What’s so wrong with socialism?

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As a concept, socialism is appealing. It’s idyllic, it seems to diminish unfairness, promote the less-fortunate, favor equality, all good things. So what’s the problem?

The true problem with socialism is an economic one. It’s about simple math.

Socialism seeks to operate an economy, or society on the whole, by rules and regulations set by a small group of people in power.

Conservatives mainly criticize socialism as a system that misplaces incentives. While humans do operate by incentive, and socialism does skew incentives, this is not the most helpful critique. Socialistic regimes have imposed different forms of incentives throughout history, like fear of torture and death, to coerce their people into desired action.

There is also a basic problem with the idea that a few people should hold so much power over many. Regardless of the purity of a person, power generally corrupts. But, like the incentive criticism, this is not the most basic problem of socialism. The truth is, even under the most compassionate, just, caring leadership in the history of the world, socialism would still be doomed to fail.

The problem of socialism is, at its most basic, a problem of pricing. A truly free market is an incredibly efficient way to set prices and wages. Whenever there is too much of a good, demand (prices) goes down, and businesses and people react by creating less of that good. Whenever there is a shortage of a good, demand (prices) goes up, and businesses and people create more of that good. In a free market, this happens quickly, automatically, and constantly. Communication stems from millions of data points (decisions, knowledge, people) occurring every second of every day accurately determining what people want and delivering those goods.

When a government or ruling body steps in to set prices or fix wages (the standard operating procedure of socialism) instead of letting the market make a determination based on supply and demand, that body is bound to fail. Any group of people, regardless of their level of training, IQ, ambition, morality, etc. can never have a complete understanding of the millions of data points, decisions, and knowledge swirling within the market every second. A few people simply can’t know as much as the several billion people on earth collectively know.

Because of this, a set price or a fixed wage will necessarily result in waste (too much of a good) or lack (too little of a good). This state of mispricing, given enough time, will result in the collapse of society.

An example of wage-fixing can be seen in modern-day minimum wage policies. Minimum wage is an attempt to promote justice and protect the less fortunate from evil greedy companies; an understandable inclination, but unfortunately a worthless solution. In a free market, wages increase naturally (with bumps along the way) as demand for labor increases. In socialism, wage-fixing makes it difficult or impossible for some businesses to hire employees at a price they can afford, even if potential employees would be glad to work for such wages. At worst this creates an insane situation where businesses aren’t allowed to hire people who want to be hired, at best the market is inhibited and incentives are skewed (business may be more likely to hire contract employees or part-time employees to avoid additional costs required by regulation). A much more effective way to thwart greedy capitalists is to give the market space to create better jobs.

Socialism, as economic practice, will always necessarily fail. No group of people can ever possess the collective information of the entire market, and so they will never be able to accurately allocate resources and set prices.

Year-end investor review

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We made it, another year is in the books and everyone has an opinion on where the market is going. My line of work involves me adamantly advising people not to try to predict markets, but even I have an opinion about what might happen in the future. Thankfully, there’s a difference between having an opinion and making a poor investing decision.

So where are we now? We’re coming off of a historically great period of market returns, especially in the category of U.S. large growth companies (the S&P 500, which happens to be the category we almost exclusively hear about in the news). Since U.S. large growth companies have faired well, so have investors, because the vast majority of investors have the majority of their investments in large U.S. growth companies. That’s great news right now. But it’s also a problem.

Large growth companies are historically one of the poorest performing asset categories in the free market. This holds in performance data going back one hundred years, but it also makes sense a priori. Large growth companies are inherently less risky than small and value companies, they stay in business longer, they seldom go bankrupt (it happens, just not as often), and their prices don’t fluctuate as significantly. Small companies are often younger, less established, and more susceptible to tough markets. Value companies are often distressed and sometimes never recover. These small and value companies default more often and their prices are more volatile, they’re riskier.

You’ve heard the principle, risk equals return. That applies here. It makes sense that as entire asset classes, small companies and value companies outperform large growth companies by a significant margin over time because their additional risk brings additional return. The fact that large growth companies have performed so well over these last ten years is great, but it also means that at some point we’ll see these returns balance out. Now, I would never pretend to know which asset classes will perform better or worse next year, that’s a fool’s errand which we refer to as ‘market timing.’ But I do know that most years will favor a diversified portfolio that leans toward small and value asset classes instead of a heavy weighting towards large growth companies. Next year the most likely circumstance is that you’ll be happy to have left your large growth company portfolio to get into a more diversified situation, which, incidentally, is true at the end of every year.

So the obvious question is how to diversify with a lean towards small and value companies. I’ve covered this before, but total market index funds won’t help you here, because of cap weighting total market funds are invested almost entirely in large growth companies. Index funds have become very popular over the last 20 years and, while they’re certainly an improvement over active funds, they’re inherently flawed. To get into an ideal portfolio takes an advisor committed to the academics of investing utilizing structured funds (a solution to the index fund problem).

Take the opportunity to review your portfolio as we head into the new year. The returns may look great, but that doesn’t mean you’re in a great portfolio.

There are only two ways to invest (part 2)

 

carolina-pimenta-J8oncaYH6ag-unsplashSo we’ve identified the two basic ways you can invest. That’s great, but how do you know which one to choose? Let’s talk about the active option.

Active investing feels right. We’re active people after all. We shop around for deals, we love sales and Facebook Marketplace. We check weather forecasts on the regular, we set future plans on our calendars. We do research before we buy things (some of us perhaps to a fault), we read reviews, we ask our friends. All of these things are active. So then active investing just seems like the normal way to do things, look for underpriced companies, do some stock research, make a prediction about the future, nothing too out of the ordinary, right?

There’s just one small problem, investing isn’t like normal life. We’ve got really smart people positing that the stock market is efficient, which means there aren’t actually and sales or deals on underpriced companies. Sure, stock prices will generally move upwards, but not because a company is underpriced. New news and information comes into the market and affects stock prices, new things happen that we can’t know for sure beforehand are going to happen. Research into specific stocks is great, professionals are doing it all of the time, but no one person can possibly have a complete understanding of a company, let alone how unknown events in the future will affect the company. There’s just too much data to make picking stocks a long-term viable strategy. Predictions in the stock market are not like weather predictions, we don’t have a radar watching a storm-front move in. And if people believe there is a storm front coming, it’s already priced into the stock prices because again, the market is efficient.

It’s really tough to be a good active investor. Even professionals fail to outperform the market at an extraordinary rate (over the last 15 years, 92% of active funds trading in the S&P 500 have underperformed the S&P 500), and even those who seem to be good at it tend not to repeat their performance. So maybe you’ve guessed by now, I don’t advocate active investing. If you really believe that the market is not efficient and that you or someone you know has a special ability to buy and sell the right stocks at the right time then active investing is the way to test your belief. Unfortunately, the odds are not in your favor.

In part 3, we’ll talk about the alternative option.

Value Investor (part 1)

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Value investing sounds really cool. It sounds savvy, it sounds smart, it sounds responsible, it sounds like it makes a lot of money. I mean, Warren Buffet is a value investor!

So what is a value investor? Well, a value investor is someone who invests in value companies. So what’s a value company? I’m glad you asked. Essentially, a value company is one whose stock price is about the same (could be a little higher or lower) than its intrinsic, or book, value. A lot of words there but stick with me. The intrinsic value of a company is what you get when you add up all the company’s assets, its land, warehouses, products (which can include patents), equipment, cash, etc. It might seem a little odd that a company’s stock price wouldn’t always be close to its intrinsic value, but the stock market prices of growth companies (the opposite of value companies) can actually trade multiples of 8 times higher than its intrinsic value. This happens because the market expects the growth company to continue growing. Value companies aren’t typically expected to grow much, they’re often characterized as distressed. So value investors are analyzing these value companies and deciding which ones they think are actually undervalued and which ones could bounce back. Again, it sounds great, they’re the brilliant nerdy guys reading all of the fine print and finding the deals in the stock market, the companies that are underpriced. All you have to do is hitch up to their wagon and ride those value companies up when everyone else figures out how valuable they actually are. Sounds pretty responsible, right?

A semi-famous value investor, Michael Burry, featured in the Big Short (as Christian Bale) crushed the growth stock market from 2001-2005. In the middle of 2005, he was up 242% when the U.S. large growth market (S&P500) was down 6.84%. Michael Burry is the quintessential weird genius that we love to fall in love with, and hand our money over to. He did things differently, he didn’t take normal massive fees, he was incredibly awkward with people in person, he kept to himself, he obsessively studied the interworkings of the companies he invested in, just about everything you would expect from the next market genius. He’s most famous for predicting, and attempting to short, the housing crash in 2007. And now’s he’s rich, and semi-famous, and still investing. He recently stated that passive investing is a bubble, that he’s concentrated on water (you get it), that GameStop is undervalued, and that Asia is where it’s at. While these investment tips might accord with the laws of value investing, they hardly seem prudent.

Michael Burry is definitely smarter than I am, but here’s what I know:

1) Ken French, a professor of finance at the Tuck School of Business, Dartmouth College, who has spent much of his adult life researching and publishing in the sphere of economics and investing, conducted a study of mutual-fund managers (Luck versus Skill in the Cross-Section of Mutual Fund Returns) and found that only the top 2% to 3% had enough skill to even cover their own costs. Eugene Fama, another father of economic and investing academia, who co-wrote the paper with Ken French, summarizes their findings this way: “Looking at funds over their entire lifetimes, only 3% demonstrate skill after accounting for their fees, and that’s what you would expect purely based on chance.” Of the managers who do exhibit enough skill to cover their own costs, it’s hard to determine whether an actual skill is at work or it’s simply a facet of luck; most free-market scholars lean towards luck.

2) Fama continues: “Even the active funds that have generated extraordinary returns are unlikely to do better than a low-cost passive fund in the future.” Some managers do well enough to cover their own costs and beat the market in a given year. Unfortunately, their success languishes quickly and they regress to the same plane that active managers on the whole occupy, which is underperforming the market.

So is Michael Burry, or any value investor, the weird, brilliant savant that we desperately want to attach our life-savings to, or is he one of the 3% of managers who have done well enough to cover their own fees, but who the data says is more likely to regress to market underperformance mean than to do it again? I know which side I’m playing.

Human capital

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What’s human capital?
To start, we need a definition. Here’s what Wikipedia has to say: “Human capital is the stock of habits, knowledge, social and personality attributes (including creativity) embodied in the ability to perform labour so as to produce economic value.” A little tricky, but basically human capital is the economic value of a person based on their skills and ability in the workplace.

So who gets paid for human capital?
In a free-market economy, everyone gets paid based on their own human capital. We each own our own skills and abilities and we collect income based on our ability and value when we work. Regardless of whether we work for a company or ourselves, we’re compensated for the value we’re able to provide.

So far so good. Now let’s tie this into investing. Without some understanding of the market, people tend to believe that they can beat the market by picking the right stocks. Consistent success (beating the market) in stock picking is actually impossible, but let’s pretend for a moment that’s not. If the market was beatable, there would naturally be people who were especially endowed with the skills and/or training to beat it. Those people would often become money managers and they would be highly sought after by the general public looking for great returns in their portfolios. But who would collect the premiums for additional returns achieved above-market returns? Stock picking would be a human capitalist skill! The brilliantly skilled money manager would collect some serious fees for his valuable ability, fees almost exactly in line with the amount of return he was able to achieve above the market. The additional return of the portfolio wouldn’t end up in the pockets of investors, it would go to the brilliant manager with the impressive human capital skills.

So here’s the point: the stock market is efficient and so it’s not consistently beatable, but even if it was, investors would not be the beneficiaries. The super-skilled money managers would rightly collect large fees, highly correlated to the additional value they were able to provide based on their human capital skills.