This article, by Justin Baiocchi, was originally published in The Northern Daily Leader on 14 February 2015.

Have you ever noticed a house for sale in your neighbourhood which seems to have been on the market forever? First one real estate agent sign appears, then another and another, and pretty soon the house looks like a primary school polling booth on election day. You can only imagine the conversations the real estate agents must be having with the sellers – ‘Yes, we know you want a million dollars, but you only paid five hundred thousand for it last year, perhaps you need to adjust your pricing a little bit?’. After about six months the agents lose interest, the advertising boards begin to fade and fray and still the sellers cling to their outlandish expectations. Usually the house eventually gets taken off the market for a year or so, until the same process is repeated again and again.

A key behavioural driver of this type of attitude in selling a home is known as the endowment effect. The theory is simple: people tend to assign greater value to something just because they own it. For example, in a famous study in 1990, researchers found that people who were given a free coffee mug demanded twice as much to sell it, as compared to what they thought it was worth before it was given to them. Though it was the same coffee mug, the simple act of ownership more than doubled the value that they assigned to the mug. You can see how this behavioural trait can be easily applied to the real estate market and of course to the stock market. Once an individual buys a house or share in a company, it immediately becomes more valuable in their eyes when compared to a potential buyer of the house or share. This can cause problems which go beyond a collection of old and faded real estate agent signs on the sidewalk. When dealing with shares, an investor who overvalues their shareholding is unlikely to ever sell, holding firm to the belief that their shares are worth more than the current market price. Such an approach can naturally lead to inappropriate decision making. There are times when it is best to sell your shares, rather than hold them all the way to the grave, but the endowment effect gets in the way of such rational decisions, often to your detriment.

One way to try and combat the damage caused by falling prey to the endowment effect is to ask yourself a simple question: if I had the money now, would I still buy this company, or would I buy something else? If the answer is something else, it’s time to sell and move on. And if you do have a neighbour with a growing collection of real estate agent signs, tell them about the endowment effect, I’m sure they’ll thank you for it. Maybe.

This article, by Justin Baiocchi, was originally published in The Northern Daily Leader on 17 January 2015.

This past weekend my wife and I put our four-year-old son, Jack, through the marshmallow test. The test itself is very straightforward – you simply ask your four-year-old (the test is only done once, when your child turns four) if they would like one marshmallow now, or two marshmallows later (with ‘later’ being an undefined period of up to twenty minutes). Somewhat surprisingly, around a third of the four-year-olds who do the test are willing to wait twenty minutes and have two marshmallows, rather than opt for the immediate enjoyment of just one marshmallow. So you’re probably asking yourself what the point of it is? Well, the purpose of the test is to measure self-control. Some of us have it and some of us don’t and around two-thirds of all four-year-olds definitely don’t have it. Many of us struggle to consistently save money, preferring instant gratification through spending over the slow accumulation of savings over time. Others however, have no problems saving money, happy to quietly sock away their savings until they’ve reached their financial goals. The difference between the two all comes down to self-control. And the reason self-control is so important, is that it plays a critical role in determining a range of outcomes related to matters like our health and wealth.

In fact, the level of self-control shown by a four-year old is an incredibly accurate predictor of how their future life is likely to play out. A group of researchers followed 1,000 children from birth until adulthood, with each child’s level of self-control measured using a number of different criteria. It was found that those children with higher levels of self-control were more likely to be richer, healthier, avoid drugs, prison and unplanned pregnancies and be better educated than those children with low levels of self-control. It turns out that your level of self-control as a four-year old is as reliable at predicting the future general direction of your life as is your level of general intelligence or your family’s socio-economic status.

Given that outcomes such as getting an education (stay at home studying rather than partying), keeping healthy (choosing the vegetables over the double-cream chocolate cake) or saving money (putting money into superannuation rather than buying a new mobile phone every year) all require some level of self-control, it’s not hard to see why it has such a strong predictive ability. And as for Jack, how did he do when it came to the marshmallow test? Well, let’s just say that Liz and I may be making quite a few trips to Long Bay Jail in the future.

This article, by Justin Baiocchi, was originally published in The Northern Daily Leader on 6 December 2014.

Some time ago I decided to decorate my office with a little greenery, sort of like bringing the outdoors indoors. Not having had much success with plants in the past, I thought that this time I would buy a bonsai tree and do my best not to kill it within the first week. I imagined that being a tree (albeit a very small one) implied a level of hardiness and resilience not enjoyed by plants. I had actually owned a bonsai tree before, while still a student at university. Being young and inattentive, I failed to give the tree the attention it deserved, until one day it jumped off my apartment balcony, meeting a messy end on the pavement far below. Some said it was simply the wind which blew the tree off the balcony, but deep down I knew it was a voluntary act of euthanasia, brought about by my preference for socialising over tending to my tree. This time I was determined to ensure my tree thrived. I did some research first, and on the basis of a Google recommendation, bought a four year-old Chinese Elm, reputed to be hardy enough for even the most incompetent owner.

Over the next week or so I carefully tended the tree; watering, pruning and shifting it around the office to catch the most light. You can imagine my surprise then, when a short time later it dropped all its leaves and started pretending it was dead. Again I turned to Google for advice and made two important discoveries: firstly, bonsai trees shouldn’t live inside, at least not permanently; and secondly, the tree needed a lot less water than I had been giving it. It turned out that my close and constant attention, particularly with the watering can, had led to me essentially drowning the tree. I needed to just put it outside and leave it alone for a while, with just the occasional watering and the tree would recover (which it did).

My mistake with the tree was not so different from a mistake many people make with their investments. They check the share prices every day, sometimes even more frequently than that, alternatively elated or depressed by the rises or falls in the share price. It’s as though keeping a constant watch on the share price will make a difference to its performance. The reality is that constantly checking your investments is more likely to lead to you making a rash decision – look! BHP just fell by forty cents, I should sell it! Research shows that short term price movements have little bearing on long-term returns and constant fiddling with your portfolio is likely to lead to lower, not higher returns. Just as I did with the bonsai, give your investments some time and space and they should perform better too.

This article, by Justin Baiocchi, was originally published in The Northern Daily Leader on 22 November 2014.

Newspaper headlines were generated this week by a very ordinary event – someone resigned from their job. Not usually the type of event you expect to see leading the 7:00 pm news bulletin. In financial circles however it was big news, for that person was none other than Gail Kelly, the CEO of Westpac Bank. Of course bank CEOs resign all the time and it seldom makes the news, so what was so special about Mrs Kelly? A fair proportion of the media attention was likely due to the fact that the resignation of Mrs Kelly caused the number of women CEOs in the top 50 largest companies in Australian to drop by a third, meaning that there remains only two women at the top of the corporate tree, with 48 men keeping them company. Proof perhaps that the glass ceiling is still very firmly fixed in place in corporate Australia.

Fortunately the majority of the media coverage focused on Mrs Kelly’s many achievements while running Westpac Bank, now Australia’s third-largest company as measured by market capitalisation. Shareholders in Westpac should be grateful to have had Mrs Kelly’s steady hands on the helm over the past six years, for good leadership at the top is not something which should be taken for granted. For to paraphrase well-known investor Peter Lynch, you should invest in a company that any old idiot could run, because sooner or later one of them probably will. The truth is that a seven figure salary and an MBA from business school are just as likely to get you a dud CEO as a good one. Though there is a school of thought which questions the value that any CEO brings to a company. In many situations the apparent performance of a CEO is more down to luck than skill. If you happened to be running a mining business at any stage from about 2001 to 2012 you would have been hailed as a great leader and no doubt received some hefty bonuses along the way. The fact that this period overlapped with one of the greatest demand-driven commodity booms ever seen was obviously just a coincidence and in no way should have detracted from the size of your year-end bonus.

Like the classic movie, company CEOs tend to fall into one of three groups: the Good, the Bad and the Ugly. Good CEOs are hard to find but can be expected to leave the company in better shape than they found it. Bad CEOs need to be moved on as soon as possible, but it’s the Ugly CEOs you must avoid. To paraphrase another great investor in Warren Buffett, when management with a bad reputation meet a business with brilliant economics, it’s usually the reputation of the management which remains intact.

This article, by Justin Baiocchi, was originally published in The Northern Daily Leader on 25 October 2014.

Earlier this week I was doing some work at the dining room table, deep in thought as I pondered the theoretical advantages of the Capital Asset Pricing Model over the Arbitrage Pricing Theory. Into this comfortable, cosy world, intruded an almighty racket of cheering and whistling, coming from the TV in the lounge. It turned out to be the grand finale of yet another reality TV show, The X Factor. As I watched the confetti and adulation rain down on the winner, I wondered whether or not we would remember her name in a year’s time. For it seems that every subsequent winner of these types of television shows seems to last for a shorter period of time in our consciousness. It’s as though the law of diminishing returns has taken hold of reality TV – if the first winner of X Factor enjoyed a fame factor of 10, this week’s winner can probably expect a 2 at best.

In many ways the life of the winner of X Factor (or Idol, or Big Brother…take your pick) resembles some of the investment fads which burst onto the investing scene – one day it’s the main topic around the BBQ; the next day it’s all over and anybody foolish enough to have been taken in is left ruing the cost of an expensive lesson. An example of this was the recent craze in rare earth metals. The story sounded plausible enough: rare earth metals are a mix of very rare and very expensive metals, with obscure names like Scandium, Promethium and Cerium. Their uses are varied and they play a role in the manufacture of everyday devices such as television screens, cameras, ipods and also a range of medical uses. As their name suggests, they are rare indeed, with major deposits located in China and the US and Australia to a lesser extent. China produces around 95% of rare earths and uses quotas and production restrictions to limit supply. In the height of the mining boom, a small Australian company, Lynas Corporation, began development of a rare earths deposit at Mt Weld, in Western Australia. The plan also included a processing plant in Malaysia. As prices for rare earth metals rose, so did investor interest. At one point in 2011, Lynas Corporation was valued at over $4 billion – an amazing valuation considering the company had yet to make a profit and had accumulated losses of $200 million.

These mundane facts did not stop investors from piling into Lynas’ shares, with disastrous but predictable results. Problems with the processing plant and a collapse in the price of rare earths brought the company to the brink. Anyone who bought shares at the peak would have lost 96.67% of their investment. The moral of the story – think of a fad stock as an X Factor winner, and think where they might be in a few years’ time.

This article, by Justin Baiocchi, was originally published in The Northern Daily Leader on 11 October 2014.

In a recent column I discussed how one of the unscientific indicators we follow in assessing the health of the stock market is whether or not the ‘funny money’ had arrived. This of course refers to the temptation by companies and investment bankers to take advantage of cheap credit to fund a range of ridiculous and complicated deals, usually just before the market falls off a cliff (in this regard, the recent proposed takeover by Glencore of miner Rio Tinto definitely hit a warning light on the funny money dashboard). One of the other unusual indicators we look for is the rise of the ‘Empire Builder’, though this tends to be more company specific, rather than an insight into the overall health of the stock market.

The Empire Builder is a company CEO who displays a number of characteristic traits. Often they are the founder of the company, or they got on board when it was just a minnow in its industry. The Empire Builder is an aggressive deal-maker, with the growth of the company almost solely due to takeovers and acquisitions. Once the takeover target has acquiesced and been folded into the parent company, the Empire Builder is already close to sealing the next deal, looking for the next opportunity. The Empire Builder is also usually feted in the financial press, lauded as a visionary leader who can do no wrong. Most Empire Builders also need a company jet, preferably a long-range Bombardier, needed to be able to visit the far-flung empire at the drop of a hat. The Empire Builder thrives in boom markets, taking advantage of low interest rates and willing lenders to build a global business empire underpinned by vast quantities of debt.

The problem with the Empire Builder, is that he or she is usually harder to spot than the funny money. Most times you only know you had encountered an Empire Builder once they have retired, generally with a large gold watch and an enormous severance package. This is because the financial statements provide no hint of the actions of an Empire Builder. Much like a pyramid scheme needs a willing influx of new victims, the Empire Builder masks his or her activities through consistent increases in company revenue as more and more acquired companies are added to the empire. It’s only when a new CEO is appointed and finds out that no-one had been actually running the company, that it becomes apparent than an Empire Builder had been in the executive suite. You can make money from an Empire Builder however: sell before they retire and use any gains to invest in a real business run by competent management. Use the Empire Builder as a boost to building your own little investment empire.

This article originally published in The Northern Daily Leader on 27 September 2014. 

I recently sat down to do some long term planning – wondering what first car I would buy our son, Jack, when he eventually learns to drive. As Jack only turns four in December, you can tell that I like to have canvassed all my options long before any decision is required. My musings were prompted by the long line of Year 12 P-platers parked outside McCarthy Catholic College every school morning. Some drove small hatchbacks with names that sounded like a schoolies party at the Gold Coast: Fiesta, Spark and Sonic. Others drove mud-splattered four-wheel-drives, while a few unlucky ones were driving mum’s old Volvo station wagon or something similar. Not that there’s anything wrong with a Volvo, or with station wagons in general, it’s just that even I’m not too old to know that neither one of those types of cars are particularly ‘cool’.

As I’ve mentioned in the past, cars can be a lot like investing. Some drivers (and investors) prefer their cars (and investments) to be fast and noisy, prone to swerving all over the place and with the odd occasional crash. Others prefer safety over speed and are quite happy getting from A to B at a sedate pace and without all the angst and concern that accompanies a crash (both in automotive and financial terms). And just as cars can be hotted up with mag wheels, spoilers, LED running lights, mega-watt subwoofers and an exhaust so wide you could fit your leg in there, so too is the world of finance prone to a bit of over-engineering. In fact, one of the informal indicators we follow when assessing the state of global and domestic financial markets, is the answer to the question: “Has the funny money arrived yet?” By ‘funny money’ we don’t mean the arrival of Billy Connolly bearing dollar bills – what we mean is, have financial markets started to get just a little bit too creative? Have well-paid investment bankers begun to invent creative and confusing ways of turning one dollar into ten? Is the financial press full of acronyms such as CDO, SIV and CLO, or words like credit derivatives, structured products and synthetic arbitrage?

The funny money usually makes an appearance near the top of any investment market, when money is cheap and it seems like the good times will never end. Private equity deals, leveraged management buyouts and ludicrous takeover bids all get funded by the funny money, usually just before the bottom falls out of the stock market (remember the almost entirely debt-funded private equity takeover bid for Qantas in late 2006?). So has the funny money arrived yet, or will the party continue on for longer? We think the latter, although Billy Connolly may not be too far away.

This article originally published in The Northern Daily Leader on 13 September 2014.

We recently had a meeting with a potential new client who was interested in our firm’s services. During the discussion Steve (not his real name of course) related a story of how he invested some money many years previously through a local stock broker. It was around $50,000 in a number of ‘blue-chip’ shares. Soon after the money was invested, and unbeknown to the broker, Steve started buying and selling the shares that had originally been purchased. The stockbroking firm on the other hand, would regularly send Steve a quarterly report theoretically showing what the shares were now worth and how they had performed. Of course the report bore little resemblance to reality, as Steve had bought and sold the shares many times over. Over the course of the years, Steve managed to turn his $50,000 into a healthy portfolio of around $500,000, mostly through jumping in and out of somewhat speculative shares. And all the while the quarterly reports from the stockbroker kept arriving, showing how the now fictional portfolio had performed.

Eventually Steve made a few bad investment choices and ended up losing all the money that had been invested. From $50,000 to $500,000 and then to $0. And in the background the stockbroker was still sending the quarterly reports showing what the initial investments were now worth. By the time someone at the broking firm realised that they had been sending out reports for a portfolio which didn’t exist, it was nearly fifteen years later. The money had well and truly been lost, but guess what the value of the fictional portfolio was showing? Based on reinvestment of any dividends, the portfolio was supposedly worth around $1.5 million. So if Steve had simply forgotten about his initial investment and had rung his broker up fifteen years later, he would have found out he was a millionaire.

I tried to replicate this myself, using an imaginary $10,000 investment in each of Woolworths, BHP, Wesfarmers and CBA at the start of 1994, twenty odd years ago. If you had reinvested any dividends since then, your $40,000 would now be worth around $770,000. That’s an annual average return of just under 16% for twenty years. So while everybody else worries about wars, recessions, global financial crises, market collapses, bank failures, mining and housing booms and busts, you could have simply and happily collected your average annual return of 16%. No stress, no fuss. Of course, if those four shares had been more like ABC Learning and HIH and less like CBA and Woolworths, the outcome would have been very different. But still, it makes you think, doesn’t it?

This article originally published in The Northern Daily Leader on 30 August 2014.

Some years ago I offered to give my father a few lessons in using a computer. Dad had never worked in an office and home PC’s only became commonplace after my sister and I had left home, so he had very little familiarity with computers. I knew we were in trouble however, when I switched on the computer and gestured to the screen, saying “This is your desktop, it’s where you keep shortcuts to programs”. Dad looked strangely at me and said “That’s not a desktop, that’s a computer screen”. Things got worse when I handed over the mouse and got him to navigate around the desktop. He ended up with the mouse on the edge of the table, about to fall off onto the floor and the cursor jammed against the far right of the screen. “What are you doing?” I said. “It’s stuck!” he said, “I can’t move it!” I gave him a withering look and told him to pick it up and put it back on the mouse pad. “What do you mean?” he said, “I can’t just pick it up. What will happen to the small arrow on the screen if I do that?” At that point I decided we had had enough for one day and ended the lesson. Some challenges in life are just too great to be conquered and teaching my father how to use a computer fell into that category.

Truth be told, he didn’t really need to learn how to use a computer. Dad’s speciality in life was playing golf and it was something he was very good at. Some people become lawyers or accountants or professional sportsmen (or women), and others become IT experts. Modern society allowed my father to specialise in his field, giving him the resources to hire a computer expert if he ever needed one. The same can be said of any profession or occupation. The surgeon offers her services to people who know little of surgery, but is more likely to hire a builder than try to build her own home. The builder in turn might be extremely efficient at building houses, but probably pays an accountant to do his taxes. And so on and so on. And as you would expect, the same principles apply to investment advice. It’s sometimes hard to tell, given the ongoing stories of bad advice, fraud and irresponsibility, but investment advice is its own specialised field. The real problem is that the barriers to entry are too low – as pointed out recently in The Sydney Morning Herald, hairdressers require a greater level of training than the minimum level set for financial planners. A bad haircut is only going to matter for a few weeks, but the impact of bad financial advice can last a lifetime.

This article originally published in The Northern Daily Leader on 16 August 2014.

One of the most interesting writers to emerge in the field of finance in recent years is Nassim Nicholas Taleb. Taleb has managed to forge a successful, if controversial, career in literature, following on the back of a long stint as a derivatives trader on global equity, commodity and currency markets. Taleb’s first book, Fooled by Randomness: The Hidden Role of Chance in Life and in the Markets was a critique of our ability to correctly understand randomness and its impacts, both on a daily basis and also in regards to investing. Taleb believes that we tend to discount the probability of severe negative events occurring – an approach akin to old line about ‘picking up pennies in front of a bulldozer’. It’s all very well making a small steady return, but when things go horribly wrong it ends really badly (i.e. you get squashed by the bulldozer). As an example, Taleb described financial option sellers as people who “eat like chickens and go to the bathroom like elephants”, meaning that they earn a small steady living selling options but when it goes wrong it’s a huge disaster. Taleb’s view was that we ignore the unknown and unforeseeable events and focus too much on those events we can predict with greater certainty, erroneously believing we understand and can predict all outcomes. Taleb advocates an investment approach which allows you to benefit from a ‘fat tail’ event (an extreme event with a low probability of occurring, but a large payoff – taken from the description of a non-normal distribution as ‘fat-tailed’).

In essence, Taleb believes in an investment approach which entails putting the majority of your money in the safest inflation-linked investment you can find (US Treasury Inflation-Protected Securities probably) and a small amount in an outrageous bet which will make an obscene amount if the sky ever falls in. There is a certain attractiveness to this approach – you can be confident that your money is safely invested, and when financial disaster does strike, your 1-in-1000 bets will pay off handsomely and you can start thinking about what colour to paint your private jet. The problem for most people however, is that the safest inflation-linked investment you can find is not going to generate much money for you to live off (a recent sale of such US Treasuries was done at a yield of 0.249% – even the interest on a bank savings account is higher than that) and the timing of the great money-making event is uncertain itself. Yes it may be coming, but you may run out of money long before your low-probability but high-payoff bet ever comes off. Taleb’s books are an entertaining read (if you can see past the machismo, self-aggrandizing and thinly-veiled insults which occasionally threaten to crowd out the good bits), but it’s no investment guide for retirees.