Misleading Knowledge, Part II

Bill is away until 17 April. So in his absence, we'll bring you some of his most insightful, caustic and witty observations from the last 14 years. This article was first published in November2006.

Here is a general rule for you: If someone wants to sell you an investment, you don't want to buy it.

Investments are different from other things you might buy. You could expect to buy a good used car, for example, simply because the previous owner needed a bigger one or wanted a snappy convertible.

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So, too, might you get a good deal on a watermelon, if the farmer had an especially bountiful crop. A nice house might be offered to you, if the previous owners' children had grown up and moved away; he might feel it was time to downsize'.

But nobody ever voluntarily downsizes an investment portfolio. Nobody ever has too many shares of a good stock or trades in a good investment just because he's had a hair transplant and is looking for a little action. Barring a forced sale, serious investors hold good investments until they believe they are no longer so good. Which means that buyers must realise: whenever they buy a share, they take it off the hands of someone who probably knows it better than they do and who judges it no longer worth holding onto.

And there's another reason to look askance at what people sell you: selling costs money. Every investment that is packaged and sold requires lawyers, accountants, secretaries not to mention advertising costs and sales commissions.

Just look in any financial magazine or newspaper. What do you see advertised? Mutual funds. Insurance programs. Managed accounts. Private banking. All the things that have such wide margins that they can afford to advertise. You will find ads for funds, funds of funds, and maybe even funds of funds of funds. Because each layer carries an extra little bit of grease. The investor who buys a fund of funds of funds is practically walking down a dark street in a bad neighbourhood with a sign on his back: "I'm Carrying $500 in Cash!"

But the professional will get a better rate of return,' you might protest. So it's worth paying a little bit in commissions.'

Is that so? It is probably so that a little grease will ensure that a professional will not do anything patently absurd and foolish. He has no incentive to do so. And he's usually learned enough about investing to avoid the obvious mistakes. In this sense, the rank amateur if he is too lazy to read a book or think about it for a few hours is better off paying the commission. But between the serious professional and the serious amateur, the returns will be about the same. Both have available to them the same information and the same theories.

The best investments are those no one wants to sell. They are the investments that pay no commissions or fees, that have no managers, that give no press conferences, that issue no quarterly reports, and that you have to work hard to find. These are the kind of investments private investors look for and often wait years to buy at a good price.

Who do we all know at least by reputation who invests this way? Guess who? Warren Buffett, the most successful investor of all time. Buffett famously disdains the gaudy baubles of the modern investment world. He uses no computers to do his research, preferring a yellow note pad and a Number 2 lead pencil. He waits on no brokers to provide hot tips. He is his own fund manager, a service for which he charges no fee. And he searches out companies often over the course of many years as a private buyer would, focusing on the earnings yield the company will bring, not on a speculative capital gain.

That is to say, in investing as in everything else, you don't get something for nothing. The investors who succeed are those who work hard at it and avoid the public spectacle of the markets. In fact, only lazy investors are ever in the market'. Instead, the more serious they are, the more they are out of the market and into specific companies that they know inside out.

For in investments, as elsewhere, it is the insiders' who generally do better than the outsiders. This should come as a surprise to no one. The insider is the person who has eliminated the most unknowns by actually knowing what is going on in the business. In this sense, he is the most private of investors in Nietzschean terms, his knowledge is far more private erfahrung -actual experience -than it is public wissen -what everybody thinks he knows.

The ordinary investor cannot be an insider in the stocks he buys. But he can come very close. He can work hard to learn the industry, study the business and get to know, in detail, both the numbers and the management. If he does his work well, he will choose an industry he likes close to home and stick to it for a number of years and gradually come to know the business better than the real insiders'. That's what Buffett tries to do.

What you're doing, of course, is lessening the likelihood that your own ignorance of the future will hurt your investment performance. The more you study, the more you know, the more familiar you are with the business the fewer unknowns there are.

Of course, you can never entirely eliminate the unknown unknowns. That is why you must also have rules, principles and theories, they allow you to make decisions even when you don't know the facts.

Our most deeply held theory here at The Daily Reckoning is that everything that lives also dies. It is just an observation, but it seems to apply to everything trees, governments, financial systems, bubbles, empires, and people themselves. There is a life cycle to all things institutions, insects, and insurrections. They begin small, they grow, they mature, they get taken over by parasites and they die. Tout casse et tout passe, as the French say. Everything breaks up and everything goes away.

In the stock market there is a life cycle of from 30-40 years from one peak to the next.

These cycles of up and down, bull and bear are well known. What you can never know for sure is where you are in the cycle. "Markets always do what they're supposed to do," say the old timers, "but never when they're supposed to do it.

While the Dow, US bonds, and US housing are probably going down, some things are probably going up. Japan has been in a slump for 16 years; it now looks like a good bet to change direction.

And gold suffered a bear market that lasted for the last two decades of the 20th century. Since George W Bush entered the Oval Office, gold has more than doubled. It seems to be in a long-term bull market.

But there's nothing like a 20-year bear market in his favourite metal to give a man a sense of modesty. As your author's gold coins fell in value; his stock of modesty increased. Now, at least, he knows what he doesn't know. That still leaves the things about which he knows nothing at all.

Here we are in terra incognita. Since 1971, for example, the world financial system has looked to dollars to store and measure its wealth. But to what does the dollar look? Nothing at all. It merely floats on its full faith in empty promises and the credit of the biggest debtor in the world the USA. We've never seen anything like it. People work all their lives to lay in a store of a pure-paper money that lost half its value in the last 20 years and could lose the other half any time. Foreign governments, pension plans, insurance companies, hedge funds too stake their financial futures on this same paper money, whose value is uncertain and whose future is unknown.

Never before have so many people had so much wealth tied up in so many dubious propositions. During the 20 years from 1980 to 2000, the capital value of America's stocks rose more than 1000% and the value of America's residential housing approximately doubled. Meanwhile, so has the American government's financing gap' gotten so large it will likely never be bridged. Between the financial obligations of the US federal government and its anticipated revenues is a canyon of $65 trillion, in present US dollars. No nation ever faced such a huge economic challenge.

Nor have the western economies including Japan ever been threatened by the competition they're now getting fromthree billion Asians. Nor has any country ever run a trade deficit on the scale of the current US shortfall of $800 billion. Nor has any country had anything like the dollar reserves now in the hands of the Chinese more than $1trn of them.

Also unprecedented is the derivatives market. As recently asten years ago it barely existed. Now, the latest news tells us it has swollen to more than $300trn. What kind of shock would it take to bring it down? Even if it only shivers and shakes, what will happen to the financial system when it does?

Against all this kudzu of dollar-based wealth, debt and delusions is a solid, slow-growing oak of gold man's traditional way of keeping score in financial affairs getting larger at the almost invisible rate of 1.7% per year.

How will it all turn out? We don't know. All we do know is that every previous monetary system has washed up. And every paper currency every previous experiment with paper money has ended in regret and recrimination. All bubbles end. All of them. And when a bubble in paper money comes to end, typically people abandon the paper and rush back to gold.

Sooner or later a day of reckoning must come for the dollar, America's trade deficit, and the world's faith-based monetary system. We don't know how. We don't know when. But it is a pretty good bet that it will happen.

Of course, if you knew how it would turn out, if you could look into the future, you could take just the right action at just the right moment to take advantage of it. But we are profoundly ignorant. All we know is that, however it ends, it would probably be a good idea to have a few gold coins in your pocket when it does.

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