So, I thought it would be useful to you if I spoke a little bit about my background and what I learned about market crashes. It took me years to discover how to invest. Obviously, I wasn’t always the expert that I am today. I’ve worked in various investment fields for more than 20 years. Most recently I have worked in the real estate market. This is interesting because real estate was also my first experience of investing.
Profiting from market crashes
For example, when I was 16 I was a student in the United Kingdom. One of my school teachers managed to predict a housing crash in the UK. He was a real smarmy and smug guy. I couldn’t stand him. But I had to admire his brilliance in managing to profit from a crash in the UK housing market.
House prices never go down…
Basically, what he did was sell his house at the peak of the market. Housing prices were going through the roof and everyone thought that it would continue forever. Even his bank manager and friends laughed at him. “House prices never go down!” they laughingly told him.
A few months later they were laughing on the other side of their faces. People were defaulting on mortgages or finding the price of their home had collapsed. At this point my (smug) school teacher bought a new house and pocketed a tidy profit. This was a classic case of market timing.
Market timing is dangerous
Now market timing is not something I recommend to anyone. It is extraordinarily difficult to pull off and no one is successful doing it long-term. What I have learned over the years is that you want to forget market timing. Over time the market always goes up. If you invest long-term you really can’t lose. But you can lose a lot with a market timing strategy if you get it wrong.
However there are ways to invest where a crash in the market need not be a devastating event. In some ways a market crash weeds out the unhealthy businesses. If you invest in the right way you will find you are insulated from their effects. I will talk more about this in later articles.
What is investing?
Experiences like this inspired me to learn about investing. So, when I went to college I decided to learn finance. I wasn’t necessarily the greatest mathematician (I’m still not) but I enjoyed the rational process that financial and investment analysis followed. Remember that concept because its important. You must always use a rational process to decide upon your investments. It protects you from loss and ensures that you will meet your investment goals.
Investment is the process by which you finance the projects of someone else….
I found that no matter what we were looking at (stocks, bonds, company finance, real estate) this same process was followed. This is because of what we mean by finance. By finance we mean finding sources of funds to pay for our projects.
Investment is the other side of the coin from finance. When you buy a stock, you are financing the projects of a company. The same when you buy a bond. You are doing the same thing. Investment is the process by which you finance the projects of someone else.
How do you value an investment?
How do you properly value an investment? It is based on the future cash-flows of that investment. In the simplest terms, you add up all the cash-flows and there’s your value. This is the same concept whether it’s a real estate investment, a stock or a bond. So, for example, if a company was engaging in a project that lasted 10 years, earning $100,000 per year, the value of the project would be $1 million. To make a profit you would need to invest less than $1 million. If the company only needed you to invest $800,000 to begin this project you would earn $200,000 over 10 years. This is a 25% return on the deal.
Now this is a really simple example and ignores such complexities such as discount rates and inflation. Plus, over 10 years, an average 2.5% annual return is really small (compared to the average return on stocks). But it’s enough for you to understand the basic of concept of valuation. It is also important that you understand what you are doing when you make an investment. I will talk more about valuation in later articles.
How I learned about investment
So, it was at George Mason University in Northern Virginia that I began to understand the basic concepts of investment. I looked at various types of investment: stocks, government bonds, bank loans, real estate etc. But it was the stock market that I was most interested in.
After I graduated from George Mason I decided to go the extra mile and study a Master’s Degree in Finance. After much blood, sweat and tears, I passed the GMAT and was accepted by the London School of Economics (LSE) in the UK. I thought this might eventually make me an expert in investment.
Confused by education
But the result was very strange. After I graduated from George Mason University (GMU) I felt like I knew everything about investment. After graduating from the LSE, I simply felt confused. You see in the US we learn primarily from textbooks. Textbooks are written like instruction manuals. This gives us the impression that pretty much every thing has been resolved. Just follow what you have learned in the book and you should be fine.
it’s not rocket science…
What I discovered at the LSE was actually quite shocking to me. You’ve heard the phrase “its not rocket science!”. Well, at the LSE it was. Some of these classes I walked into were totally incomprehensible to me. They used all kinds of complex math and statistics that I simply couldn’t understand. Remember when I said I wasn’t the best mathematician? Well at the LSE you needed to be!
Finance can seem like a foreign language
Now I thought I understood finance when I studied it at GMU but at the LSE it felt like they were speaking in a foreign language! They had a branch of finance called financial econometrics. This was basically statistics applied to finance. Now I knew a little about statistics and a lot about finance but I didn’t understand a word. I walked into these classes… and walked straight out!
Fortunately, the investment classes were at least for me, fairly straightforward. I combined these with some accounting and economics classes. I actually found these to be quite interesting. So, after a truly significant amount of work, I was able to graduate.
But like I said, I was confused. Whereas the textbooks at GMU were fairly direct and straightforward, the work at the LSE was highly theoretical. I had no idea how to apply what I learned to what was really important: making money!
The trouble with education
The trouble here was that while the individual topics that I covered were interesting they were presented piecemeal. There was no framework. I understood the concepts but I had no context.
My first investment job
I remember when I started my first job at PricewaterhouseCoopers (PwC) in Washington DC. I found that while people were impressed with my LSE degree it had taught me nothing about how to perform at work. There was virtually no crossover from my degrees to the real world.
However, two useful things happened to me at PwC. There, I had my first work experience of real estate investment. I was analyzing mortgage-backed securities (MBS). I learned a lot about the residential real estate market and how it is ultimately financed by capital markets. How does this work? Well basically, after making a mortgage loan, a mortgage lender sells this loan to a small company set up specifically for holding these loans. The small company issues bonds to investors. So, these funds from the investors ultimately finance consumer mortgages.
The second was that I got laid off. What?! Yes, this was a useful lesson. At PwC I had a pension plan. I only had about a year’s worth of contributions in it. This was my first lesson of how troublesome pensions can be. I had a 401K. 401Ks allow you to take early distributions under certain circumstances. Unfortunately, my circumstances didn’t apply.
Paying penalties on your own money!
However, I was out of work and needed to eat. So, I cashed in my tiny pension (and was charged a hefty penalty for it)! The point is that pension plans generally restrict your access. Sometimes access is completely restricted until you retire.
This is important to know before you starting contributing funds to a pension. You may want to save some of your investment funds for more accessible investments.
Essentially, my first personal investment experience was with pension plans and honestly, I don’t think that I made the best of it. But I was young and I felt like I had plenty of time to make up for it. That kind of thinking can get you into trouble though. For a while you have plenty of time… until you don’t.
The trouble with stocks
After leaving PwC I worked for a year at a dotcom company. At the dotcom I learned another powerful lesson. As part of my compensation I received stock options. At the height of the dotcom boom I thought that these would make me rich!
For those that don’t know, stock options are basically the right to buy stock at a specified price (known as the strike price). In my case, I had the option to buy stock in the company that I worked at. If the market price is higher than the strike price you can exercise the option, buy the stock at the lower strike price and then immediately sell at the higher market price. From this you earn a profit.
Throughout the year I watched as my stock options went up in value. I delayed exercising them because I expected the market price to keep going up. Well the following year the company went bust as the market crashed. If I had exercised the options earlier I might have made some money. Instead, I lost all of this money.
What did I learn here? Trying to beat the market on one stock that you don’t understand very well is very risky. Yet people try to do this all of the time.
Back to investment companies…
After the Internet company went bust I eventually made my way back to investment. I worked for Sallie Mae for 4 years doing financial reporting for student loan securitizations. As you can imagine, I developed a lot of expertise in understanding how these bonds were structured. I also learned about the types of investors that bought these products.
Typically, the investors were large institutions. Think pension funds, life insurance companies. You might find that your pension is partly invested in these types of investments. After I realized this, I realized that one of the best avenues to passively invest is through a fund.
Do financial advisors have your interests at heart?
I initially tried this by hiring a financial advisor. Now there are some very good financial advisors out there. But there are also some that don’t necessarily have your interests at heart. I don’t know which kind of advisor this guy was but he was very passionate about a UBS managed IRA. Now maybe it was the only product he had. But he seemed to have a lot of conviction about it so I began contributing to the fund.
The interesting thing about this fund is that once I bought it, I began paying more attention to the market. I would call him from time to time to change the allocations. “Great, we’re managing your account like it’s a billion-dollar pension fund!” he quipped.
Don’t overreact to the market!
To be honest I was probably overreacting to changes in the market. I made this mistake many times over. I later learned that it is better to set an appropriate allocation based on your personal situation. And then you keep it that way unless something significant in your circumstances changes.
This is because you are taking a long-term view. If you take a long-term view then you don’t care about short-term fluctuations in the market. If the market crashes, history shows that it always recovers. It may take some time but it does recover.
The trouble with this whole situation is that the financial advisor did not assess my personal situation. He had a product that was “perfect” for everyone. What I later discovered is that everybody’s situation is unique. And there are likely many options that will solve your problem.
Bankers don’t understand investment!
After I left Sallie Mae, I took a job at Deutsche Bank in London. Here I carried on working on securitized bonds, learning more about the capital markets and how investment banks create these instruments. But after a while I was keen to get more involved in creating these deals for myself.
So, I left Deutsche Bank and got involved in commercial real estate lending. I was responsible for both analyzing these deals and creating new ones. I would negotiate directly with hedge funds, private equity companies and other groups to put together huge real estate deals ($100s of millions).
But here I noticed something. The other bankers I worked with, while experienced, did not know the first thing about investing their own money. They had pensions but never, ever looked at them. Many of them would keep their savings in the bank. As I said in my previous article, the bank is a terrible place to keep your money.
Or worse, they would use their money to buy the stock of the bank that they worked for. Great idea, because if that bank goes bust (as Lehman Brothers did) you lose all of your wealth at the same time that you lose your job.
How I leveraged my college background
My academic background in finance helped me here. I already knew about the principles of diversifying your investments. To be fair I implemented it imperfectly. But it was already helping me. I certainly knew enough not to leave my money in lousy, low-interest savings accounts.
At the same time as I was financing real estate projects I was studying The Chartered Financial Analyst® (CFA) program. According to the website the CFA “credential is held by over 150,000 professionals around the world. The charter gives a strong understanding of advanced investment analysis and real-world portfolio management skills.”
I combined the skills I learned from studying the CFA program with my significant experience gained from years of working in the investment industry. I was able to develop a systematic approach to my personal approaches.
The key is knowledge
The key is knowledge. Knowledge of how to invest and where to invest. I gained this knowledge both through experience and through studying. As a result, I was able to change how I invested.
More importantly I no longer view market crashes as the disasters that the media would like us to believe. Now some people can profit from them. But frankly the best idea is merely to insulate yourself from their effects.
Initially I was afraid of losing money. This fear induced me to place undue faith on financial advisors. Also, I got stuck in the access trap of pensions. I wound making losses in my pensions. This was both from early withdrawal penalties or from moving around to different funds. I also lost money through various other pitfalls that await you in pensions.
As I result I developed what I call the Investment Framework. I will explain how this works in later articles. But in summary, it will allow you to invest without fear of loss. You will be able to improve on the rates from the bank. You will be able to ensure that your family has a secure financial future. And you will be able to control access to your money.
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