Mutual Funds for the Utterly Confused

What happens when you thrust a group of medical students into a situation where their knowledge of subject is put into practice? It could be problem, even if it is something simple like blood pressure and blood pressure regulation. When a student learns an underlying principle, the ability to put into use is not always as easy as it sounds. Why?

Anna Fyrenius along with Charlotte Silen and Staffan Wirell asked that same question. They understood the complexities of medical study where the unfortunate side effect of intense learnng and that this sort of problem developed because of an inability to conceptualize the situation. In other words, they knew how things worked but not necessarily why, how what one organ did was completely dependent on how another reacted, and how to solve the problem along this time line.

They introduced the subject of their paper as an “oversimplification and reduction of inherent complexity are factors pointed to as being involved in the creation of misconceptions in physiology” or the students had no concept of the connections because it was explained in a point A to point B method somewhat similar to a “if this happens, it was because of this happening prior”. And as we all know when we discuss the human body, that is not always the case.

In the world of bond investing, it is about simplicity yet the underlying principles of this type of investment cannot be ignored. You don’t need to know how to fix a car to drive one, but some knowledge, whether learned or experienced over time, gives you a good deal of working knowledge about how the car drives, how it reacts under certain circumstances, and what skills you need to bring to the experience in order to avoid an accident. But this experience can be costly when it comes to investing. Lost money is not easily retrieved even after it has taught you the lesson.

The principles involve a discussion about yield and risk. Bond investors have numerous choices when buying fixed income securities but by and far, the best way to purchase a bond is through a mutual fund setting.

At the close of chapter three I bring up the author Jorge Luis Borges.  Mr. Borges was an Argentina writer was initially known for his literary criticism and essays.  But as he matured, he moved into a different style of writing and from this cames a collection of short stories, one of which I reference in the book.

The story, Funes the Memorious appeared in a collection of stories entitled Ficciones (Editorial Sur, 1942) was about a fictional Borges - inserted inot one of his own stories - and the tale of young man who had amazing talents both before a horseback riding accident and especially after.  The young man in the story, Ireneo Funes was capable of telling anyone who asked what time it was without the aid of a watch.

Some time pases between that first meeting and the story places Borges back in the same town as the boy.  His intent is to study Latin and relax.  I realize that this isn’t everyone’s idea of relaxation but the story was set in 1887 and forms of relaxation were limited to either literary pursuits the likes of Emerson or Pliny the Elder or perhaps simply rest from labor.

The boy’s mother heard that Borges was back and after recounting the tragedy that had befallen her son and the dark place the now-crippled child lived, she asked for some of the Latin material he possessed for the boy to use. he sent her away with what he deemed the most difficult tomes. 

The story continues with Borges discovery the boy’s incredible talent as he went to recover the books.  Since the accident the boy tells him, he is able to remember and reconstruct every moment of every day, and because that sort of simple recall was not enough, he develops his own system of labeling these scenes by number.

Borges wonders how this is possible in boy so far from what at the time was considered the civilized world. The talents afflicts the boy’s sleep and he tells Borges, in the dark of the night, amazing tales that should be beyond the understanding of a poor village boy.

The reason I bring up this memory story right before we begin the bond section of the book is the often difficult “bondspeak” that is necessary in the full comprehension of this type of investment.  Bonds, the tool by which business is built, offers the investor an unusual bargain in return for yield (a payment for your investment usually expressed as a percentage). It will require quite a lot less than Funes was capable of but the astounding part is, you will be versed well enough after reading this chapter to converse about the nature, the need, and the importance of bonds in your portfolio.

If you would like the read the story in its entirety, you may find it here.

It is generally accepted that commerce came first and language came shortly thereafter. The need to communicate was much more likely based on the transfer of goods, even at the basest of levels than it was to express desire or hope. Iranian archaeologist Yusef Majidzadeh believed that he found the basis of written language after years for searching through the of empire of Mesopotamia.

The city this man sought was Jiroft. Ever since the Iranians lowered their culture wall and allowed archaeologists like Majidzadeh back into the country, he has sought a city that he believed to not only be rich in Bronze Age capital but the oldest example of written language.

I mention this in the book “Mutual Funds for the Utterly Confused (McGraw-Hill, 2008)” for two reasons. First, the man’s perserverance (with a little bit of luck thrown in by way of a flash flood that suddenly revealed the ancient city), a belief that he never lost sight of and the chances of this language, almost 4,000 years old will reveal how commerce got its beginning.

Granted, only three tablets have been found and on those three, only 59 symbols appear. Hardly the stuff of contracts, mergers or even bailouts but significant nonetheless.

Debt is what makes our society function. It does so by allowing one person to borrow money with the promise of repaying it. They in turn take the money and invest it in an idea or into another investment, hoping to make a return on the money, enough to pay back the lender and do so with interest and to give the borrower a profit for her/his efforts.

As we start the chapter on the Collective Investment Scheme. we begin to explore how, when investors group themselves together in a mutual fund, they can achieve less risk and greater reward because of it. Mutual Funds, which I explain have five basic components, help investors achieve this goal much more easily than if they had done it alone.

Superposition is thought experiment. Schrödinger’s cat was the experiment. back in 1935, soon after Einstein published his famous EPR paper on quantum mechanics, Erwin Schroedinger offered his experiment on the belief that until something is measured, it occupies all possible states.

The experiment goes something like this: Schrödinger arranged for his imaginary cat to be kept prisoner in an imaginary box, where the radioactive decay of an atom decided whether or not the cat lived or died.

Schrödinger said that until you open the box, the cat is both alive and dead, in a superposition of states.

He said this was a nonsense. But now we realize it does actually work. The observer problem can be solved like this: If you put an observer in the box too, what happens is that observer + cat are in the state “observer sees cat dead and cat is dead” AND “observer sees cat alive and cat is alive” but until we open the box, we still don’t know which.

The universe behaves as if it wants to leave it until the last possible minute to tell us what happens.

In our discussion in the book “Mutual Funds for the Utterly Confused (McGraw-Hill, 2008)”, we look at the possibilities of superposition and money market funds. If you have been paying attention - close attention because there is some many newsworthy financial events taking place as I write this, it is hard to keep track of which ones apply to you.

Money market funds received some bad news on September 17th, 2008 when the Primary Fund, managed by money market shop The Reserve announced that because of their holdings in Lehman Brothers mortgage backed securities (MBS), they would be forced to do what had only been done once before - “break the buck”.

These safest of safe havens offer investors the opportunity of keeping their dollar at a dollar while receiving some yield for their “Investment”. That dollar net asset value is supposed to remain constant. Not since 1994 when Denver-based Community Bankers U.S. Government Money Market Fund returned 96 cents, has a money market fallen below the dollar level. The Primary Fund fell to 97 cents and told those trying to redeem that withdrawals would have a seven day cooling off period before the money would be returned.

Big fund companies such as Fidelity and Vanguard Group were able to shore up their funds allowing them to remain at zero. This will come with a cost as well that has yet to be passed down to investors. Anne Crowley of Fidelity Investments was quoted as saying “We can state unequivocally that Fidelity’s money market funds and accounts continue to provide security and safety for our customers’ cash investments.”

This turned the superposition, the physics theorem that suggested that you could be safe and gain/lose yield at the same time, in other words, be two places at the same time on its collective head. We now knew the fate of the cat in the box.

Stephen Roach is the chairman of Morgan Stanley Asia.  From his perspective, one that has one foot in the door of the US markets and the other focused on what is Asia, the following quote made the book “Mutual Funds for the Utterly Confused (McGraw-Hill, 2008)“: The vulnerability of the of the over-extended American consumer can hardly be taken lightly.  That could well be a problem for the rest of a U.S.-centric global economy.”

This was before the talks of the bailout - which at the time of this writing was predicted but not yet a Washington reality.  This was before several major banks disappeared. Before Bear Stearns and Lehman brothers exited the public domain.  Before the word toxic was being bandied around like so much backwater sludge and before we realized that no matter what we were to try (or are currently trying) were born in the spirit of free markets and deregulation.

I offered lessons to the investor in the book about Mexico and Brazil and Argentina, all excellent examples of global investors and their seemingly insatiable appetite for risk.  The US fell directly into the same trap and allowed it to happen.  Even as the administration was touting a strong dollar policy, the worth of the greenback continued t slip in value off American shores.

This made the cost of the products we so deeply craved much more expensive and because many of the world’s goods are transferred from seller to buyer with dollars attached, this left our suppliers holding vast amounts of dollar-based wealth.  Sadly, the only thing they could do with it was to strengthen their own economic footprint with xenophobic hoarding of resources and vast investments in their own infrastructure  - and to loan us the money back.

We were hit with a double whammy of sorts as this worldwide quest resources drove the prices up - in dollars - for Americans who were hard pressed to find the money to buy what they needed, namely food and fuel.

Back in March of 2008, Mr. Roach wrote the following in a New York Times editorial: “The current recession has been set off by the simultaneous bursting of property and credit bubbles. The unwinding of these excesses is likely to exact a lasting toll on both homebuilders and American consumers. Those two economic sectors collectively peaked at 78 percent of gross domestic product, or fully six times the share of the sector that pushed the country into recession seven years ago.”

Because of his focus on Japan and the Asia markets, he worried that the similarities between the US and this former economic giant were too alike to avoid comparison. Japan he wrote, “initially denied the perils caused by bubbles” and in doing so, he pointed out that “In Japan, a banking crisis constricted lending for years. In the United States, a full-blown credit crisis could do the same.”

But the same weak dollar that has been around for going on seven years now, may be the single thing that saves us.  Focusing on the consumer he suggests would require and enormous investment in infrastructure that would help build back the confidence of our exports.  meaning that we need to export hard goods, not just services.

These concerns about the strength of a country’s economy made international investing a perilous undertaking.  Now that peril is present here.  No matter what happens in the near term, bailout or no bailout, the dangerous landscape that was once solely offshore has hit home. Will any medicine offered now help with a quick cure?  Probably not. 

And as I read between the lines - as numerous news reports find numerous damaged 401(k) and retirement plans - I hear the faint whisper of stocks being used for investments in these plans.  Once you move away from the realm of mutual funds, your risk grows exponentially.

But I do offer a caveat for investing with mutual funds, in your retirement plans or outside of the tax-deferred status that those plans offer.  “Mutual Funds”, I write, “do not provide a safe haven from events of this kind.”  To which I add: “They provide a safer haven.”