Reality Check

I don’t think it will come as a surprise to anyone reading this letter that the current economic and financial dislocation is the most challenging we have ever faced. Trillions of dollars of wealth have disappeared as the excesses of the credit bubble imploded, vaporizing most of the former giants of the financial system, freezing credit, and pushing the economy into the steepest economic decline since the 1930’s. I am quite certain that 2009 and possibly 2010 will see economic distress that few people alive today have experienced.

How do we respond to a challenge like this? Should we just hang on and hope things get better? Or should we be thinking about stocking up on canned goods and ammo and heading to Montana? The government has thrown trillions of dollars at this problem with seemingly nothing to show for it. Are our leaders that incompetent, or is this financial Armageddon?

When the market drove off a cliff in October, normal diversification failed. Stocks dropped, bonds dropped, gold dropped, commodities dropped, real estate dropped. Everything dropped except cash; and the yield on cash dropped to zero. There was nowhere to hide.

So what are we going to do? How can we make investment decisions when the financial system itself appears to be in danger? Yes, the future is always uncertain, but now it’s really uncertain.

The Crisis is your Friend

In a situation as big and bad as this one, investors tend to see only two choices: run and hide, or batten down the hatches and ride it out. In the first case, the investor sells everything, and puts his money in T-bills or cash. He feels good, because the news keeps getting worse, and the markets keep going down. He thanks his lucky stars that he cashed out when he did, and decides to wait for a time when he feels confident again, before committing his money to risk. This behavior is called selling low, and buying high.

In the second case, the investor decides to grit his teeth and ride it out. He has been investing for five years, and in his mind, he is in this for the long-term. Given that the market has already fallen over 50%, his comfort level is already on thin ice. As the economy and the market continue to deteriorate, his ability to withstand his portfolio moving up and down finally breaks down. He may very well survive the bottom, but at some point in some rally, he will cash out, glad to have recovered some of his losses, vowing never again to gamble in the stock market. This behavior is called buying high and selling low.


There is a third choice. Many years ago, we had a house guest: an extremely brilliant and wise Rabbi. I asked him one day how he dealt with problems that appeared to have no good solution. He said that when he comes across a challenge like that, he reframes the entire issue in his mind, and this change of reference can transform a previously intractable situation into one with workable options. This behavior is called thinking outside the box.

So I have reframed the situation. At first blush (maybe the second blush too), the idea seems preposterous: The current worldwide financial crisis and severe economic dislocation is a once in a lifetime opportunity to build wealth with a reduced level of risk. Forty years ago you could have legitimately wondered if I was smoking something strange. But those days are gone, so either I have completely lost it, or perhaps there is a germ of truth in this.

If you will humor me a bit longer, I will make the case for how we can not only survive this very dangerous situation but how we can use it to our benefit. Nothing will change except our perspective.

Reality: Better than the Alternative

I recently got an email from a friend. It appears that a small winery needs to raise cash, and they are selling cases of award winning premium wine for $5.00 a bottle. I did a little checking, and five years ago the same wine was selling for $23.00 a bottle. Two years ago it was selling for $18 a bottle, and late last year it was available at $10 a bottle. If I had bought the wine on sale at $18 and loved it, and I bought some again at $10 and felt the same way; wouldn’t it stand to reason to back up the truck at $5.00 a bottle? That’s how our value managers think.

“The investment world has gone from underpricing risk to overpricing it.” So wrote Warren Buffett in his most recent letter to shareholders. “When the financial history of this decade is written, it will surely speak of the Internet bubble of the late 1990s and the housing bubble of the early 2000s. But the US Treasury bond bubble of late 2008 may be regarded as equally extraordinary.”

US Treasury bubble? Aren’t US Treasuries inherently safe? As it turns out, the answer depends on your perspective. If your concern is just whether they will pay interest and principal on time, they are safe. Nevertheless, the history of investing teaches us that nothing is “inherently” anything. For the investor who is trying to make good investment decisions, price is a far more reliable indicator of safety than reputation. Given the price (or yield) of Treasuries today, despite the guarantee, there is considerable risk to owning too many of them for too long.

Risk is an elemental part of the investment landscape. There is risk in every investment, and there is risk in every investment decision. You can no more avoid risk than you can avoid gravity. Our strategy with risk is to understand it, measure it, and respect it. If we understand risk, we know where it is lurking. If we can measure risk, we know when it’s appropriate to take some on. And if we respect risk, we know that being prepared for a risk that doesn’t actualize is far better than being unprepared for a risk that does.

There is no way to know if investments that appear to be bargains today won’t become even greater bargains tomorrow; or whether the investments that appear to be risky will actualize their risk. Over short periods of time, markets are voting machines; and they can drive prices to levels that have no relationship to their value, whether perceived or actual. The reason that the value proposition is such a powerful tool is because ultimately, markets are weighing machines; and if there is value to be realized, markets will adjust to recognize that value. That is not a prediction; it is the nature of the market mechanism itself.

Three and a half years ago, in the fall of 2005, I began to write in this newsletter about the complacency in the investment world at large, suggesting that it was an appropriate juncture for all clients to reassess risk. I had no idea how long the calm would last, or how much higher the market would go. But it was clear that investment risk was increasing and building some cushion was a sensible response.

Today, the complacency has been replaced by fear. And just as complacency can lead investors to forget there is risk, fear can lead investors to forget there is opportunity.

The purpose of changing our perspective is to gain a measure of clarity – so we can understand the world as it is, not only as it feels. There is still a lot of danger out there, and we need to respect that, and make sure it is reflected in our investments. But increasingly, there is also opportunity. That is the nature of fearful times. Accordingly, we can acknowledge our fear without letting it get in the way of making good decisions, knowing that it is a far more acceptable price to pay than the alternative.