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:

20140625_econ

Click on the table for a larger version.

 

1. Merriam-Webster.com

2. http://www.businessdictionary.com/article/1052/macroeconomics-vs-microeconomics-d1412/

 

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

Foundational Ideas in Probability Theory

Likelihood

The likelihood that an event will occur is measured by probability and is quantified as a number between 0 (impossibility) and 1 (certainty).

Expectation 

The expected value of an experiment is the probability-weighted average of all possible values. An important concept here is the law of large numbers which states that the average result from a series of trials will converge to the expected value.

Estimation 

One of the main goals of statistics is to estimate unknown parameters. An estimator uses measurements and properties of expectation to approximate these parameters. Estimation theory is a very important concept in Statistics as usually we have data for the sample and not for the population.

 

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.”)

Thoughts on Toronto’s Real Estate Prices

Preamble and Caveats 

  • The buy vs rent decision is personal and based on a person’s needs/wants
  • There are always outlier examples for unique situations
  • Utilize a buy/rent calculator
  • Personalized decision, yes – but one shouldn’t make what is most likely their largest financial decision without knowing both sides of the debate
  • Take the long view
  • I use points from Alex Avery and Hilliard Macbeth because I found their books to be well thought-out and reasoned. I fill in my own thoughts later in the post.
  • It’s important to note that the debate isn’t an isolated question of whether or not it’s better to rent or buy. One must take his/her given individual circumstances (financial/needs/wants/preferences) and decide if current real estate prices make  sense for his/her situation.

From Alex Avery: 

  • Beware of those who advise you to buy
    • What are their obvious and non-obvious personal interests?
    • Avery’s aim is to include an alternative view to the housing dogma
    • Seek unbiased advice
  • Avoid the cult-like promotion of home ownership (friends, family, government and lenders)
  • Buildings never go up in value; only land does.
  • The return on investment on a piece of real estate is more than just sales price minus purchase price
    • interest on the mortgage
    • taxes
    • maintenance
    • insurance and
    • transaction costs on both ends
  • Over the life of a mortgage, the homeowner shifts from paying rent to the bank to paying themselves.
    • Implicit rent – the opportunity cost of having your money locked up in the house even when fully paid off
  • Renting offers flexibility
    • Liquidity
  • Buying is not necessarily a good investment – either in the short term because of transaction costs or in the long run because of the possibility of lower house prices and the opportunity for higher returns from owning a less concentrated pool of dividend-paying equities
  • Canadian house prices haven’t delivered returns anywhere near those of the Canadian stock market based on 25 years of data, a quarter of a century that represented an incredible period for Canadian house prices
  • Real estate purchases often come with loads of leverage
  • Housing is a consumption item
  • Bottom line – Renting is the more logical, cheap, flexible and low-risk way to go
  • [Re: Vancouver and Toronto] Both markets share a lot of commonality in that they have land constraints so they’re structurally expensive markets. Better off to rent.
  • Important to save and invest the difference between rent payment and mortgage payment

From Hilliard MacBeth:

{via Canada Business} LINK

  • Canadians are carrying unprecedented levels of household debt. All it would take, he argues, is a slight uptick in interest rates — just a percentage point or two — and a large number of homeowners could be pushed over a default cliff.
  • In his view, a perfect storm of factors — low interest rates, laissez faire policies, foreign buyers and alternative mortgage lenders — have set the Canadian housing market up for a big fall. He says it’s already underway in Alberta, Saskatchewan and Newfoundland and will inevitably spread. If it looks anything like the subprime debacle in the United States, the crash would unfold steadily over a span of four year or so.
  • “The bubble will burst, and it will be a hard landing, which means a greater than 20-per-cent decline in house prices,” says MacBeth. In fact, he says, Canadian prices could decline from current levels by 40, even 50 per cent by 2020. “This means some financial institutions will get into trouble. [The Canada Mortgage and Housing Corp.] will lose billions, and there will be a recession.”
  • Consumers are overstretched, they’re paying more than they think; and almost no one makes a profit off their house in the end. One problem is that banks are approving loans for greater amounts than people can afford, he says. MacBeth knows clients who received a mortgage based on their future, not current, earnings. As well, lending is usually based on two incomes, yet he says it’s rare for both spouses to work full-time until they retire. One person often takes time off to raise kids, which makes it harder to make the payments
  • But the biggest risk around our real estate obsession is the way it breaks the cardinal rule of wealth preservation: diversification. Not only are many of us tying up most of our wealth in one asset, but we’re doing so with an asset closely correlated to our poorly diversified financial markets.

General Rebuttals 

  • People will always need somewhere to live. You can’t sleep in your electronic shares of Walmart. Having real estate is sort of like a forced savings plan. Without it, many would save nothing for retirement.
    • All true – but not true for everyone and for every personal situation. Again, it comes back to what your requirements (what do you need?) and do current prices make sense. Alternatively, what other investment opportunities do you have and do you have the ability to take advantage of those?
  • Why pay someone else’s mortgage? Alt – why throw away money when you could be building equity?
    • Irrelevant. What matters are the costs incurred to live in a place.  Renting is not throwing away money, it is incurring a cost in order to have a place to live. Building equity just means turning some of your money into a house. It’s one of many ways you could invest your money.
    • Don’t forget there are additional costs with ownership including maintenance, taxes and insurance.
  • Interest rate debate – rates will never go up significantly
    •  The statement completely ignores history
    • From a risk management perspective it is still important to stress test your budget should interest rates rise (if you own)
    • Are you aware of what drives interest rates?
    • Interest rate raises are not the only reason a housing crash can happen. Take for example the States, interest rates were not raised substantially prior to the collapse in 2006.
  • Buy. They ain’t making anymore land.
    • True (let’s ignore the man-made islands). But any asset becomes dangerous at certain prices.
  • Look at how much money I’ve made. Best investment ever. Prices always go up.
    • Yes, you may have made a lot of money but would you have been better off financially if you invested elsewhere? Real estate traditionally tracks inflation and while true real estate has gone up over time so have other assets that have far outperformed real estate. If you buy any asset at an inflated price you risk lower or even negative returns in the future.
    • Historically, real estate investments were a cash flow game while capital appreciation was the kicker. Nowadays, the equation has flipped. Is this the new norm or is something amiss?
  • My house is a hedge against inflation.
    • True. But during times of inflation interest rates rise and can rise rapidly. If your mortgage is substantial your ability to service the debt could erode just as rapidly.
  • Buying a house with a small downpayment maximizes my leverage and gains. Where else can I make these kinds of gains?
    • You’re presuming the value of real estate always goes up. Historically, the value of real estate moves in lockstep with inflation which means in the long run the value of the equity will be the same as it is now in 20 years (purchasing power).
    • Leverage works both ways. If you overpay for the asset, a downturn could wipe out your equity and you are left in a position where if you had to sell your house for less than your mortgage value.
    • In a worst case scenario –  if the above happened with increasing interest rates – you’re stuck with potentially a mortgage you can no longer afford and the selling price would result in a huge loss
  • Let’s assume housing prices never go down – what possible benefit is there to renting?
    • Testing out a new neighborhood, mobility, avoiding overpriced homes vs rent
  • Toronto and the surround areas are still cheaper than other major cities like London, Hong Kong, New York and San Francisco
    • This tackles one of my pet peeves which is lazy thinking and comparisons and complete avoidance of 1st principles of what you are trying to say
    • The absolute prices may be cheaper in Toronto but without context its kind of meaningless. London, Hong Kong, New York and San Francisco citizens all have higher incomes compared to Toronto. So really this is a question of affordability.

Home Ownership Positives 

  • Forced Savings through the mortgage payments
  • Tax incentives (home buyers plan, capital gains exemption on principal residence)
  • Leverage (double edged sword)
  • Feelings (pride, settling roots in a neighborhood, control over the property)
  • For many people real estate has been their greatest appreciating asset of their lifetimes
  • Stability – can’t be kicked out by a landlord, rents can go up substantially, ability to customize your dwelling

Other Thoughts 

  • In this section I go through several components of a mental model list I have to see how it applies to the current real estate situation in Toronto. Note there are overlap/connections with a lot of these.
    • Lack of inversion – failure to consider disconfirming evidence
      • What’s the flip side; what can go wrong that I haven’t seen?
    • Failure to consider the range of likely future outcomes
    • Failure to consider probabilities
    • Failure to consider how consensus psychology is affecting prices
    • Failure to distinguish from process and outcome.
      • Example: “People have been saying the housing market is overvalued for years and look how much I’ve made on my house so far.”
    • Always be willing to see both sides of every argument or investment stance you take.
      • I’ve found that people often times try to impart their ‘wisdom’ on you but they themselves do not understand both sides of the story.
    • Failure to consider history.
      • No asset always go up all the time. Bubbles exist and do pop.
    • Pascal’s wager – In making decisions under conditions of uncertainty, the consequences of being wrong must carry more weight than the probabilities of being right. You must focus on how serious the consequences could be if you turn out to be wrong: Suppose this doesn’t do what I expect it to do. What’s going to be the impact on me? If it goes wrong, how wrong could it go and how much will it matter? Pascal’s wager doesn’t mean that you have to be convinced beyond doubt that you are right. But you have to think about the consequences of what you’re doing and establish that you can survive them if you’re wrong. Consequences are more important than probabilities.
    • Failure to use a decision making model.
      • What is the best thing that can happen if I do this?
      • What is the worst thing that can happen if I do this?
      • What is the best thing that can happen if I don’t do it?
      • What is the worst thing that can happen if I don’t do it?
    • Failure to consider the short-term and long-term consequences of your action/decision. What is the opportunity cost?
    • Failure to consider the ‘outside view’. The outside view asks if there are similar situations that can provide statistical basis for making a decision. Rather than seeing a problem as unique, the outside view wants to know if others have faced comparable problems and if so, what happened.
    • Moral hazard of financial lenders (especially in a bull market)
      • Financial lenders lack skin in the game as CMHC insures mortgages against default and taxpayers take on the majority of all mortgage risk
      • Consider what happened in the States in 2007-2009
    • Failure to consider tail-events or ‘black swans’
    • Shiller’s Bubble List
      • Rapidly increasing prices.
      • Popular stories that justify the bubble.
      • Popular stories about how much money people are making.
      • Envy and regret among those sitting out.
      • Cheerleading by the media.
      • Don’t confuse market cycles with bubbles. Bubbles of a particular asset class don’t come back.
    • What matters most is not what you invest in, but when and at what price
      • The less care with which others conduct their affairs, the more care with which you should conduct yours. When others are afraid, you needn’t be; when others are unafraid, you’d better be
    • Recency bias – human tendency to overemphasize more recent data
      • Example: “Look at how much prices have gone up – they’ll continue to do so!”
    • Crowd folly – the tendency of humans, under some circumstances, to resemble lemmings. Mimicking the herd invites regression to the mean.
    • Envy/jealousy tendency – a completely wasted emotion that a person should work hard to avoid. Major problems arise from envy because people increase risk when they envy the financial success of someone else.
    • Herd instinct – also known as fear of missing out – such investor behavior can often cause large, unsubstantiated rallies or sell-offs, based on seemingly little fundamental evidence to justify either. Herd instinct is the primary cause of bubbles in finance.
    • Margin of safety
      • Overpay and overleverage could have disastrous results for individuals and families

Charts

housing-market-canada-stats-compressor

hilliard1-623x360

o-household-debt-to-income-570

o-consumer-debt-570

out-of-contril

 

Updates as of April 7, 2017

  • Based on the March average price, a house in Toronto cost 11.7 times the median total family income. Back in the day, it was said that a house was affordable when it cost three times your income.
  • Not only to have home prices in the GTA now absorb an unprecedented 13 years of median family income, but to have 30 per-cent-ish run-ups against a backdrop of a 2 per cent inflation rate, wages that are barely going up 2 per cent as well, and nominal GDP growth of around 4 per cent. This should put 30 per cent into some sort of perspective when we conclude that what we have on our hands is a near three standard deviation event. LINK
    • Rosenberg acknowledges there is a supply issue which is feeding the strong competition among buyers
    • a “balanced market” sees a months’ supply figure around 6.0
    • the sales-to-new listings ratio sits well into “sellers’ market” territory at 70.8 per cent, which compares to 69.4 per cent a year ago — a ratio between 40 per cent and 60 per cent is considered indicative of a “balanced market.”
    • A house is an asset indeed, but should never be compared to a stock or a bond or even other investable properties. It is a place to live.
    • So there are indeed some supply and demand fundamentals that are underpinning prices. Insofar as the demand is rising because people think they are investing in something hot just because of the accelerating momentum, well, these people are going to end up being pretty big losers.
    • Not even in the late 1980s, did housing get this expensive on this basis, and we know all too well how the Bank of Canada ultimately reacted and what happened next.
    • So while Toronto residential real estate is indeed expensive for the locals, it is far less so for foreign investors, especially for Americans who can buy Canadian assets at a 25 per cent discount from a currency perspective.

Updates as of March 22, 2017

  • In October 2016, lawmakers ratcheted up their interventionist efforts with a restrictive mortgage “stress test.” This measure now requires all homebuyers with less than a 20-per-cent down payment to have enough income, after all household debt and expenses are taken into account, to qualify for the same mortgage at the Bank of Canada’s five-year posted rate — 4.64 per cent at the time of writing.
  • To qualify for mortgage insurance under the new rules, a borrower’s gross debt service ratio (mortgage payments, taxes and heating costs as a percentage of income) must be no more than 39 per cent. A borrower’s total debt service ratio (the carrying costs of the home and all other debt payments as a percentage of income) must be less than 44 per cent.
  • The maximum amortization period for an insured mortgage has been slashed from 40 years to 25. And government-backed mortgage insurance is available only on properties that have been purchased below $1 million. Moreover, to discourage a spate of foreign buying, a property must be owner-occupied to qualify for mortgage insurance.
  • In October, the CMHC — for the first time in the Crown corporation’s 68-year history — issued a “red” alert for our national housing market. “High levels of indebtedness coupled with elevated house prices are often followed by economic contractions,” Evan Siddall, CMHC’s CEO, warned in a Globe and Mail article published October 17, the same day that new federal mortgage rules came into effect. “The conditions we now observe in Canada concern us.”
  • Homeowners who sell residence are now required to report it in their tax returns
  • The government appears to be favouring the idea of sharing the risk on insured mortgage debt between lenders and taxpayers.
  • Household debt has been identified as a key risk for the Canadian economy.

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.