Sunday, 20 July 2014

Are Investment Managers Worth The Money?

One of the problems with low interests is that it allows for weak business models to survive when they shouldn't, thus, when interest rates normalize the ensuing economic downturn is worse as the "marginal" businesses can no longer make a profit and they get flushed from the system through bankruptcy. For example, a one million dollar loan at 4% costs the borrower $40,000/yr in interest. If his business is generating $100,000/yr in profit, minus the $40,000 interest, he has $60,000 left over to either pay his wages or expand his business. Should interest rates normalize to 8% however, he now must pay $80,000 in interest and only has $20,000 left over to pay his own wages with... and will likely go broke in the near future. Therefore, a healthy interest rate also leads to a healthier economy, since only the best and strongest of businesses can keep their head above water in an environment of normal interest rates.

When looking at the stock markets, however, I am puzzled at what investment managers call "success." Usually, they all talk about "beating the market" as it is, which is rather misleading. If the stock markets in general decline by 20% and the investment manager loses only 15%, he claims "success" because he beat the market by 5%. This is nonsense. A loss is a loss, however, I do see what they are going after because apparently if you average out the growth of the stock market since the Great Depression, it returns an average of 9% a year (if you include dividends), and compared to the interest rates we've been offered since the Dot.com bubble, a 9% return from stocks has without a doubt beaten the rates one could get from more "secure" investments like bonds, treasuries or term deposits. It makes sense to chase after a 9% annualized average return when you can only get 2% elsewhere. But, ask yourself then, why in the hell would anyone have invested money in the stock market during the 1980's and 1990's when you could get anywhere from 8% to 15% (or even higher in the early 80's) from buying secured, low-risk 10 year bonds? Well, the truth is, if you could get say, 10% guaranteed return, along with almost zero risk of actually losing capital, you would be a moron to invest in the stock market at 9% return with a much higher risk of losing a significant portion of your capital. Thus, in order to entice you to put your money into stocks, you might have to beat the guaranteed return of safe investments by at least 5% (ie 15% return) in order to convince you to take the risk... otherwise, why take the risk?

So, when compared to how low interest rates allows for bad businesses to survive when they shouldn't, is it really any different for a modern investment manager to claim a "successful" annual return of 8%-9%? I started investing in the late 1990's, just before interest rates started to seriously fall, so I can't speak with any authority on how the markets worked in the 80's and 90's, but I cannot imagine people flocking to give an investment manager their hard earned capital for a return that was less then a 10-year bond would yield. It would just be poor business to do so. No investment manager would have survived in such an environment, only those that could beat the 10-year bond would have survived. What does this say about the validity of our modern investment managers? How many would be drummed out of business if interest rates normalized at a mere 5% above the inflation rate, which has long been considered "the proper interest rate?" Even when taking the government's faked CPI numbers at face value, this should bring interest rates to 7% or 8%. If accurately figuring CPI - the same way we did in the 1980's - we should be receiving 13% to 17% interest. What investment manager could beat that return consistently in the stock markets? Not a whole lot.

Not only is there a lot of dead-weight staying alive in the business world because of low interest rates, but there is also a lot of dead-weight investment managers claiming to be stock market experts, that simply couldn't cut the mustard should interest rates merely return to their historical norm. I am very leery of investment managers. They are complacent and many of them are buffoons who would likely serve society better by working the fry basket at McDonald's.       

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