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Against The Gods
The Remarkable Story Of Risk
By Peter L. Bernstein
Against The Gods by Peter Bernstein is a wonderful, historical account of mankind's intellectual understanding of risk. The book follows the intellectual development of risk management and how people throughout the centuries have changed their views of what constitutes risk and how investment risk can be mitigated.
Anyone who likes the history of mathematics or investment will probably enjoy this book. It is scholarly, but also fun-to-read and interesting. It will help investors think about how they, themselves, interpret "risk." And, it gives us insight into how some of the world's greatest minds have viewed risk.
The book's cover is a reproduction of Rembrandt's Storm on the Sea of Galilee, which depicts a group of people fighting to maintain control of their sailing ship (or, just trying to hang on!) while their craft is tossed about by the storm.
Long ago, people felt they were at the mercy of arbitrary gods or forces, which could act at whim, either to support a person or defeat him. The gods played dice with us mere mortals. So, there was no point in contemplating risk management. Just as the storm tosses the wooden ship about, so, too, would our lives and destinies be determined by fate.
Of course, people of ancient times played games of chance and wagered. But, it was not until years later that many thinkers, philosophers, mathematicians, and merchants realized that the study of simple children's games offered great lessons for adults-especially relating to financial decision making.
People learned that they could evaluate risk and take steps to mitigate it. They no longer were at the mercy of the gods. They could control their own fate. They could minimize risk in their endeavors. They could evaluate probabilities and chance.
Against The Gods tells us many stories. One of my favorites is the story of a coffeehouse opened by Edward Lloyd in 1687 where merchant sailors met to discuss colonial trade and seafaring issues. The chance of any given vessel going down in a storm was not great, but it did happen. And, if it did, it could wipe out a trader financially.
So the traders began contributing small sums of money to be paid to a member who lost a ship. The merchants benefited from the deal. In all likelihood, their ship did return safely. In that case, they were out only a small portion of the profit the ship earned on the journey. But, if the unfortunate happened, and the ship was lost at sea, they remained solvent. They recovered the financial loss of their ship from the pool of money. The merchants learned to protect themselves from the volatility of negative events.
Soon people specialized in the business of pooling money to protect against misfortune. They became known as underwriters. The insurance industry was born. And, the coffeehouse evolved into Lloyd's of London, one of the pioneer insurance companies.
Bernstein tells how farmers, who were previously helpless against uncertain market prices for their crops, learned to mitigate risk by entering into contracts with food producers, who agreed to buy their crops at a fixed price in the future, regardless of the future open market price of the crops.
If the future market price of the crops were significantly less, the farmer was protected from the danger of having produced crops with no or low market value. Of course, if the market value of the crops rose, the farmer would not receive the extra benefit, as he had agreed to sell them at the lower price.
Similarly, the food producer is protected against a significant increase in prices. Overall, such contracts lower price volatility and risk to both farmers and food producers. Both parties benefit. The concept of a futures contract was born.
Many stories later, Bernstein tells us of Black and Scholes who developed a mathematical model of options' pricing. Rejected by the editors of prestigious financial journals, who only published papers from authors with Ph.D's, eventually the paper was published and went on to become "one of the most influential pieces of research ever published in the field of economics or finance." Uncertainty, itself, could now be valued.
"Options bear a strong family resemblance to insurance policies and are often bought and sold for the same reasons. Indeed, if insurance policies were converted into marketable securities, they would be priced in the marketplace exactly as options are priced. During the time period covered by the premium payment, the buyer of an insurance policy has the right to put something to the insurance company at a prearranged price-his burned-down house, destroyed car, medical bills, even his dead body-in return for which the insurance company is obliged to pay over to him the agreed-upon value of the loss he has sustained...."
Later, in an attempt to reduce stock portfolio volatility, Bernstein tells us the story of how "portfolio insurance" came to be and how and why it failed.
Some of the academic studies are downright funny in their classification of the obvious. For example, the "endowment effect" which states that people tend "to set a higher selling price on what we own (are endowed with) than what we would pay for the identical item if we did not own it."
For example, when you were a kid and another kid wanted to buy a candy bar of yours, you asked $5. When you wished to buy one, you offered five cents. That's called "Greed." Whatever you want to call it, it's discussed in Against The Gods.
"Why corporations pay dividends has puzzled economists for a long time. ... From 1959 to 1994, individuals received $2.2 trillion of the dividends distributed by all corporations, financial as well as nonfinancial and incurred an income-tax liability on every dollar of that money. If corporations had used that money to repurchase outstanding shares in the open market instead of distributing it in dividends, earnings per share would have been larger, the number of outstanding shares would have been smaller, and the price of the shares would have been higher. The remaining stockholders could have enjoyed "home-made" dividends by selling off their appreciated shares to finance their consumption and would have paid a lower tax rate on capital gains that prevailed during most of the period. On balance, stockholders would have been wealthier than they had been."
To explain this, Bernstein discusses behavioral finance, saying investors psychologically divide their money into two pots. One pot for spending. One pot for saving. Selling shares for consumption could injure the psyche.
While it is true that dividends are a very-heavily-taxed way for a large corporation to reward its shareholders, I'm a big fan of dividends for consumption, rather than selling shares. Always willing to unpuzzle economists, I'll explain my views below.
I found Against The Gods by Peter Bernstein to be excellent reading, which I highly recommend to all serious investors. I found myself not only reading, but rereading this top-notch work.
The Remarkable Story of Risk
Suppose you have $1 million dollars saved. You are retired and spend $50,000 per year to live. The income represents 5% of your portfolio value, about the maximum amount you can withdraw without invading principal. Four percent is a safer and more conservative withdrawal. (Your long-term, total return on such stocks might be 8 to 10%-5% in dividends and the rest in stock price appreciation. Thus, your capital and income just keep up with inflation, which typically runs at 3 to 5% over time.)
Suppose your $1 million is invested in solid, dividend-paying stocks, paying an average annual dividend of 5%. Over the long-run, hopefully, the dividend grows and keeps pace with inflation. Your consumption needs are financed from a pure business return. As long as the companies in your portfolio continue to do well as businesses, the continued existence of the stock market becomes almost inconsequential.
Suppose, however, your $1 million dollars is invested in growth stocks paying no dividends, but which are expected to have higher growth. You would need to sell 5% of your shares annually. This assumes the continued valuation of your portfolio at $1 million. However, stock market volatility can really hurt you. Given a bad bear market, the value of your shares could easily fall in half, despite the companies doing well operationally.
In the growth-stock situation, your portfolio is now valued at $500,000. You still need to withdraw $50,000 to support yourself. This represents 10% of your portfolio. You will be invading principal. If the market stays down for a few years, when it recovers, you won't have many shares left! You will have been dollar-cost-averaging in reverse!
To really illustrate the point, assume the stocks drop to only 25% of their initial value. This can happen in a bad market, especially to growth stocks. Your portfolio now stands at a $250,000 valuation. It will be depleted in only five years if the market stays down. The investor who depends upon dividends will not be forced to sell shares at dirt-cheap prices.
For more about this topic, be sure to read my book, Becoming An Investor: Building Wealth By Investing In Stocks, Bonds, And Mutual Funds..