Economics – Schools of Thought

Some of the general population know that economics is “a social science concerned chiefly with description and analysis of the production, distribution, and consumption of goods and services” (1). A smaller subset know that economics can be broken into microeconomics and macroeconomics. To oversimplify between the two, microeconomics deals with individual agents and their interactions whereas macroeconomics deals with aggregates in the economy (as a whole).

In other words, macroeconomics refers to the ‘big picture’ study of economics, so looking at concepts like industry, country, or global economic factors. Macroeconomics includes looking at concepts like a nation’s Gross Domestic Product (GDP), unemployment rates, growth rate, and how all these concepts interact with each other (2).

What most people don’t know is that there are actually different schools of economic thought and the key differences between them. The goal of this article is to at a high-level describe the key differences. To this end, I found this table provided by Business Insider:


Click on the table for a larger version.





Master Investors on Patience

“In my free time, I listen to some old Wall-Street Week TV shows (I keep quite an extensive personal archive). In 1996, Louis Rukeyser interviewed the legendary Philip Carret and asked him what was the most important lesson of his 75 years of experience. Carret answered just one word: “Patience”. Francois Rochon

“The key rules are don’t swing the bat unless it’s a slow pitch right down the middle of the plate, and don’t be bullied by the market into doing something irrational, whether buying or selling. This may sound obvious or clichéd to some, and perhaps confusingly ironic to others, but the ability to sit and do nothing may be the most rare and valuable investing skill of all. Inevitably, extreme price dislocations occur that create real opportunities for action, and only the patient and prepared investor can recognize such ideal situations and take full advantage.” Chris Mittleman

“I think the record shows the advantage of a peculiar mind-set – not seeking action for its own sake, but instead combining extreme patience with extreme decisiveness” Charlie Munger

“Most people are too fretful, they worry too much. Success means being very patient, but aggressive when it’s time.” Charlie Munger

“I just wait until there is money lying in the corner, and all I have to do is go over there and pick it up” James Rogers

“I like to be very patient and then when I see something, go a little bit crazy.” Stanley Druckenmiller

“The big money is not in the buying and selling … but in the waiting” Charlie Munger

“The single most important skill for being a good investor is to be very content with not doing anything for extended periods and that’s perfectly fine” Mohnish Pabrai

“Our success rests on having the discipline to wait patiently for opportunities to present themselves and then having the courage to run towards them when everyone else is running away” Steve Leonard

“Legendary investor Peter Lynch always emphasized the importance of being patient: “Frequently, years of patience are rewarded in a single year” Francois Rochon

“The beauty in this business is that there are just hordes of future opportunities waiting and some of them may be huge if you’re patient. And I think Ben Franklin summed it up well: “He who has patience can have what he will” Frank Martin

How Not to Blow Up Your Portfolio

Assuming average investing capability and not withstanding a prolonged economic depression the following would help an investor to avoid devastating and permanent loss at the portfolio value level.

  • Diversification through prudent asset allocation – the key here is determining what uncorrelated assets to buy and in what percentages
  • Periodic re-balancing of assets as percentages rise above pre-determined choices
  • Avoiding excessive leverage at the portfolio level or even avoiding leverage altogether.
  • Hard-caps on what percentage to allocate to a particular asset class and individual asset selection. For example, not allowing your position in stock XYZ to exceed 10% of your portfolio.
  • Be careful with averaging down
    • Value investors are notorious for averaging down and many have done so successfully but there are some general rules with respects to it including:
      • Avoid averaging down (alot) on highly financially leveraged businesses
      • Avoid averaging down (alot) on highly operationally leveraged businesses
      • Avoid averaging down on companies that face obsolesce

Howard Marks Quotes Part 2

See part 1 here.

  1. The investment business is full of people who got famous by being right once in a row.
  2. One of the main reasons for this is the enormous influence of randomness. Events often fail to materialize as they should. Improbable things happen all the time, and things that are likely fail to happen. Investors who made seemingly logical decisions lose money, and others profit from unforeseeable windfalls. Nothing is more common than investors who were “right for the wrong reason” and vice versa.
  3. Investors would be wise to accept that they can’t see the macro future and restrict themselves to doing things that are within their power. These include gaining insight regarding companies, industries and securities; controlling emotion; and behaving in a contrarian and counter-cyclical manner.
  4. While we can’t see where we’re going, we ought to have a good sense for where we are. It’s possible to enhance investment results by making tactical decisions suited to the market climate. The most important is the choice between aggressiveness and defensiveness. These decisions can be made on the basis of observations regarding current conditions; they don’t require guesswork about the future.
  5. Superior results don’t come from buying high quality assets, but from buying assets – regardless of quality – for less than they’re worth. It’s essential to understand the difference between buying good things and buying things well.
  6. A low purchase price not only creates the potential for gain; it also limits downside risk. The bigger the discount from fair value, the greater the “margin of safety” an investment provides.
  7. The price of a security at a given point in time reflects the consensus of investors regarding its value. The big gains arise when the consensus turns out to have underestimated reality. To be able to take advantage of such divergences, you have to think in a way that departs from the consensus; you have to think different and better. This goal can be described as “second-level thinking” or “variant perception.”
  8. Over the last few decades, investors’ timeframes have shrunk. They’ve become obsessed with quarterly returns. In fact, technology now enables them to become distracted by returns on a daily basis, and even minute-by-minute. Thus one way to gain an advantage is by ignoring the “noise” created by the manic swings of others and focusing on the things that matter in the long term.
  9. Cyclical ups and downs don’t go on forever. But at the extremes, most investors act as if they will. This is a big part of the reason for bubbles and crashes. There are three stages to a bull market:• the first, when a few forward-looking people begin to believe
    things will get better,
    • the second, when most investors realize improvement is
    actually underway, and
    • the third, when everyone concludes that things can only get
    better forever.
  10. It’s important to practice “contrarian” behavior and do the opposite of what others do at the extremes. For example, the markets are riskiest when there’s a widespread belief that there’s no risk, since this makes investors feel it’s safe to do risky things. Thus we must sell when others are emboldened (and buy when they’re afraid).
  11. What the wise man does in the beginning, the fool does in the end. “First the innovator; then the imitator; then the idiot.” – Warren Buffett
  12. Every investment approach – even if skillfully applied – will run into environments for which it is ill-suited. That means even the best of investors will have periods of poor performance. Even if you’re correct in identifying a divergence of popular opinion from eventual reality, it can take a long time for price to converge with value, and it can require something that serves as a catalyst. In order to be able to stick with an approach or decision until it proves out, investors have to be able to weather periods when the results are embarrassing. This can be very difficult.
  13. Never forget the six-foot tall man who drowned crossing the stream that was five feet deep on average.

Boom and Bust: Tulip Bulb Mania

The infamous tulip mania is generally described as the first recorded speculative bubble and nowadays is often used as a descriptor of any bubble that has resulted in prices of an asset rising far beyond any calculation of intrinsic value.

The Dutch were introduced to the tulip flower sometime in 1593 when it was brought over from Turkey to Holland. Since this new flower was a novelty it already had some built-in demand, however, over time the species contracted a virus which altered its colour, often described as ‘flames’. A combination of factors led to the tulip to sell at a premium over other flowers and became a status symbol among the wealthy. Market factors began to take over and enterprising persons began to store/inventory tulip bulbs for sale with the intention to sell at high prices. And thus, the seeds for a boom were planted.

As the supply of tulips decreased due to increasing demand, scarcity took over. Prices began to trade higher and higher that people began selling whatever assets they already had in order to purchase more tulips. At one point tulips enjoyed a twenty fold increase in price in one month. At its peak, the rarest tulip bulbs traded for as much as six times the average person’s annual salary.  By 1963, tulip bulbs were traded on market exchanges where everyday citizens could buy/sell allowing for further speculation by the masses.

Eventually, the market dynamics that caused the rapid and unwarranted price increases eventually led to the tulip crash as people tried to liquidate as quickly as they could on a rapidly falling ‘asset’ which induced panic selling.

In the end, even if a prudent speculator had sold at the highs or a citizen managed to avoid any of the mania, many citizens faced financial ruin after the collapse, severely damaging the local economy.

Caveat: the tulip mania and bubble was popularized in the book, “Extraordinary Popular Delusions and the Madness of Crowds”, by Charles Mackay published in 1841. However, more recent research conducted in the 1980’s says speculation was limited to merchants and craftsman and the fallout of the crash had very limited economic impact on the larger economy.

Nevertheless, the tulip bulb mania metaphor persists to this day. Still, there is no dispute that tulip prices rose and fell dramatically during this time period. The lessons learned whether imagined or real, are still valid.


Seth Klarman – Lessons

1. Things that have never happened before are bound to occur with some regularity. You must always be prepared for the unexpected, including sudden, sharp downward swings in markets and the economy. Whatever adverse scenario you can contemplate, reality can be far worse.

2.When excesses such as lax lending standards become widespread and persist for some time, people are lulled into a false sense of security, creating an even more dangerous situation. In some cases, excesses migrate beyond regional or national borders, raising the ante for investors and governments. These excesses will eventually end, triggering a crisis at least in proportion to the degree of the excesses. Correlations between asset classes may be surprisingly high when leverage rapidly unwinds.

3.No where does it say that investors should strive to make every last dollar of potential profit; consideration of risk must never take a backseat to return. Conservative positioning entering a crisis is crucial: it enables one to maintain long-term oriented, clear thinking, and to focus on new opportunities while others are distracted or even forced to sell. Portfolio hedges must be in place before a crisis hits. One cannot reliably or affordably increase or replace hedges that are rolling off during a financial crisis.

4.Risk is not inherent in an investment; it is always relative to the price paid. Uncertainty is not the same as risk. Indeed, when great uncertainty – such as in the fall of 2008 – drives securities prices to especially low levels, they often become less risky investments.

5.Do not trust financial market risk models. Reality is always too complex to be accurately modelled.

Attention to risk must be a 24/7/365 obsession, with people – not computers – assessing and reassessing the risk environment in real time. Despite the predilection of some analysts to model the financial markets using sophisticated mathematics, the markets are governed by behavioral science, not physical science.

6.Do not accept principal risk while investing short-term cash: the greedy effort to earn a few extra basis points of yield inevitably leads to the incurrence of greater risk, which increases the likelihood of losses and severe illiquidity at precisely the moment when cash is needed to cover expenses, to meet commitments, or to make compelling long-term investments.

7.The latest trade of a security creates a dangerous illusion that its market price approximates its true value. This mirage is especially dangerous during periods of market exuberance. The concept of “private market value” as an anchor to the proper valuation of a business can also be greatly skewed during ebullient times and should always be considered with a healthy degree of skepticism.

8.A broad and flexible investment approach is essential during a crisis. Opportunities can be vast, ephemeral, and dispersed through various sectors and markets. Rigid silos can be an enormous disadvantage at such times.

9.You must buy on the way down. There is far more volume on the way down than on the way back up, and far less competition among buyers. It is almost always better to be too early than too late, but you must be prepared for price markdowns on what you buy.

10.Financial innovation can be highly dangerous, though almost no one will tell you this. New financial products are typically created for sunny days and are almost never stress-tested for stormy weather. Securitization is an area that almost perfectly fits this description; markets for securitized assets such as subprime mortgages completely collapsed in 2008 and have not fully recovered. Ironically, the government is eager to restore the securitization markets back to their pre-collapse stature.

11.Ratings agencies are highly conflicted, unimaginative dupes. They are blissfully unaware of adverse selection and moral hazard. Investors should never trust them.

12.Be sure that you are well compensated for illiquidity – especially illiquidity without control – because it can create particularly high opportunity costs.

13.At equal returns, public investments are generally superior to private investments not only because they are more liquid but also because amidst distress, public markets are more likely than private ones to offer attractive opportunities to average down.

14.Beware leverage in all its forms. Borrowers – individual, corporate, or government – should always match fund their liabilities against the duration of their assets. Borrowers must always remember that capital markets can be extremely fickle, and that it is never safe to assume a maturing loan can be rolled over. Even if you are unleveraged, the leverage employed by others can drive dramatic price and valuation swings; sudden unavailability of leverage in the economy may trigger an economic downturn.

15.Many LBOs are man-made disasters. When the price paid is excessive, the equity portion of an LBO is really an out-of-the-money call option. Many fiduciaries placed large amounts of the capital under their stewardship into such options in 2006 and 2007.

16.Financial stocks are particularly risky. Banking, in particular, is a highly leveraged, extremely competitive, and challenging business. A major European bank recently announced the goal of achieving a 20% return on equity (ROE) within several years. Unfortunately, ROE is highly dependent on absolute yields, yield spreads, maintaining adequate loan loss reserves, and the amount of leverage used. What is the bank’s management to do if it cannot readily get to 20%? Leverage up? Hold riskier assets? Ignore the risk of loss? In some ways, for a major financial institution even to have a ROE goal is to court disaster.

17.Having clients with a long-term orientation is crucial. Nothing else is as important to the success of an investment firm.

18.When a government official says a problem has been “contained,” pay no attention.

19.The government – the ultimate short-term-oriented player – cannot withstand much pain in the economy or the financial markets. Bailouts and rescues are likely to occur, though not with sufficient predictability for investors to comfortably take advantage. The government will take enormous risks in such interventions, especially if the expenses can be conveniently deferred to the future. Some of the price-tag is in the form of back-stops and guarantees, whose cost is almost impossible to determine.

20.Almost no one will accept responsibility for his or her role in precipitating a crisis: not leveraged speculators, not willfully blind leaders of financial institutions, and certainly not regulators, government officials, ratings agencies or politicians. Below, we itemize some of the quite different lessons investors seem to have learned as of late 2009 – false lessons, we believe. To not only learn but also effectively implement investment lessons requires a disciplined, often contrary, and long-term-oriented investment approach. It requires a resolute focus on risk aversion rather than maximizing immediate returns, as well as an understanding of history, a sense of financial market cycles, and, at times, extraordinary patience.

False Lessons

1.There are no long-term lessons – ever.

2.Bad things happen, but really bad things do not. Do buy the dips, especially the lowest quality securities when they come under pressure, because declines will quickly be reversed.

3.There is no amount of bad news that the markets cannot see past.

4.If you’ve just stared into the abyss, quickly forget it: the lessons of history can only hold you back.

5.Excess capacity in people, machines, or property will be quickly absorbed.

6.Markets need not be in sync with one another. Simultaneously, the bond market can be priced for sustained tough times, the equity market for a strong recovery, and gold for high inflation. Such an apparent disconnect is indefinitely sustainable.

7.In a crisis, stocks of financial companies are great investments, because the tide is bound to turn. Massive losses on bad loans and soured investments are irrelevant to value; improving trends and future prospects are what matter, regardless of whether profits will have to be used to cover loan losses and equity shortfalls for years to come.

8.The government can reasonably rely on debt ratings when it forms programs to lend money to buyers of otherwise unattractive debt instruments.

9.The government can indefinitely control both short-term and long-term interest rates.

10.The government can always rescue the markets or interfere with contract law whenever it deems convenient with little or no apparent cost.(Investors believe this now and, worse still, the government believes it as well. We are probably doomed to a lasting legacy of government tampering with financial markets and the economy, which is likely to create the mother of all moral hazards. The government is blissfully unaware of the wisdom of Friedrich Hayek: “The curious task of economics is to demonstrate to men how little they really know about what they imagine they can design.”)

Warren Buffett Quotes

Only buy something that you’d be perfectly happy to hold if the market shut down for 10 years.

If you aren’t willing to own a stock for ten years, don’t even think about owning it for ten minute.

Time is the friend of the wonderful company, the enemy of the mediocre.

Over the long term, the stock market news will be good. In the 20th century, the United States endured two world wars and other traumatic and expensive military conflicts; the Depression; a dozen or so recessions and financial panics; oil shocks; a fly epidemic; and the resignation of a disgraced president. Yet the Dow rose from 66 to 11,497.

Successful Investing takes time, discipline and patience. No matter how great the talent or effort, some things just take time: You can’t produce a baby in one month by getting nine women pregnant.

I call investing the greatest business in the world … because you never have to swing. You stand at the plate, the pitcher throws you General Motors at 47! U.S. Steel at 39! and nobody calls a strike on you. There’s no penalty except opportunity lost. All day you wait for the pitch you like; then when the fielders are asleep, you step up and hit it.

An investor should act as though he had a lifetime decision card with just twenty punches on it.

You only have to do a very few things right in your life so long as you don’t do too many things wrong.

The key to investing is not assessing how much an industry is going to affect society, or how much it will grow, but rather determining the competitive advantage of any given company and, above all, the durability of that advantage.

It’s only when the tide goes out that you learn who has been swimming naked.

People always ask me where they should go to work, and I always tell them to go to work for whom they admire the most.

I learned to go into business only with people whom I like, trust, and admire.

here comes a time when you ought to start doing what you want. Take a job that you love. You will jump out of bed in the morning. I think you are out of your mind if you keep taking jobs that you don’t like because you think it will look good on your resume. Isn’t that a little like saving up sex for your old age?

I’m not interested in cars and my goal is not to make people envious. Don’t confuse the cost of living with the standard of living.

You’ve gotta keep control of your time, and you can’t unless you say no. You can’t let people set your agenda in life.

I believe in giving my kids enough so they can do anything, but not so much that they can do nothing.

What the wise do in the beginning, fools do in the end.

In some corner of the world they are probably still holding regular meetings of the Flat Earth Society. We derive no comfort because important people, vocal people, or great numbers of people agree with us. Nor do we derive comfort if they don’t.

I had a great teacher in life in my father. But I had another great teacher in terms of profession in terms of Ben Graham. I was lucky enough to get the right foundation very early on. And then basically I didn’t listen to anybody else. I just look in the mirror every morning and the mirror always agrees with me. And I go out and do what I believe I should be doing. And I’m not influenced by what other people think.

If you’re in the luckiest 1% of humanity, you owe it to the rest of humanity to think about the other 99%.

Risk comes from not knowing what you are doing.

I enjoy what I do, I tap dance to work every day. I work with people I love, doing what I love. The only thing I would pay to get rid of is firing people. I spend my time thinking about the future, not the past. The future is exciting. As Bertrand Russell says, “Success is getting what you want, happiness is wanting what you get.” I won the ovarian lottery the day I was born and so did all of you. We’re all successful, intelligent, educated. To focus on what you don’t have is a terrible mistake. With the gifts all of us have, if you are unhappy, it’s your own fault.




Mean Reversion and Regression Toward the Mean

In the past I have incorrectly assumed mean reversion and regression toward the mean to be essentially the same thing. According to Wikipedia:

In statistics, regression toward (or to) the mean is the phenomenon that if a variable is extreme on its first measurement, it will tend to be closer to the average on its second measurement—and if it is extreme on its second measurement, it will tend to have been closer to the average on its first. To avoid making incorrect inferences, regression toward the mean must be considered when designing scientific experiments and interpreting data.

In finance, the term mean reversion has a different meaning. Jeremy Siegel uses it to describe a financial time series in which “returns can be very unstable in the short run but very stable in the long run.” More quantitatively, it is one in which the standard deviation of average annual returns declines faster than the inverse of the holding period, implying that the process is not a random walk, but that periods of lower returns are systematically followed by compensating periods of higher returns, in seasonal businesses for example.

I’ll be honest and just say the above doesn’t really explain to me how they are different outside of one term being used in statistics and the other in the world of finance. But for our purposes and looking at the big picture or the big idea, we care about the concept of extreme observations and how they are more likely to be followed by less extreme ones. For the purposes of this article, I will use reversion and regression interchangeably unless otherwise noted.

There are several examples that are often used to demonstrate mean reversion such as the basketball player who ‘catches fire’ and can’t seem to miss. More likely than not after some time has passed, the player will regress to his/her usual shooting percentages. The opposite would also hold true. Another example, highly intelligent parents in general are not expected to have offspring as intelligent as themselves (ignoring the structural advantages that may be present).

Outliers from the expected average can more often than not be attributed to randomness and small sample sizes.

Let’s move towards its significance to the world of finance. Consider the following from Jason Zwieg:

From financial history and from my own experience, I long ago concluded that regression to the mean is the most powerful law in financial physics: Periods of above-average performance are inevitably followed by below-average returns, and bad times inevitably set the stage for surprisingly good performance.

In other words, investments can be priced far above or far below their long-term average returns for periods of time, but in the end they eventually tend to move back towards their average. Outperformance is followed by underperformance and vice versa. To the contrarian investor this translates to buy low and sell high.

We can also note the tendency for people to create narratives and attribute causes to effects while completely ignoring the mental model of reversion/regression to the mean. A prime example of this is, “this time it’s different because…”.

We cannot say with certainty that when one observes fairly favourable/unfavourable results that the opposite will immediately occur. But we can surmise that the probability increases as extremes are reached.

Finally, regression/reversion to the mean is one mental model to consider when filtering information that comes your way and should not be used exclusively as real changes do occur which can explain a long-term and sustainable drift away from averages.


Howard Marks – Misc Quotes

  • To be a disciplined investor, you have to be willing to stand by and watch other people make money that you passed on. You don’t have to invest in everything. You don’t have to catch every trend. You should invest in the things you know about.
  • To be a successful investor, you must have a philosophy and a process that you stick to even when the times get tough. This is very important.
  • Keynes said the markets can remain irrational longer than you can remain solvent. That’s especially true of leveraged investors. That’s the danger of leverage.
  • In investing, to succeed you must survive.
  • Two kinds of forecasters – ones who don’t know, and ones who don’t know they don’t know. You must decide which one you are.
  • The most important choice that any investor can make in the intermediate term is whether to be aggressive or defensive. Not whether it’s stocks or bonds. Not whether it’s a developed market or an emerging market. But whether it’s a good time to be aggressive or defensive. And I believe this distinction can be made on the basis of observations regarding the current situation. They do not require guesswork about the future.
  • The concept of market efficiency – that the price of each asset accurately reflects its underlying intrinsic value, or that the market price is fair – must not be ignored. You can know something and it’s possible to know more than others. But the going in presumption should be that everybody is well-informed, and if you think you know something they don’t, you should be able to express the reason for that. It’s not easy, because everyone is trying just as hard as you are.
  • Sometimes there are plentiful opportunities for unusual returns with low risks, like after the meltdown of Lehman Brothers (2008). And sometimes the opportunities are fewer and risky. It’s important to wait patiently for the former. You should not act the same regardless of the market environment. You should turn aggressive when things are low, and defensive when things are high.
  • When there’s nothing clever to do, it’s a mistake to try to be clever.
  • In investing, the behaviour of participants alters the landscape (George Soros’s concept of ‘reflexivity’). If people find a bargain, they’ll raise the price so that it isn’t a bargain anymore. It’s not good to assume that the market that offered you bargains in the past will also offer you bargains in the future. And the one thing we must not do is extrapolate asset prices.
  • The most corrosive of all the difficult human emotions is the feeling to sit by and watch other people make money. Nobody likes that. You don’t like it at 60, you don’t like it at 80, you don’t like it at 100, but when it hits 150, you say, “Okay, I’ll get on board.” And that’s usually closer to the top than it was to the bottom.


Jeff Bezos On Dreamy Businesses

A dreamy business offering has at least four characteristics. Customers love it, it can grow to very large size, it has strong returns on capital, and it’s durable in time–with the potential to endure for decades. When you find one of these, don’t just swipe right, get married.