Some finance reading

For our amusement, here's a post on finance. Many in the patch have well-developed financial thoughts, so I hope patch comments teach me a thing or two.

Here's a few books I've read over the years that have influenced my thoughts, some of their claims, and random musings interspersed. Claims are not facts, since everything in economics is debatable. Still, many of them I believe (not all).

- A Random Walk Down Wall Street. Filled with wonderful stories and fascinating analyses, its major theme is the now oft-repeated truism:

Claim #1: most active money managers perform worse than passively managed index funds, especially after trading costs.

The author Burton Malkiel is a professor of economics at Princeton, a strong proponent of the "efficient market hypothesis" (that a stock price rapidly reflects all known information about the stock), and closely affiliated with the Vanguard Group that offers index funds in line with Malkiel's philosophy. Other themes:

Claim #2: over the last hundred years, stocks have produced higher long-term returns than any other investment vehicle (bonds, gold, art, etc.)

Claim #3: there are two basic ways to value stocks: "firm foundation" (try to determine the true value of the underlying company) and "castles in the air" (try to determine whether someone else will pay more for the stock in the future).

These two basic ways are both present in the market, an essential dualism we will never fully resolve.

He also reviews many past trends in the markets, and updates every decade, so I should buy the new edition.

- One Up on Wall Street. The author is Peter Lynch, manager of the Fidelity Magellen Fund for decades. "If you had invested $10,000 in the Fidelity Magellan Fund when Lynch became manager, ten years later you would have $190,000."

Claim #4: It is possible to beat the market over the long term, but really damn unusual.

I only can remember two people who have beat the market consistently for decades on a large scale, and they are financial superstars. One is Lynch, and the other Warren Buffett, press-dubbed "the sage of Omaha" who manages the fantastically successful Berkshire-Hathaway conglomerate.

A fun parable about after-the-fact observations: mail 512 people that the stock market is going up next week and 512 it is going down. Whichever direction it goes, you correctly predicted the future to 512 people. Divide your remaining trusting audience in two, and repeat. After 10 weeks there is one schmuck who may very well be convinced you are the seer of wall street. Now .. well, if you're a finance guy, you fleece him. To restate generally, out of a large population following random variation may emerge a few exceptional events. Similarly, Lynch and Buffett may simply have been lucky guessers out of a huge pack of fund managers. However, it's hard not to pay attention anyway, especially when they write well.

Claim #5: Don't pick stocks unless you're willing to spend a lot of time doing it right and monitoring the market for when conditions change.

Actually every finance book I've read said the above, but it is a precursor to Lynch's

Claim #6: Buy what you know, especially if your knowledge is uncommon.

If you use a product and like it a lot, if you see a company in your area doing well, chances are you know something more than Wall Street. Research it carefully (claim #5) and buy. This claim can't really be proven or disproven, but it is one of Lynch's big claims. Note it opposes directly the "efficient market hypothesis" claimed above.

- The Intelligent Investor. Warren Buffet (aforementioned star) says "By far the best book on investing ever written." It was written by his mentor, Benjamin Graham.

Claim #7: Successful investment requires a margin of safety.

Graham is a firm "value investor", i.e. look for stocks representing companies that have a proven record of solid earnings and with a price under-representing the "true value." Then in the long term you can't lose. He goes into great detail about many ways to judge solid earnings (e.g., a low price-to-earnings ratio averaged over a number of years, no forward-looking statistics, read the proxy carefully for crazy "nonrecurring charges" which are actually recurring, "pro forma" accounting which means to report earnings as if accounting rules weren't important, avoid odd constructions like preferred stock, warrants to purchase stock, convertible issues) and under-representing true value (e.g., sufficiently low price-to-book value, low debt). This is a 500 page book that reads mostly like an accounting manual, and I wish someone would extract his rules into a concise form.

Claim #8: Successful investing requires emotional discipline.

Graham says several times (and the between-chapter commentary reinforces) that the market sometimes is paying too much, sometimes too little. If you really want to make money, you have to discount what the market is telling you. This turns out to be rare. In fact, I believe Buffett claims that some people can do this right away, but most will never be able to learn it.

- Berkshire Hathaway's shareholder letters. You've heard Warren Buffett is smart and rich. What you may or may not have heard is that he's a great writer. He talks about economics, business, and people in a precise, readable, lively way. He describes a large reinsurance deal in his 2006 letter "Our tale begins around 1688, when Edward Lloyd opened a small coffee house in London." In his 2007 letter: "Former Senator Alan Simpson famously said: 'Those who travel the high road in Washington need not fear heavy traffic.' If he had sought truly deserted streets, however, the Senator should have looked to Corporate America's accounting." Especially you should read his Fortune article describing why for the first time in decades he started betting against the U.S. dollar, taking us to the two-island world of Squanderville and Thriftville.