Financial Thinking

Investment management isn’t like other work. In all cases of physical labour, input is directly proportional to output. When a person decides to dig a hole, the more he digs, the bigger the hole gets. The more people work together at assembly a car, the faster it goes. Intellectual work is different. Because insight arrives all at once, the time spent considering a problem is not proportional to the payoff of the solution.

Investment management, or stock trading, is different again. Although it requires some insight, it is also an interaction with a market. We don’t thoroughly understand the dynamics of a market (it isn’t a case of Brownian motion and doesn’t fit the parameters of Gaussian statistics), so although we can measure the input (time spent in research), we can’t predict the output. How much additional research time (fundamental or technical) will translate into an extra 1% of return? There isn’t an answer to that question.

That doesn’t mean we can ignore our investment portfolio. Because markets are volatile and movement is unpredictable, an investor needs to watch the investment portfolio for a scenario where action is required. Some examples may be a sudden price movement, up or down, that presents a selling or buying opportunity; a surprise announcement by a company, suggesting improved or worse performance in the future; or even an economic development that will favour one asset class over another (eg. increasing interest rates favouring stocks over bonds).

But it isn’t helpful to constantly tinker with a portfolio. Frequent trades rapidly increase costs to the portfolio. Further, it’s difficult to assess the total impact of a small number of actions over a period of time, determining whether the manager is helping or hurting the annual return. On top of that, getting the timing right to buy and sell, over a short hold period, is a lot more particular given that the total return for the trade will be small. Over a longer period, and a larger total return over that period, buy and sell timing will be more forgiving.

As Peter Cundill says in his new book (which I haven’t read yet), there’s always something to do. While I check the market and my portfolio once or twice a day, I really don’t expect to do anything about it. I make all my investment decisions once a week, after Friday’s close, while I have all weekend to calmly reflect. And I don’t act every week. I place trades as market conditions or cash buildup allow, typically less than once a month. For me, this schedule has worked profitably.

Which brings us to the dilemma of professional investment managers. They go to work everyday. They receive generous paycheques. So in order to “earn” their income, they stay busy all day every day trying to find ways to add value to their portfolio. This is not the ideal schedule to follow. Being connected is important, because an opportunity to act might arise any day. However, while there is always something to do, trading should be done on a slow-paced schedule, allowing ideas to mature and prove their worth.

In economics, there is a saying that bad money will drive out good money, which is referred to as Gresham’s Law. It can be easily understood by thinking about how currency may have been used in the Middle Ages. Think of gold or silver coins; we’ll use gold in our example. When a person wanted to pay $50, he would use $50 worth of gold bullion, which was shaped into a $50 coin. But an enterprising goldsmith had the idea to hollow out the coins, replace the gold with lead, and still use a $50 coin to buy $50 worth of goods. He will then hoard the real gold. As soon as people realise that some coins are gold, while others are gold-plated lead, they will no longer pay with pure gold coins. Those will be hoarded or melted down, while gold-plated coins will be used for payment and stay in circulation.

We can see that bad money drives out the good because people keep what they value, and trade what they can. In this case, what people value is gold, for its inherent value. But besides money, people also value time and energy, skill and effort. This leads me to propose that the bad always drives out the good in any enterprise, including in management and governance. This goes contrary to Adam Smith’s idea of the invisible hand, where each person, working for their own self-interest, inadvertently furthers the good of society.

In management, a part of the idea that the bad drives out the good is the Peter Principle. The principle was developed in public schools in Canada, and it can still be seen at work. It describes the situation where good teachers are promoted to principal. This leaves the mediocre and poor teachers behind, teaching. Good principals are promoted to superintendent, leaving behind the mediocre and poor principals. Good superintendents are promoted to the district administration, leaving behind the mediocre and poor ones. In the case of each individual, he or she is promoted to their level of incompetence. Obviously, hierarchies aren’t sufficiently wide to promote everyone to their level of incompetence, so some positions will continue to be competently staffed. It does explain, though, why middle management is often incompetent.

There are more insidious reasons that bad management drives out good management. One reason is the cost. If five talented managers can very effectively run an organization, three mediocre managers can passably run an organization for far less money. Further, if a manager is tasked with supervising a department, but without producing any real measurables except the work of others, a  very human manager will soon find the least amount of effort it is possible to expend; that is to say, people are lazy. Certainly, harder work could translate into intangibles such as team spirit, morale or the ability to inspire collaboration, but the manager’s job doesn’t normally depend on any of these things, only that the work continue to get done. In this way, laziness drives out productivity, and not just in managers. In fact, people who pride themselves on their productivity are likely to transfer to a different department, or change jobs to a company that still values productivity.

People will also leave a company due to the atmosphere. Imagine a department with two middle managers. One is kind, while the other is mean-spirited. It might not actually take any imagination, since most people have worked with a mean person before. Is that offending person likely to leave the company because of bullying or a negative work environment? It’s far more likely that the kind manager will finally tire of the poisoned atmosphere and leave. The same would likely be true in the case of dishonesty, commandeering or politicking. Nice guys finish last, by taking themselves out of the competition and going somewhere they feel valued.

Bad governance also drives out good governance. Good governance, to me, means representing the needs and desires of shareholders or constituents, and acting on their behalf. It means communicating a vision, providing leadership and guidance. That sounds like a lot of work. I know of people who are willing to put in the time and effort, but there are too few of them. Worse, it doesn’t last. Leaders become complacent, believing that their track record speaks for them, or that relationships from the past don’t need to be refreshed. In this case, fresh energy and enthusiasm need to be injected into the organisation. This is why we change our government every couple elections, even if it just means replacing old faces with new ones. We are really replacing complacency with energy and enthusiasm.

Entropy is a nefarious force that affects all aspects of our world. It means that, in order to progress and grow, or even just to keep an organization functioning, requires constant effort and energy. Anything less will cause the bad to drive out the good until an eventual collapse.

I got a margin call again last week. I thought I had solved the problem after the first margin call, because I didn’t want to experience that again. I think I had used only half of my available margin (eg. $100k loan + $100k margin available), but I still got a margin call. So I transferred in cash from my wife’s account, since she had a lot of excess margin (eg. only a quarter used).

That solved the problem for a while, but I got another margin call. I solved it the same way, but this time we each have very little margin left. There is a possibility that if the market falls another 5%, I could be under margin again. How did I get in this position? I thought I bought when the market was already low. It turns out that low is relative, since I bought when the TSX was around 12,800. It had already dropped, but it continued to fall.

The reason I got into trouble was that I forgot where margin comes from. Margin comes from the value of the stocks an investor already owns. When I open a margin account and deposit cash, I have no margin (used or unused). But when I buy shares, the shares have a loan value. There are three possibilities: 30%, 50% or no margin. For example, a large liquid stock may only require 30% of its value to be paid in cash, because 70% of the share price is loan value. A smaller, less liquid stock may require 50% to be paid in cash and provide 50% loan value. A penny stock or illiquid holding has no loan value.

What happened to me is not only that my stocks fell in value (like everyone else’s), but that their loan value changed. Some stocks were no longer marginable. Others went from 30% to 50%. In that way, the amount I could borrow in my brokerage account fell rapidly, far faster than the market value. And that’s what produced the margin call.

Margin magnifies the unpredictability of stock prices. Next time, I’ll use far less margin. But for right now, I’m waiting for share prices to recover before I sell and pay back the loan.