Tuesday, December 15, 2015

I Don't Know Nothin'

I found Kinematics and Machine Dynamics to be the most difficult course I ever encountered while obtaining two undergraduate degrees and one graduate degree. It was not unusual to spend 3 hours working on a single homework problem. We were encouraged to work in teams, as the professor wasn’t confident we could complete all our assignments without group cooperation. Actually this wasn’t a bad idea. In real life almost all engineering problems are solved by project teams. One of our assignments called for the analysis of what the professor termed a “donkey engine,” an early type of steam engine used on paddle wheel river boats. It was called a donkey engine because it would “kick” in unpredictable ways. Later engines used governors to control this behavior. Recently I discovered that James Maxwell wrote the definitive paper on this subject back in the mid nineteenth century just before he published his famous equations that became the basis of the science of electrodynamics.

None of us were able to solve the donkey engine problem. The professor never provided us with the answer. Early in my career at the laboratory, I told this story to my coworkers. They didn’t believe me, so I gave them the opportunity to find the solution. They were experienced engineers. Most of them had their master’s degree. None of them could solve the problem. Finally my boss, a brilliant man with a PhD in mechanical engineering tried and failed to derive the equations of motion for the donkey engine. He concluded the system was too close to instability to be solved using normal, linear predictive methods.

From time to time, I am asked to predict the movement of stock market. If I could perform this miracle on even a semi-regular basis, you could try to visit me on my beachfront estate on the island of Maui, if you could get past my security force. People like the rube in the painting believe or at least entertain the idea that someone can predict the movement of the market with mathematical certainty, while the fortuneteller’s confederate is busy picking the victim’s pocket. Think about it. If I had the magic box that could predict the movement of the market, why would I share it with you?

I started studying investment as a discipline about 14 years ago. After much effort, I have come to the conclusion that, “I don’t know nothin,” at least not with anything that approaches mathematical rigor. What I have learned are some rules of thumb that have helped me save and successfully invest enough that I was able to retire comfortably at age 62.

Here are some of those rules of thumb, rules that work “thumb” of the time. Remember all these statements are based on past performance, which may or may not have anything to do with the future.

1) If you invest in American equities your money will grow at approximately 7% per year over any sufficiently long period of time. That sufficiently long period of time may not reach fruition until after you and your coffin have been carried home to victory on the Wabash Cannonball.

2) In any given year you can lose as much as half the money that you are holding in stocks. It happens. If you lose half your money, you will need to double your money to get back to even. That could take a long time. It is better to lose ½ of ½ of your money, especially if you are retired. If half of your money is in bonds and cash you will be able to pick up bargains after the market collapse, just like Joe Kennedy did back in 1933.

3) Bonds are not guaranteed. A wise man looking around for safe investments in 1910 might well select some German and Russian bonds for his portfolio. His great grandchildren may still have these souvenirs of a better time framed and hung on the wall of their study as a historical curiosity.

4) The world will end every eight to twelve years. About once a decade the market will suffer something that falls between a major correction and a crash. Count on it.

5) Indicators may or may not be of any use. For two or three years, all the fundamental indicators have been telling us the market is over valued. However, there is another rule of thumb at work here, “Never fight the Fed.” As long as the Federal Reserve Bank and the Department of the Treasury continue to pump astronomical sums of funny money into the economy, indicators are indicating something but not providing us with any useful information.

6) Debt is bad. Corporate debt is bad. Over the course of about two months, I discovered, KMI, one of my “safe” stocks that performed well for a long time had a debt problem. Now, I’m pretty much back where I started on that one. Large scale individual debt is bad for an economy. Excessive Sovereign debt is dangerous for a country. Debt has to be repaid. The principal and interest repaid to the creditor are funds that can’t be used to generate new sales and salaries in the private sector that can then be taxed by the public sector. During this “winter season” when debt is being squeezed out of the economy, the donkey engine can kick in unpredictable ways—like hyperinflation or bankruptcies for individuals or default for Governments. These events can cascade through society with truly disastrous results, like World War II.

So what can I say that is of any value to the beginner or even the experienced investor? If you spend less than you make over a working lifetime, you will have a surplus to invest in stocks, bonds, or real estate. If you don’t invest too much in any one thing or too much at any one time, it is likely that you are going to be all right.

I really can’t beat what Solomon wrote a long time ago. A broadly diversified portfolio containing different types of investments and wise trustworthy friends and counselors who have your back are your best protection against the uncertainties one finds under the sun.

Ecclesiastes 11:2
Invest in seven ventures, yes in eight, you do not know what disaster may come upon the land.

Ecclesiastes 11:6
Sow your seed in the morning, And at evening let your hands not be idle,

Proverbs 15:22
Plans fail for lack of counsel, but with many advisers they succeed.

Ecclesiastes 12:13
Now all has been heard, here is the conclusion of the matter. Fear God and keep his commandments, for this is the duty of all mankind.

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