Thursday, May 13, 2010

Finance Book of the Year


Panic: The Betrayal of Capitalism by Wall Street and Washington  by Andrew Redleaf and Richard Vigilante, is a giant of a book, but its title is very misleading. The book is not at all about how Wall Street and Washington "betrayed" capitalism. It's about how the vast majority of investors, politicians, and bureaucrats fail to understand how markets really work. Most of what we learned about modern portfolio theory has blinded us to some key insights which the authors share. I've been immersed in markets for over 30 years, and I can't remember the last time I read a book or article that made me rethink so many of my deeply-held beliefs.

Are you one of the many that believe in the Efficient Market Hypothesis? In the Capital Asset Pricing Model? Do you agree that, in general, the more risk you assume the greater your reward should be? Do you believe that portfolio diversification is key to managing risk? Do you think that highly liquid markets are by nature efficient? Well, think again. Read the book and discover what you have been missing.

Here are some choice sound bites from the book: "Risk is not the foundation of profit but its most dreaded enemy." "Profit is the payment earned by the exercise of judgment to reduce the risk of an enterprise in an economical way." "Investors are paid for being right, not for the possibility of being wrong." "Diversification is always and everywhere a confession of ignorance." "The preference for public financial markets over all other markets creates a preference for weak ownership over strong." "Both the mortgage crisis and the crash are best understood as the result of government policies that pushed trillions of dollars in assets out of the hands of relatively strong owners and into the hands of weak owners." "The dream of market efficiency and the dream of socialist efficiency are the same dream ... both yearn for capitalism without capitalists." "Free economic markets are especially good at rewarding the creative and productive use of capital ... yet no matter how free the market, it is the men not the market who do the creating."

In addition to offering numerous and seemingly paradoxical insights into markets and investing, the book does a great job of explaining how the financial crisis of 2008 came about and how, with the help of hugely misguided government intervention, it eventually led to a global recession. In my professional career I have spent hundreds of hours trying to explain derivatives to colleagues, professionals, and executives, so I was amazed to see what a good job the book does of making extremely complex securities understandable to just about anyone.

The authors' prescriptions for making things better include: less government regulation, not more; less reliance on securitization, structured finance, and portfolio diversification; more respect for entrepreneurs and savers; a rejection of "too big to fail;" and the elimination of "agencies" such as Freddie and Fannie. I hasten to note that the authors are bipartisan critics, heaping plenty of scorn on the "crony capitalists" that inhabit both Republican and Democratic administrations.

All investors can benefit tremendously from this book, but it should be required reading for all politicians and bureaucrats. That's because the more the government tries to shield us from risk and uncertainty, the worse things become. Rarely have I seen anyone do such a good job of explaining why that is so.

HT: Ashby Foote, who not only recommended, but kindly sent me a copy of the book

18 comments:

  1. I will order my copy TODAY.

    Thanks.

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  2. Ditto!

    "The preference for public financial markets over all other markets creates a preference for weak ownership over strong."

    This is a troubling concept. It is difficult for shareholders to influence management, in large publicly held companies. The SEC is sandbagging attempts to make it easier for shareholders to put rival slates up for board elections.

    And yet--that's one of our main avenues for investing, publicly held companies!

    In recent years, as a result, I have turned more to hands-on property investing, and not with any relish.

    Of course, there is also the old saw, "The cost of weak ownership is already priced into the stock."

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  4. How much of of what Wall St does is in the pursuit of allocating capital from financiers to producers? Not much at all. We need to purge this country of middlemen parasites.

    Back to basics and the Constitution. The global economy is polluted with social capitalists floated by the Fed and other Central Banks.

    Failure needs a restocking in our vocabulary.

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  5. Oddly enough, on my reading list is another book entitled "Panic," Michael Lewis, he of "Liar's Poker" fame.

    You would think authors writing on the identical topic would choose differing titles.....

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  6. It sounds interesting and on point in a number of areas. However, it really lost me on the recommendation for “less” diversification.

    I have always taken Shakespeare’s prescription for “the first thing we do, let’s kill all the lawyers” as good theater. Public’s “purge (exterminate/kill???) middlemen parasites” is quite chilling. I hope that it is simply that anonymity facilitates thoughtlessness. Would a better society purge/kill everyone between the cow and my quart of milk?

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  7. Mr. Grannis:

    Thank you for the book reference. Will look into ordering.

    Will return the favor. Take a look at this book: “From Economic Man to Economic System” by Demsetz.

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  8. For those of you who are interested, I am sharpening my pencil again. I have placed small buy orders slightly under the market for XLK and POT. Again, I may be early but I plan to gradually scale into this market decline. I am also looking to add TEVA but have not entered an order yet.

    IMO this decline is a continuation of the correction that began with the Euro crisis. It is necessary and healthy for the market looking out to the end of the year. We have a little more work to do on the downside.

    Just sayin'

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  9. rg32,

    Firstly, you put all your eggs in one basket to make your riches, then diversify to keep.

    Second, purge means regulate the skunk out of people who make a living carving out massive profits using massive leverage by simply gaming the market.

    Third, milk in this country is subsidized so I would gladly see a purging of middlemen wasting my tax dollars. Here is a great article on the topic.

    "For some 50 years, price supports have been the backbone of the pricing system for
    milk and dairy products."

    http://www.ers.usda.gov/publications/aib761/aib761.pdf

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  10. Very nice opinion piece in today's WSJ explaining and defending OTC derivatives: http://online.wsj.com/article/SB10001424052748704370704575228660014097380.html?mod=WSJ_Opinion_LEFTTopOpinion

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  11. My XLK order filled. POT has not.

    One of the reasons tech has been sold off so hard is the strengthening US dollar. Tech has a lot of sales overseas and it is being seen as a drag. My view is longer term and I see the selloff as an opportunity to continue to slowly build positions.

    The stronger US dollar argues for less near term inflation. Growth, even slow growth with very low inflation can be a good thing.

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  12. Public,

    Re the skunks:

    I don't mind the skunks who use massive leverage using their own money. If they're wrong, they will pay.

    Where I agree with you is the skunks who use other people's money (PARTICULARLY bank deposits) leverage it up and cry for help if they're wrong. Those are the TRUE SKUNKS!

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  13. Hi Scott, after reading this book, has it made you change or rethink your current investment strategies and/or portfolio? Thanks.

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  14. It's made me think about a lot of things. I haven't changed anything yet, however. For the moment, I am much less confident that markets are efficient, and that may make me less confident that the market signals I rely on to tell me the mood of the market are not as reliable as I thought, but I'm going to have to think about this for awhile. It's made me more confident about the ability of good investors to "beat the market," and that is reassuring. I think I will probably end up reading the book again in a month or so to solidify my thoughts.

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  15. Public Library,
    Middlemen only exist for situations where they can make other parties better off. Milk subsidies are not middle men, they are a tax.
    For a better understanding of the value of middlemen, I point readers to the great podcast series EconTalk. Here is the episode on middlemen:
    http://www.econtalk.org/archives/2008/10/munger_on_middl.html

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  16. Redleaf runs a great fund group, and his investor letters are every bit as good as these excerpts from the book.
    He is starting to blog, so check out www.capitalismbetrayed.com

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  17. Good news that Ashby sent you a copy Scott. He posts many good things on George Gilder's fourm, gildertech.com
    Also, Richard was the editor of the Gilder report. He is a tremendous writter on free markets and economics. Andy is a brilliant analyst who seems to be focusing on China's economic stability as central to global recovery. One way to watch China is to develop a nice list of China Companies and watch their stock prices.

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  18. Rashy,

    An economicly stable China would be a great thing long term for a growing global economy. I fear however that they still have some evolving to do before they can truly be counted upon for global economic leadership.

    One thing China has done is discourage domestic consumption as an economic growth engine. This leaves the economy in a position of potential instability if their export markets suddenly freeze up, as they did in the recent recession. This has led to dramatic efforts to stimulate domestic investment to offset the lost exports. This government induced spending is most difficult to calibrate. It can lead to wild swings in economic activity that are hard for central planners to predict and thus plan for. Thus the economy rests on the two legs of investment and exports. Their economy really needs the third leg of domestic consumption to give it more stability. However, the savings encouraged by the government are DIRECTED by the government empowering the central government rather than the private sector. This results in money being employed far less efficiently. South Korea and Tiawan have both transitioned to consumer societies and their economies are far more stable. Until the Chinese government loses its high control needs and trusts its private sector more, it will remain a high risk economy for investors.

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