Investing Demystified

by Lars Kroijer

  Not buying insurance against things we can afford to replace or have happen does not mean that those things don’t happen. It just means that instead of having the small bleed of constantly paying small premiums for lots of small things we will once in a while be paying out larger replacements amounts for things we did not insure against. Personally, I also think the whole hassle of keeping track of insurance policies is a pain I would rather avoid and I also seem to constantly hear stories about insurance companies that either fought claims or made claiming on a policy a huge headache.

  Without being scientific about it, including all insurance forms that I don’t buy (including life insurance) I think I save about £500 per year in expense ratio and insurance company profit. Assuming that I took this money every year for the next 30 years and invested it in the broader equity markets and was able to return 5% on that money, my savings from not buying insurance over the period would amount to around £35,000 in present money. This is money I have instead of it being in the insurance company’s pockets in 30 years. Importantly this saving does not assume that I don’t have accidents or have my car stolen. In fact it assumes that I’m at risk of those things exactly with the same probability that the insurance companies assume.

  There is probably going to be a massive ‘always seek expert advice’ or ‘don’t try this at home’ disclaimer from my publisher in the front of this book, and here it really applies. You should not save on insurance premium payments in instances where you can’t afford the loss; and everyone is different in terms of what they can afford to lose. Almost nobody could afford to lose their house in a fire so they should insure against this possibility (you probably couldn’t get a mortgage if you didn’t). Most people in countries without national health services couldn’t afford episodes of bad health so should get health insurance. Many can’t afford to have bad things happen to their car or have their homes broken into, so they should insure against that. But most people can afford to lose their mobile phone, having to cancel a flight or holiday, or an increase in the price of their electricity bill, and they should not insure against those things. And even if there are things you need to buy insurance for you should always get a high deductible, which in turn will lower the cost of the insurance policy. Over time, having no insurance or a good discount when you do will save you quite a bit of money, and that should make you sleep better at night. And perhaps you will look after that mobile phone just a little bit better because it’s not insured, which in turn will lower the risk that you inadvertently lose it.

  Similarly there are many instances when life insurance makes sense. As with the case of annuities, many life products have an investment component to them, but obviously also a life component. If you are in a situation where your death or disability will cause unbearable financial stress on your descendants then the premium you pay on these policies makes sense. As with the example of car insurance, you should do so when you or your descendants can’t afford the loss. Whether they can or not is obviously a highly individual thing, but bear in mind that as with all insurance products there is a tangible financial cost to the intangible peace of mind many people cherish by being insured. Make sure it is worth it.

  1 www.telegraph.co.uk/finance/personalfinance/pensions/

  9407283/Fees-that-canhalve-the-value-of-your-pension.html

  2 For UK specific thoughts on financial planning and pensions I recommend Jonquil Lowe’s Be Your Own Financial Adviser (Pearson Education, 2010).

  3 I used a couple including one from University of Pennsylvania: wharton.upenn.edu/mortality/perl/CalcForm

  chapter 16

  * * *

  Apocalypse investing

  Not long before the financial crash of 2008 a book called The Black Swan – The Impact of the Highly Improbable (Penguin, 2008) written by Nassim Nicholas Taleb was published. The book caused quite a stir in the financial community. The title of the book refers to the common assumption that swans are white. Swans had always been white and it had almost become part of the definition of being a swan, that it is a beautiful, graceful, white bird. The swan-watching community (if there is such a thing) was aghast and confused when a black swan appeared out of nowhere. All that it took for granted was thrown to the wind if such a fundamental assumption as the swan’s colour could be shattered in an instant.

  Taleb goes on to make a mockery of common parameters of risk used in finance. He describes how if you assume that the annual standard deviation of the S&P 500 was 15%, a drop of 45% would represent a 3 standard deviation move and without skew or fat tails (i.e. big moves are more likely than suggested by a normal distribution, as discussed earlier) this should happen approximately 0.14% of the time, or about every 700 years, when in reality it seems to happen every couple of decades. I’m grossly simplifying, but I think Taleb would forgive me in the interests of getting a complex point across in a paragraph.

  Where am I going with this? I think a book on how to invest your assets would not be complete without commenting on how to think or react in what most of us consider highly unlikely and undesirable scenarios. We discussed the short-term government bonds of the most creditworthy governments in the world, and how there are probably no securities that are lower risk than those. But what if we, for a moment, allowed the possibility of a complete collapse of society with governments going bust and law, order and property rights negated?

  It’s hard for most of us to imagine what this kind of complete breakdown looks like without knowing much more about the reasons it happened. It struck me as odd, in the recent movie Contagion about a deadly virus that even with 40 million people dead in the US, and in a state of complete panic, the main characters still seemed to walk around in clean clothes and drive their cars. Would there really have been functioning general stores or petrol stations with the world in such a state? Would your credit card be working? Electricity and water? Could you get your money from the bank and if you could would that money actually be worth anything?

  I am going against the logic of Taleb’s book in even discussing how society’s breakdown could happen or its consequences. Taleb discusses the ‘known’ unknowns and the ‘unknown’ unknowns, and in my mind basically concludes that we don’t know squat, other than the fact that unlikely events are more likely to happen than we think. (Paradoxically he discusses buying government bonds and put options to protect against this, which both assume somewhat functioning financial markets to profit from the disasters.) However, even discussing ways that the highly unlikely may happen and its consequences, in Taleb’s mind I may be missing the whole point that the unknown is exactly that and trying to forecast it is a doomed undertaking.

  Still, how we protect ourselves and our loved ones from an investing perspective if society breaks does depend slightly on how it happened. Was it due to a massive natural disaster that we survived? Was it war? Was it an epidemic that wiped out half the world’s population over a couple of months of science-fiction-type mayhem?

  Gold as security

  The ownership of gold in such a meltdown may make a lot of sense. Over the past centuries gold has served as a great bartering tool, whether held as gold bars or in the form of jewellery. Thinking of gold as a good hedge for markets that are so desperate that your investment in assets such as AAA-government bonds is worthless suggests a state of almost complete collapse. We all remember the horrible stories from World War II when people bartered gold or jewellery for things like food or shelter, or the possibility of escape. People who have studied history and worry that it may indeed repeat itself may find that owning gold has some insurance value to them.

  One point of caution on owning gold: suppose you own it by owning a gold-mining company or an exchange traded fund (ETF) that tracks gold. The value of those assets will track the value of gold closely as the world heads towards turmoil. But would they be of value to you in the case of complete breakdown? Perhaps not. Depending on the disaster there may not be a functioning stock exchange where you can s
ell your gold correlated securities, and the bank where you held the securities in custody might be long gone.

  Perhaps as a cautious investor you have some gold bars at a very conservative bank in a vault that could withstand 10 atomic bombs or whatever disease the evil spirits have thrown our way. But again the gold here may not be of use to us when we need it. Would the bank actually be open for us to go and collect the gold? In that desperate state of the world would we trust that the employees of that bank had not broken into the vaults and stolen the valuables if that meant feeding their children? Even in the case where you were able to go to the bank and pick up your valuables, you may not want to. In a completely broken-down society imagine what it would be like to walk out of a bank with a bunch of gold. You would undoubtedly glance nervously over your shoulder as you exited and police protection on leaving may be non-extent.

  If not gold, then what?

  Obviously the scenarios I describe above are extremely unlikely. Major disasters of the magnitude described have only happened a couple of times over the past century, and even in those cases it was not everywhere in the world simultaneously. Of course those caught up in the horrors of war or mayhem find it scant comfort that things are better elsewhere, as they are forced to deal with what is in front of them. If you can’t realise the value of securities or even pick up valuables in a safety box at a bank the breakdown of society as we know it today would be so complete that we individually would probably be worried about other things such as shelter, security, food and water. Probably the last thing on our minds would be how to best invest our assets. In fact people with the paper version of this book would probably burn it for warmth while mocking the apparently orderly and stable society most investment books take for granted.

  In certain circumstances, ancient jewellery has historically been a great preserver of value in times of great distress. It is easy to store, hide and transport. That said, as with gold I would caution you against storing lots of expensive jewellery at home: the risk of theft could quickly eliminate any benefit from holding it. (My wife thinks jewellery as a store of value is an excellent idea, encouraging me to get some.)

  In certain cases property may be a good asset in times of great distress even if it is illiquid for immediate use. Ignoring the possible benefit of it as arable land, if the crisis passes there may well come the day where the rule of law prevails and you can reclaim your assets. While shares in companies may be worthless with companies long gone, property will probably maintain some value.

  Finally, there is some protection through the holding of the broadly diversified portfolio. Although the scenarios discussed above are clear calamity scenarios there is some chance that part of the portfolio will survive and maintain some value as a result. Even in an highly interconnected world the rational portfolio is highly geographically diversified and holding securities in companies in diverse locations such as Australia, Brazil, Canada, Europe, the US, China and Japan may be of some value if calamity strikes your London home base. For all the securities in a rational portfolio to be worthless a calamity would have to strike simultaneoulsy all over the world.1

  How could 2008 and 2009 have happened?

  My point with the crazy stories above is that your best investments in times of great distress depend on how you define great distress. If you define great distress as what happened in 2008, the AAA-rated government bond is indeed a great preserver of value. In fact, things could have gone a whole lot worse than what happened in 2008 and that would still be the case. But although my suggestions of societal breakdown may seem alarmist and like scenes from a bad science fiction novel, if we are talking about extreme ‘black swan’ events then conventional thinking would be out the window.

  I remember talking to a few friends at collapsing financial firms in October 2008 and again in March 2009 as they were navigating their way through the mayhem. One phrase I remember hearing a couple of times, mainly as a joke, was ‘If this gets any worse, it is guns and ammo time.’ While I chuckled at the time, it was interesting and scary how fast the world moves into panic mode, even without an obvious trigger like war, epidemics or natural disasters. This was a panic caused by the falling house of cards that most of us had helped build through the creation, purchase, regulation, complicity, or ignorance of a crazy, headless, expansion of credit. (I recommend How I Caused the Credit Crunch by Tetsuya Ishikawa (2009, Icon Books). Tets, who was very involved with crisis events while at Goldman and Morgan, has written a funny book about the financial crises.)

  As bad as things were at the worst point of the 2008–09 crisis they could clearly have been much worse. There were still functioning financial markets, no governments had defaulted (they had in fact been able to oversee large and necessary bailouts), there was no hyperinflation or threats of war, and there was no widespread civil unrest.

  Suppose now that instead of the world recovering from the darkest days of the 2008–09 crisis things had taken a bad turn for the worse. We would probably have had a complete collapse of the financial system. Virtually no banks would be in business, or at least not be operating like we take for granted they do today. Your insurance policy would probably be worthless with the underwriter bust. Many governments around the world would be unable to meet their short-term debt maturities and be in default. There would be nobody with liquidity to buy their debt.

  With no functioning financial institutions, trade and commerce would completely dry up. Why would you deliver goods to store when there was no real way you could get paid? Similarly, petrol stations might not be working and public transport would be a mess. A friend told me that the UK has about three months of food reserves and six weeks of fuel assuming normal consumption patterns. Tax revenues would plummet further as there would be far lower incomes to pay tax on and commerce had come to a halt (so no sales tax or VAT). The absence of tax income and inability to refinance their short-term bonds would cause the government to severely cut back on spending, including benefits, pensions, education and medical care. Sensing what was in store the government might increase spending on police and the military. With the inability to fund itself the government might start issuing IOUs (promissory notes), but these could lose credibility quickly as it became apparent that the prospect of repayment was poor.

  The main losers of large-scale government cutbacks would probably be extremely agitated and civil unrest would break out. We have seen cases of civil unrest (like the London riots) or larger protests at government spending cuts in relatively normal states of the world and since the picture I’m painting is much worse, even more widespread unrest could dominate. Where that could lead is anyone’s guess, but probably nowhere good. The whole infrastructure of society would come under great stress.

  The scenario I describe above probably won’t happen in my lifetime, the lifetime of my children or even the grandchildren I hope to have one day. More than anything my point with this chapter is to demonstrate that we must have a flexible mind when we consider all the possible outcomes in our investing lives. The question is: how should we think about investments in a state of complete societal breakdown, not seen in my lifetime, at least in the Western world? These include potential scenarios where property rights have broken down, there is no police or food on the shelves of the stores, and your money is worthless anyhow.

  As I see it the rational portfolio remains superior in virtually all states of the world, except in the scenario where the world is left without property rights and all investment assets across the world are worthless. In a highly unscientific ranking of different levels of societal breakdown here are some thoughts on what you might want to own2:

  Depending on the level of breakdown we could still be safe with AAA-government bonds (they would not still be AAA) potentially from countries other than our own.

  In slightly worse scenarios we would probably want to own fixed assets such as a house or property, and there would still be value somewhere in the broadly diversified rational portfol
io as the whole world probably did not go bust all at once.

  In an even worse scenario than this where property rights are out the window we would probably want to own high-value, yet easy to hide and transfer, goods like gold or jewellery.

  And in complete mayhem we want to own shelter, security, food and water. And indeed guns and ammo.

  Avoiding fraud

  While different from the broader kind of calamity discussed above, for some people Bernie Madoff and other fraudsters like him have become their personal equivalent.

  Whole books have been written about how to avoid investing with the next Madoff, and rightly so. Madoff is the epitome of the worst the world of finance has to offer. He was stealing from people whose confidence he had gained, and left many people bankrupt while he was living the high life.

  A couple of former investors of mine were hurt by the Madoff debacle. Knowing these investors I can attest that they were not naïve simpletons, but sophisticated and diligent managers. That they could still get caught investing in what turned out to be frauds has served as a reminder to me that few people are entirely safe from the prospect of becoming the next victim.

  While every measure and precaution should be taken to avoid something like Madoff’s scheme happening again, there are undoubtedly people concocting elaborate schemes right now. It is something different every time and the explosion of international finance with increasingly sophisticated instruments only adds to the possibilities of tricking investors.

  I don’t have a guaranteed way of avoiding fraud, but I do think that the kind of index-type investing recommended in this book minimises the probability of fraud. We are not paying an intermediary to be clever on our behalf. We think that is futile and expensive, and we trust the market to find the best value for securities. Most frauds over time have been committed by someone who was entrusted with other people’s money to generate great returns. We are not entrusting anyone with our money and telling them to go perform miracles. We don’t think it can be done.