On Failure And Planning Ahead In Life

On Failure And Planning Ahead In Life
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On Failure And Planning Ahead In Life by David Merkel, CFA of AlephBlog

Recently, we had a problem at the Merkel house: a toilet overflowed and the water did not shut off, flooding the room, and leaked into the basement. Why did this happen? Two things went wrong at the same time:

The toilet needed to be plunged, because there was a blockage preventing water discharge, and
The flapper malfunctioned, and so water continued to flow.
If only one of these problems had happened, we would have had an ordinary problem. I can plunge a toilet, easy. I can hear the toilet singing, and know that the flapper is up, jiggle the handle, and end the problem.

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Most of the time, when we plan against failure, we look at solutions that address single failures. We do not contemplate two things going wrong at once.

Yet, when we look at big failures in investment, there are often two things that went wrong at the same time. Usually it follows a pattern like this:

Take a risk that in ordinary times often works out, but
You don’t get that times are not ordinary, and so the odds are actually stacked against you.
I have several examples for this. Taking on debt to buy a house was a wonderful strategy until overall debt levels to finance housing got to high, but at that time, the momentum effect of rising house prices was sucking people into buying houses, because they thought it was easy money.

Financial stocks were the market leaders for many years up through 2007, as investors assumed that ordinary risk control would protect the banking system. But what happens when debt levels are too high, so that many debts are incapable of being paid?

As Warren Buffett has said (something like), “We get paid to think about the things that can’t happen.” Multiple failures leading to large bad results are worth thinking about. So what aren’t we thinking about now?

Failures in retirement security systems as the Baby Boomers age.
Failures in government debt as overleveraged governments can’t make debt payments.
Inflation rises rapidly as the economy revives amid increased lending from banks.
Deflation persists as the central bank tries to force-feed credit to an already overleveraged economy.
(There are many patting themselves on the back thinking that the Central Banks and Governments got us out of a crisis, when they only delayed the crisis. High nominal debt levels relative to GDP create their own crisis.)

I would encourage you to think about your investments, and ask the following questions:

Are there hidden factors that could lead to a big failure? (Think of what happened to mortgage REITs in 2008 when the repo market crashed.)
How well would the investment fare if inflation went up significantly?
How well would the investment fare if real interest rates went up significantly?
How well would the investment fare if we hit another patch where financing is not available? Can the investment self-fund?
How much future prosperity does the current price of the investment embed in its valuation?
I know, glum words. But this might be a good time to look at what you own, and ask how survivable it is under stressed conditions.

All for now.


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David J. Merkel, CFA, FSA — 2010-present, I am working on setting up my own equity asset management shop, tentatively called Aleph Investments. It is possible that I might do a joint venture with someone else if we can do more together than separately. From 2008-2010, I was the Chief Economist and Director of Research of Finacorp Securities. I did a many things for Finacorp, mainly research and analysis on a wide variety of fixed income and equity securities, and trading strategies. Until 2007, I was a senior investment analyst at Hovde Capital, responsible for analysis and valuation of investment opportunities for the FIP funds, particularly of companies in the insurance industry. I also managed the internal profit sharing and charitable endowment monies of the firm. From 2003-2007, I was a leading commentator at the investment website RealMoney.com. Back in 2003, after several years of correspondence, James Cramer invited me to write for the site, and I wrote for RealMoney on equity and bond portfolio management, macroeconomics, derivatives, quantitative strategies, insurance issues, corporate governance, etc. My specialty is looking at the interlinkages in the markets in order to understand individual markets better. I no longer contribute to RealMoney; I scaled it back because my work duties have gotten larger, and I began this blog to develop a distinct voice with a wider distribution. After three-plus year of operation, I believe I have achieved that. Prior to joining Hovde in 2003, I managed corporate bonds for Dwight Asset Management. In 1998, I joined the Mount Washington Investment Group as the Mortgage Bond and Asset Liability manager after working with Provident Mutual, AIG and Pacific Standard Life. My background as a life actuary has given me a different perspective on investing. How do you earn money without taking undue risk? How do you convey ideas about investing while showing a proper level of uncertainty on the likelihood of success? How do the various markets fit together, telling us us a broader story than any single piece? These are the themes that I will deal with in this blog. I hold bachelor’s and master’s degrees from Johns Hopkins University. In my spare time, I take care of our eight children with my wonderful wife Ruth.
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