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Posted on 10 Apr 2008 by Forager

Don't always bet on black

Nassim Taleb, author of The Black Swan and Fooled by Randomness, is interviewed in this month’s Fortune magazine. The interview is excellent, and so are his books. But when Taleb’s theories go mainstream, it’s time to start thinking about what is likely as well as what is possible.

The crux of his argument is based on Karl Popper’s falsifiability theory. It was once assumed by Europeans that all swans were white but, no matter how many white swans were seen, the theory could never be proved, only disproved (which, in fact, it was with the discovery of black swans in Australia). Just because something has never been seen before doesn’t mean it doesn’t exist.

The risk models used by the world’s largest financial institutions, which rely solely on what has happened in the past to predict what will happen in future are, therefore, useless (and, in Taleb’s opinion, extremely dangerous).

The meltdown of the US mortgage market and the hundreds of billions lost by said financial institutions has thrown Taleb’s theories into the limelight. Although he’s described this financial disaster as a ‘grey swan’ at best (being somewhat predictable), people have thrown the past out the window and are looking for black swans all over the place.

It’s now time to remember that black swans are rare. Flip a coin 10 times and the probability that you flip 10 heads or 10 tails in a row is 1/512. But flip a coin a thousand times and the probability that you’ll get a run of at least 10 heads or 10 tails, at some point, is more than 85% (it’s been a while since I’ve done probability theory, so correct me if I’m wrong – I get 85.6%). Play for long enough, and it’s highly likely that you’ll get a freakish run or two.

But they’ll be few and far between. And at the moment many securities, especially in debt markets, are being priced as if there’s a black swan swimming in every pond. Set yourself up so that the rare events won’t send you broke – little or no debt, thoughtful diversification and a thorough understanding of what you own – and small risks can be rewarded with extremely attractive returns.

Posted on 01 Apr 2008 by Forager

Australia's own credit crisis

The question is not if, but when, this country’s own credit crisis is going to catch up with us. If you missed tonight’s ‘Debtland’ episode of Four Corners, you can watch it here. Be warned, it’s disturbing (if a little sensationalist).

It is a fact that we’re in the midst of a debt binge of unprecedented proportions. The ratio of credit to disposable income in Australia is north of 180% – one of the highest of any country in the OECD (in the US, that ratio was 140% before the crunch).

The most common argument you’ll hear professing we don’t have a problem is that debt is high, yes, but so are household assets. If there are so many assets, where’s the income those assets are producing? Houses yielding 3% net rental returns on their supposed value don’t help service debt costing 10%, or 20% in the case of personal credit cards.

So how can this go on so long? I thought the most insightful comment from the program was this from JP Morgan banking analyst Brian Johnson (no relation):

Banks can do dumb lending year after year after year. But that isn’t what creates the problem. It’s when banks stop doing dumb lending.

I’d argue that it is the dumb lending that creates the problem, but you get the point. As long as the banks keep feeding their customers’ addiction to debt, they don’t have to worry about defaults. It’s a Ponzi scheme of sorts – and one that might soon come tumbling down.

The global credit crisis is making it difficult and expensive for the banks to access funds. And that means they’ve got less funds to lend and will need to tighten their lending criteria. Is this the trigger that finally brings the party to an end?

Maybe, maybe not. But one day we will have to deal with the hangover this binge leaves us with. The banks will be at the forefront but the implications for the wider economy are worth some serious thought.

Posted on 29 Mar 2008 by Forager

Sydney's most dangerous place

If you were to new to investing, heading to an investment expo might be a logical thing to do. Logical maybe, but very dangerous.

I’m at the Property and Investment Expo in Sydney’s Exhibition Centre. The Intelligent Investor stand is wedged in between Aussie Rob’s Lifestyle Trader and about 10 CFD trading spruikers. Suffice to say, we don’t have much competition in the sensible long-term investing advice market.

One of the other presenters just put a slide up that showed a sharp rise and then equally sharp fall in some stock’s share price and remarked ‘if you’d seen that spike, you could have jumped on it’. Greg just picked up a flyer for a horse betting system called Fortune 100. It’s a ‘privately owned company registered in NSW, and located at Varsity Lakes, Queensland, beside the IT Centre of the internationally renowned Bond University’ (my emphasis).

It would be hilariously funny but that there are so many people here who know no better and are about to be fleeced of their money. They’d be safer with the aquatic sharks in the nearby aquarium rather than the financial ones floating around here.

Posted on 27 Mar 2008 by Forager

Helicopter Ben running out of ammo

Federal Reserve Chairman Ben Bernanke earned the moniker ‘Helicopter Ben’ by suggesting that, if people refuse to borrow, the Fed can always follow Milton Friedman’s advice and drop money out of a helicopter. It might soon be time for him to start the rotors spinning.

The theory behind monetary policy is simple. You put interest rates up, people borrow less. You put them down, people borrow more. That theory has never played out in practice and it never will. People borrow money when the think they can make money and, when they’re worried they’re going to lose it, they won’t borrow a cent. The former is a problem for Australia’s Reserve Bank Governor, Glenn Stevens. The later a much bigger problem for the US Federal Reserve Chairman, Ben Bernanke.

He and his colleagues on the Federal Reserve Board have cut rates from 5.25% to 2.25% in the space of 12 months. They’ve attempted to directly introduce liquidity, lent money to non-banks for the first time since the 1930s and taken significant amounts of credit risk on to the taxpayers’ balance sheet. The net effect: Federal Reserve credit has grown by an annualised 2.2% since August.

‘The great de-leveraging’ is in full swing and no amount of interest rate cuts will bring it to a premature end. No one wants to borrow and it’s no wonder. The Case-Shiller house price index, which measures house prices in the 20 largest cities in the US, fell 10.7% in the year to January. Housing approvals hit a 13-year low and, not surprisingly, consumer confidence has fallen to its lowest level since 1973. A recession is undoubtedly underway.

When the excess homes built in the boom are being lived in, the banks have written off all their stupid loans and rent provides a sensible return on an investment property, things will slowly return to normal. More rate cuts look likely but, with the official rate already at 2.25%, Bernanke doesn’t have too many shots left to fire. In any case, it won’t make much difference.