Sunday, February 22, 2009

Why your investment adviser can't advise the world

As stock markets around the world continue to plummet, most investment advisers are telling their long-time clients to stay put and wait for a rebound. With the world overflowing with newly printed (actually, electronically created) money waiting to be invested, a rebound might come despite sentiment that is now so extremely negative.

But the problem with investing (as opposed to saving) is that it is primarily a social phenomenon (rather than an individual one) and therefore has some of the characteristics of both a Ponzi scheme and a zero-sum game. Our savings usually go these days into bank accounts that are insured. The value doesn't fluctuate or rather fluctuates very gradually upward with each interest payment. No matter how many people choose to open savings accounts or CDs at a bank, your principal can neither go up nor down. (The interest payment you receive, however, might go down if too many people flood the bank with money that it cannot deploy profitably in the form of loans.) And, even if some choose to save in part through the purchase of, say, jewelry, gold coins or land, we insure these against loss and liability. Their market price can't be controlled, but loss from theft, damage or lawsuit can be. And, only a fool would think to put all of his or her savings into any one of these alternatives to bank accounts.

The same things can't be said for what most people call investments. Here people were advised to pile into the stock and bond markets with all of their savings. And, in these markets it is essential that there be people who continuously bid for what we have chosen to invest in in order for its value to increase or at least be maintained. Hence, investing is a social phenomenon. A sharp investment adviser will put his or her clients into the next profitable thing early and then have them sell to the latecomers before the trend reverses. And who are the latecomers? Some of them are undoubtedly people put into the same investment by other investment advisers who see the next profitable thing only somewhat later than our aforementioned sharp investment adviser. As each new cohort of investors piles into an investment, the early ones have an opportunity to bail out. This is what I mean when I say investing has some resemblence to a Ponzi scheme. The new investors pay off the original investors by buying their assets at a higher price.

Now, some will complain that if there is overall continuous growth in the economy, the latecomers will make money as the economy continues to expand. There is some truth to this, and yet the fabulous expansion of the world economy in the 20th and early 21st centuries hasn't prevented wide swings in markets that have made paupers of the latecomers. Whether that growth can continue is an open question since we are facing mulitple resource limits and the headwind of climate change.

But setting aside the growth question, we can still see that the social aspects of investing make it far more hazardous than what we call saving. For if a lot of people decide all at once to sell assets similar to what we ourselves own, they can create a panic that leads to much lower prices. And, that, of course, is what we've seen in the past several months.

But not everyone is poorer for this happening. There are short-sellers who have been making gobs of money. Those are the people that remind us of the zero-sum aspect of investing. They only make money if we who are in the market lose it.

The current market meltdown makes clear that the risks faced by amateur investors were much higher than they were told. Professional investors understand the risks better (but not much better, it seems!). Investing is really a form of gambling. If you go into a casino and lose your money, you will, of course, be disappointed. But you shouldn't be surprised. Unprepared, many amateur investors were surprised by recent events.

The upshot is that the vast majority of people are not fit to participate in the casino of investing. Their talents lie elsewhere. We are about to return to a world where a much smaller group of people risk capital in the stock, bond and commodity markets, people who can afford to or at least think they can afford to do so. For everyone else it will be back to the staples of savings: bank accounts, savings bonds, perhaps some gold coins, silverware, jewelry or a little land.

And, what of all those people who are currently being told that they should hang on for a rebound in the market? Well, it might very well come. And, if it does, will they be counseled to sell after a 20 or 30 percent rise? And, if they take such advice, it will turn out like every other socially-driven market move. Some will act first--perhaps from a special premonitory insight--and reap the rewards. Others will follow in successive waves. It is logistically impossible for everyone can sell at once because, as in every Ponzi scheme and zero-sum game, there has to be someone to sell to.

Unfortunately, there is a bell curve that describes the success of financial advisers just as there is in every other profession. This has less to do with talent than with the structure of the investment game. If your doctor tells you to eat right, exercise and get plenty of rest, it's advice that every one of his or her patients can profit from. But if everybody acted at once on the basis of one adviser's counsel, the investment game wouldn't work. And, that's why your investment adviser will never be able to advise the world.

Sunday, February 15, 2009

Please state the nature of your emergency

When a 911 operator answers a call, the operator often begins as follows: "Please state the nature of your emergency." As anyone who has called 911 knows, how you describe your emergency has everything to do with how the police respond.

I was speaking to a friend by phone recently who is very active in sustainability efforts where he lives. He's noticed that many of those who were showing interest in cooperating with his efforts last year have now withdrawn into concerns about their own immediate future. The growing economic crisis is concentrating their minds on such questions as: Will I keep my job? Will I be able to afford my house or apartment? What should I do with my savings, especially if they have declined significantly? For those running organizations the most basic question is one of survival. Can my business survive lower sales? Can my nonprofit survive declining donations and grants?

The emergency has been defined primarily as a financial emergency, and so all these people are reacting quite rationally under that definition, my friend conceded.

When faced with what we perceive is a crisis, we focus on the crisis first and worry about what we perceive are long-term problems later. Another contact, Nate Hagens of The Oil Drum, told me that he worries that as the economic crisis deepens, people will become even more focused on the immediate. That, of course, has serious implications for those concerned about long-term sustainability. He has written about why humans discount the future so steeply as follows:
If we didn't have mortgage payments and college funds for our kids, our discount rates might even be steeper. It's quite logical - animals that deferred opportunities to eat, might come back and their food was stolen, or they might have been eaten themselves in the interim - the long arm of selection would have favored organisms that valued immediacy over those who preferred to wait.

But the human penchant for focusing on the immediate is easily hijacked by modern forms of stimuli, Hagens adds:

Our culture presents a smorgasbord of options that allow us to 'feel' like our ancestors did when they were successful. Neuroscientist Robert Sapolsky likens the physiology of two grand master chess players to a marathon runner - the body is experiencing the same neurotransmitters (presumably, they did not have chess back on the Pleistoscene). Many of the options available to us that engage our neurotransmitters are maladaptive. Pornography, fast food, arcade games, lottery tickets, etc. all give us feelings identical to those our ancestors were good at pursuing. But now they often trick our brains into thinking they too will lead to evolutionary success.

For those who don't engage in the pursuits listed above, Hagens offers another illustration of a highly abstract human task which activates ancient neural circuits:

Take stock trading for example. Neuroscience scans show that stock trading lights up the same brain areas as picking nuts and berries do in other primates, suggestive of what our ancestors must have 'felt' as they tried to increase resources.

This last example suggests why so many people are focused on the financial aspects of our crisis. The very top leadership around the world is positively convinced that the crisis we face is primarily a financial crisis with financial solutions. Hence, the huge bailout and spending packages being simultaneously proposed by governments around the world. These policymakers may simply believe (unconsciously, of course) that getting out of this economic slump is merely a question of picking nuts and berries at a much faster rate.

Here we have the problem of how the nature of the emergency is defined. Because the economic crisis has been labelled primarily a financial crisis and because that type of crisis appears to activate well-worn pathways in the human brain, this interpretation has gained wide acceptance.

But if we were to state the nature of the emergency as a sustainability crisis, could such an interpretation gain wide acceptance? Given the presumed short-term focus of most human behavior, such an outcome seems unlikely.

Certainly, people will agree that our current financial system is not sustainable. That much has become obvious. Or has it? Even here we find that most of the solutions to the financial crisis currently being offered merely prop up or try to re-energize existing financial institutions and practices. So, even now--in the throes of a tremendous crisis in which basic institutions ought to be questioned--most leaders and most people in general are not currently examining how the "nuts and berries" are produced. We simply want more of them and hope that doing more of what we've done in the past (for example, expanding debt) will work.

If the current efforts to revive the economy do not work, perhaps then we as a society will look more seriously at setting up alternative financial structures. But, that leaves us a long way from considering urgent areas of sustainability: energy depletion, food production, water depletion, population and climate change.

Each area has the potential to produce more than just local or regional crises. But until they are understood as urgent, I fear that little will be done on a national or international level. This, of course, does not preclude local efforts where people perceive these threats as immediate and ongoing. But I am reminded of Benjamin Franklin's saying, "We must all hang together, or assuredly we shall all hang separately." If some communities successfully address sustainability and other don't, it seems only a matter of time before those that don't become the predators of those that do.

So, my question remains. How can the sustainability crisis (of which the current financial crisis is most certainly a symptom) be framed as something that deserves our immediate and ongoing attention? What well-worn, evolutionarily successful pathways of thinking and feeling are available to motivate broader action?

The issue can't be merely that the problems we face in sustainability are too abstract. After all, stock trading is pretty abstract; but, it seems to map nicely to an already available pathway of thinking and acting. Can we find more of these and use them to communicate the sustainability imperative?

Clearly, simply stating the nature of the emergency as we have in the past is not enough.

Sunday, February 08, 2009

The information society and its limits

The breathtaking expansion of the Internet and the sources of information now available on it have served to conjure a cybernetic vision of unlimited growth--growth that can never be slowed for long by lack of physical resources because it is mostly virtual. The Internet has undoubtedly allowed people to find information readily that would previously have taken hours of meticulous searching in a library or might not be found at all.

The vast quantities of information now available require some kind of filtering, and so various filtering services including news aggregators, weblogs, and specialty sites of all kinds have arisen. All of that is to the good. True, much of the information on the Internet is of questionable veracity. And, much of what passes for information not only on the Internet, but also in the broader media is nothing more than polemic dressed up as analysis. And, of course, the sheer volume of it all would be overwhelming were it not mitigated by the available filters or by simply turning away from the computer, the television and the radio.

But so many people cannot or will not turn away for any extended period of time. Instead, they believe they need to be "updated" on a regular basis. I put "updated" in quotes since to me the news seems more or less the same every day with a few widely spaced and prominent exceptions. It is these exceptions that I pay attention to. But most stories fit into rather predictable categories which I label as follows:
  1. Prices are going up (or, more rarely, down).
  2. There's corruption in government. (Who knew?)
  3. The corporations are out to get us.
  4. It's dangerous out there. (Crime stories)
  5. Isn't that weird? (Human interest stories)
  6. GI Joe. (War coverage)
  7. How to lose 10 pounds without dieting. (Service stories)

Perhaps you can think of other categories. And, while stories in some of these categories are indeed important, those stories rarely provide the context or the intelligent analysis required to make them useful. On the other hand, crime stories are usually just sensationalism designed to attract subscribers and viewers.

Putting into the proper context what information we actually do need for something other than aiding and abetting our consumption--for, say, understanding public policy--requires conceptual training that can only come from reading well-written books and articles and engaging with other rigorous minds who challenge our own point of view. That is a much slower training process, and it will never occur at Internet speeds.

Environmental education giant David Orr likes to say that what we lack is "slow" knowledge. It is easy to learn how to take down a whole forest with a chainsaw. That's fast knowledge. But as I wrote in a previous post:

Teaching people the importance of trees in creating and protecting the soil, encouraging biodiversity, preventing runoff, storing carbon and influencing climate is a task that requires time, concentration and reflection. It assumes a body of knowledge about the natural world that most people simply don't have and therefore must acquire. And, it assumes an eye trained to look for subtleties in the natural landscape. Moreover, such learning does not yield the immediate and visible economic benefits of the chainsaw.

But even if we take the time to acquire the slow knowledge we need, we cannot solve the knowledge problem with more information. The world is too complex to comprehend by merely apprehending its parts. And, no human being can see all of the universe or even his or her part of it well enough to give anything but a very fragmentary account. We will always have huge areas of ignorance, particularly about the long-term consequences of the actions we take to reshape the ecosphere to our purposes.

And, even where we believe we have a lot of information--for example, the confident predictions about world oil and natural gas reserves or about the amount of uranium that can be extracted from the Earth's crust--we ought to look not to what we know for confirmation, but to what we don't know for guidance regarding the risks we face. Orr suggests that those lacunae in our knowledge should entreat us to employ wide margins of safety both in our daily actions and even more so in our collective policies.

It is possible, for example, that the optimistic estimates of the world's energy supplies are correct. The consequences of that would be that business as usual could proceed for a few more decades during which we could take a very leisurely attitude toward making the transition to a new energy economy. (I am, of course, setting aside the very serious risks related to climate change in this illustration.) The consequences of being wrong, however, could include catastrophic collapse. Hence, Orr's suggestion that we employ wide margins of safety when acting on what we think we know.

The hubris of the information society is that it imagines that data matter more than understanding and that we are moving closer and closer every day to completing the book of knowledge. The truth is we are creating vast new areas of ignorance. Two examples, one domestic and one industrial, illustrate the problem. Our highly productive modern farming and food production system has allowed the vast majority of people to forego learning anything about plants in their immediate area which are edible. And, since public policy in the United States (but no longer in Europe) puts the onus on the public to prove that a new chemical is harmful before it is banned (rather than putting the onus on industry to prove it is safe), industry releases thousands of new chemicals each year into the environment ignorant of their possible negative effects on humans and on ecosystems.

The most important first step in countering this trend is to recognize it and to act with the heightened sense of attentiveness, care and prudence which that recognition demands.

Sunday, February 01, 2009

Lightering our way to abundance

Lightering is the process of transferring oil cargo between vessels of largely different sizes and is undertaken as many port facilities cannot accept ocean-faring tankers of the size of oil transports.

An old Wall Street shibboleth says that nobody rings a bell at the top. To prove the point, even as oil and other commodities were making blistering new highs on a daily basis last year, few people saw the carnage that was to come in those markets as the year progressed.

But the same cannot always be said at the bottom of a market. Quite often, there are many bells ringing. It's just that by the time a bottom arrives investors are usually too exhausted, too nervous or too broke even to care. And, it's true that the price of any commodity or stock can trace out a bottom for a very long time, longer than most people have patience, especially if they've already been burned in a crash. And so, the bells can go on ringing for years until they just seem like background noise.

Still, I am willing to take a stab at what may turn out to be a fool's errand and suggest that crude oil prices have bottomed out. My signal? The image of oil supertankers cruising aimlessly for weeks near many of the world's ports waiting for someone to purchase their cargoes. And, when someone finally does, the supertanker is obliged to lighter oil onto another smaller ship because the buyer only wants a portion of what's in the hold. When all the supertankers are full, the next step will simply be to spill oil on the ground at the point of extraction. But since this is an unlikely outcome, I suspect that oil producers will scale back production because they have to. The transit system and the storage system are now overflowing.

Of course, demand for oil could drop even further if the world economy continues to shrink. But at some point there will be a bedrock level below which oil consumption cannot fall or the lights will go out on civilization itself.

There is, in fact, one other promising sign of a bottom, and that's the move by oil companies and Wall Street firms to secure tankers in which to store oil in order to play the contango in the oil market. By leasing a tanker and filling it with oil purchased at the current low price while simultaneously selling it on the futures market for delivery later this year at a significantly higher price, they can generate considerable profit--enough to pay for the costs of storage on the high seas and take home handsome paychecks to boot.

The smart money is saying that oil won't remain this cheap much longer or that the prices on long-dated futures contracts will collapse. Either way the oil companies and investment bankers make money. But, even though the bottom may be in, it could take a long time for oil prices to move considerably higher.

What is disturbing about the entire tableau is the false impression it leaves that oil is an abundant resource. People are led to believe that if we can hardly find storage for all of the oil, it must be available to us in such quantities that we have few worries for the foreseeable future. But nothing could be further from the truth.

Oil is a commodity that unlike coal or copper is difficult and expensive to store. It's a flammable liquid capable of exceptional environment damage that must be carefully sequestered in special tanks with berms around them to prevent the spread of a leak or of a fire; or, it must be put in hugely expensive double-hulled tankers. Although it can be transported by truck as can coal and copper, it is most often transported by pipeline since this is quite a bit cheaper. The upshot is that you can't store oil just anywhere, and the storage space that is available is quite limited compared to its production. U. S. inventories last week stood at just 23.6 days of supply. And, this is at a time when storage facilities are chock full of the stuff.

Our existing oil infrastructure is pulling petroleum out of the ground at a rate that is currently faster than we can use it. This makes for a temporary glut and in no way mitigates the long-term problems we face with declining petroleum supplies. But we are now treating oil, not as the world's key commodity, a commodity upon which our very way of life depends, but as a plaything for investors to game for temporary profits. It's all part of the mentality that resources are interchangeable, that all of them can be replaced with enough ingenuity and investment whenever we need to without disruption to our lives, and that we have no cause to worry about the colossal waste of finite oil resources that is being fostered by low oil prices.

In the face of the worst economic downturn since the 1930s, the current focus of policymakers is understandably to restart world economic growth. And, many experts have pointed out that low oil prices and low energy prices in general are a plus for this purpose. They give energy consumers the equivalent of a huge tax cut.

But as those in the oil industry already know, low prices will lead to a reduction of new supply in the future, a reduction that could cripple any attempts to restart economic growth. And, failure to provide adequate supplies of the world's most essential fuel will not only stifle growth, but also impede attempts to create the renewable energy economy that we will need as oil supplies decline due to geologic constraints. We need the energy from fossil fuels and especially from oil to help make the next energy transition. That calls for a massive change of direction for energy investment that simply cannot take place in an environment of low energy prices.

The implication is that we now need to put a floor under fossil fuel prices so as not to discourage the development of alternatives. That means new taxes, but ones that could be offset with reductions elsewhere. We need to discourage what we don't want, namely, wasteful use of fossil fuels, and thereby encourage what we do want, namely, carbon-free energy technology.

And, although you couldn't tell it by this week's reports from the high seas, there is no way we are going to lighter our way to abundance.