THE ACCIDENTAL QUOTESMITH

I’d like to share some of the wisdom of one of the people who unwittingly inspired this book. For legal reasons, he shall remain nameless. Let’s just say that he was a very senior person at one of the institutions for which I have worked, and as I got the chance to listen to him, I realized that one could scarcely do better than to listen to him and run the opposite way as fast as humanly possible.

“Tell me, Bill, what has changed—other than the prices?”

I would argue that anyone who asks this question should be permanently barred from the investment business. The investment world has basically two interrelated tasks. One is the buying and selling of money, and the other is putting a price tag on risk. Indeed, one of the wisest quotations I ever read went as follows: “There are no bad bonds—only bad prices.”

Here’s a good illustration. At one of my places of employment, it became fashionable to say that we wanted to own only short-dated bonds. The basic reasoning made enough sense—even if a company’s finances are deteriorating, in most cases it will be able to keep, or raise, enough cash to make good on its most immediate and pressing debts. The ones coming due many years in the future, though, are naturally far more speculative. You do whatever you have to do to pay off tomorrow’s obligations, because if you don’t, you won’t be around to deal with the ones coming due in subsequent years.

So it seems reasonable enough to focus your investments on bonds coming due in the fairly near future. Agreed? Well, before you jump on board, let’s remember to think about one critical element.

THE PRICE!

You see, it’s all well and good to think in terms of the investments most likely to be redeemed. But do they make sense at any price? The answer is a resounding no.

What good does it do you to pay 99 for something that will pay you 100 in a year? Even if you think it’s pretty safe, you have no margin of safety if you turn out to be wrong! You have one point of upside and 99 points of downside!

My good “friend” who was espousing this view was spending virtually all his time analyzing, from every imaginable perspective, the only meaningful position he had. It was a doozy. The bonds were quoted in the mid-90s, coming due at 100 in about a year-and-a-half. So the risk/reward was this: You’d get the bonds’ coupon income, plus about five points of capital appreciation, if everything went according to plan. If something went wrong, you could potentially lose up to 95 points. The guy basically bet his career on this trade.

The result is not particularly relevant. What I need you to understand is that the process was flawed. If you knew some further details of this situation, you would know this was a company whose survival was highly tenuous, not the type of investment for which a wise speculator would accept a 5/95 upside/downside ratio. But, it was true; the bonds were due to mature in the relatively near future.

Please don’t get me wrong. There may be investments where the 5/95 upside/downside ratio could make complete sense, if the probabilities are more like 1/99. But few investments are more foolish than taking a small upside with a big downside when there is a very legitimate possibility of something going seriously wrong.

In horse racing, most jurisdictions require all winning bets to receive at least a nickel in profit on every dollar wagered. Some people with more money than they know what to do with find horses they think cannot possibly finish worse than third and bet large sums on them to show (finish third or better). They figure they are getting paid as if the horse will be worse than third one out of every 21 times when they think the real chances of it happening are far less likely.

There’s a reason why they call these folks “bridge jumpers.” Of course their bets pay off far more often than not. But a horse can hurt itself, fall down coming out of the gate, be sick, crash into another horse and be disqualified, and so on. There are all kinds of strange ways to lose money doing this. But when so many things can go wrong, and the best you can do is win $1 when you will lose $20 if any of these things should happen, what sense does it make?

The point is, when you are dealing in the world of investments, everything depends upon the price. A good trade at one price is a horrible trade at another price. This may seem obvious to you, and once upon a time, I thought it was obvious as well. But after some of the things I have heard and seen, I have come to reconsider.

So this is one of the main ways you make Wall Street work for you. Always, always, always focus on price. When all the talking heads are saying how great an investment is, ask what you can make on it, and what you are risking. When they are saying how bad something is, ask how much you stand to lose if you buy it now. Because it’s astonishing how rarely they ask themselves this question. They are so busy trying to do whatever each other is doing that they forget the most basic principles.

“Yes, they were going to invest with you for at least four years. But you’ve lost money, so the rules of engagement have changed.”

Pretty fancy stuff, eh? Rules of engagement. But, you see, this is the kind of thinking that permeates Wall Street management. We may have a deal, but the deal applies only if you are making money. Lose money, and we go back to the drawing board.

What’s so bad about this? Well, it means that anyone who might be a party to an arrangement like this cannot make any real investments.

Because real investments lose money some of the time. Most winning investments are losers before they become winners—it’s just the nature of things. When you buy something, the odds are very high that it will trade lower than where you bought it for at least a little while.

So, knowing that you are an individual, accountable only to yourself, should make you feel pretty good. You don’t have to deal with a decision-making assembly line where losses, no matter how natural, are viewed the way a squeamish person watches a horror movie. When they panic, you pounce.

A little footnote here: The quote gets even better when you learn that the accidental quotesmith, he of the rules of engagement, had remarked to me just a few weeks earlier, “It’s nice to have money tied up for the long term, isn’t it?”

“The markets just aren’t volatile any more. Volatility is a thing of the past. Information gets transmitted too fast, people react to it, and then there is nothing more to do,” he continued.

The accidental quotesmith said these words in late 2005. The VIX—a measure of market volatility—was around 12, nearly an all-time low. As I write this, it is around 55, and a week ago it was 80.

So don’t assume that, because things are a certain way today, they will always be that way. The best investors—and mind you, I don’t claim to be one of them—know that the world consists of trends and cycles.

Being mindful of trends is critical, and there is no greater investment mistake than to buy something just because, once upon a time, it was higher and now it has come down. Perhaps something significant has indeed changed, permanently impairing the value. More likely, the market may well have been wrong in its earlier judgment.

But cycles are even more intrinsic. In the nice, safe, comfortable world of textbooks and theory, assets have a correct price at which they trade. You don’t learn much about how they actually get to that price. But that’s the messy, dirty process by which you make money.

In the process of getting to that price, they start out on one side of it, and on the way there, they usually overshoot. Being overly focused on where we happen to be today means missing out on the process.

Understanding that every day, every trade is simply a piece of a greater whole is one of the most important steps in making Wall Street work for you.

To read more on this topic, please see the column I’ve written for Minyanville.com (free registration required):

How Betting the Horses Makes Better Investors (4/6/2009)