The Red Pill

Wall Street traders (bless their dark souls) hold that there are two kinds of personalities – the stock type and the bond type. Stock guys are thought to be optimists while bond people have a gloomy reputation. There must be some truth to this because in ten years I have not met a bond manager with a sunny disposition.

Thankfully, Morpheus’s medication did not offer Neo a glimpse of the bond matrix. That’s one rabbit hole even he couldn’t have got out of easily.

Luckily, most of us are stock-people. We extol and defend our favorite stocks to the point of irrationality. In the meantime, it is forgotten that the bond market dominates the economy in a way that stocks never have and never will.

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Jessica Alba and the Sharpe Ratio

A boiler-plate image of a happy retired couple looking into the sunset at a beach. Sunset images are less popular among financial advisors than ones with greenery and dogs. Advertising executives are of the view that green leaves convey a subliminal message of green dollar money. And the bounding dogs imply vitality – i.e. you will still be alive by the time your investments have matured to the point that you can afford to play with your dog in a park in the middle of the week.

The investing public in America has been relentlessly carpet-bombed with the stock investing mantra. Most financial advisors will repeat it for you: “Thou shalt heed that stocks are the best hedge against inflation, they may earneth thee 10% a year. Buy them ye must!”. And just like the Mormon Church, this is followed up with colorful marketing paper containing smiling pictures of financially secure people and their jubilant dogs.

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Why Stocks and Bonds Exist

The story of stocks and bonds is that of entrepreneurship. In the United States alone, over 500,000 new businesses are started every year. I suppose, having a “boss” is not an easy thing for many people.

A popular US Army recruiting slogan created in 1980. It was changed to “Army of One” just before the real wars began in Afghanistan and Iraq.

If anything, the urge to start businesses is stronger than ever before. A recent survey of millennial college kids showed that roughly 2/3rd of them would like to be entrepreneurs – to “be all that you can be” in the words of Uncle Sam above.

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Buy and Hold on … (to your Amygdala)

The purpose of any financial investment is to grow your money, pure and simple. But there is a bit more to what “making money” really means. Suppose you invested $10,000 ten years ago and today that investment is worth $12,000. That sounds like a good thing. But what if all the stuff you could buy for $10,000 back then now costs $14,000? No longer sounds like a good thing. Inflation is the hot sun that keeps melting away the ice-cream of your investments.

How do we know how much inflation there is? The Federal Government, helpful as always, has been publishing the inflation rate since 1947 through the Bureau of Labor Statistics (BLS). The number they provide is known as the Consumer Price Index (CPI). How they get to this figure is rather involved : they first make an educated guess as to what the average American family consumes and then measure how the price of this stuff is changing every month. If you want to know what the Government thinks your household budget looks like, take a peek at the graphic below:


The big one is housing of course, taking a 43% bite out of the family budget.

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The Age of Mutual Funds

The concept of a stock is not a new one. Nearly four hundred years ago, shares were issued by the East India Company to help pay for its voyages and colonial conquests in Asia. In America, the New York Stock Exchange (NYSE) was formed in 1792 when a group of brokers signed the Buttonwood agreement – named after a large Buttonwood tree which existed on Wall St at that time. In those innocent times brokers conducted trading under that shady tree, scampering to the nearby Tontine coffee house during inclement weather. But before we get too misty-eyed it is worth noting that the Tontine coffee house was also a hub of many other forms of trading, including African slaves who were registered there before being sent off to the cotton plantations.

The NYSE has certainly experienced remarkable growth but the idea of paying someone else to pick a portfolio of stocks did not come into its own until the 1920s, when the first mutual funds were launched. An interesting bit of history here is the Wellington Fund, launched during that time which still exists today (ticker: VWELX). It was managed for a while by John Bogle who is the founder of Vanguard investment company, prolific author, and one of the few true pioneers of the investment industry. By a quirk of fate, both Mr. Bogle and the Wellington Fund are approximately equally old, about 86 years.

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Masters of the Universe…?

wolfcollageThe term “Wall Street” is a bit of an anachronism at this point. The actual Wall St in New York’s financial district ceased to be the hub of financial firms decades ago. The action is now shared with midtown Manhattan, Connecticut, Chicago and oddly enough, the la-la land of Southern California. The New York Stock Exchange (NYSE) remains a Wall St fixture but it competes with the Nasdaq located at Times Square as well as other niche exchanges and the so-called dark pools. In any event, the NYSE does not trade bonds, commodities or foreign exchange each of which is by itself a larger market than stocks.

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Future Expectations

Every stock that you own is an ownership stake in the future profits of some business. Naturally, these future profits may not be realized or may fall short of expectations which could lead to decline in the stock’s value. But what do these profits depend on? Mainly two things : the profit margin and the total revenues earned by the firm. You multiply them and voila, you have the profit. Now imagine that you combine all the publicly traded companies in America into one giant corporation. The performance of the “stock” of this entity is approximated by well-known indexes like the S&P 500, the Dow etc. We call this thing the “stock market” or just the market. We will get to bonds and other asset classes later, but similar rules apply there.

One reason why thinking about the market as a whole is useful is because the total sales of this construct correspond approximately to the Gross Domestic Product (GDP) of the United States. In other words, you could expect the total market sales to grow approximately at the rate of growth of the economy as a whole. It’s nice to be able to link the market to something in the “real economy”!

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What is Risk?

There are few things in the world of investing that are as often misunderstood as the matter of risk. In my career, time and again, I have found it an uphill battle to impress upon investors that they must figure out their risk appetite before anything else. It doesn’t help of course that various billionaire legends regularly pour cold water on the very notion of risk. “Where is the risk?” they ask. If you know what you are doing, there is no risk, right? And after all, who doesn’t know what they are doing?

A popular internet meme reminding investors of Mr. Warren Buffets wisdom.

Plenty of people as it turns out.

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