a fee to manage a client’s portfolio are incented to manage that portfolio well and help it grow. Conversely, financial advisers are paid commissions for selling products and are incented to sell more products to more and more people. When I bring this to someone’s attention for the first time I usually get this look of astonishment. Most refuse to believe it, because no one in their right mind would design an industry like that. But remember today’s investment industry wasn’t designed; it evolved.
Investment advisers represent their clients as fiduciaries. According to Wikipedia, “A fiduciary is a person who holds a legal or ethical relationship of trust between himself or herself and one or more other parties…. Typically, a fiduciary prudently takes care of money for another person. In such a relation, good conscience requires the fiduciary to act at all times for the sole benefit and interest of the one who trusts.” This is exactly what investment advisers do – they manage the investments of others.
In the aftermath of the financial crisis many people were shocked to find out that this is not what financial advisers do. Financial advisers sell products and are no more responsible for those products than any other salesman in any other industry. People were shocked to find out that financial advisers might sell products they themselves would never buy, and were horrified to learn that financial advisers would agree to buy investments from one client in order to sell them to another. That is the definition of being a broker after all, but their business cards stopped using that word years ago.
In response our leaders in Washington have now decided that all advisers should have to be fiduciaries. Doesn’t that sound wonderful? Unfortunately, there are a multitude of problems with this, but for the sake of space we’ll just discuss the most obvious one: A commissioned salesperson cannot act in the sole interest of his clients, since the commission is a huge conflict of interest. I know what you are thinking: Sure the commission is a conflict, but my financial adviser is a good guy, he goes to my church and coached my son, he would never succumb to conflicts.
Issues like this are very interesting for people like Dan Ariely. Ariely, a professor at Duke University, is a pioneer in what we call behavioral economics, the study of how people actually act in real world settings as opposed to how traditional economic models suggest. Traditional economics assumes greed, and therefore would assume that a commission-based adviser would do whatever he could get away with to maximize his commissions. Behavioral economics show that, as you suspected, most people have a moral compass which prevents them from cheating to the maximum. In his book, “The Honest Truth About Dishonesty”, Ariely presents many studies which show that while most people will cheat if given the opportunity, they only cheat by a little. However, one of his findings is that conflicts of interest are stronger than most think.
The normal reaction to conflicts of interest from regulators is to demand disclosure. Ariely did this in one of his studies, and in fact the people who disclosed the existence of a conflict acted even worse. His theory is that the open acknowledgement that the conflict exists eased their conscience and allowed for greater cheating.
But wait, it gets worse. Another great contributor to cheating is the distance between the cheater and the ones being cheated. Financial advisers are sellers of products, and those products are designed and managed by people far removed from the actual investor. Finally, the nail in the coffin of moral behavior is witnessing someone else cheating and not only getting away with it, but being rewarded for it. Financial advisers are rewarded for selling more products and bringing in more clients. Your guy may be a straight arrow, but if there is one bad apple in his office whom he sees getting praised and rewarded, then your guy will likely follow suit, or leave the business in disgust.
In other words, Ariely suggests a list of things one can do to help promote honest behavior, and today’s traditional financial industry does just about every one of those things wrong.
Many sports pundits believe that the rules of college basketball need to be changed. They want to shorten the shot clock and make it easier for the offensive players to move. They believe that changing the rules will bring back the glory days when players actually made half or more of their shots and teams routinely scored eighty points or more in a game. These rule changes may or may not be a good thing, but one thing is certain: Changing a few rules is not going to magically enhance the skill level of the average college basketball player. To do that there will need to be more fundamental changes to the current AAU system.
In like fashion, Washington wishes to stamp the word fiduciary on anyone who calls themselves an adviser. That may or may not be a good thing, but one thing is certain: Calling a broker a fiduciary isn’t going to magically end conflicts of interest. To do that, we will need fundamental changes to the industry. Firms like Iron Capital are part of that fundamental change. I’m often asked if I’m proud of that. As Dean Smith said, “You should never be proud of doing the right thing. You should just do the right thing.”
Charles E. Osborne, CFA, Managing Director
~The Right Thing
We live in a connected world. I’m sure you know what I mean. You may be on a trip somewhere and you run into a neighbor, or you might meet someone for the first time and find out you grew up down the street from one another. This past fall my wife and I enrolled our son in a newly established charter school, and the wife of one of the founding board members was one of my Wake Forest classmates. I once boarded an airplane and sat down next to an old high school friend I had not seen in twenty years. When I was a young single professional I went out with a colleague in my office, and we were going to be joined by an old friend of his named Richard. I commented that I went to high school with a Rich who had the same last name, but my friend told me it couldn’t be the same person because his friend hated it when people called him Rich. A few minutes later Rich and Richard ended up being the same person after all. In the immortal words of come- dian Steven Wright, “It is a small world, but I wouldn’t want to have to paint it.”
I don’t know what is more amazing, how many times the world reminds us how connected everything is, or how many times we seem to forget. We seem to want to silo everything. We do it in our budgeting. I cannot tell you how many times I have spoken to people with spending problems and had a conversation that goes like this:
Me: You are spending more than you make, that must stop if you wish to get ahead.
Client: Well the problem is the price of gas went way up and I drive so far to work every day that it really has caused a big deficit in my budget for commuting.
Me: But what about this big vacation you took?
Client: Oh that is not a problem. I stayed within my vacation budget.
Clients like this fall into the trap of using complicated budgeting software that breaks everything down and completely forget that it is the whole that matters. The various budget categories are all connected. If one’s personal budget has ten categories and he runs a deficit in one of them then he must make up for that somewhere else. Otherwise he ends up spending more than he actually has. If day-to-day expenses increase, then he may not be able to spend as much as he otherwise would on vacation.
This siloed way of thinking impacts people’s investments as well as their budgets. Clients come to us all the time with portfolios that make no sense simply because they are all parts and no whole: They have an account for college funding for each child; his and her 401(k) accounts; old job retirement accounts; and that one stock Aunt Betsy left them. Each account has a different strategy, sometimes even different risk tolerances. Some folks have conservative money and risky money.
There are lots of reasons for this hodge podge approach to financial and investment planning. Some of it is simply the pace at which we live these days – everyone is moving so fast that nothing gets done correctly. We know things are not correct, but we just never seem to get around to fixing them. Some of it is that people really do silo these things in their minds. “The money Aunt Betsy left us is sacred because she was my favorite Aunt, so whatever you do, don’t lose a dime.” “The college fund for Sally? Well let’s face it, she is the youngest so we won’t be contributing a lot. Let’s roll the dice and see if we can’t win the lottery. If that doesn’t work out she can just live with her older brother, we sent him to Harvard.” Of course this is not logical when we stop and think about it, but when do we ever do that?
Most people conduct most of their financial dealings with their emotions, not their logic. They loved Aunt Betsy. They really want to go on that vacation. They love their kids and deep down just know that their kids will all get scholarships. This is where we come in.
I once heard a speech about the Declaration of Independence. How it starts with the line, “We hold these truths to be self-evident.” What does that mean, self-evident? The speaker said it meant that when one thinks about it for just a second she sits back and says, “Well duh.” The trick is that one has to take that second to actually think about it. Many simply never do that. They see a headline in a newspaper and never take a second to say does this actually make sense? In fact, to the extent most people do think, they tend to do it in reverse; they draw their conclusions and then search out evidence for those conclusions, ignoring all other evidence.
A few years ago in the heat of the financial crisis I got into a discussion with a friend about government deficits. I suggested that one should wait until the crisis had passed before worrying too much about the deficit. He sent me a paper written by an economist he had heard speak and highlighted a line about the long-term problems with deficit spending (with which I agreed, by the way). He failed to highlight the very next sentence which said that the middle of a big recession is not the time to deal with deficits. But that sentence did not fit his already drawn conclusion. I’m not even sure it ever registered with him.
That economist understood that the world is connected. Deficit spending is not a good thing, especially when done chronically year after year. There are, however, other issues. Spending more than one makes to take a fancy vaca- tion is one thing, but spending more than one makes because of an illness is an entirely different issue. Nothing can be intelligently analyzed in a silo.
Today there is nothing that fits this description more than the price of oil. Oil has dropped in price by more than fifty percent and the explanations for this are incredible. According to the pundits and Wall Street apologists, this is a logical reaction to the plummeting demand for oil and the oversupply caused by America’s energy boom. This is when one should start to question the headline.
The drop in the price of oil has been taking place since June, and there have been no significant changes in supply or demand for oil since June. That does not stop those who have already drawn a conclusion from seeking out data to support that conclusion. Speculators are lining up to be quoted about the plummeting demand for oil. The only problem is that out in the real world, according to government organizations that track such things, there is no drop in demand.
The U.S. Energy Information Agency (EIA) projects global demand for oil growing in 2015 by nine hundred thousand barrels a day…yes, growing. This number corresponds to the estimate given by the International Energy Agency (IEA). It is true that their projections for next year were higher a few months ago, so if one assumes these organizations are actually correct in their forecasts – granted that is a huge leap of faith – then one could say the growth in demand is slowing, but demand is not shrinking in the least and it certainly isn’t plummeting.
Much has also been written about the “glut” in oil supplies. Currently the world is producing more oil every day than we consume, but that is not unusual. According to the EIA the world produced 91.96 million barrels a day in 2014 while we consumed 91.44 million barrels a day – a difference of 520,000 barrels a day. In 2012 the world produced 89.76 million barrels a day and we consumed 89.14 million barrels a day – a difference of 620,000 barrels a day. Of course 620,000 is more than 520,000 and there was no crash in the oil price in 2012. In 2013 the world consumed more than it produced as demand increased more than supply, and my bet is that happens once more.
People who live in New York and never drive anywhere may not under- stand this, but everyone else will use more oil if the price is cheaper. Consumer Reports recently named the new car models with the lowest consumer satisfaction. Guess what, they were all tiny, super fuel-efficient cars. Gas is a lot cheaper than it was when those disgruntled consumers settled for those models. The toe bone is connected the foot bone and the foot bone is connected to the heel bone. Don’t be surprised if consumers start going back to larger, less efficient cars.
Many of the pundits who go on and on about the plummeting demand for oil claim that it is because the global economy is evidently collapsing. A day later the very same pundits will talk about third quarter GDP for the U.S. coming in at 5 percent growth. The U.S. is the largest economy on the planet. We are the largest consumer of oil. We love our big cars and hate the tiny things high-priced oil made us buy. Yes, Europe has issues and China is growing up and no longer having pubescent growth spurts, but the heel bone is connected to the ankle bone and the ankle bone is connected to the shin bone. The U.S. economy has positive momentum and now the U.S. consumer has just been given a huge budget saving price cut at the pump.
Here is one of those self-evident moments: The economy of the United States cannot grow at five percent, or anywhere close to that, and the demand for oil drop. One of those big market- moving stories must be incorrect. After all the shin bone is connected to the knee bone. Everything we consume in the U.S. requires energy in order to be produced and transported. GDP (gross domestic product) is a measure of everything we produce and consume. The knee bone is connected to the thigh bone and the thigh bone is connected to the hip bone.
So what is really causing the price of oil to drop? In my opinion that is the wrong question. The question should be the same question we started asking in 2008: Why in the world did oil’s price go so high in the first place? In 2008 I wrote about the roaring price of oil. Once again, back then supply and demand were blamed. Of course it was true that demand from emerging markets had an impact, just as greater production from the U.S. is having one now, but then as now, the price jump happened rapidly while the supposed excuse had been around for years. The best research we could find in 2008 suggested that the supply and demand alone would justify a price in the $60 to $70 range. Nothing has happened since then which would substantially change that estimate. EIA data suggest that global supply and demand have grown slowly and largely together since 2008.
What has changed is institutional investors. I mentioned in 2008 that pension plans, endowments and other institutions were piling into oil. Stocks looked bad in their rearview mirror and commodities had been rising so they started selling stocks and adding commodities to their portfolios. Oil was trading at $140 per barrel when I wrote that. Those investors were a large part of the reason, because if everyone buys the same investment at the same time the price goes way up. You see, the hip bone connected to the back bone and the back bone is connected to the shoulder bone.
Fast forward six years and those stocks all those institutional investors got out of have come all the way back and then some. But those institutional investors and their retail financial adviser copy cats have been going into commodities. Oil was already down almost $40 per barrel over that time period. Once again with eyes glued to the rearview mirror these same institutions are now questioning their collective wisdom. Many have begun to exit such “alternative” strategies. The shoulder bone is connected to the neck bone and the neck bone is connected to the head bone. This ride in oil is far more about Wall Street than it is about Main Street’s demand for oil.
The problem with investing in commodities such as oil is that they are not really investments. As Benjamin Graham taught us, “An investment operation is one which, upon thorough analysis, promises safety of principal and an adequate return. Operations not meeting these requirements are speculative.” A commodity is simply worth what someone is willing to pay and that is a speculative operation. When one takes a moment to think it becomes self-evident: speculation is driving the price of oil.
The pundits don’t want you to see the connections. Wall Street makes money from trading – to them it makes no difference in which direction the price is going. Emotions drive trading, and in the case of oil, the emotion is fear. Those emotions are more easily manipulated when issues can be siloed. But, Dem Bones are connected. Whether it is budgeting or managing one’s investments or anything else, the more one understands that Dem Bones are connected, the more self-evident the prudent path becomes.
Charles E. Osborne, CFA, Managing Director
In 1913 a great flood hit the state of Indiana. It started on March 21, which happened to be Good Friday. A windstorm hit the state followed two days later, on Easter morning, by rain. It rained for three days, causing the Wabash River to rise and flood by Tuesday morning March 25. The water continued to rise for two more days, completely flooding the town of Logansport and leaving many of the town’s residents stranded and fearing for their lives.
At approximately midnight on March 25 the mayor of Logansport sent out a distress call to General Leigh R. Gignilliat at nearby Culver Military Academy boarding school. Culver, which is located on a large lake, had just a few years earlier launched a summer Naval School where summer campers could learn to operate cutter boats. Culver’s boats were in dry dock for the winter. Each boat was twenty-eight feet long and eight feet wide and weighed approximately 3,000 pounds.
Gignilliat woke the corps of cadets and they started loading the cutters onto rail cars. By 3:00 a.m. on March 26 the boats were loaded and the cadets jumped on the train and headed to Logansport. They went as far as the train could go, unloaded the boats and began their rescue mission. Over the next two days those cadets saved the lives of more than 1,500 residents stranded by the floodwaters. The following year, in 1914, the town of Logansport commissioned and donated a bronze and brick memorial gate in appreciation for what
those cadets had done. Logansport Gate, as it is known today, now forms the back gate to Culver’s campus.
Seventy years later a young man named Chuck Osborne matriculated at Culver and was required to memorize that story, among others. It is a great story, and I still get emotional when I retell it. One can only imagine what it was like for those teenage boys to come to the rescue of so many. For Culver students then and now the story becomes ours, as it was a seminal event that helped shape the institution and its mission to create leaders who learn to lead by doing, or should I say lead from in front. That story helps to bring purpose and meaning to being part of the Culver institution.
We all have those kinds of stories. They may not involve saving lives (trust me I have never done anything that heroic), but they define our life stories. The groups we belong to, the people with whom we have shared fellowship, the places we have lived and things we have witnessed: These things bring meaning to our existence and most of the time they happen when we are doing something as part of a defined group. It could be our high school, like the story I shared, or it could be family, church, etc. However, for most of us we spend the majority of our lives, and therefore our stories, doing something we usually think of as work.
From the time we are in our early twenties until today, we have spent most of our time working. We are often defined by our work. “This is Chuck he manages money,” or “This is Susan, she is a lawyer,” or “This is Bob, he is the captain of a tug boat,” or maybe, “This is Dawn she is a stay-at-home mom.” Certainly there is more to each one of us than just our jobs, but our jobs are a significant part of our lives.
So what happens when it is time to retire?
Retirement is the number one goal that we hear from our clients. The vast majority of the money we manage is being accumulated for the purpose of providing retire- ment income. The two most frequent questions we are asked from our clients are, “Do I have enough for retirement?” and “How do I transition from accumulating a retirement portfolio to living off a retirement portfolio?”
In our experience most fear the first question more than they should. They hear claims like the one recently made by Senator Maria Cantwell who stated that “…92 percent of Americans are unprepared [financially] for retirement.” Of course the senator was quoting a study, and there are lots of them. Most claim that anywhere from 53 percent to 84 percent of Americans will have inadequate income in old age. Andrew Biggs and Sylvester Schieber recently co-authored an article in The Wall Street Journal claiming that “…these statistics are vast over- statements, generated by methods that range from flawed to bogus.” Biggs is a former principal deputy commissioner of the Social Security Administration and Schieber is a former chairman of the Social Security Advisory Board. They know a little bit about the subject of American retirement readiness.
Their claim matches what we have seen in our own client base. We help many of our clients with retirement and other forms of financial planning. There are certainly times when in doing so we must bring our clients bad news, but the majority of the time we deliver to our clients the news that they are better prepared then they originally thought. We can see the stress disappear from their faces as we go through the results.
The second question is easily answered. Several years ago now we created our income strategy. It is based on our belief that a prudent investor is absolute return-oriented and not concerned with the investment results of others. If a retiree needs to take income from her portfolio that equals 5 percent of the total, then we should invest that portfolio to achieve 5 percent income while taking as little risk as possible. In today’s market that means owning the stock of companies like AT&T that makes dividend payments equal to 5.19 percent of the current price of the stock, or in industry terms yields 5.19 percent. Should rates rise and the United States Treasury offer to pay 5 percent interest on its debt, then she would own Treasuries. The point is to get the retirement income in the safest way possible. It also has the side effect of leaning more to stocks when interest rates are low and toward bonds when interest rates are high, which just happens to be a logical way to maximize returns over time.
Once the ability is calculated and the strategy understood, the conversation usually ends. But, it should not. There are two other questions that few ask, but everyone should. The first deals with health. Remember the story of Tithonus in Greek mythology: Tithonus was kidnapped by Eos, Titan of the dawn, to be her lover. Eos asked Zeus to grant Tithonus immortality, but she forgot to ask for eternal youth. Tithonus indeed lived forever but became old and frail and eventually was too weak to move his limbs. He begged for death but it would not come. The moral of the story is be careful for what you wish.
Retirement may seem great but one needs to plan for keeping in shape. For many Americans what little exercise they get comes from work. When they stop working they stop moving, and when that happens they start falling apart like Tithonus. In their book, “Younger Next Year,” authors Chris Crowley and Henry Lodge do a great job of discussing the importance of staying active as we age. Lodge is a doctor in New York and Crowley is one of his patients. They discuss the importance of exercise in retirement.
Our joints need to be moved and our muscles used or they lock up and deteriorate. The older we get, the faster that starts happening.
The second unasked question is perhaps even more important: What am I going to do to bring meaning to my life? Work provides purpose. We get up in the morning because we have to get to work. I am reminded of the simple prayer written by John Wesley, founder of the Methodist church. “God, grant that I may never live to be useless.” People need to be useful, helpful, needed. If you don’t believe me, watch the crowd on the plane the next time you fly. It starts in the security line as the person in front of you is unprepared to take his shoes and belt off and get out his laptop and quart-sized bag of allowed liquids, because he just had to check all of his messages instead of getting prepared while he meandered through the line for the last twenty minutes. I have often thought that airports should have signs that read, “If your email is so important that it can’t wait 20 minutes then you would be flying private. Put the iPhone away!”
Of course it doesn’t stop there. The minute the plane lands everyone has their phones back out, off of “airplane mode” and seeing what they missed over the last hour in flight. It makes them feel needed. It makes them feel important. While we may not need as much of that as we get with our electronically connected society, we do need some of it and for most of us it comes primarily from work.
Being prepared for retirement is not just about having the money. One needs a plan to stay active, to be involved and to create that sense of purpose. What am I going to do to keep my body active and healthy? What am I going to do for social interaction, fellowship and purpose? When faced with these questions many may come to the conclusion that the supposed bliss of retirement is nothing but a myth. When forced to fill their days, some will choose to play golf and other stereotypical retirement activities, but most will decide that work isn’t all that bad. They may want different work – fewer hours or more flexibility. They may want something more dear to their hearts, like volunteering at a charity, their church, the hospital or some other worthy institution. A person turning sixty-five years old today has a life expectancy of more than twenty years. We all love vacations, but a twenty- year vacation is a bit much.
I can only imagine the sense of purpose and fulfillment that those young Culver cadets felt with every life they saved. They were just boys. The gate that was given to Culver in recognition of their efforts is now more than 100 years old. For those unaware of its history and meaning, today the gate is the place where hungry students go to pick up the pizza they just ordered from local favorite Papa’s Pizza. Even in old age we all need a purpose.
It is our job to help our clients meet their financial goals, the most important of which is usually retirement. This may seem strange coming from someone who manages money for a living, but when it comes to retirement the old saying is true: There is more to life than money. We would be remiss in our duty if we didn’t remind you of that from time to time.
Charles E. Osborne, CFA, Managing Director
~The Retirement Myth
Do you really write “The Quarterly Report”? I get that question a lot. The answer is yes. Most people who know me well think my wife actually writes the report. Her career has been in corporate communications and she is a good writer, but she simply edits. (She will actually tell you she only proof reads my writing, but that is just because she is too modest.) In my opinion it takes two skills to be able to write well: First, you have to be able to tell a story; I learned that from my father. Second, one needs knowledge of language and something we are increasingly destroying in our 140-character culture: grammar.
I learned most of what I know about grammar in the eighth grade. My eighth grade English teacher was a volunteer; her husband was a successful doctor and she didn’t need to work. She volunteered her time at my church-run school because she felt it was her calling to teach middle schoolers how to speak and write in proper English. My hands are beginning to shake just thinking about it now – she was the toughest teacher I ever had, and my first report card that year had on it something that my mother had never seen: a letter other than A – and it wasn’t B either. Mom threatened to not let me play basketball. My father interceded on my behalf and made a deal – I could play my favorite team sport as long as I got that grade back up where they expected it.
So I did just that. I worked harder in that class than I probably did in any other class until I got into my major in college. Along the way something happened that I really didn’t appreciate until many years later: I learned the English language. While that skill can be very helpful in one’s career it does have one very negative side effect: I get chills up and down my spine when people abuse our language, which they increasingly do on a daily basis.
Some things one just has to learn to live with, such as the misuse of good and well, especially in sports. Golfers, for example, will start their post-round interview saying, “I hit the ball really good today,” and I want to stand up and scream at the TV, “No you didn’t! You hit it WELL!!” But, I resist that urge because the proper use of well and good is a battle that cannot be won. Please don’t misunderstand, I am not judging; it is just a knee-jerk reaction ingrained in me by teachers who would respond to the question, “Can I go to the restroom?” with, “I don’t know. Can you?” Then one would sit there holding it in until the correct, “May I…” was presented. I suppose those teachers would be brought up on child abuse charges in today’s schools.
What really bothers me is when people use words that are not really words, especially in an effort to seem more intelligent. Irregardless is a classic example. The fact that it isn’t a word does not seem to discourage those who either do not know what regardless means or just feel that it is not sophisticated enough. Resiliency is another good example. A few months ago I was watching a sports event and the announcer kept saying it: resiliency. It was like fingernails on a chalk board. As it turns out, resiliency is a word. It means resilience, but people stopped using it a few hundred years ago because why in the world would one use a four-syllable word when three syllables do the job. It has unfortunately returned to some popularity thanks to the pseudosophistication movement. Resiliency, it seems, has a great deal of resilience due to its more sophisticated sound.
This poor use of language is not just a problem for those of us who enjoy watching sports. It is rampant in corporate America, where it is seemingly more important to be able to construct sentences with nonsensical industry speak than it is to actually know anything. Branding was the first example I experienced at my first annual conference with Aetna Retirement. Until that time I thought branding was something a cowboy did to a cow in an old western, but there I was listening to some guy high-up in the marketing department who talked for 40 minutes, used the word brand or branding 250 times and somehow said nothing. I felt like Tom Hanks in the movie “Big.” He was a young boy who woke up in the body of a grown man after wishing to be big. In his first business meeting he simply raised his hand and said, “I don’t get it.”
In no industry is this truer than in ours. The investment world has a language all its own, and it gets used and abused. The degrees of abuse range from simple confusion to practical dishonesty. It starts with how we refer
to ourselves: In the good old days when people spoke plain English the investment world was made up of bankers, brokers and investment advisers. Bankers helped companies raise capital to get started or more often to expand operations. Brokers brought buyers and sellers of investments together. Investment advisers managed other people’s investments. It was fairly simple.
Then technology brought buyers and sellers together without the middle man, and the broker, instead of going away, became the financial adviser. They used that term because they were prohibited from calling themselves investment advisers. Investment advisers really didn’t mind however, because they had long been known as money managers. So financial advisers became wealth managers. Every time I have heard someone use the term “wealth management” I have asked what it means. No one has yet given me an intelligent answer.
This is not all harmless marketing spin. Most of our individual clients come to us with accounts from the big brokerage firms, Merrill Lynch, Morgan Stanley etc. Clients over a certain age will say, “I manage my money, and Bob at Merrill Lynch is my broker.” Younger clients will say, “Morgan Stanley manages my money.” They say that because they don’t understand the difference between wealth management and money management. Well, it is the same as the difference between irregardless and regardless. One is a real word, the other isn’t.
Understanding how our industry works is confusing enough. Understanding who is in the business of giving advice versus the business of selling products is a huge step. However the language barrier doesn’t stop there. Regardless (notice: no ir needed) of whether an investor wishes to DIY – that is the contemporary non-English way of saying do it yourself – with the help of a broker or to use an adviser, she must navigate a labyrinth of industry speak in order to build a simple portfolio. Concepts such as risk are described as “beta” and “standard deviation.” Philosophy and process are described as “value, growth, or GARP” – growth at a reasonable price. Portfolio construction is described as “diversification” and investments that cost more are called “alternative.”One is then told that the alternatives he invested in are losing money because they have a low “correlation,” and that is evidently something he should want. Following an index that constantly changes is described as “passive” while owning the same core companies for several years is “active.” The newest thing is “smart beta.” I’m not sure if that means regular old beta is dumb, but I saw an article just last week saying that “smart beta” is here to stay, so we better get some.
All of this is designed, whether purposefully or just by the subconscious habit of human nature, to make those of us in the industry look smart and you, the clients, feel dumb. But don’t! Albert Einstein once said, “If you can’t explain it to a 6-year-old, you don’t understand it yourself.” As I understand it Einstein was a pretty smart guy.
This has long been an issue with fast-talkers who are really more interested in making a sale and gaining a commission then they are in understanding what they are selling, or more importantly in understanding their client’s actual needs. Increasingly, however, it seems to be an issue with actual investors. We often meet people who are just dying to use the five industry terms they picked up to impress us, and I can almost feel their disappointment when we ask them to describe their objectives in plain language.
In plain language people don’t want exposure to beta, smart or otherwise; they want to stay in their home during retirement. They don’t want an uncorrelated alternative portfolio; they want to provide their children with an education. They don’t want market neutral alpha; they want a reasonable certainty that they will not outlive their assets. A 6-year-old can understand that.
Plain, correct language that any 6-year-old would understand is always the best way. An investor always plays one of two roles: she either owns something that she believes will increase in value over time, or she loans money to someone else who promises to pay it back plus interest. We call those roles equity and debt, respectively. Risk to an investor is losing money, not some mathematical formula. This is what we do at Iron Capital. We are investment advisers, or money managers if you will. We represent our clients, not any financial institution. We invest our clients’ money in things we understand. We know what we own and to whom we have loaned. We make prudent investments and structure portfolios to meet real needs while avoiding any permanent losses. It may be considered old-fashioned or boring, but it works. It is a lot like grammar.
Of course there will always be those who are too hip to speak properly and too self-important to speak simply. Irregardless of the truth, the folks who come up with smart beta and reverse CDOs and alternative strategies of every sort have a great deal of resiliency in their ability to produce marketing spin. Why wouldn’t they? After all, they do it so good.
Charles E. Osborne, CFA, Managing Director
~The Things People Say