The Really Bad News Part II
Your investment advisor likely puts together your portfolio in the same way the busted banks put together their own portfolios of mortgage-backed securities
In Part I we talked about the first big idea that your investment advisor probably shares with your banker, especially if your bank is one of the big important ones that almost blew up the world 18 months ago.
That first big idea is: “risk drives return.” How much your investment portfolio earns for you, over time, depends on how much risk you are willing to take: the more risk, the more reward.
We ended last time by saying that the old masters, like Warren Buffett’s teacher, Benjamin Graham, taught just the opposite: the way to increase return is to REDUCE or eliminate risk whenever possible.
Your investment advisor does not believe this is possible because doing so would mean out-judging the market. And that, your advisor says, can’t be done.
Here’s why. The principal method for reducing risk in securities investment is to make sure you don’t pay too much. Benjamin Graham wanted a 50 percent margin of safety for stocks: he wanted to pay 50 percent less than he though the stock was worth.
Your investment advisor, like your banker, does not think that is possible because he does not think that any investor can, on a regular basis, get prices more right than the market. So trying to out-figure the market on price is a fool’s errand.
And if you can’t out-figure the market on prices, practically speaking you can’t reduce risk, you can only “manage” risk in an “efficient” manner.
Basically this means that your investment advisor will assemble a “diversified portfolio” of securities from various “asset classes” such as stocks, bonds, REITs, etc. Depending on your age and goals and “risk profile” he will put you more into stocks, which he regards as more risky, or more into bonds, which he regards as less risky.
What he will NOT do is look under the hood too carefully at WHICH stocks and bonds he is putting you into. As long as the picnic basket is diversified, he believes the details don’t matter. His goal is to get for you the average historical return of the various asset classes in which you are invested, NOT to do better by, say, favoring IBM over GE.
Why? Because of what we just discussed. He does not believe that he or anyone else is qualified to judge the price/value of individual securities in that way. He does not believe he can judge whether GE or IBM is a better value.
He goes by the averages.
And that is what crashed the banks. The banks put together their own portfolios of mortgage-backed securities in the exact same way your investment advisor puts together your investment portfolio.
The bankers were absolutely sure—just as they had been taught in business school—that they did not need to know the details of Jim’s mortgage, or Sally’s or Bob’s. They did not need to know if Bob was a drunk, or Sally had just been fired, or Jim was a pathological liar. They were playing the percentages.
The problem is that once you decide that looking under the hood is old fashioned, you begin to cut yourself off from vital information. You fire the green-eyeshade guys who run the data, you change your systems so that eventually it becomes difficult or even impossible to get the information should it suddenly seem important.
That’s how we got into a situation where it was impossible for the CEO of any great modern bank to get an answer to a simple question like: How many of the homeowners whose mortgages we have a stake in can actually afford the houses they are living in.
That’s how we got into a situation in which neither the regulators nor the bankers nor investors could know for sure whether Bear, or Lehman, or Citi, or Morgan, or Goldman, or Wachovia were “really” broke or just suffering the effects of market Panic.
So what you want to ask yourself today is, “When was the last time my investment advisor looked under the hood?”
Tags: Andrew Redleaf, bankers, banking crisis, Hedge Funds, Regulation, Richard Vigilante, Whitebox
