Canards and experience: what we’ve learned about truth

February 23, 2009
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In a time when the unanticipated has become the anticipated — in the sense that there are enough economic news tremors and quakes daily to dull our responses — there are truisms and theories that prove and reprove themselves. And unfortunately there are those of long-standing support that are disproved under unprecedented conditions of stress.

Painful lessons

Too much risk is a bad, bad thing.

If the corporate world (and particularly the financial sector) has learned any lesson in the past year, it would be that the specter of earning more profits than your neighbor shouldn’t outweigh the possibility of spinning your company into spectredom and out of business.

When the ship is on fire, it’s every rat for himself.

Whatever the available hatch or door, corporate leaders and investors looked for an out when things started heading south. Some even went beyond the escape route and instead continued to feather their nest with unmerited bonuses. Imagine that!

Debt is always cheaper than equity — except when equity is cheaper than debt.

The opening clause is a business school basic — the following clause is the current situation. The business school basic worked well when earnings grew and interest rates were stable. Supplement those conditions with inflation and tax considerations and the use of debt becomes even more appealing. But when it stops working — as it has in recent months — it’s a breathtaking failure. Combine deflation and a weakened economy, and interest payments can be an insurmountable hurdle. This basic just got the royal heave-ho.

Financial markets are efficient. While suspect since the 1990s, the Economic Market Hypothesis developed at the University of Chicago has attracted more questions than answers. The hypothesis posits that financial markets are “informationally efficient” — or that prices on traded assets reflect all known information.

Re-stated: It’s impossible to consistently outperform the market by using information that the market already knows, except by luck. Re-stated again: If it sounds too good to be true, it probably is. With the prospect of increasing government policy and enforcement directed toward financial markets, fresh opportunities for savvy and anticipatory investors may arise.

Modern Portfolio Theory: This decades-old theory posits that rational investors will use diversification in their portfolios to provide stable returns given certain levels of risks. This is another theory that works well in times of stability, but can be disastrous when the markets wilt.

Home prices always appreciate. This worked well for eight decades. This also may be the most protracted bubble in modern economic history. It’s been widely accepted as conventional wisdom for generations — but it’s obviously not working well today.

Take these to the bank, if it’s still standing

If you don’t understand it, don’t invest in it.

Einstein put it a little differently: “If you can’t explain it simply, you don’t understand it well enough.” When was the last time you heard mention of SIV (Structured Investment Vehicle) or CDO (Collateralized Debt Obligation) outside a sentence that contained the words “bailout” or “subprime mortgage crisis”? The lesson is to invest in businesses that you understand — and that the businesses themselves understand. One caveat: Just because you understand a business doesn’t mean it’s time to buy it.

Live within your means.

Expanded lifestyles can’t be sustained on debt. Living below one’s means provides a margin of safety in bad times, whether present or future. For those who do, there’s an additional incentive: When prosperity returns, those who lived within their incomes will be that much further ahead.

Don’t chase returns.

The most frequent selling point for an investment vehicle is the big return it is generating for its investors. But if you’re hearing that line from someone selling investments, chances are good it’s already too late to reap those levels of returns.

Don’t put all your eggs in one basket.

The examples are plentiful — and all around this beautiful peninsula of Michigan. Keep your investments in individual equities in the single digits as a portion of your portfolio —and low single digits are preferred.

Julie M. Ridenour is director of business development for Norris, Perné & French LLP.

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