Category Archives: Book Review

The David Swensen Asset Allocation


The Yale Model

I have been looking for a good book about asset allocation, and I decided to pick up David Swensen’s book, “Unconventional Success.”

David Swensen should undoubtedly be regarded as a superinvestor. He took over Yale’s endowment in 1985 and achieved a return of 16.1% from 1985 through 2005. This is a considerable achievement, particularly considering the vast sums of capital that Swensen needs to deploy. He achieved these results by focusing extensively on moving away from the heavy allocation to bonds that the Ivy League had before the 1980s. His asset allocation is known as the “Yale Model,” which involves a widely diversified portfolio across asset classes and massive exposure to alternative asset classes, like private equity and venture capital.

“Unconventional Success” is not about how David Swensen achieved these returns for Yale. If it were, I wouldn’t have been as interested in the book considering I don’t run an endowment and never will. The book, instead, is aimed at small investors like myself.

The book is geared towards small investors who want to set up a simple, passive portfolio that will preserve their wealth and give a decent rate of return over the long run. Ben Graham would have called this “defensive investing” back in his day.

The Importance of Asset Allocation

Asset allocation is a critical topic. It is especially crucial for the FIRE crowd. While I admire the superhuman savings rates of FIRE bloggers, I think many of them are making a mistake by putting 100% of their savings in US equities, or an equivalent to VTSAX.

While US equities have been the best asset class over the long run, they are often prone to horrific drawdowns and “lost decades”. While over the long run everything will likely work out, 10 years of flat returns is a long time, especially when you are “retired” and don’t have an income.

Take the 1970s, a flat decade for US stocks. Stocks delivered a .26% real rate of return after inflation with a max drawdown of 40% during the ’73-’74 drawdown. The 2000s is another example. During the 2000s, stocks delivered a nominal return of 1.2% and a real return of -1.21%.

Again, everything worked out. If you had a long time horizon, you made out fine. If you were dollar cost averaging, it wasn’t a big deal. But if you’re retired, it is probably worth having a more diversified asset allocation.

It’s fully expected that elements of a balanced portfolio across asset classes will enter bubbles periodically (REITs in the 2000s, US equities in the 1990s, international developed in the 1980s via Japan), but in a balanced portfolio you won’t have 100% exposure to them. Another important aspect of a balanced portfolio is to have exposure to asset classes that will deliver a return in all economic environments.

US Stocks & US Bonds: The Classic Allocation

This is a blog about value investing and stock selection. That is not what Swensen’s book is about. In fact, Swensen advises strongly against individual investors picking their own stocks and believes that small investors don’t stand a chance. I do it anyway. As Han Solo says, never tell me the odds.

People often come to me for financial advice because they know I’m obsessed with this stuff. My advice is pretty simple: look at the Vanguard life strategy funds, look at the drawdown that happened in 2008, decide which one you could have lived with, keep piling money into it, and try not to look at it for 30 years.

Some mix of stocks and bonds are the standard asset allocation. Stocks supply the long run return, bonds deliver a boring rate of return but provide comfort to psychologically bear with the horrible 50% drawdowns that rear their ugly head every once in awhile. When it feels like all hope is lost, your bond allocation reaches out and says “come with me if you want to live.

Bonds give you the behavioral will to survive significant stock drawdowns. Stocks supply the long-term returns, with gut-wrenching volatility.

This has been the standard investing advice for decades. Swensen thinks that the small investor can do better. He starts by adding in asset classes beyond the standard US equity/bond allocations that dominate most individual portfolios.

The Core Asset Classes

Swensen describes his views on what he calls the “core asset classes” that deserve a place in a portfolio.

US Stocks: Swensen is talking about market cap weighted US equities, of course. No value tilts, trend following, etc. Good old market cap weighted US stocks. Since 1900, US stocks have delivered a 9.37% rate of return. This beats any other big asset class. Those high returns include horrific drawdowns, including a nearly 80% drawdown occurring in 1929-32.

US Treasury Bonds: Swensen is particular about bonds: he’s talking about US government bonds. He is not interested in corporate bonds, which he doesn’t believe deliver a high enough return relative to government bonds to justify their risk.

Bonds will not deliver a substantial rate of return but will protect investors during drawdowns. He also does not recommend owning foreign bonds, as they don’t have the creditworthiness of the United States.

He also recommends that half of an investor’s bond allocation go to TIPS or Treasury inflation-protected securities. TIPS were introduced in 1997 and are bonds that will increase in value if inflation rises. Conversely, they decrease in value if inflation falls. Swensen believes they deserve a place in the portfolio because they will protect against significant equity drawdowns, but they will also help the performance of the portfolio during a time of high inflation like the 1970s. Since 1997, TIPs have delivered a 4.78% rate of return.

Since 1997, we haven’t had a serious inflation problem, so this allocation hasn’t really had its chance to shine.

Meanwhile, the rest of the bond allocation exists primarily to shield the portfolio during drawdowns. The total bond market has delivered a 6.42% rate of return since 1900. They really help during drawdowns. From 1929-32, the total bond market provided a 24% return. During the global financial crisis, the bond market gained 11%.

Of course, that’s the total bond market. Long term US treasuries really shine in drawdowns. In 2008, while every other asset class felt like Britney Spears circa 2007, Vanguard’s long term treasury fund (VUSTX) gained 22%. This occurs because, during a meltdown, investors flock to buy US treasury bonds for safety and the Fed is typically pushing up bond prices to drive down interest rates.

International Developed Equities: Swensen recommends diversifying outside of the United States in developed international equities. Developed meaning that they are no longer growing rapidly and are in a similar position of economic development to the United States. Think of Western Europe & Japan. Since 1976, this asset class delivered a 9.04% rate of return. Like the US market, they are subject to horrific drawdowns.

Emerging Markets Equities: Emerging markets are economies that have recently entered a level of industrial level of development from an agricultural subsistence economy. The ultimate example in recent years is China. Since 1976, emerging markets have delivered a 9.04% rate of return.

Like international developed, they are not entirely correlated with US equities. From 2000 to 2010, a period of time when US equities lost money, they delivered a 10.61% rate of return. Since 2008, they have only achieved a 1.56% rate of return. For this reason, they fit nicely into a portfolio. Historically, they tend to offer high returns when US equities are not performing well.

Much of this has to do with valuations at the start of the decade. US equities were merely much cheaper than emerging markets or developed markets in 2010. Conversely, US equities were ridiculously more expensive than the rest of the world in 2000, which is why they sucked for the decade of the 2000s. The nice thing is that all of the world economies don’t usually enter bubble territory at once.

REITs: REITs, or real estate investment trusts, are companies that own a broad portfolio of income-producing real estate assets. Since 1970, REITs have delivered a 10.99% rate of return. This is another asset class not wholly correlated with US equities that can provide a decent return. Real estate also tends to increase with inflation, which is why Swensen believes REITs deserve a place in a portfolio for their inflation protection.

In particular, they held up well during the tech meltdown. From 2000 through 2002, REITs delivered a 13.78% rate of return while US equities were cut in half. Their worst moment was during the housing crisis when they declined as an asset class by 47%.

REITs also shined during the 1970s inflation, which led to an abysmal return for US equity investors. During the 1970s, REITs delivered an 11.32% rate of return.


The Building Blocks

According to Swensen, the “core asset classes” are the critical building blocks of a portfolio. They will rarely all work at once. An investor will be diversified across asset classes, and the different asset classes will all work their magic at different times.

The bonds exist as protection during stock drawdowns. TIPs have the added benefit of protecting an investor during inflationary periods. Longer termed treasuries will protect the investor during panics or truly horrific deflationary episodes, like 1929-32.

Meanwhile, the rest of the portfolio is divided up into asset classes that should deliver a very high rate of return. The nice thing about the asset classes that Swensen selected is that they don’t all perform well at the same time.

When stocks absolutely sucked during the 2000s and barely beat inflation, REITs and international equities still performed very well. During the 2010s, US stocks did great while international stocks sucked. If we have a repeat of the 1970s, stocks will probably be crushed, but REITs and TIPs will pick up the slack. Ideally, the approach should help an investor avoid “lost decades” like US stocks not delivering any return in the 2000s. You’ll always hate something in your portfolio, but you’ll also probably have something to love in your portfolio.

Most importantly, you can buy all of these asset classes directly through low-cost mutual fund and ETF vehicles. You’re not doing anything fancy with options or hedging. You don’t need to pay excessive fees to someone to do this for you. All of these asset classes are available in most 401(k) lineups, as well.

An added advantage is that these can all be easily managed. A small investor can do this themselves without any help.

DIY Asset Allocation

Swensen recommends that an investor hold no more than 30% of an asset class in their portfolio. This allows the diversification to work. It prevents one asset class from dominating the portfolio. Swensen’s specific recommendations are as follows:

US Stocks – 30%

Foreign Developed Stocks – 15%

Emerging Markets Stocks – 5%

REITs – 20%

US Treasury Bonds – 15%

US Treasury Inflation Protection Securities – 15%

Here is how you can construct this portfolio using simple, low-cost Vanguard ETF’s. You could also do this with mutual funds. My preference is for ETF’s because they maximize your tax benefit. The simplicity is key here: you could rebalance this once a year in your underwear. Investing is one area of life where it actually pays to be a little lazy and not meddle too much.

US Stocks – The Vanguard ETF for US stocks is VTI.  The mutual fund equivalent is VTSAX. Many of the FIRE bloggers recommend putting 100% of your net worth into one of these. Personally, I think that’s fine if you have a long time horizon. However, if you’re already retired, you probably don’t want to be in an asset class that could potentially do nothing for 10+ years and would benefit from diversifying into more asset classes. The expense ratio is a dirt cheap .04%.

International Developed – The Vanguard international developed ETF is VEA. The expense ratio is .07%.

Emerging Markets – The Vanguard emerging markets ETF is VWO. The expense ratio is .14%.

Side note: Alternatively, you could replace the three equity ETF’s above with one ETF – Vanguard Total World Stock Index, VT. This is a market cap weighted index of all stocks in the entire world for an expense ratio of .1%. Currently, the portfolio is 60% in US stocks, 10% emerging markets, and 30% international developed. If this ETF is 50% of your portfolio – you will get right to Swensen’s recommended allocations. 30% of your portfolio will be in US stocks, 15% will be in international developed, and 5% will be in emerging markets. Of course, these allocations won’t remain static and will fluctuate based on the performance of countries within the global portfolio, but it seems like a much easier way to simplify a Swensen portfolio with one equity ETF instead of three.

REITs – The Vanguard real estate ETF is VNQ. The expense ratio is .12%.

TIPs – The Vanguard TIPs fund is VTIP. The expense ratio is .06%.

Treasuries – Swensen doesn’t specifically recommend long-duration treasuries in the book. My preference for long-term treasuries is merely because they will do the best when the markets fall apart, which is the whole reason they’re in a portfolio. Vanguard doesn’t have an ETF for long duration treasuries, but they do have a mutual fund, VUSTX. The expense ratio is .2% on the investor shares. iShares has an ETF for long duration Treasuries, TLT. The expense ratio on that is .15%. If you want to follow Swensen’s advice and own treasuries of all durations, there is also an iShares product called GOVT.

Backtesting Swensen

How have Swensen’s allocations performed over time?

Since 1985, when the data is available for his recommended mix of asset classes (the TIPs returns are made up from 1985 through 1997 based on inflation rates), the Swensen portfolio has returned 9.77%. After inflation, 6.99%. $10,000 invested in the Swensen allocation in 1985 would be worth $238,007.

The worst year for the portfolio was 2008, in which it lost 26.58%. The total US stock market lost 37% during that period, and REITs were cut in half, while a 60/40 portfolio lost 20%. Before the global financial crisis, the worst year for the Swensen portfolio was a loss of only 6.92%. This occurred during the early 2000s meltdown when US-only equity investors saw their portfolio cut in half.

The portfolio really shined during the 2000s, when US stocks did nothing. The portfolio achieved a return of 6.88% from 2000 to 2010, or 4.34% after inflation.

TIPs didn’t exist in the 1970s, but substituting Swensen’s bond allocation for intermediate-term treasuries, the Swensen portfolio would have delivered an 8.26% rate of return and a small return of .41% over inflation. This is during a period where double-digit inflation led to losses across nearly every asset class. Moreover, the Swensen portfolio did this when bonds were crushed due to rising interest rates. The fact that it kept up with inflation at all is impressive. If TIPs existed back then, I would guess that the portfolio would have done even better.

Since the book was published in 2005, the portfolio has continued to do well. It has returned 6.68% or 4.56% after inflation.

Other Considerations

Taxes – Avoiding taxes is a significant consideration for most. The bond and REIT allocations will generate most of their return via dividends, not capital appreciation. If you hold them in a taxable account, you will have to pay taxes on the payments every year. To avoid this, you might want to consider carrying them in a non-taxable account like an IRA or 401(k).

Other asset allocations – Swensen’s allocations aren’t the holy grail of passive investing. There are other alternatives. Meb Faber and Eric Richardson cover a lot of interesting allocations in The Ivy Portfolio. Meb even has an ETF that covers his recommended asset allocation, which he dubs the global asset allocation, GAA. Another great book on the subject is DIY Financial Advisor from the great people at Alpha Architect.

Tweaking it – If you’re like me, you like to test and tweak things yourself. For instance, my preference is to gear my passive equity allocations towards value. US small cap value is the best performing asset class of all time. Since 1927, small-cap value has delivered a 10.93% rate of return. Why not gear more of my portfolio towards that? Or, you might want to set aside some of your portfolio to buy a portfolio of value stocks, like I did. If that’s not your bag, maybe you want to try trend following and momentum, even though I think that’s hocus pocus and nonsense.

There are some great resources available to experiment with your own allocation. One great resource is Portfolio Charts, a helpful visual resource where you can analyze different asset allocations from the Vanguard Three-Fund Portfolio to the classic 60-40, and it includes an analysis of the Swensen allocation. The author also maintains an excellent blog discussing asset allocation.

If you want to get deeper than that and experiment with more asset allocations, there is this resource at the Bogleheads forum. This is what I used to generate the return data listed through the blog post. You can experiment in that Excel spreadsheet with all different kinds of allocations.


There is no holy grail to investing. If you’re looking for a simple, low cost, easy to implement portfolio that doesn’t require a lot of work – the Swensen portfolio is a great place to go. Odds are, you’ll avoid “lost decades” and will preserve your capital over a long period.

As I stated before, 100% US equities might work for the FIRE bloggers, but I really think more of them should consider a more diversified asset allocation. They can’t afford lost decades, after all.

If you’re crazy like me, you also like picking your own stocks or pursuing a pure quant based approach like the Magic Formula or Acquier’s Multiple. Personally, I explicitly set aside this account that I track on the blog to buy and sell shares. My 401(k) and taxable account are in more of a diversified asset allocation like Swensen’s. My equity allocations are (obviously) geared towards value.

The bottom line is that you have to find what works for you. Good luck on your journey.


This wouldn’t be one of my blog posts if I didn’t throw in something completely random. This is pretty funny.

PLEASE NOTE: The information provided on this site is not financial advice and it is for informational and discussion purposes only. Do your own homework. Full disclosure: my current holdings.  Read the full disclaimer.

“Saudi America” by Bethany McLean


The Book

I recently finished “Saudi America” by Bethany McLean. The book was excellent, timely, and aligns with my interest in the subject of energy. The book tells the story of the renaissance of American energy production that occurred in the last 10 years as a result of fracking.

The book is exceptionally current and fresh. Bethany talks in depth about very recent events, such as the rise to power of MBS in Saudi Arabia and the Trump administration’s odd obsession with coal.

The book doesn’t take sides and presents all sides of the argument. Bethany shows the side of the fracking optimists: those who think that the United States has a vast energy supply that we’ve barely scratched the surface of. The energy supply could end our connection with the Middle East and lead to American dominance of global energy production.

There is the other side of the argument: the environmentalists and short-sellers like David Einhorn who don’t believe that fracking can generate enough free cash flow to be sustainable, and she also shows that a world of destabilized oil powers isn’t necessarily a good thing for the United States. Saudi Arabia, for instance, uses their oil wealth to supply their population with bread and circuses. If the Saudis went bust, do we really want the country to become unstable and slip the region into more chaos than it already is?

The book doesn’t come to firm conclusions and presents all sides of the argument. This is chiefly because the story isn’t over yet. We don’t know how all of this will shake out and this is a new, revolutionary development.

For all of the books written about social media and the growth of the internet in the last decade, I’m shocked that more people haven’t tackled the incredible phenomenon of the U.S. energy boom. While the media is obsessed with our smartphones and Facebook, this energy renaissance is the most important economic and geopolitical story of the last 10 years. The impact is more far-reaching and significant than the phenomenon soaking up all of the media attention lately: crypto, social media, and the 24/7 cable news cycle focused almost exclusively on unimportant shenanigans in Washington.

Peak Oil Worries

I was attracted to this book due to my fascination with the concept of peak oil. I first encountered the idea of peak oil in high school in the late ’90s and have been obsessed with it ever since.

The idea of peak oil is simple. There is a fixed amount of oil on the planet. When it peaks, we inevitably need to reduce our use of it. This is problematic because nearly all of the improvement in human living standards over the last 200 years was caused by capitalism combined with human beings figuring out how to harness fossil fuels.

Per capita GDP was flat for more of human history. Then, in 1800, it began increasing exponentially. For most of human history, people were really just expensive livestock. Every person was another mouth to feed, and most of our ancestors lived lives that were miserable, poverty-stricken, and short. We take our standards of living for granted today. It’s truly staggering to imagine that most of the human race for most of history lived in a state of extreme, grinding poverty.

The growing and widespread use of fossil fuels changed the dynamic.

Everything we enjoy about the modern world is made possible because we can harness fossil fuels. This makes the inevitable reality horrifying: at some point, we will run out of them. Estimates vary, but the Earth only has so many hydrocarbons in it. At some point, our use of fossil fuels will peak. This is what is the theory behind peak oil: at some point, our extraction of it will be peak and with it, our civilization.

This is the future pictured in the Mad Max films. A brutal, post-apocalyptic world where we’ve burned all the fossil fuels and the return of the scarcity the characterized most of human history. It’s also the future depicted in Ready Player One, which described a decades-long Depression caused by the exhausting of our energy reserves.

The chief proponent of peak oil was M. King Hubbert. He theorized in the 1950s that the U.S. would peak in oil production around 1970 and it would decline from there. It turned out that he was correct. Conventional U.S. oil production peaked around 1970 and then entered a steady rate of decline.

The U.S. itself did not reign in its thirst for oil. We sought more oil from the world, chiefly Saudi Arabia. The Saudis had an ocean of oil which we increased our dependence upon. The biggest field in Saudi Arabia is the Ghawar oil field, which pumps out 5 million barrels of oil a day.

Since U.S. oil production began declining in the 1970s, President after President paid lip service to “energy independence” and did little about it. In practical terms, the only real legislation passed to encourage U.S. energy independence was a ban on U.S. energy exports in 1975.

While U.S. production peaked in 1970, there were many competing theories for when world energy production would peak. I worried in the mid-2000s that peak oil was upon us and the peak of our civilization had been reached.

In the summer of 2008, I was cash-strapped and paying $4 a gallon for gas. I watched the money drain away, and I thought to myself: this is it. This is peak oil.

Not the peak, after all

I was wrong. Oil production did not peak in 2008. In fact, the U.S. was about to undergo an energy renaissance that would wind up reshaping the world.

The oil production that was long on the wane in the United States wound up turning around. At this point, U.S. oil production now exceeds the 1970 peak.


Catalysts of the Revolution

What caused the fracking revolution? This is a question that Bethany answers in depth in the book. The answer is two-fold: cheap capital made available from Wall Street combined with technological ingenuity.

The first catalyst was technology. The technique of fracking involves breaking apart rocks underground and unleashing natural gas and oil trapped within the rocks. The rocks are “fracked” and broken open and the gas/oil is unleashed. The tech and engineering behind it are over my head, but the fracking technology which existed since the 1940s had advanced in the 2000s to the point where it was economical to pursue in the United States. Oil prices also increased to a level where the technology was worth the investment.

The second catalyst was cash.

After the financial crisis, with interest rates at historic lows, Wall Street wanted to lend money. They wound up lending a large amount of high yield debt to the frackers. The money flowed into fracking ventures of various kinds, from the semi-respectable to the dubious.

Critics like David Einhorn believe that fracking will never generate sufficient free cash flow to be sustainable. In other words, the frackers will be destroyed by the high capital expenditures involved in successfully pursuing fracking.

When oil prices collapsed in 2015, it appeared that the shorts may have been correct. Many frackers went bankrupt. Others used it as an opportunity to restructure their loans.

The pessimists were disappointed, though. Fracking wound up surviving, but it’s unclear if this is a testament to the fiscal soundness of their operations or the willingness of Wall Street to throw cheap money around for the purpose of minting fees.

The new era was solidified in December 2015 when the 1975 ban on drilling was lifted. This was a momentous decision that was barely covered in the press. The era of declining U.S. energy production which began in the 1970s was over.

The Future

The future for fracking is uncertain. No one is sure how much oil exists within our shale deposits. Estimates vary wildly. The optimistic projections estimate that the U.S. contains trillions of barrels of oil. To put this in perspective, the Saudis produce about 10 million barrels of oil per day.

Skeptics believe that these estimates are too optimistic. They also think that fracking still hasn’t demonstrated its ability to generate cash flows that exceed the cost of capital.

Another concern is that regardless of the estimate, the supply of oil is finite and we will run out of it. At the end of the book, Bethany cites Charlie Munger, who advises prudence. He makes a good point that oil is used heavily in our farming industry and, because of this, it is one of the most precious resources that we should use prudently. Munger explains:

“Every barrel that you use up that comes from somebody else is a barrel of your precious oil which you’re going to need to feed your people and maintain your civilization. You want to produce just enough so that you keep up on all of the technology. And you shouldn’t mind at all paying prices that look high for foreign oil. You will be better off because you delayed gratification, instead of grabbing for it like a child.”

There are also environmental concerns. The burning of fossil fuels makes modern life possible, but it is also contributing to climate change and threatens our long-term survival as a species.

The story of the American energy revolution isn’t over, which is why the book doesn’t try to moralize and clearly define who is right and who is wrong. It tells the story. It also contains fascinating portrayals of the characters involved: from the risk-taking fracking executives to the skeptical short sellers.

From my point of view, I think Munger (as usual) is right. We should exercise prudence even if our newfound energy supply is abundant.

Oil is a critical, precious, non-renewable resource. We shouldn’t waste it. As a nation, we need a coherent energy policy that seeks to produce as much energy as possible without the use of fossil fuels. We need to plan for the reality that, eventually, we’re going to run out of it. It might be 50 years from now. It might be 200. Regardless of when it happens, the end is coming and, for the sake of our children, we should develop a coherent plan to deal with that future. When we run out of oil, it could potentially have far-reaching economic implications. Let’s mitigate those consequences. Let’s plan for the future.

Prudence will likely lead to a better world. We don’t want to live in the world of Max Rockatansky.

Whether you agree with me or not, I recommend Bethany’s book. It will give you perspective on the most important economic event of the last decade and help you come to your own conclusions.

PLEASE NOTE: The information provided on this site is not financial advice and it is for informational and discussion purposes only. Do your own homework. Full disclosure: my current holdings.  Read the full disclaimer.

“Margin of Safety” by Seth Klarman


Seth Klarman

I recently finished Margin of Safety: Risk-Averse Value Investing Strategies for the Thoughtful Investor by Seth Klarman.

Seth Klarman is a legend. Since the early ’80s, he has delivered a 16% CAGR for his investors. This is amazing considering the size of his fund (Baupost manages $30 billion) and the fact that he frequently holds a lot of cash during bull markets.

He stayed true to his value investing roots. Among the big billionaire “guru” investors still alive today, Klarman is the true disciple of Benjamin Graham-style value investing. While most value investors eventually “graduate” from cigar butt value investing to Buffett-style long-term investing in companies with moats and high returns on invested capital — Klarman stuck to cigar butts. This is particularly interesting considering that he manages $30 billion at his firm, Baupost Group. Usually, the shift from cigar butt investing occurs because it’s no longer scaleable as investors manage too much money. Klarman has been able to keep the party going.

Klarman finds companies that are at a cyclical nadir and sells them once their fortunes have improved. He also does extremely sophisticated investing in things like distressed debt.

He is a quiet guy that doesn’t grant a lot of his interviews. He focuses on his craft and delivers his returns to investors, largely shunning the limelight. Due to the lack of interviews and his legendary investing returns, value investors have been hungry for information about him and his process. They find it in his 1991 book, “Margin of Safety”. The book only sold 5,000 copies when it was originally published and was never re-issued. Due to the small number of copies and the legend of Klarman, copies of the book now sell for $800-$1,000 on Amazon.

I’ve read the classics of value investing and this was one of the few I didn’t read in its entirety. I was glad I did. I think a better title for this book would be “The Intelligent Investor 2.0″. It’s very much a more modern reiteration of the same principles outlined by Ben Graham in “The Intelligent Investor”.

Other possible titles: The Intelligent Investor 2: Electric Boogaloo. The Intelligent Investor 2: Invest Harder. The Intelligent Investor 2: Attack of the Speculators.

Acquiring & Reading the Book (If you want to learn about Margin of Safety, you can skip this ridiculous story)

Getting my hands on a copy of the book was not easy. I found it in Prague and tried to acquire it with a trusted team of colleagues. Unfortunately, we failed. When the situation went bad, my colleagues were murdered in an awful sequence of events. After failing the first time, I tracked down the book to a train moving along the Chunnel in France. The person who had the book tried to escape from the top of the train to a helicopter via a tether. I tied the tether to the train, forcing the helicopter into the Chunnel itself. I acquired the book and then destroyed the helicopter via a chewing gum explosive.

Fearing that the book’s wisdom could be dangerous, I went to a remote cabin to read it. Once I reached the cabin, I read the book out loud. The text was so powerful that it summoned demons, who assaulted me. The ensuing battle with the army of the undead caused me to lose my arm, which I promptly replaced with a chainsaw. Ultimately, the battle opened up a vortex to the year 1300, but that’s another story.

This is actually the plot of the first “Mission Impossible” movie combined with the “Evil Dead” film series.

I read the book on the beach and it was quite pleasant. Anyway, on to the book review!

Speculation vs. Investing

One of the first points that Klarman stresses is the difference between speculating and investing.

As Klarman sees it, understanding this distinction is the key to long-term success. You should ask yourself before making a decision: is this an investment or is this a speculation? I’ll bet that if you asked Klarman, he would say that if you get anything out of the book, understanding this difference is the most important.

What is the difference between speculating and investing? Seth sums it up with this:

“Investments throw off cash flow for owners. Speculations do not. The returns to speculations depend exclusively on the vagaries of the resale market.”

In other words, investments are something for which you can actually calculate a margin of safety or a yield. Your calculations might be wrong, the investment might not be successful, but at least you have a clue about what to expect. Bonds, stocks, private businesses, real estate (with cash flows in the form of rent) — all of these have a defined rate of return. You can figure out what they are worth and purchase them with a margin of safety.

Speculations, in contrast, are things for which your return is dependent solely on what someone else will pay in the future. Obvious examples are collectibles or art. There is no way to determine based on math and financial statements what they are worth. Whether it is a beanie baby or a Picasso, there is no way to determine a margin of safety.

Other, less obvious examples, are respected investment categories like commodities. Buffett frequently makes this point about gold. Gold sits there and doesn’t throw off any cash flow that you can use. There isn’t a way that you can calculate a margin of safety. It’s the same for oil. The asset itself doesn’t produce anything. There isn’t any way you can purchase gold or oil and have a margin of safety.

Real estate doesn’t have a margin of safety unless you plan on renting it out in which case the asset generates cash flow. If you’re buying a house because real estate is “hot” and you think the price will go up, then you’re a speculator.

Cryptocurrency would be another example of speculation. Bitcoin, Ripple, Ethereum. Say what you will about the future of blockchain, but your return on these assets are solely dependent on what other people will pay and there is no way to generate a margin of safety.

Speculations can work out. You can make a lot of money speculating, but keep in mind that it is speculation. The outcome was never certain. There is a high likelihood that the “winners” in speculative assets were simply lucky. Their tales of easy wealth are nothing but survivorship bias.

Graham makes the same points in The Intelligent Investor, but his definition is vaguer. Klarman gets very specific on what is and isn’t investing. The cash flow definition is a great way to think about it.

Of course, the differences between what is speculation and what is investing could be hotly debated. For me, I think Klarman’s definition makes a lot of sense. Examining financial decisions through the “investing vs. speculation” template would likely help many investors avoid a lot of trouble.

If you take a look at an opportunity and it is more of a speculation than an investment, it’s probably a good idea to move on. Only invest in assets for which you can calculate a margin of safety.

Wall Street is not your friend

“If you depend on Wall Street to help you, investment success will remain elusive.”

Klarman points out clearly that Wall Street is not the friend of investors and you should treat their advice and their products with caution. They exist to generate revenue for themselves: typically via underwritings. They are incentivized to earn fees and commisions which often come in the form of investment fads. They do not exist to generate returns or control risk for individual investors.

Seth suggests avoiding IPO’s entirely. When you think through it, investing in IPO’s is nearly always a dumb idea because: 1) The company is going public at a good time for them and they are incentivized to get the best price possible. They aren’t attempting to create a margin of safety for you. 2) The business is often unproven and the investment in the IPO is a speculation on the future, which is unknowable.

Sure, every now and then, you’ll hit a home run like Google, Facebook, or Microsoft. Those home runs are impossible to predict. Klarman explains:

“Investors even remotely tempted to buy new isssues must ask themsleves how they could possibly fare well when a savvy issuer and a greedy underwriter are on the opposite side of every undewriting. Indeed, how attractive could any security underwriting ever be when the issuer and underwriter have superior information as well as control over the timing, pricing, and stock or bond allocation? The deck is almost always stacked against the buyers.”

The history of Wall Street is a history of fads that end badly for investors and every bull market has a new take on the oldest stories in Finance. Klarman spends a lot of time discussing the investment fads of the 1980s: namely, the junk bond craze and the corresponding bad behavior that went along with it. If you want to read more about the behavior of this time period, I would recommend reading Liar’s Poker by Michael Lewis. The Predator’s Ball and Den of Thieves are also good summaries of the period.

While Klarman focuses on the insanity of the 1980s, it’s important to keep in mind that every bull market exhibits this kind of behavior. What’s important for investors is to identify this behavior and avoid it.

Klarman also warns against Wall Street research. Wall Street research departments have a bullish bias. This exists for a few reasons, but chiefly it is because they have a vested interest in stocks increasing and they want to maintain close relations with companies so they can generate income from new issues of debt and equity.

He points to an example of Marv Rothman, who was fired from his job as an analyst at Janney Montgomery Scott in 1990. Marv wrote a critical analysis of Donald Trump’s casino empire, arguing that Trump was overleveraged and wouldn’t be able to meet his debts. Marv turned out to be correct, but he was fired because his firm wanted to make deals with Trump to generate income.

This continues to this day. Consider the bullish ratings on Enron that went on to nearly the very end or the lack of “sell” ratings in all market environments.

As Gordon Gekko put it, if you want a friend, get a dog. Wall Street and much of the financial world is not your friend. There are certainly good people on Wall Street and the financial world, but your instinct should be cautious. As Ronald Reagan put it, “trust but verify”.

“Like dogs chasing their own tails, most institutional investors have become locked in a short-term, relative-performance derby.”

Klarman also points out that Wall Street is entirely focused on short-term performance. They obsess over how much they lag the market benchmarks. This causes them to operate as a herd, buying and touting the same investments like lemmings to avoid falling behind the averages.

You see the herd behavior not only in individual stocks but in entire investment classes. In the late ’80s it was Japan. In the mid-2000s obsession with emerging markets, the late ’90s obsession with dot-coms, or the current obsession with cryptocurrency and disrupters. They use the same buzzwords, they invest in the same things. A good investor ignores this noise.

He also points out that the more money an institutional investor manages, the less likely it is that they can deliver impressive results. They also engage in “performance dressing,” whereby at the end of every quarter and year they try to stuff their portfolios with the best-looking stocks and discard the weakest performers. This is the opposite of what a savvy investor would actually do.

Fortunately, Klarman believes that these activities and these flaws can be exploited by smaller investors. By looking at what Wall Street is getting rid of recklessly (like panic selling in a stock getting thrown out of an index, spin-offs sold without rhyme or reason, etc.) there is often value in these situations.

“Picking through the crumbs left by the investment elephants can be rewarding.”

Margin of Safety = Avoidance of Losses

“Most investment approaches do not focus on loss avoidance or an assessment of the real risks of an investment compared with its return. Only one that I know does: value investing.”

In Klarman’s view, the most critical aspect of value investing as an investment philosophy is the avoidance of losses. In Klarman’s view, the purpose of buying stocks with a margin of safety is the minimization of risk. The margin of safety is thought of as a margin for being wrong.

“The problem with intangible assets, I believe, is that they hold little or no margin of safety.”

Klarman is a classic cigar butt value investor. He is skeptical of the Buffett approach which emphasizes enduring value created by strong franchises and moats. Klarman believes in classic Graham-style investing. He believes you should wait until you have a clearly defined margin of safety and only buy when a sufficient margin exists.

“Sometimes dozens of good pitches are thrown consecutively to a value investor. In panicky markets, for example, the number of undervalued securities increases and the degree of undervaluation also grows. In buoyant markets, by contrast, both the number of undervalued securities and their degree of undervaluation declines.”

Klarman agrees with Buffett’s view that the key to investing is “waiting for the right pitch”. In other words, securities markets constantly offer new securities at different prices. You don’t have to figure out every situation as you don’t have to swing at every pitch. You don’t have to swing at every one. You don’t have to remain fully invested.

Klarman vs. Academics

“Value investing is, in effect, predicated on the proposition that the efficient market hypothesis is wrong.”

“Even among the most highly capitalized issues, however, investors are frequently blinded by groupthink, therebycreating pricing   inefficiencies.”

Klarman thinks that the efficient market hypothesis is bunk. The academics argue that markets are mostly efficient and incorporate all available information at any given time. There are therefore no “mispriced securities”. Klarman dismisses this.

“Technical analysis is indeed a waste of time.”

Additionally, Klarman also dismisses the entire field of chart reading and technical analysis. A chart is a reading of Mr. Market’s sentiment about a stock. He believes that you should try to profit from Mr. Market’s folly and not pretend that there is an wisdom that can be gleamed from a chart. Time is better spent researching the business and attempting to determine your margin of safety.

“I find it preposteorous that a single number reflecting past price fluctuations could be thought to be completely describe the risk in a security. Beta views risk soely from the perspective of market prices, failing to take into consideration specific business fundamentals or economic developments.”

“If you are buying sound value at a discount, do short-term price fluctuations matter? In the long run they do not matter much; value will ultimately be reflected in the price of the security.”

Klarman is also strongly critical of the academic’s notion of “beta”. Academics view beta as the underlying volatility of a stock and that is their preferred measure of risk. Klarman believes this is bunk and thinks you should focus on risk in the sense of (1) whether or not the business itself can cause a permanent loss of capital or (2) if you are making the purchase with a margin of safety.

What was the beta of mortgage-backed securities before their collapse? They likely showed very little volatility, but this was meaningless as the underlying underwriting standards were collapsing.

I majored in Finance in college and the focus of the curriculum was almost entirely on the different aspects and permutations of the efficient market hypothesis. I didn’t believe it then and I don’t believe it now. Looking at the history of markets, I see absolutely no evidence that they are efficient. We witnessed a bubble in internet stocks, a bubble in real estate and now we’re witnessing a bubble in cryptocurrencies. The markets are insanely volatile and will continue to do so. 50% drawdowns occur once every 20 years. 20-30% reductions occur once every 5 years. The underlying businesses that make up the indexes haven’t experienced this level of volatility. Mr. Market is a far more instructive way to describe markets than the capital asset pricing model.

As Joel Greenblatt likes to point out, look at the 52 week highs and lows of popular stocks. Did the actual business prospects of those firms experience the wild price swings of their stocks? Of course not.

Value Investment Philosophy

“Value investing is a large-scale arbitrage between security prices and underlying business value.”

“Value investing is simple to understand but difficult to implement. Value investors are not supersophisticated analytical wizards who create and apply intricate computer models to find attractive opportunities or asses underlying value. The hard part is discipline, patience, and judgment.”

Klarman identifies three key components of a value investment strategy:

  1. Bottom-up investing. Klarman recommends ignoring macroeconomics and focusing on specific businesses. He refers to this as “bottom-up” investing. Starting with the company itself, then worrying about the macroeconomy. This is in contrast to “top-down” investors who focus on the macro picture. As Klarman sees it, this is simply too hard for anyone to successfully implement over time. I believe he’s right. Think of all of the so-called “gurus” of macro who predicted the 2008 crisis. Have any of them been able to successfully forecast the last decade of a bull market? Most of them predicted unrealized bouts of hyperinflation and saw bubbles in everything from commercial real estate to municipal bonds.
  2. Absolute performance orientation. Klarman thinks you should ignore the rest of the market completely and focus on your own returns. Concentrating on what the rest of the market is doing can cause you to make stupid decisions to keep up with other investors. The reason that professionals frequently underperform the averages is, ironically, because of their relative performance orientation. Focusing on relative returns prevents them from doing anything differently than the averages.
  3. Paying careful attention to risk. Risk is defined not as the academic notion of beta, but the probability and amount of loss due to permanent value impairments.

Business Valuation

“Business valuation is a complex process yielding imprecise and uncertain results. Many businesses are so diverse of difficult to understand that they simply cannot be valued. Some investors willingly voyage into the unknown and buy into such businesses, impatient with the discipine required by value investing.”

After discussing the merits of valuing a business separate from the market price, Klarman goes on to provide his opinion about different methods of business valuation. He examines the different forms of business valuation and looks at it as a complex art. Different valuation techniques should be used for different kinds of business. There isn’t any kind of “one size fits all” approach to valuation. Most importantly, Klarman recognizes that some businesses cannot be valued. A fast-growing company with a brand new product, for instance, is impossible to value correctly because there are simply too many unknowns. Valuation is hard enough to figure out with a stable company, let alone brand new companies with a million different rapidly changing variables.

  1. Liquidation value – Liquidation value, net current asset value, or net working capital is the purest measure of a business’s worth. In Klarman’s view, the best time to use this analysis is when the business is unprofitable.
  2. Net present value – He suggests using net present value when looking at a very stable business with predictable cash flows. In other words, a net present value or assessment of discounted cash flows should not be used in all circumstances. It should only be used if the business is predictable and the assumptions are extremely conservative. It is easy to game this kind of analysis, so it is important to use this with caution and conservatism.
  3. Earnings – Klarman cautions against earnings provided by the business as they are frequently subject to manipulation by unscrupulous management. It’s important to dig into the earnings and assess whether or not they are real.
  4. Book value – Klarman cautions against the use of book value as the value on the balance sheet isn’t necessarily accurate. Inflation can rapidly increase the price of real estate holdings, for instance. Technological change can rapidly depreciate the usefulness of plant, property, and equipment. These changes aren’t always captured on the balance sheet. Klarman doesn’t look at book value alone as a particularly useful tool for assessing the worth of a business. Balance sheet analysis should be deeper.
  5. Dividend yield – Klarman cautions against looking solely at dividends in assessing value. He points out that some businesses are simply terrified to cut a dividend even if the business is falling apart, which in effects turns the dividend into a liquidation that ultimately destroys value.

Finding Value Opportunities

“Computer-screening techniques, for example, can be helpful in identifying stocks of the first category: stocks selling at a discount from liquidation value. Because databases can be out of date or inaccurate, however, it is essential that investors verify that the computer output is correct.”

In the hunt for areas that value investors can exploit, Klarman recommends a number of key areas. The first, and most obvious, is looking for cheap stocks with the use of screening. Klarman restricts this to liquidation or net-net scenarios, but I believe that the use of screening among other methods of statistical cheapness is just as valid.

However, Klarman cautions that you should investigate the numbers in the screener for yourself. Find the financial statements (which you can easily do at and confirm that the numbers match the valuation output from the screener.

Klarman believes that you should research an understand your positions, but also cautions against doing too much work. There is only so much that can be known and the research process is subject to diminishing rates of return. This is also a reason that we should buy stocks with a margin of safety. Because all of the facts aren’t knowable, it’s important to have a margin of error built into the analysis.

“Out-of-favor securities may be undervalued; popular securities almost never are. What the herd is buying is, by definition, in favor.”

In the hunt for investments, he mentions many of the same areas covered more in-depth in Greenblatt’s You Can Be a Stock Market GeniusYou can read my review of that book here.

He talks about many of the same things as Greenblatt: spin-offs, share buybacks, recapitalizations, asset sales, bankruptcies, liquidations. He also discusses thrift conversions (an area exploited by Ed Thorp as explained in A Man for all Markets).

Klarman also devotes a chapter to discussing the value in distressed debt. I actually work in operations for a bank and deal extensively with distressed debt. He’s right: the opportunities are enormous. Unfortunately, they are difficult to exploit for small-time investors. Usually, you need to be an accredited investor to buy these assets. They are also subject to minimum transfer requirements, which are normally at least $1 million. For hedge funds and big investors like Klarman, they are an attractive area to exploit. For small investors like myself, not so much.

Klarman can also hire forensic accountants and lawyers to dig into distressed situations and find out if there is any underlying value. This is simply beyond my capabilities or those of most small investors.

With that said, it is still fascinating to read his process and how he categorizes the different types of distressed opportunities.


I highly recommend that you read a copy of Margin of Safety. There is a reason that the book is so feverishly sought after. Klarman clearly communicates the key principles of value investing for small investors.

To summarize some of his key points:

  • Clearly understand the difference between investing and speculation. Avoid speculations at all costs. An investment is something which currently (or will in the future) generate cash flow and a speculation is an asset that generates no cash flow for which you are attempting to re-sell at a higher price in the future.
  • Margin of safety is designed to minimize losses and controls for your investment thesis being wrong. The future is unknowable and a margin of safety is a way of protecting yourself from what could go wrong.
  • Business valuation is complex and can involve many different kinds of analysis. There is no one-size-fits-all approach. It’s important to use the appropriate technique (or overlapping techniques) depending on the situation you are presented with. Avoid situations where value cannot be calculated.
  • When dealing with financial professionals and Wall Street, always remember that they are not on your side. Avoid Wall Street fads. Do your own homework. Remember that investment professionals and Wall Street firms have their own incentives which may not align with yours.
  • The efficient market theory and the concept of beta are nonsense.
  • Avoid top-down macroeconomic analysis. Macro is too hard and there is too much room for error. Bottom-up investing on a case by case basis will lead to better results. I’m definitely guilty of this, but do my best to try to avoid it.
  • Adopt an absolute performance orientation. Constantly comparing your returns relative to a benchmark over short-term time periods can lead to bad decisions in an effort to keep up. The irony here is that focusing on absolute returns ends up crushing the averages over long stretches of time, as Klarman proved throughout his career. I admit this is hard for me after lagging the S&P 500 last year, but I know it’s something I need to constantly keep in check. The biggest challenge in investing is managing your emotions.
  • Klarman thinks technical analysis is a waste of time and I agree with him. A stock chart is a reading of Mr. Market’s sentiment. Value investors are trying to profit from Mr. Market’s folly. Reading the chart is getting get sucked into Mr. Market’s insane game. You are trying to exploit Mr. Market, not get caught up in his capacity for manic euphoria and bouts of depression. In the time you spend trying to find head-and-shoulders patterns, finding Fibonacci sequences, consulting tarot cards, looking at astrology, applying calculus to chart movements, calculating Elliot Waves, comparing a chart to 1987 or the Nikkei, etc. – you could be researching the business and trying to asses value.

Unrelated. This is great:

PLEASE NOTE: The information provided on this site is not financial advice and it is for informational and discussion purposes only. Do your own homework. Full disclosure: my current holdings.  Read the full disclaimer.

“You Can Be a Stock Market Genius” by Joel Greenblatt


The Book

“You Can be a Stock Market Genius” is Joel Greenblatt’s classic 1997 book. Don’t be dissuaded by the ridiculous title. This is a money making handbook for the small investor who is willing to get their hands dirty and do a lot of homework.

Joel Greenblatt is one of the best investors of all time.  I reviewed another book of his: The Big Secret for the Small Investor in this blog post.

The two books have the same philosophical value investing orientation but are polar opposites in terms of difficulty. The Big Secret is for passive buy-and-hold investors who don’t want to deal with all of the homework of actively picking stocks. You Can Be a Stock Market Genius is a homework-intensive strategy that Joel employed when he was running his hedge fund from 1985-1995 and achieved 50% annual returns.

No passive strategy will get you 50% returns. No systematic quantitative approach will get you 50% returns. Achieving that kind of stellar performance requires a hell of a lot of work and luck. The book is Joel’s outline of the various hunting grounds that he used to generate those amazing returns.

The Small Investor’s Advantages

The book opens with an inspiring message. The small investor has advantages over prominent professionals. Big professionals managing billions of dollars in capital can’t: (1) concentrate in a handful of small positions, (2) take the career risk of dramatically underperforming the benchmark (they’ll get fired), (3) won’t invest the time and resources necessary to investigate weird and tiny situations that they can’t allocate a significant portion of their capital to.

A small investor can do all of those things.

In a world where ETFs with 50 positions are considered “concentrated”, Joel’s definition of “concentrated” is wildly different than the mainstream view. The mainstream view is that “risk” is volatility of returns and “risk” can be reduced by holding more positions. Joel suggests that as few as 8 stocks in different industries is sufficient to properly diversify a portfolio.

8 stocks would result in so much volatility that it would be career suicide for any professional investor. Most people can’t handle volatility. A small investor with the right temperament can. Unfortunately, most small investors squander this advantage. We’re never going to beat Wall Street at their own game: namely, smoothing out returns and reducing volatility (i.e., pain) with fancy financial engineering.

What we should do is focus on the advantages that we have: (1) Temperament – If we have the proper temperament to endure volatility, we can achieve better results. (2) Size – If we’re willing to focus on areas that are hated and ignored, roll up our sleeves and do the work, we can concentrate in situations that Wall Street pros can’t.

I did some backtesting of my own a few months ago to test the limits of concentration. I looked in a Russell 3000 universe with a straightforward strategy of buying the cheapest stocks on an EV/EBIT basis. I constructed portfolios rebalanced annually beginning with 1 stock (the cheapest in the universe) and then just adding the next cheapest. I then plotted the monthly standard deviation of returns (Wall Street’s definition of risk – which is a flawed concept, but whatever).


It looks like Joel Greenblatt is correct. Most of the volatility is meaningfully reduced with a handful of positions. He offers a caveat, however, and suggests that if you are going to run a concentrated portfolio, it is best to diversify among a group of different industries. In today’s market, for instance, it may be tempting for a value-driven bottom feeder like myself to own 10 retail stocks. This would be a bad idea.

Wall Street pros and most investors have no stomach for volatility. We saw a vivid example of this in February. The market fell 10%. This is a remarkably normal event in the grand scheme of things. I was on vacation at the time that this happened and couldn’t help but laugh at the insane overreaction to this little event. It generated headlines like this: “Stocks Plunge and Traders Panic” – The Wall Street Journal, “Dow falls more than 1,000 in biggest daily point-drop ever” –

If you want to achieve better than average results, you need a better than average temperament to ignore this nonsense.

How to think about the market

Joel tells two stories in the book that represent excellent ways to think about the stock market.

The first is a story about his in-laws. His in-laws were amateur art collectors. They weren’t looking for the next Rembrandt or Picasso, they were looking for small-scale mispriced works of art. They went to yard sales and flea markets looking for paintings that were cheaper than their value. They would find paintings that were at the yard sale for $100 that they knew were worth $1,000, for instance.

This is a useful way for small investors to think about the stock market. The professionals need to find the next Rembrandt and Picasso. We should let them fall over themselves trying to figure out what company is going to be the next Facebook or Microsoft. Most of them will fail and a handful will be lauded as geniuses (they were probably just lucky). For us, we can achieve satisfactory results by merely finding things off the beaten path that is a decent discount against their intrinsic value.

Joel tells another great story where he went to the best restaurant in New York, Lutèce. Joel asked one of the chefs if an appetizer on the menu was good. The chef replied with: “it stinks.” The message was clear: it didn’t matter what you ordered off the menu. Everything was excellent because Joel was at the best restaurant in New York. The best way to invest in the stock market is to identify those places that are the best places to invest, where no matter what you pick, the chances are that it will be good.

The book outlines some key hunting grounds where Joel had success finding these opportunities.


The goal of investing is to find mispriced assets. You want to seek out areas of the market where stocks are prone to mispricing.

One area that Joel finds to be replete with mispricings is spin-offs. Spin-offs are divisions or subsidiaries of a larger company. The larger company decides to “spin off” that piece into a separate company.

Why do companies do this?  They may think that if they isolate the entity in the market, it will be able to command a higher valuation.  For instance, let’s say (in an extreme example) that an insurance company owned a financial software division. Software companies have higher P/E ratios than insurance companies. However, the market might not appreciate the software company because it is buried in an insurance company. If they spun it off – the software company would probably command a higher valuation if it were isolated.

The larger firm might also want to separate itself from a “bad” business that is weighing it down. They might just want to use the spin-off to unload debt on a smaller firm. There could be tax or regulatory reasons. They might have difficulty selling the business, so they decide to dump it in the form of a spin-off.

Whatever the reason, spin-offs are prone to mispricing. This is because institutions and people often sell them for reasons other than the intrinsic value of the company. Some institutions might not even be allowed to own it due to small market capitalization, or it doesn’t fit into their “strategy.” Individual investors probably wanted to hold the larger business and have no interest in owning something completely different. In any case, spin-offs are prone to indiscriminate selling, which creates mispricings and opportunities for smaller investors like us.

In the book, Joel takes you through several real-world examples of spin-offs. He explains why the spin-off was pursued and why he thought it was an attractive opportunity to invest in.

Currently, I own one spin-off in my portfolio: Madison Square Garden Networks (MSGN). My rationale for holding it is described here. I became aware of the opportunity when looking at a list of recent spin-offs back in 2016.


Joel then moves onto mergers as an opportunity for mispricings.

He first addresses the obvious: merger arbitrage. Merger arbitrage is buying a stock after a deal is announced and trying to earn a spread between the buyout price and the market price. For example, let’s say a company is trading at $30 and another company buys it out for $40. As soon as the deal is announced, the stock will rally to $39. A merger arbitrage strategy would buy the stock at $39 and wait for the deal to be consummated.

Joel thinks this is a dumb strategy and I agree with him. The reason is that you are taking on the risk of the deal not going through, in which case the stock will plummet. Mergers fall apart all the time, usually for regulatory reasons. Why take on that risk to make a measly 2.5% gain in the example I provided (in the real world, those spreads are even smaller and keep getting smaller as more people become involved in merger arbitrage).

It’s a strategy that might make sense for a big institution that can hire lawyers and analysts to know for sure whether a deal will indeed go through, but that’s not something small investors like myself can take advantage of.

Where Joel does believe there are opportunities for investors is in the world of merger securities. Often, a buyout can’t be financed entirely with cash and debt. Sometimes, strange derivative securities are sold (usually warrants) to fund a piece of the transaction. Investors will often indiscriminately unload these merger securities, and this will create mispricings.

The difference between a warrant and an option is that a warrant is issued by the company. That’s it. Both of them are merely a contract to buy or sell a stock at a pre-determined price on a future date.

Joel thinks this is a good area of opportunity. I don’t disagree, but I think that pricing merger securities are beyond the abilities of most small investors like myself. I’ve never owned an option or warrant in my life and place it in my “too hard” pile. You might want to tackle it and more power to you.

Like the spin-off section, Joel takes you through a few real-world examples of times that he purchased merger securities and did very well. I think the strategy is too hard to implement for the small investor, but you might disagree.


Emotions create mispricings. Greed and comfort with consensus create insane valuations for amazing companies. Revulsion, hatred, and fear create mispricings among “bad” companies. Nothing generates an “ick” feeling more than bankruptcy.

Joel does not recommend buying stock in bankrupt companies (that’s in the “too hard” pile”). The reason is apparent: equity holders can get wiped out in a bankruptcy. He does believe that the debt of bankrupt companies is often mispriced and offers incredible mispricings. Unfortunately, distressed debt investing is not only challenging to research for small investors but frequently impossible for anyone but an institution to invest in.

He believes that small investors can invest in companies emerging from bankruptcy or going through a restructuring. Often, a company went bankrupt only because it was loaded up with too much debt. They might have a viable business model that was merely being weighed down by too much debt. After emerging from bankruptcy or going through a healthy restructure, it may give the company an opportunity to shine. Meanwhile, the stigma of the bankruptcy creates a nice discount from intrinsic value.


Most classic value investors (me included) think that options are an area that is best for most people to avoid. I agree with this sentiment. Options (and warrants, which are the same thing) are a zero-sum game. Only one side of the trade wins: either the person who wrote the contract will win, or the person who bought the contract will win. They can’t both make money. Zero-sum games are usually areas of the market that are difficult for small investors to make money.

Joel takes a bit more of a liberal attitude towards options. While he doesn’t recommend actively trading options, he does suggest using long-term options (LEAPs – options contracts that mature in over a year) as a way to leverage up the return on a value stock. A LEAP will experience much more significant price swings than the overall stock. If a reasonably priced value stock experiences a 20% gain, for instance, the underlying LEAPs contract will experience a much more significant increase. It’s a way of leveraging up the bet, with the caveat that if the stock falls below the strike price, it will expire worthless. More risk, more reward.

Joel does not recommend that these bets comprise a significant portion of a portfolio, but argues that they can serve a place to amplify returns.

For me, I put all of this in my “too hard” pile. When I contemplate buying options or warrants, it sounds to me like someone saying “Let’s try crack. What could go wrong?”


You should read this book! My brief summary doesn’t do the book justice. While I gave you the broad strokes in this blog post, there is nothing like reading the book and going through the case studies which Joel provides. He provides you with his entire process: how he found out about a specific opportunity, what he liked about, where he researched it and how the idea worked out.

The first and last chapters are useful for developing a template for thinking about markets. As I stated earlier, the goal is to find mispricings. That often means going off the beaten path and finding forgotten and hated corners of the market. Joel provides a roadmap to a few areas that served him well, but they are by no means the only ways to do it.

PLEASE NOTE: The information provided on this site is not financial advice and it is for informational and discussion purposes only. Do your own homework. Full disclosure: my current holdings.  Read the full disclaimer.

International Index Investing: A Metric to Measure Quality

themazeA recap of my thinking

Recapping the last few blog posts: I think valuations are too high in the United States. Choose your poison: CAPE ratios, market cap to GDP, or the average investor allocation to equities. All suggest low returns in the coming decade.

At the same time, I know that attempting to time the US market using valuation is a fruitless effort. Markets can stay expensive for a long time. Since 2000, the US market has only gone to its “average” historical valuation once, in the depths of the 2009 financial crisis. Avoiding the market for a long time in a low return asset like cash or t-bills ultimately hurts future returns. It can even result in negative real returns if inflation picks up. If interest rates stay this low, then the market can certainly remain expensive. The direction of interest rates is the key question when determining future valuations.

For value investors, timing based on the valuation of the broader market is particularly tricky because there is often value in individual securities even if the broader market is overvalued. For instance, in the early 2000s, value stocks had a nice bull market while the broader market melted down. In Japan, while the broader market was crushed, Joel Greenblatt’s magic formula returned an amazing 18% annual rate of return from 1993-2006.

So, I think that a portfolio of 20-30 cheap stocks over the next 10 years will handily beat the S&P 500.

The caveats to this:

(1) Value doesn’t usually experience a bull market while everything else goes down. The only time this happened was the early 2000s. Value stocks normally go down with everything else. I suspect the current disconnect between value and growth stocks will see value triumphant, but we likely won’t see that happen until a decline happens in the broader market.

I suspect the current cycle will be more like the 1970s when value stocks went down with the broader market in 1973 and 1974 and then staged a very nice bull market after ’74.

The current cycle has much more in common with the early ’70s than it does with the late 1990s. The high flying stocks of the early ’70s weren’t crazy speculative companies like they were in the late ’90s. The hot stocks of the ’70s weren’t garbage like, they were quality companies like McDonalds and Xerox. It’s the same thing today. The high valuations aren’t in junky speculative companies, they are in quality names like Facebook and Amazon.

The decline of 1973-74 wasn’t driven by a bubble popping like 2000, it was caused by a macro event (the oil crisis), which brought down the richly valued companies by bigger drawdowns than everything else. I think the same thing will probably happen to the US market this time around. What event will cause this is unpredictable (a war with North Korea, inflation causing a hike in interest rates?), but I think something is likely to come along that will cause a major drawdown.

A smart guy like Nassim Taleb would call this a “black swan” or “tail risk” event. I prefer a simpler way to express this: shit happens.

(2) Trying to time the US market with CAPE ratios is ineffective. The alternatives (cash, T-bills) do not yield enough to justify moving in and out of the US market. Tobias Carlisle did some great research on this here.

(3) Even value stocks are expensive in this market. For instance, a stock screen I like to comb through is the number of stocks trading at an EV/EBIT of less than 5. Out of the entire Russell 3000, I can only find 16 of them outside of the financial sector. Of these, half of them are in the retail sector.

At the beginning of 1999, there were 38 of these opportunities in a diversified group of industries. After the manic tech euphoria of 1999 where money flowed from “boring” stocks into tech, the number grew to 70 at the start of 2000. This group of stocks returned 20% in 2000, while the S&P 500 went down by 10.50%.

Expensive Value Stocks

The value opportunity set in the United States is currently limited.

Much of what fueled the early 2000s bull market in value stocks was the wide availability of cheap stocks in diverse industries. This simply isn’t the case today, as the small number of value opportunities in the U.S. is concentrated in one industry: retail.

I currently have 30% of my portfolio invested in the retail sector, which I’m comfortable with. If I were to buy all the cheap stocks in the United States, over 60% of my portfolio would be invested in retail. While I think retail stocks will ultimately stage a resurgence, I’m not certain of it. A 60-80% concentration in one industry is too risky. The sector could easily be cut in half again. 30% is the maximum extent that I am willing to commit to an individual industry. If retail were cut in half, my potential loss if 15% of my portfolio. If I expanded that to 60% or 80%, I could lose 30-40% of my entire portfolio. That’s a much more difficult event to recover from.

I could achieve more diversification by taking a relative valuation mindset to the current market, but I think this is dangerous. I prefer absolute measures of valuation — like a P/Sales of less than 1, the price is below tangible book, EV/EBIT of less than 5, 66% of net current asset value, earnings yields that double corporate bonds, etc.

A major reason I prefer absolute measures of valuation is that I think high valuation ratios in the cheapest decile of a market is a sign that the valuation metric is losing its effectiveness. A good example of this is price/book.

Price/book worked marvelously prior to the 1990s, but its effectiveness has been dramatically reduced since then. This is because Fama & French identified price/book as the best value factor. This made it respectable to buy low price/book stocks, while previously low price/book investors were regarded as oddballs (rich oddballs who consistently beat the market, like Walter Schloss!). Once Fama & French gave it their blessing, vast amounts of institutional money poured into low price/book strategies. Price/book became synonymous with value and this ruined the effectiveness of the factor.

If too much money chases low P/E, P/Sales, EV/EBIT stocks, then they will suffer the same fate as price/book. They will still work due to human nature (investors will always find ridiculously cheap stocks repulsive), but the effectiveness will be diminished. Institutional big money can ruin the factor. I think a good way to tell that this is happening is to focus on absolute metrics of valuation rather than relative valuation compared to the rest of the market. If too much money chases the value factor, then absolute measures of valuation will rise. By focusing on absolute levels of valuation, I can avoid this.

EV/EBIT is by far the best of all value factors, but if too much money chases it, the effectiveness will be reduced.

This is why I think focusing on absolute valuation is a way to prevent falling into this trap. Think about it through the prism of the real estate bubble: a house cheaper than the rest of the neighborhood was still a bad bet in 2006 because all real estate was in an inflated bubble. A single house might have been a good relative value and suffered less of a price decline than everything else, but it was still expensive. Focusing on an absolute level of valuation would have helped avoid this trap.

Going International

The beauty of the modern world is that I’m not limited to the United States. Previous generations of investors had a handful of options: cash, bonds, US stocks. Fortunately, I don’t have to sit on a pile of cash earning nothing while I wait for US markets to deliver me juicy opportunities, which is a bad strategy that can cause real inflation-adjusted losses the longer that the adjustment takes. I could wind up sitting on cash for a decade, absolutely decimating my real returns.

A great alternative to cash while the US market is expensive is investing internationally. While I don’t trust my ability to research foreign companies, I am comfortable investing in an index of a foreign country. While I think foreign stocks are more prone to fraud, I don’t think the financial results of an entire index can be fraudulent.

A few weeks ago, I did this in a very crude way. I invested 10% of my portfolio into a basket of the 5 cheapest country indexes on Earth.

If I’m going to do this in a bigger way, I need a better quality metric. It seems obvious to me that higher quality countries (like the United States) should command a higher valuation than a low-quality country. The definition of a bargain would also depend on the economic quality of that country. For instance, the US at a CAPE Ratio of 15 (where it was in 2009) is a screaming bargain, while Russia at a CAPE of 15 is probably a bit expensive in comparison to the risk. I’ll invest in a country of any quality – but I should demand a higher margin of safety if it is a low-quality country.

But how does one measure the “quality” of an entire country? This is a tough thing to quantify. Mainstream economists do this by splitting up the “developed” (i.e., already rich) parts of the world from “emerging” (trying to get rich) and “frontier” (poor). This doesn’t make sense to me to use as a quality metric. An emerging or frontier market may have better prospects than a developed, rich country.

What makes a country’s economy “quality”?

One of my favorite books about this subject is P.J. O’Rourke’s “Eat the Rich“.  P.J. has written some of my favorite books of all time (Parliament of Whores in particular).


In the book, P.J. tries to define what makes countries “good” economically. His question is pretty simple: “Why do some places prosper and thrive, while others just suck?”

P.J. explains the conundrum in the following passage:

It’s not a matter of brains. No part of the earth (with the possible exception of Brentwood) is dumber than Beverly Hills, and the residents are wading in gravy. In Russia, meanwhile, where chess is a spectator sport, they’re boiling stones for soup. Nor can education be the reason. Fourth graders in the American school system know what a condom is but aren’t sure about 9 x 7. Natural resources aren’t the answer. Africa has diamonds, gold, uranium, you name it. Scandinavia has little and is frozen besides. Maybe culture is the key, but wealthy regions such as the local mall are famous for lacking it.

Perhaps the good life’s secret lies in civilization. The Chinese had an ancient and sophisticated civilization when my relatives were hunkering naked in trees. (Admittedly that was last week, but they’d been drinking.) In 1000 B.C., when Europeans were barely using metal to hit each other over the head, the Zhou dynasty Chinese were casting ornate wine vessels big enough to take a bath in–something else no contemporary European had done. Yet, today, China stinks.

Government does not cause affluence. Citizens of totalitarian countries have plenty of government and nothing of anything else. And absence of government doesn’t work, either. For a million years mankind had no government at all, and everyone’s relatives were naked in trees. Plain hard work is not the source of plenty. The poorer people are, the plainer and harder is the work that they do. The better-off play golf. And technology provides no guarantee of creature comforts. The most wretched locales in the world are well-supplied with complex and up-to-date technology–in the form of weapons.

You should read the whole book (it’s really funny), but the gist is pretty simple: what causes prosperity is economic freedom. Economic freedom doesn’t just mean “people can do whatever they want”, it is capitalism within a defined rule of law that is enforced.

The magic ingredient that can make a country rich is economic freedom, and it’s what turned the United States from a third world nation of farmers into the richest country on Earth that it is today over a relatively short span of history. The people of the United States weren’t more talented or better than anyone else. We were the first to wholeheartedly embrace capitalism while the rest of the world fiddled around with bad ideas like feudalism, mercantilism, socialism, and communism.

The secret to US success is now out.

Since the fall of the Berlin Wall in 1989, economic freedom has been advancing throughout the world (even though it has retreated in its birthplace, the United States). The worldwide spread of capitalism and economic freedom have been profoundly positive for humanity. In fact, the global rate of poverty has been cut in half since 1990. It’s not a coincidence that this decline began at the exact moment that the Soviet Union collapsed. As the world embraces capitalism, it is growing increasingly prosperous as a result.

If we acknowledge that economic freedom is the best measure of the “quality” of a country, how do we quantify that?

The Index of Economic Freedom

The Heritage Foundation has done the world a service by quantifying economic freedom in their index of economic freedom, which they update annually.

They define economic freedom in four key categories:

  1. Rule of law – property rights, judicial effectiveness, government integrity.
  2. Government size – tax burden, government spending, fiscal health.
  3. Regulatory efficiency – business freedom, labor freedom, monetary freedom.
  4. Market openness – Trade freedom, investment freedom, financial freedom, openness to foreign competition.

Each category is scored and the total is grouped in the following levels:

Free: 100-80 (Australia, Hong Kong, Singapore)

Mostly Free: 79.9-70 (The United States, Ireland, the UK, Sweden)

Moderately Free: 69.9-60 (Israel, Japan, Mexico, Turkey)

Mostly Unfree: 59.5-50 (Russia, Egypt, Iran, China)

Repressed: 49.9-40 (Venezuela, North Korea, Cuba, Afghanistan)

Going forward, I think I will buy “free” and “mostly free” countries (a score of 70-100) if their CAPE Ratio is below 15. By this metric, Singapore is the most attractive market in the world right now, with a CAPE ratio of 12.9 against an economic freedom score of 88.6.

If I’m going to buy countries that are “mostly unfree”, I should demand a higher margin of safety — i.e., it should be a compelling bargain, with a CAPE ratio below 10. Russia would be defined as “mostly unfree” (Russia currently has a score of 57.1). However, at Russia’s current CAPE ratio of 5.6, it would still meet my requirements and provide an adequate margin of safety.

The quick and dirty way I think about P/E ratios or CAPE ratios is in terms of earnings yield. Take the P/E or CAPE ratio and divide it with 1. For instance, Russia’s CAPE is 5.6, so its earnings yield (1/5.6) is an astounding 17.85%, well worth the heightened risk of owning that country’s stocks. The US, with a CAPE ratio of 30, would have an earnings yield of 3.33%. This means US investors can expect a total return of about 34% in the coming decade. In comparison, if Russia delivers a compounded return of 17.85%, it’s a return of 438%.

It’s also important to consider that the returns will be lumpy. Much of the return could be concentrated in a few years and there will likely be a large drawdown at some point. Stocks deliver high returns because of these drawdowns. The high returns of stocks are a compensation for this risk. The US returns aren’t terrible, especially when compared to bonds, but they’re nothing to get excited about.

Among the other two positions I chose, Poland and Turkey, they are in the murkier area of “moderately free”. I think I’ll buy these type of markets when they get below a CAPE ratio of 12.

Here is where my current positions stack up in terms of both CAPE ratio and standings in the index of economic freedom:


Using these guidelines, I made a good choice with both Singapore and Russia, but likely paid too much for Brazil and Poland. As I expand my position in international indexes while the US market is expensive, I will use the index of economic freedom as a rough quality metric when determining the appropriate price to pay for each country.

When I rebalance my portfolio in December, I am going to expand this segment of my portfolio. When the US market suffers a drawdown, I will reduce this segment of my portfolio and purchase more bargain stocks boasting low absolute valuation metrics.

PLEASE NOTE: The information provided on this site is not financial advice and it is for informational and discussion purposes only. Do your own homework. Full disclosure: my current holdings.  Read the full disclaimer.

“There’s Always Something to Do” by Christopher Risso-Gill


I just finished “There’s Always Something To Do” and enjoyed the book. It is a quick read about one of the greatest investors of all time, Peter Cundill. Peter was a fascinating and wise individual. In addition to successfully navigating the markets, Peter also valued fitness and regularly ran marathons in under 3 hours.

Sadly, Peter passed away at the age of 72 after a struggle with a rare neurological disorder, ActiveX.

Peter Cundill’s Epiphany

Peter Cundill was a Canadian investor who began investing in the late 1950s and 1960s. He had value instincts, but never took a true value-oriented approach during that period and was disappointed by his results.

In 1973 at the age of 35, Cundill read “Super Money” by Adam Smith on a plane ride. “Supermoney” took a close look at the insane money culture of the 1960s (not dissimilar from the insane money culture that rears its ugly head during every bull market) and found one group of people who stuck out as different: the disciples of Benjamin Graham. Featured prominently were a young Warren Buffett and Walter Schloss.

Reading the book was an epiphany for Cundill. He absorbed all of Graham and Dodd’s work. Of particular interest to him was Chapter 41 of Security Analysis, “The Asset Value Factor in Common Stock Valuation”. After a careful evaluation of Graham and Dodd’s work, Cundill decided to launch his value-oriented strategy. He explained the shift in strategy in a letter to his investors in which he said:

“The essential concept is to buy under-valued, unrecognized, neglected, out of fashion, or misunderstood situations where inherent value, a margin of safety, and the possibility of sharply changing conditions created new and favorable investment opportunities.”

The Peter Cundill Stock Screen

In addition to explaining the overall strategy, Cundill also set strict quantitative criteria for his fund. The criteria included:

  • The price must be less than book value, preferably less than net working capital.
  • The price must be less than one half of the former high and preferably at or near its all-time low.
  • The price-earnings multiple must be less than 10 or the inverse of the long-term corporate bond rate, whichever is the less.
  • Over the last five years, the company was profitable each year and increased its earnings over the five year period.
  • The company must pay dividends
  • Low levels of long-term debt.

Peter also set sell rules for his fund, agreeing to sell at last half of any given position after its price had doubled. Peter looked throughout the world for bargain stocks. He didn’t restrict himself to North American markets and scoured the world for bargains. Every year, he visited the worst performing market in the world while searching for investment opportunities.

He launched his fund at an opportune moment for value investing in 1974, after the calamitous bear market of 1973-74 when everything was crushed.

To give some perspective on how many bargains were available on the market in 1974, here is a great exchange between Forbes magazine and Warren Buffet. Forbes: “How do you feel?” Buffett: “Like an oversexed guy in a whorehouse. Now is the time to invest and get rich.”

Peter’s first decade of deep value investing was extraordinarily successful: from 1974 to 1984, his fund delivered a 26% rate of return.

International Cigar Butts

Peter pursued investment opportunities of the “cigar butt” variety. He didn’t adhere to the Buffett style of buying wonderful companies and holding for the long term. Cundill bought deeply undervalued securities and sold when they reached fair value.

He also didn’t restrict himself to stocks and he took up large positions in distressed debt.

Peter was called the “Canadian Buffett,” but I think his approach shares more similarities with the investment style of Seth Klarman.

Peter’s Wisdom

The book is a short, quick read and covers Peter’s investment career and his unfortunate illness. I wish the book covered Peter’s personal life a bit more in depth, but it was still a good read and filled with bits of Peter’s wisdom. Some of my favorite Peter Cundill quotes are below:

  • “The most important attribute for success in value investing is patience, patience, and more patience. The majority of investors do not possess this characteristic.”
  • “The value method of investing will tend to give better results in slightly down to indifferent markets and less relatively sparkling results in a raging bull market. What matters, however, is that the method will provide a consistent compound rate of return in the middle teens over very long periods of time.”
  • “I’m buying your stock because it’s cheap and for no other reason.” – Peter’s response to the management of J. Walter Thompson, who didn’t understand why Peter was buying their stock!
  • “I think that the financial community devotes far too much time and mental resource to its constant efforts to predict the economic future and consequent stock market behavior using a disparate, and almost certainly incomplete, set of statistical variables.”
  • Particularly relevant: “Computers actually don’t do much more than making it quicker for investors to react to information. The problem is that having the information in its raw state on a second by second basis is not all the same thing as interpreting and understanding its implications, and this applies in rising markets as well as falling ones. Spur of the moment reactions to partially digested information are, more often than not, disastrous.”
  • “If it is cheap enough, we don’t care what it is.”
  • “Curiosity is the engine of civilization. If I were to elaborate it would be to say read, read, read and don’t forget to talk to people, really talk, listening with attention and having conversations, on whatever topic, that are an exchange of thoughts. Keep the reading broad, beyond just the professional. This helps to develop one’s sense of perspective on all matters.”
  • “I think it is very useful to develop a contrarian cast of mind combined with a keen sense of what I would call “the natural order of things.” If you can cultivate these two attributes you are unlikely to become infected by dogma and you will begin to have a predisposition towards lateral thinking – making important connections intuitively.”

PLEASE NOTE: The information provided on this site is not financial advice and it is for informational and discussion purposes only. Do your own homework. Full disclosure: my current holdings.  Read the full disclaimer.

“The Fourth Turning” by William Strauss and Neil Howe


A Lucky Trip to the Bookstore

When I was a kid, I went with my family to Wildwood, NJ every summer.

As a geek, instead of spending time in the sun like a normal kid, I was mainly drawn to the shore for the pizza and arcades. I would spend most of my time either in an arcade or reading a book.

I’d also make a habit of taking my lawn mowing earnings and buying a book on the boardwalk that I would read back in the motel.

In the summer of 1998, I came across a book that grabbed my attention. It was called Generations: A History of America’s Future from 1584 to 2069. The book (published in 1991) told the story of America’s history as a series of generational biographies. It also informed me that those born during 1982 and after were part of a new generation, called Millennials. (Yes, they coined the term.)

The authors, William Strauss and Neil Howe, were trying to find out if the generation gap that existed between the baby boomers and the G.I. generation during the 1960s was a unique event. They found out that not only was it not a unique event, but there is a rhythm to history caused by different generations interacting with each other.

I finished Generations in that weekend, and I was transfixed by the story. It was a unique way to look at history. Most history books are simply a recounting of events. It never captured what people actually experienced and thought during those times. I went home to my dial-up internet connection and found that they just came out with another book, The Fourth TurningI found that one at a local bookstore and quickly devoured it.

Strauss & Howe’s Theory

Strauss & Howe noticed a rhythm to history. They discovered that there is a cycle of generations that persists throughout history. The generational cycle fuels a sequence of historical moods, defined below. These 4 distinct moods last for roughly 20 years and form an 80-year sequence.

Cycles of History

High – The most recent high was the “American High” that lasted from the end of World War II through the assassination of John F. Kennedy. A high takes place after a civilization-defining crisis. The last crisis was the Great Depression & World War II. After the Crisis is over, everyone wants to get back to normal. Pragmatic civic solutions are embraced and the culture has a long-term orientation. Think of the Presidency of Dwight Eisenhower: interstate highway systems, the establishment of NASA, reductions in public debt. It is an era of strong public institutions and public cohesiveness. Critics would say that highs are also eras of stifling conformity and a lack of creativity. During a high, the outer world is doing well, while the inner world is neglected.

Awakening – The most recent Awakening was the “Consciousness Revolution”. Young people rebelled against the conformity and strong institutions created during the Crisis and strengthened during the High. This is an era during which the established institutions are criticized. A new generation of young people emerges with their own take on morality and culture. It is an era of the challenge to the status quo and a focus on new ideas about values and morality. Cultural creativity surges. While institutions were strong and conformity was reinforced during the high, during an awakening the emphasis of society begins to shift to individualism and new ideas. An awakening is an era in which culture undergoes a renaissance and is fundamentally changed.

I think that Awakenings are the most enlightening and thought-provoking eras in history.

Unraveling – The most recent Unravelling was defined as the “Culture Wars” by Strauss and Howe. In retrospect, I think “The Great Moderation” (coined by economists) is a tremendous alternative term for it. After society has gone through a consciousness-altering and culture shattering awakening, the values of the Awakening begin to become ingrained in our culture. People want to move on and focus on their own lives. This was very much the attitude of the mid-1980s. After the Generation Gap, Vietnam, Watergate, and cultural upheaval, people wanted to settle down and focus on their own lives. The attitude is “after all that, let’s have a good time.”

The culture becomes fragmented and individualistic, with everyone free to pursue their own interests and passions. From the perspective of some, this is an isolating force. Meanwhile, distrust in institutions is high, and they began to show signs of stress. Problems start to brew but are ignored (slavery before the Civil War, the sovereignty of the colonies before the American Revolution, the lack of an international order due to the decline of the British Empire before World War II).

I think that Unravellings are probably the most fun of all the historical eras. Of course, all of that fun comes at a dire cost.

Crisis – We are currently in a Crisis. When the current crisis began is subject to debate. I would argue that it started on 9/11, while I believe Neil Howe says it started in 2008. I prefer 9/11 . . . because I’m an optimist and I would like the Crisis to be resolved sooner rather than later!

The last Crisis was the Great Depression & World War II. This is when the problems that were brewing during the Unravelling come to a head. The institutions that were weakened during the Unravelling, now fall apart and are replaced.

During a Crisis, problems that were mounting during an Unravelling become too big to ignore any longer. Old institutions are torn down and new ones are created. Unfortunately, this unique mood tends to create wars and financial crises.

On the positive side, while Crises throw everything into turmoil, they make the world a stronger place. They create institutions and leadership that beget a stabler and stronger world.

The cycle of historical moods creates a cycle of generations that are shaped by the events. The generations at different life stages create the unique cultural mood of each turning in the cycle. The two drive each other in a kind of historical ecosystem. The generational cycle is below:

Prophets – These are the children of a High. The current example of this is the baby boom generation. Their parents went through hell in the Crisis, and they are determined to create a good life for their children. They are indulged as children. They are encouraged to be inquisitive and to think about the weightier issues facing their civilization. They grow up with a distinctly ideological, moralistic, crusading attitude that carries them through into adulthood. Growing up in a stifling and conformist world that values the technical over the spiritual, they want to create the opposite of that.

Prophets produce intensely ideological leaders and some of the most creative people in history. There is a reason that this generation produced people like Steve Jobs and Steven Spielberg. Creativity and expression are a part of the baby boomer DNA.

Nomads – Nomads are the children of an Awakening. While adults focus on their inner world and challenge cultural conventions, Nomads are left with a mostly unsupervised childhood in which they are encouraged to find themselves and learn about the world on their own. Their parents, the “artist” archetype, grew up with a stifling and strict childhood during the Crisis. They want to give their children more freedom and less structure. This childhood causes Nomads to get into a lot of trouble, but it also creates a generation of richly individualistic and rugged people. Think about ’80s teen movies. There are no parents in sight and if they are around, they’re clueless about what’s going on. They don’t make movies like that anymore because the dynamic wouldn’t resonate with modern audiences.

Parents in modern movies tend to be deeply involved in their child’s lives (for good or bad) because that’s the current dynamic.

Pathologies increase during Nomad youth (drugs, crime, teen pregnancy, etc.), but so does entrepreneurialism. The current example of this is Generation X. It includes some of the greatest entrepreneurs of all time, people like Jeff Bezos. Before them, the last example was the Lost Generation — veterans of World War I, participants in the roaring 20s, and people like Dwight Eisenhower who led society through the Crisis. Growing up in a world that has its head in the clouds, they want to return the world to pragmatic reality.

Heroes – Heroes are the children of an Unravelling. Their parents are predominantly Prophets who want to instill their ideas and values into their children. They are fiercely devoted to raising their children and maximizing their future. They are nurtured as children but given more structure and attention from society than Nomads. The current example is the Millennial generation.

While Generation X was growing up, for instance, Disney ceased making animated films, and the culture became somewhat indifferent towards young children. All of that changed with the arrival of Millennials, with a society entirely focused on preparing children for the future. Pathologies get better — Millennials actually improved crime rates, SAT scores, and have lower rates of teen pregnancy than their Xer peers. They are conformist and prone to groupthink, far less individualistic than their Xer and Boomer elders. They also tend to be more optimistic than Prophets and Nomads.

The last hero generation was the G.I. Generation, Tom Brokaw’s “Greatest Generation”. This was the generation that was young adults during the Great Depression and World War II, who rose to the occasion and acted as a group to save the country. It’s yet to be seen if Millennials will live up to the last Hero generation. I think they will rise to the occasion if challenged. If they don’t . . . well, then I guess I’ll have to focus more on my low Shiller PE international strategy. (I’m biased.)

Growing up during a complacent Unravelling with weakening institutions, Heroes want to see a world that is the opposite of that. Instead of weak institutions, they want healthy institutions, and they want to see those institutions do big things. Big things can be good or bad – think of the Moon landing and the Vietnam War. They are two sides to the same coin. Instead of rampant individualism, they want to create a cohesive conformist culture.

Hero generations are marked by their positive and optimistic attitude. You can see this in modern Millennials. This is in sharp contrast to the youthful attitudes of the 1980s and 1990s, for instance, when it was “cool” to be cynical. It’s not anymore.

Artists – Artists are the children of a Crisis. They are raised primarily by Nomads. Nomads become strict and structured parents after seeing all the trouble that they got into with free reign in their youth. Artists are raised during a civilization-threatening Crisis and this also impacts their outlook. They grow up to be largely conformist young adults, with a deep yearning to break free of that. Entering midlife during an Awakening, they lead the charge into breaking free of conformity and rules. Think of Martin Luther King Jr.

The last Artist generation is the Silent Generation, born between roughly 1930 and 1945. Growing up with strong conformist institutions, they want to see society break free of that and create a more individualistic world. The most prominent member of the Silent Generation in the investing world is the one and only Warren Buffett.

Side note: I love to think of the dynamic between Benjamin Graham (a Nomad  member of the Lost Generation) and Warren (an Artist member of the Silent Generation). Graham was focused in an almost cynical way on intrinsic value to eliminate losses (i.e., the cigar butt approach) after experiencing the speculative fervor of the Unravelling (the 1920s). Graham’s focus was always on how much he could lose and not how much he could make. Warren, while he internalized Graham’s lessons about margin of safety and intrinsic value, took a much more optimistic view of the world (as Artists tend to do) and instead pursued the purchase of “wonderful companies at good prices” and holding for the long term. That right there shows a dynamic between a Nomad view of the world and an Artist perspective.


On the surface, the theory of generational archetypes coming in sequence and seasons of history sounds a bit new-agey and mystical. It’s really not. Strauss and Howe’s observation is simply that different generations raise their children in unique ways (usually in critical ways that are different from the way they were raised). Those children then grow up and raise their children differently than the way their parents raised them. They think they are doing something “unique,” but most of it was already done before.

The cycle of different generations raising their children in different ways creates unique personalities to generations.

These personalities align at different life stages create unique cultural moods. A society in which Artists are calling the shots (i.e., the ’80s and ’90s) will be uniquely individualistic to a point where younger generations will find it isolating (think Bowling Alone). A society in which Nomads are calling the shots (the late 1940s and 1950s) will be pragmatic to the point where younger people find it soul-deadening (think The Man in the Grey Flannel Suit).  A nation run by Prophets (the 2000s and today) will seem overrun with overblown ideology. A society run by Heroes (the 1960s and 1970s) will seem capable of achieving anything, but spiritually empty.

Another criticism is the claim that the generational theory is a vain attempt to predict events. This is not the case. Good and bad events happen throughout each stage of history. Strauss and Howe are quick to point out that they are not anticipating specific events, they are predicting a general cultural mood that will react to events in unique ways.

A Crisis era generational alignment (Prophets are in power, Nomads are in Midlife, Heroes are young adults) will react to events differently than an Unravelling era generational alignment (Artists are in power, Prophets are in Midlife, Nomads are young adults). In an Unravelling, after a foreign attack, the country will try to find a quick solution. In a Crisis, after a foreign attack, the Prophet instinct will be to use this as an opportunity to enact sweeping changes and mobilize. Think of George W. Bush’s declaration of an “Axis of Evil” after 9/11.

A crisis is merely an era in which institutions are run by Prophets. Prophets tend to have itchy trigger fingers to impose their moral will, and they will have a compliant cohort of young Heroes who can help them make that happen. This doesn’t mean a war must be the way that the crisis is resolved, but the unique assembly of generations at different lifecycles raises the probability of it.

That’s the key to generational theory. It’s not the events themselves that drive history, it is the reaction of civilization to those unique events.

Similarly, an Unravelling is an era in which Artists are running the show and want society to fully embrace individualism. With crumbling institutions and an individualistic entrepreneurial “kill what you eat” young cohort of Nomads, it’s natural for a society to become financially reckless.

Another criticism is that this theory ignores the unique personality of people within a generation, who may not ascribe to these stereotypes. This is valid, but I think it’s hard to deny that each generation has a unique personality. There are people within the generation who defy generational stereotypes, but on the whole, they do have a distinct character, and there are commonalities.

The Bad News & The Good News

The next 10 years will likely see this era resolve itself. 2025 is exactly 80 years after 1945, the year that the last crisis ended. This means that we are entering a dangerous time in history in which we will need to rise to the occasion. We will face a challenge of history on par with the American Revolution, the Civil War, and World War II. New institutions will likely be created, and old ones will be torn down.

I hope this era doesn’t end the United State’s position are the world’s preeminent superpower, but that is indeed a possibility. It might very well set the stage for another country’s emergence as a superpower. It may also result in better global institutions and cooperation.

The excellent news is that regardless of how this crisis shakes out, it’s eventually going to be over and we will enter the First Turning in the next decade. The First Turning will be rigid, conformist and corporatist — but the economy will likely do very well, and I’ll take that over a Crisis.

Investing & Economics

In terms of investing ideas, I was struck by how Strauss and Howe’s ideas align with Ray Dalio’s thoughts about the long-term debt cycle. Dalio identified an 80-year debt cycle (the last one culminated in 2008, the one before that in 1929) that strongly aligns with Strauss and Howe’s theories.

Dalio has a mammoth paper about this, that is well worth your time. He also has an excellent short video explaining this that I’ve mentioned before on this blog.

Another interesting parallel is the work of Hyman Minsky. Minsky described a financial cycle which I think fits into the larger 80-year cycle. Minsky’s idea (similar to Dalio’s) is that debt drives the long-term economic cycle. After a financial crisis (the Great Depression or the 2008 financial crisis), firms avoid debt. This reduces the risks to the financial system. Over time, the reduced financial risk will ultimately spur more lending and borrowing. Increasing debt levels increases the risks to the financial system, which ultimately turn into a Crisis moment. The Crisis moment changes attitudes towards debt, and the cycle repeats.

(Disclaimer: As I wrote earlier, while Macro is a lot of fun to think and theorize about, it is in most investor’s interest to avoid it. Even though I know this, I simply can’t help myself!)


I think you should read this book. This book changed the way I look at the world and I think it will change your perspective, too. You’ll not only gain unique insights into history, you will begin to see people of different generations in a new light. Current events will also make a lot of sense through a generational lens.

Even if you don’t buy into Strauss and Howe’s theory, you will enjoy looking at history through the perspective of culture and people instead of a simple recounting of events.

PLEASE NOTE: The information provided on this site is not financial advice and it is for informational and discussion purposes only. Do your own homework. Full disclosure: my current holdings.  Read the full disclaimer.

“Deep Value” by Tobias Carlisle


Deep Value” by Tobias Carlisle is one of my favorite books. I have a brief review in the books section of this website, but I think it is worthy of a more in depth review. The price of the book is expensive, but it is well worth it!

Mr. Market is Crazy

For years, I’ve believed that value investing works. It makes sense to me intuitively. It’s better to buy something cheap than something that’s expensive. I’ve read The Intelligent InvestorSecurity Analysis and all of Joel Greenblatt’s books and internalized the lessons. It just makes sense to me to buy earnings and assets for as little as possible.

It also makes sense to me that markets are fallible. I spent my high school years (I graduated high school in 2000) fascinated with a seemingly unstoppable market. I was only a teenager, but it seemed crazy to me that companies producing no earnings could command such high valuations. I remember thinking at the time: “It makes no sense, but these people know more than I do about the subject.” It turns out that they didn’t. An army of market prognosticators with extensive experience and impressive academic credentials were no smarter than me, a 17-year-old kid who hadn’t even gone to college yet.

I went through a similar experience during the real estate bubble. When I looked at charts of real estate prices, I once again instinctively thought that it was insane. Homes were increasing by 30% a year when incomes were stagnant and the raw materials to build the homes weren’t going up. It made no sense. Once again, I turned to the experts. Few were raising any alarms or taking the problem seriously. Surely, a financial bubble couldn’t form in an asset as illiquid and solid as real estate. I assumed that the experts must be right and I must be missing something. After all, they were more knowledgeable than I was. Then, along came 2008.

In 2008 during the crash, I kept thinking back to Benjamin Graham’s description of Mr. Market that I read about in The Intelligent Investor. Ben Graham was right. The stuff I learned in college about efficient markets couldn’t be true. Mr. Market is crazy and Ben Graham was right all along.

Why does it work?

While I believed that value investing works and this was confirmed by my observations, I never understood why it worked. It makes sense that buying dollar bills for 50 cents will work out in the long run, but how is this value realized?

Ben Graham was actually asked this question by Congress in the following exchange:

Chairman J. William Fulbright: What causes a cheap stock to find its value?

Benjamin Graham: That is one of the mysteries of our business, and it is a mystery to me as well as to everybody else.

This is the key question that “Deep Value” delves into, through an analysis of data and real world examples.

Mean Reversion

The most powerful force through which value is realized is mean reversion. I always thought of mean reversion in the sense of a stock chart, a price will revert to the mean.

What Tobias explains is that mean reversion applies less to stock charts and more to the actual performance of a business. Tobias explains, for instance, that the biggest earnings gainers of the next few years are typically the worst performing businesses. Other similar studies are brought up in the describing this tendency of businesses to change course.

Poorly performing businesses are trying to turn things around. They are not resting on their laurels. Meanwhile, changes are typically occurring in their industries that are improving things for the better.

I think it’s easiest to think of this phenomenon in terms of chemical companies and basic economics. Chemical companies can all produce the same thing. They all have the same resources. If a chemical runs up in price, all of the chemical companies are going to make more of it. At this point, all of the chemical companies are doing great and their stocks are likely to be bid up to high valuations. Eventually, the chemical will be over-produced and it will drop in price. All of the chemical companies will drop to low valuations. This situation sets the stage for the recovery. The chemical companies will inevitably scale back production. Some companies may go out of business, which will further reduce supply. The reduction in supply will eventually spur an increase in the price, which will ultimately lead to a recovery in the chemical business.

Meanwhile, news stories will be written about what a terrible business it is to produce this chemical, causing this wisdom to seep into the minds of investors. There then exists a situation where chemical companies can be purchased at a discount at a nadir in the business that is about to turn around.

The situation is doubly lucrative: a cheap stock at a point in the business cycle where it is about to turn around.

The lesson here is that human beings tend to think that the future will unfold like the past. Trends that are in place today will go on forever. This is rarely the case and it is one that Tobias demonstrates through a careful analysis of the data.

Mean reversion in business is the main force driving the realization of value.

The Illusion of “Quality”

Prior to reading deep value, I always assumed that the best course for the value investor was to combine “cheap” with “quality”. Yes, there are cheap ugly stocks out there, but many of them are dreaded “value traps”. Meanwhile, careful analysis can lead an astute investor to value investing gems: cheap companies that don’t have any real problems, companies that are growing and generating attractive returns on capital.

Tobias reveals that adding elements such as growth or high returns on capital to a value model actually underperforms cheap by itself. The ugliest value stocks are frequently the ones that lead to the highest future outperformance. This makes sense: if something is truly cheap, there must be a reason for it, and the scarier the reason then the better the bargain an investor will get. Moreover, the uglier the stock, the more likely its prospects for mean reversion.

This lesson is reinforced throughout the book with real world examples and massive quantities of data.

The Acquirer’s Multiple

Tobias’s preferred metric of “cheapness” is Operating Income/Enterprise Value (or other variants, such as EBIT/EV or EBITDA/EV). He provides data showing this metric’s historic outperformance. I found the same thing in my own backtesting, and O’Shaughnessy also verifies this in his most recent edition of What Works on Wall Street in which EBITDA/EV is given a prominent chapter.

The multiple works because it identifies stocks that are not only cheap but have healthy balance sheets. The balance sheet health allows them to survive whatever problems that the business (or industry) is enduring.

Another reason it works is that the metric is most often used by acquirers such as private equity firms.

What is Deep Value?

Another goal of this book is explaining how “deep value” is distinct from other types of value investing.

Most associate value investing with the investing style of Warren Buffett. Buffett began his career buying what he derisively called “cigar butts”, or simple cheap stocks. They were cigar butts in the sense that you could pick them up off the street for free because they were so cheap, and enjoy one last puff.

Buffett moved on from this style for a few reasons. The first was the influence of Charlie Munger, who was less influenced by Graham and was more interested in buying quality businesses.

The second was scale. Buffett became too big to nimbly buy a cheap low capitalization cigar butt, take his free puff, and move on. Frequently, Buffett had to buy up such large quantities of cigar butts where he became mired in the operational struggle.

The second was a handful of experiences that pushed Buffett in the direction of greater quality investments. In investments such as Dempster Mill (a struggling manufacturer of farm equipment) and Hochschild Kohn (a retailer forced to compete at razor thin margins in Baltimore), Buffett had to take controlling influence in each company to turn them around. In both situations, controlling a struggling company took its toll and consumed significant time from Buffett.

The experiences with Dempster and Hochschild stood in contrast to a different kind of investment that Buffett made in the 1970s: See’s Candy. See’s was a good business with a great brand. It generated high returns on capital and required little meddling. Once Buffett bought See’s and saw the benefits of high returns on capital, there was no turning back, and this became the basis for his future investment style. From then on, he bought large stakes in companies generating high returns on capital and held onto them for long periods of time to let them compound.

The 1970s and onward style of Buffett’s investing career is what most people think of when they hear “value investing”. Deep value, in contrast, is the style of investing that Warren Buffett used earlier in his career when he was managing smaller sums of capital and generated higher rates of return. Deep value is the style originally advocated by Benjamin Graham and later applied by investors such as Walter Schloss.

Deep value is buying cheap for the sake of being cheap and allowing mean reversion to return the stock to its intrinsic value.

The Buffett style of investing is certainly preferable because it generates higher compounded returns for longer periods of time, but it is extremely difficult to find businesses that generate high returns on capital that will not succumb to the forces of mean reversion. It is also a crowded trade, as all value investors are attempting to marry quality with cheapness.

Practical Application

Tobias maintains an excellent free stock screener keeping track of the best-ranking stocks according to the acquirer’s multiple, which you can use to systematically implement a value investing strategy. The large cap version is free, he also offers a paid version for the all-cap universe.


It’s rare that a book comes along that changes my mind and makes me see things from a different perspective. “Deep Value” was one of those books. I’ve read it three times so far and each time I gain a greater insight into the ideas that it conveys. I can’t give it a higher recommendation.

PLEASE NOTE: The information provided on this site is not financial advice and it is for informational and discussion purposes only. Do your own homework. Full disclosure: my current holdings.  Read the full disclaimer.

“Ready Player One” by Ernest Cline

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Years ago, I heard about a book called “Ready Player One“. I fully intended to check it out, but forgot about it and was sidetracked.

A short time ago, I read that Stephen Spielberg was working on a movie adaptation of the book and thought I had to check it out for myself.

Boy, was that a great decision! “Ready Player One” was one of the most fun books I’ve read in years.

The Book

“Ready Player One” is set in a dystopian 2044.  The world finally hit “peak oil” decades earlier and the world has been consumed by an energy crisis ever since.  The energy crisis triggered a worldwide depression and increases the occurrence of war, famine. The middle class has essentially disappeared and the poor live in trailers stacked high into the sky.

To escape from the world, users go to the OASIS. The OASIS is a virtual world. Users can put on a pair of virtual reality glasses and be transported to any place, limited only by their imaginations. Most fictional worlds are covered — there are authentic recreations of different universes: Star Trek, Star Wars, Firefly, Middle Earth, Blade Runner . . . just to name a few. Most of humanity spends all of their time in this virtual universe, mainly because the outside world is so horrific and the online world is so completely immersive.

At the beginning of the book, the creator of the OASIS (James Halliday) dies. With no living heirs, he leaves behind his entire fortune and controlling interest in the OASIS to whoever can find it in a series of puzzles embedded in the OASIS. Halliday creates a series of quests and puzzles in the OASIS for whomever can solve them. They are all rooted in his obsession with the 1980s and early video games.

The protagonist of the book (Wade Watts, known in the OASIS as Parzival) is one of millions of people looking for Halliday’s Easter Egg. He’s poor and growing up in a stack of trailer homes. As you might imagine, he’s up against significant competition, including a rival multi-billion dollar corporation intent on seizing the OASIS and Halliday’s fortune for themselves by any means necessary.

The Fun

The book is incredibly fun. Not only is it a great adventure with interesting characters and a compelling vision of the future, but it is a deep nostalgic trip into the 1980s. It includes references to everything imaginable from the decade. The protagonist’s virtual meeting room in the OASIS is modeled after the living room from “Family Ties“. One of the quests involves the movie “War Games”. Things covered include Rush, Pac-Man, obscure video games like “Dungeons of Daggorath“, pizza shop arcades . . . actually, it’s hard to think of what facets of pop culture from the ’80s aren’t covered. The protagonist even drives a Back to the Future inspired Delorean in the Oasis. Naturally, it is capable of space flight and light speed!

I grew up completely absorbed in the pop culture of the 1980s and the decade has a special place in my heart, so that’s probably a major reason why I loved this book. It was also nice to read a book written by fellow geek who loves the decade even more than I do. My video game experiences are mostly from the NES and SNES era, but I could still appreciate all of the Atari references.


If you’re looking to kick back and go on a rip roaring adventure, I can’t recommend this book enough. It’s the perfect summer read. Definitely check it out before the movie comes out next year.

Next on the agenda is Cline’s second book, Armada.  I’ll let you know what I think when I finish it!

PLEASE NOTE: The information provided on this site is not financial advice and it is for informational and discussion purposes only. Do your own homework. Full disclosure: my current holdings.  Read the full disclaimer.

“The Map and the Territory” by Alan Greenspan


I recently finished Alan Greenspan’s 2013 book, The Map and the TerritoryThe book is Greenspan’s attempt to explain what went wrong in 2008 and why it shocked most economists.

Greenspan Hate

Since 2008, it has become quite fashionable to hate on Alan Greenspan. Right wingers in the mold of gold bugs and Ludwig von Mises acolytes look at him as someone who fine-tuned the economy into oblivion. Left wingers look at him as a libertarian ideologue who was close friends with Ayn Rand and stripped the financial sector of regulation and let banks do whatever they want, leading the economy into oblivion.

In the current environment of bipartisan vitriol, it seems crazy that back around the year 2000, Greenspan was lauded as a genius and the greatest Fed chairman of all time. The title of Bob Woodward’s 2000 book about Greenspan reflects the popular sentiment: MaestroGreenspan was the Mozart of economics, solely responsible for the economic miracle of the late 1990s.

When someone’s reputation becomes that pumped up, it’s bound to mean revert.

Mean reversion can be quite nasty. The praise heaped on Greenspan in the late ’90s and early 2000s was more than he deserved. Similarly, the hatred heaped on him lately is also not deserved. What is amusing is that the recent criticism simultaneously paints him as both an interventionist and a libertarian ideologue. Greenspan hatred is bipartisan, but the reasons for the hatred are completely contradictory.

The Record

I think that Greenspan made some mistakes, but they have to be weighed against his triumphs. His record as Fed chairman was often exemplary, even considering the mistakes he made at the end. He wasn’t an ideologue. He was a pragmatist who tried to navigate the mess of our government to achieve the best possible result. My guess is that he started out as a gold-bug Ayn Rand libertarian, but realized that purist libertarian idealism wasn’t compatible with getting jobs in government where he could actually wield influence. He wanted to actually influence public policy, not just talk about it. To be effective, he had to be open to compromise.

That Greenspan era is referred to as “The Great Moderation“. The Great Moderation was an amazing economic achievement. The Greenspan era was one of infrequent shallow recessions, low inflation, low unemployment, climbing asset prices and resiliency in the face of multiple crises.

Resiliency is a key point. During his tenure, the United States faced the following crises: the crash of 1987, the Asian financial crisis, the demise of Long Term Capital Management, the collapse of the dot com bubble, the savings and loan crisis and 9/11. While the markets experienced some wild gyrations over these events, the real economy barely noticed. Even after the collapse of the dot com bubble and 9/11, unemployment peaked at only 6.3%. To put that in historical perspective, 6.3% was the unemployment rate in 1994 and 1987 during times of expansion.

The failures are the focus right now. The failures include: believing that banks wouldn’t take excessive risks with capital (a preposterous position in retrospect), fighting the regulation of derivatives (covered in this excellent Frontline documentary). He likely took interest rates too low for too long in the wake of 9/11 and the dot com bubble (as has been theorized by the economist John Taylor). Indeed, low rates in the early 2000s might be the very reason that the recession of that period was so shallow. The Great Recession might very well have been the bill coming due for having such a relatively easy recession earlier in the decade.  None of that can be proven, of course.

Although, imagine if Greenspan did not respond to the collapse of the dot com bubble and 9/11 and didn’t let interest rates plummet. He would have been blamed for making a recession worse than it needed to be at a time when we had low inflation and could have handled lower rates because inflation was so low. It all would have been to lessen the severity of a future recession which, in this alternate universe, might never have even happened. Hindsight is 20/20, which is an advantage of being a pundit and a cost to getting your hands dirty and taking positions in the public arena, as Greenspan did.

As for regulations, Greenspan should have pursued tougher regulation of banks and regulated derivatives. Although, it is important to keep in mind that this would have put him at odds with all the banks and the entire Washington establishment. The Clinton administration and the Republicans in Congress back in the ’90s loosened restrictions on banking and didn’t want to regulate derivatives. There was a bipartisan consensus on these issues back then, as demonstrated by the passage of Gramm-Leach-Biley. The deregulation combined with public policy that actually encouraged risky lending as a form of social justice was simply toxic. A good example of this is the Community Reinvestment Act and its intensification under the Clinton adminstration.

If Democrats are on board with deregulating, then who is going to stop it? When it comes to tearing down regulations, Republicans are the gas and Democrats are the brakes. In the ’90s, there were no brakes. It was all gas, with predictable long term results. Greenspan should have sounded the alarms, but I don’t think that one man (albeit, a very influential man) could stop an out of control Mack truck barreling down a highway.

Everyone deserves blame for the financial crisis. Certainly some more than others, but most people had a hand in it. The regulators failed, Washington failed, the banks failed. More importantly and less discussed is the fact that we failed. We failed as citizens to appropriately monitor our institutions. Growing up back in the ’90s, I was always amazed at the complete and total lack of interest that most adults had in current affairs. Civic engagement fell off a cliff. The voters were asleep at the wheel while our politicians made reckless decisions. A democracy is only as strong as its participants. We weren’t paying attention when Washington was engaging in reckless actions. We gladly borrowed the money without doing the arithmetic, but then blamed the banks when the bills came due. Nearly everyone had a hand in what happened. Greenspan failed, but one man is not singularly responsible for our collective failing as a society to appropriately monitor our institutions and act with financial prudence.

The Book

This is a book review, so I suppose I should actually review the book and stop talking about Greenspan!

The book itself is a real tour-de-force of ideas. Greenspan takes the reader through a tour of his thoughts and insights into the economy, which are too numerous to list them all. The book does contain a few very big ideas, which I’ll discuss here.

Much of the book is devoted to retelling the story of the crisis and the mistakes made. Greenspan doesn’t come out and say: “I screwed up and I am sorry”, but I think it amounts to that. He discusses how we need stronger regulations. He laments the bailout and the actions of the banks. He also makes a strong argument that we need to address the risks posed by too big to fail institutions.

He even talks about better ways to deal with the environment and takes the reader through a seemingly crazy experiment of trying to determine the actual weight of GDP.

Animal Spirits

It’s clear that Alan Greenspan spent most of his career trying to reduce the economy to equations, to mathematical arrangements that can be measured. That’s why it is fascinating in the book to see him examine the importance of flesh and blood human beings to the economy. John Maynard Keynes referred to human emotions driving economic activity as animal spirits. Humans don’t always make sense. 2008 helped Greenspan wake up and realize that animal spirits are key even if they can’t be measured.

That’s why the first chapter is called “Animal Spirits”, as Greenspan catalogs all of the ways that human emotions affect our economic judgement, which isn’t a surprise to most of us, but is indeed a revelation to economics that have spent their careers trying to reduce human behavior to beautiful mathematical models.

Greenspan tries to quantify some of these emotional judgments. For instance, he observes that the yield curve (where longer maturities supply higher interest rates), has been firmly in place throughout the history of civilization.  The earnings yield of the US stock tends to stay around 5-6% over long stretches of time, implying that this is the human preference of return for the risk of owning equities. (Sidenote: This might explain why Jeremy Siegel observes that the long-term return of equities after inflation is around 6% for nearly 200 years in his book Stocks for the Long Run.)

Greenspan marvels throughout the book at the extent to which human emotions drive economic behavior. He observes that the cultural diversity of Europe is a major reason for the Euro’s struggles as a currency to unite the region. Culture plays a role in determining the savings rate of a country (does the country value consumption in the present over long term saving?) as well as the effectiveness of regulation (is the culture permissive towards corruption and cheating?).

The Entitlements-Savings Trade Off

The most interesting point that Greenspan makes in the book is that there is a trade-off between entitlement spending and savings. This makes intuitive sense because in societies with generous entitlement programs, there is less incentive for people to save money. If you know that the government will pay for your retirement, what is the point of foregoing consumption in your youth to save for retirement? Should a 30 year old pick a vacation or increased 401(k) contributions? Our tendency is definitely towards the vacation and a generous safety net only makes that choice more appealing.

In fact, Greenspan demonstrates that the sum of total savings and entitlement spending adds up to 28-32% of GDP. Over time, as entitlement programs expand and the population becomes older, increases in entitlement spending reduce the nation’s savings rate. Every dollar that we spend on entitlement programs like social security and Medicare is one less dollar that we save.

In 1965, for instance, about 5% of GDP was social benefits and 25% of GDP was saved. A total of 30%.  By 1992, about 10% of GDP was devoted to social benefits and 20% of GDP was saved. Again, a total of 30%, with the increased social spending crowding out private savings. In 2010, the amounts converged. 15% of our GDP went to social spending and 15% of our economy was devoted to savings.

Due to increased entitlement spending, national savings declined from 25% to 15%.

This is bad because savings is the raw fuel of investment. That’s less money for banks to lend, that’s less money available to issue corporate bonds, that’s less money that can be raised in the equity markets. The less capital that is available, the less investments are being made in the future productive capacity of our economy.

I think Greenspan argues pretty conclusively that there is very likely a trade off between the two. Does this mean we should tear down our entitlement programs completely to maximize our savings rate? Of course not. With that said, entitlement reform should be pursued to contain the growth of entitlement spending before it endangers the federal budget and crowds out private savings.

I think this shows a larger trade off at the core of all public policy, which we like to pretend doesn’t exist. What liberalism offers in its most extreme form is a society with maximum safety and public comfort (i.e., generous safety nets, government funded retirement, a universal basic income). What conservatism offers in its most extreme form is a society with maximum dynamism (i.e., high economic growth and creative destruction). It seems foolish to think that we can have it all: have government take care of everyone’s materials need in a dynamic and fast growing economy. This trade off is at the core of our public policy debate. We should stop pretending that the trade off doesn’t exist.


You should read this book! Even if you dislike Greenspan (I’m imagining Ron Swanson on the right and Lisa Simpson on the left), it doesn’t hurt to get his perspective. He was at the center of most economic policy for the last 50 years and has some useful insights. I also think it’s impressive that he took the time to write this book and take us down his own intellectual journey in the wake of 2008. Most people develop their opinions about the world around the age of 20 and barely budge after that. Greenspan is 91 years old and approaches everything with an open mind, ready to look at the data and reevaluate his opinions. The world would be a better place if we all took that approach.

PLEASE NOTE: The information provided on this site is not financial advice and it is for informational and discussion purposes only. Do your own homework. Full disclosure: my current holdings.  Read the full disclaimer.