Tag Archives: Finance

Sunken Treasures

X Marks the Spot

“First come the innovators, who see opportunities that others don’t. Then come the imitators, who copy what the innovators have done. And then come the idiots, whose avarice undoes the very innovations they are trying to use to get rich.”— Warren Buffet

A great deal of investing comes down to a process of identifying innovators, scrutinizing imitators, and screening out idiots.

This principle is applicable to everything from stock-picking to assessing management teams. Nowhere, however, is the concept more prevalent than in venture capital.

Every day, VC firms in Silicon Valley and beyond are inundated with pitches from startups touting innovative products and groundbreaking technology. Therefore, the clear determinant of a VC firm’s success lies in their ability to locate genius in a sea of mediocrity.

The obvious difficulty of this endeavor is reflected in the breakdown of a VC firm’s expected returns. As industry veteran Fred Wilson summarized it:

“I’ve said many times on this blog that our target batting average is ‘1/3, 1/3, 1/3’, which means that we expect to lose our entire investment on 1/3 of our investments, we expect to get our money back (or maybe make a small return) on 1/3 of our investments, and we expect to generate the bulk of our returns on 1/3 of our investments.” — Fred Wilson

To put it much more crudely:

An already difficult process then becomes even harder after the wild success of a truly innovative company. For example, Uber’s dominance prompted an outbreak of “Uber for X” startups.

From a behavioral standpoint, it’s not easy for an investor to resist companies claiming to be the ‘Uber for X’ after witnessing Uber’s success.

To be clear, there have been successful imitators. Wag!, the “Uber for Dogs”, being a prime example.

However, for every imitator like Wag! and Lyft, there is a longer list of failed imitators. Cherry, for instance, was the “Uber for carwashes” that eventually closed up shop.

That said, even the successful imitators aren’t perfect… poor Fluffy.

During the late 17th century, London’s nascent stock market experienced a wave of innovation. In 1687, only 15 public companies were listed on the London Stock Exchange. By 1695, however, that figure had increased tenfold.

The impetus for this investment boom is partially due to the Nine Years War, which restricted overseas trade with foreign powers. British investors were forced to deploy their capital into domestic investments as a result.

“A great many stocks have arisen since this war with France; for trade being obstructed at sea, few that have money were willing it should lie idle, and a great many that wanted employment studied how to dispose of their money…which they found they could more easily do in joint-stocks, than in laying out the same in lands, houses or commodities…” — John Houghton (1694)

What truly kick-started this period of speculation and startup investments, however, was a successful treasure hunt.

The Innovator

“Thanks be to God! We are all made!”

— Sir William Phips (1687)

Sir William Phips was described by his contemporary, Daniel Defoe, as someone who “sought wealth and advancement through money-making schemes financed by others”.

A trader and seafarer by nature, Phips commanded boats making frequent trips to the West Indies. In the course of these journeys, Phips heard rumors of a sunken ship in the Caribbean , the Concepción, which held unimaginable treasures.

Though many would scoff at such gossip today, the rumors were not unfounded. The Spanish had transported scores of precious metals from Mexico for over a century, and many of these ships did not make it home.

Before long, Sir Phips decided to try his luck at locating the Concepción. Just as the modern founder ventures to Silicon Valley in search of funding on Sand Hill Road, Sir Phips returned to London in search of an investor.

Phips found his 17th century venture capitalist in the Duke of Albemarle, and his syndicate of investors. The group of financiers quickly formed a small joint-stock company for funding the expedition. This joint-stock company could be considered a VC firm equivalent.

This was truly ad-venture capital.

Eventually, the Duke of Albermarle proved to be one savvy venture capitalist. After endlessly searching for the sunken Concepción, Sir Phips finally located his treasure in 1687.

In the wake of his incredible discovery, Phips and his crew spent over two months hauling up 32 tons of treasure from the ocean floor.

32 tons

Upon the treasure hunter’s return, the Duke of Albemarle and others received an astronomical 10,000% return on investment.

As for the captain himself, Phips took an 11% cut of the profit, which amounted to £12,000. This was an absolute fortune, as the average income for a merchant in 1688 was £400.

Sir William Phips represents a true Innovator. The treasure hunter had a bold, and risky business proposal, but offered an extremely enticing return if it proved successful.

The Imitator

[Wreck-recovery companies] made much noise at this time, and shares for them were presented to persons of distinction to give reputation to the affair and to draw on others. So the patentees were sure to be gainers but the sharers under them lost all they paid in, some of whom, it seems, were men of good understanding but were allured by the hopes of getting vast sudden wealth without trouble.”- Anonymous (1692)

Reflecting the excitement surrounding new technologies and inventions, there were a record number of patents filed in London between 1691–1693,

The speculation in treasure hunting specifically is evidenced by the increase in patents related to diving and shipwrecks during the 1690s.

Over a 19-year period (1672–1689), there were 5 patents filed for ‘diving engines’. In just two years, however, there were 17 patents filed for diving engines from late 1691 to late 1693.

In this period, patents provided a level of status and credibility that investments from prestigious VC firms similarly offer startups today. One Londoner commented in 1695, “Oh, a patent gives a reputation to it, and cullies in [i.e. takes in] the company”.

While it’s unclear whether Phips had used a similar device himself, these new products captivated British investors. In response to investor’s thirst for a 10,000% return, new companies advertised diving engines for salvaging sunken treasure off the ocean floor.

The prospectus of one such company promised investor’s a 100% return.

Just as the success of modern companies like Uber led to an outburst of “Uber for X” companies, Sir Phips’ expedition sparked the formation of numerous diving and treasure hunting companies.

The below is only a partial list of such companies:

Despite the number of new companies formed to emulate Sir Phips’ success, “none of these expeditions were successful — indeed the only ‘finds’ consisted of a few cannons”.

The Idiot

“So I have seen shares in Joint-Stocks, Patents, Engines, and Undertakings, blown up by the air of great words, and the name of some man of credit…and many families been ruin’d by the purchase [of these shares].” — Daniel Defoe (1697)

In this bizarre treasure hunting bubble of the late 17th century there were plenty of idiots. On the funnier side, there were those that sought patents for ideas like “catching fish with lights”, and the “sea-crab” apparatus.

However, investors were just as idiotic. Typically sensible Londoners embraced their inner idiocy as the cravings for profits grew stronger. The bubble even drew in former critics:

Captain Poyntz came forward with a petition on April 20th, in which he stated that persons who had secured patents for wrecks, sold shares at ‘extravagant rates and had as yet done nothing’. He too obtained a patent on April 29th.”

There were also many that suffered a fate similar to Daniel Defoe, who had invested and lost £200 in John Williams’ diving engine company. Later, he complained that Williams had only “pretended to be a skillful engineer in retrieving wrecks”.

Defoe, unable to identify Williams as an Idiot, was forced to deal with the consequences. Despite his best efforts to sue Williams, he eventually lost every penny of his investment.

Every investor wants to put their money in the Phips Treasure Hunt. However, finding Sir Phips is a treasure hunt in itself.

If you can identify Sir Phips before he embarks on his expedition, then the risk is worth the return.

Should you miss out on such a successful investment, however, ensure that you carefully scrutinize future opportunities borne out of its success. While imitators can certainly provide an attractive investment, you may end up holding shares in the “sea-crab” company.

Venture capital firms today acknowledge the difficulty of identifying the Innovator in how they construct their portfolios. The average investor should similarly ensure that they have a check in place.

Fail to identify the idiot in advance, and pretty soon you become the idiot yourself.

After losing his full investment in a sham diving company, Defoe lamented:

“I could give a very diverting history of a patent-monger…whose cully [fool] was nobody but myself” — Daniel Defore (1697)

The Road To ETFs

Jamie Catherwood is a Client Portfolio Associate at O’Shaughnessy Asset Management. Known as the ‘Finance History Guy’ on Twitter, Jamie posts articles and content on the history of financial markets. You can follow him at https://twitter.com/jfc_3_

There is no questioning the fact that Exchange-Traded Funds (ETFs) have revolutionized modern finance.

But what led us to this invention?

What were the ETFs of a thousand years ago?

Are they really so different than today?

Since their inception in 1993 with the launch of SPY, the industry has grown exponentially. While many associate ETFs with passive investing, there are far more active applications.

The ProShares UltraPro 3x Crude Oil ETF ($OILU), for example, is about as far from a passive investment as one can get. There are even some active managers that now offer ETF versions of their mutual fund strategies.

Most importantly, ETFs have provided access to the markets for small/retail investors. It’s now easier than ever to obtain a low-cost, diversified portfolio.

Similar to a past article discussing the ancient roots of active management, the road leading to ETFs can be traced back a thousand years. Since the 10th century in medieval Italy, innovative financial products have been designed to benefit smaller investors through diversification and lower costs.

The modern Exchange-Traded Fund is just the latest iteration.

“A View of Genoa”

“Contracts like these exhibit the complexity and breadth of financial innovation in which even small investors could participate in commercial enterprises”Robert Yee

Merchants in medieval Venice and Genoa faced an ongoing issue: the high costs of financing their voyages to other ports.

The answer? The commenda contract.

These contracts were revolutionary at the time due to a few reasons:

  • They offered a ‘passive’ investment option
  • Partial, or ‘fractional’ investments
  • Newly developed systems for sharing profit/liabilities

The commenda was a contract between a financier and merchant to fund a ship’s voyage to various ports so that a merchant could sell his goods.

Sometimes described as a ‘sedentary investor’, the passive financier invested capital to cover the costs of a merchant’s voyage, but did not travel himself.

His merchant partner, the ‘active investor’, utilized this investment to fund his voyage, which he was responsible for overseeing. The merchant was considered an ‘active investor’, since he was risking his own life at sea in the pursuit of profit. Ships were frequently lost at sea, and there was no guarantee that the merchant would return home.

Talk about skin in the game…

While quite similar in nature, two variations of the commenda contract existed in medieval Italy: The Bilateral Commenda, and Unilateral Commenda.

Commendator: ‘Passive’ Investor / Tractator: ‘Active’ Merchant

In a Unilateral commenda, the ‘passive’ investor funded the entire venture, and was responsible for 100% of the losses, but received 75% of the profits.

Conversely, under a Bilateral commenda, the investor only put in 66% of the capital, but was responsible for 66% of the losses. Profits between the passive investor and merchant were split 50%–50%.

Both versions were important, but the bilateral commenda most embodies the spirit of ETFs today.

Rather than risking his own life, bilateral commenda’s offered a passive investor the ability to fund only 66% of the merchant’s voyage, and still receive 50% of the profits. Unlike the unilateral commenda, which required him to fund 100% of the voyage, the ‘sedentary’ investor could now allocate that excess capital across a diversified portfolio of multiple bilateral commenda contracts.

Such diversification benefits were not lost on investors like Godric of Finchale:

“He purchased the half of a merchant-ship with certain of his partners in the trade; and again by his prudence bought the fourth part of another ship.” Reginald Durham (12th Century)

To be clear, the potential return on investment (ROI) was more attractive for the ‘active merchant’, since he was only required to fund 33% of the voyage in return for 50% of the profits.

However, the return opportunities offered to each partner in a bilateral commenda perfectly encapsulate the active/passive management debate today.

While the “active merchant” could theoretically obtain a higher ROI, there was a much higher level of risk involved. Far from enjoying safety and comfort on land, the merchant was forced to put his own life at risk to pursue that higher return. His entire return rested on his ability to outperform on one voyage.

As there was an opportunity for a higher ROI, there was the equally feasible option that the merchant did not return home from his voyage. A 0% ROI.

For most Italians, it was better to be the ‘sedentary’ investor that did not have to risk his life, and could diversify his investments across a pool of commenda contracts.

In addition to their unique investment partnerships, bilateral commenda’s were known for their liquidity. Like ETFs, this allowed passive investors to easily buy and sell whole (or partial) positions in a merchant’s voyage, which was a true innovation.

In fact, similar to a Dividend Re-Investment Program for ETFs, one variation of commendas, the Societas Maris, allowed passive investors to easily reinvest their dividends from previous voyages into new opportunities.

The commenda was a success among smaller investors, which was evidenced by a 12th century book titled “Commenda Contracts of Humble People” (1178).

“Investments by relatively humble people who sporadically supplied small sums and the large extent to which investors diversified in Venice suggest that the Venetians established financial relations even when they knew beforehand that their bilateral relations would last for a short period of time and would be of little value” — Yadira González de Lara

Courtyard of the Amsterdam Stock Exchange

While there were certainly other innovations in finance since the commenda contract, the next major development covered in this article was the birth of the mutual fund in 1774.

Dutch financier Abraham van Ketwich is considered the father of this first mutual fund, Eendragt Maakt Magt (Unity Creates Strength), which was founded in 1774.

Although it was a mutual fund, and not an ETF, the reasoning behind the invention of Eendragt Maakt Magt is similar to ETFs:

“The prospectus required that the portfolio would be diversified at all times. The 2,000 shares of Eendragt Maakt Magt were subdivided into 20 ‘classes’, and the capital of each class was to be invested in a portfolio of 50 bonds. Each class was to consist of at least 20 to 25 different securities, to contain no more than two or three of a particular security, and to ‘observe as much as possible an equal proportionality’.”K. Geert Rouwenhorst

The ‘Eendragt Maakt Magt’ Prospectus

In essence, the Eendragt Maakt Magt was an equal-weighted index fund designed to offer investors a broad, diversified exposure across ’20 classes’ of bonds.

Occurring so shortly after the market crisis in 1772–1773, which was sparked by concentrated bets on the East India Company, some have argued that Van Ketwich’s fund was intentionally designed to offer a conservative, and more diversified fund for smaller investors. Van Ketwich even kept fees abnormally low at 0.20%, not unlike passive funds today.

Eendragt Maakt Magt’s investments were also detailed in the prospectus, preventing the fund’s managers from taking many active investment decisions. As a further safeguard against active management, the prospectus promised that the fund’s securities would be stored in an “iron chest with three differently working locks”. If any investment decisions were made, the chest would have to be unlocked by three separate authorities.

Despite it’s lack of liquidity due to the iron chest, the connections between the Eendragt Maakt Magt and ETFs remain clear. Both investment vehicles aimed to provide small/retail investors with a diversified portfolio at a low cost.

Given this focus on an equal weighted, diversified portfolio offered to small investors at a low cost, the Eendragt Maakt Magt could even be considered a rough equivalent of the passive ETF.

ETFs have significantly altered the investment landscape in the 21st century, but the road to their invention was marked with the innovations of savvy investors throughout history.

There were many more crucial innovations that demonstrated the characteristics of ETFs today, but the bilateral commenda and Eendragt Maakt Magt offer two lesser known examples.

Each of these revolutionary products offered a diversified, and conservative investment option for small/retail investors at a low cost.

Just like the commenda, and Eendragt Maakt Magt, one day investors will reflect on ETFs as another innovation of the past.

The question is, what invention is the ETF leading us to?

VLOG: Savvy Social Security Strategies For Maximizing Benefits

Are you closing in on retirement and have questions about social security?

When you begin to collect benefits, how you collect them, and what potentially can impact those payments can be very confusing. Danny Ratliff and Richard Rosso, both highly qualified CFP’s, delve into the many most commonly asked questions about social security and how to maximize the benefits in retirement.

Still have questions? 

No problem.

We at RIA Advisors, a registered investment advisory firm, specialize in preserving and growing investor wealth in times like these. If you are concerned about your financial future, click here to ask a question and find out more.

As Seen On Forbes: The Market Bubble Helped Goldman Fix Its Image

As seen on Forbes by RIA’s Jesse Colombo: “Goldman Has Rehabbed Its Reputation And All It Took Was This Huge Bubble“:

During the Global Financial Crisis and a few years after it, investment bank Goldman Sachs became Public Enemy #1 for its role in the mid-2000s housing bubble, mortgage crisis, and related scandals. The bank took on a reputation as a “great vampire squid wrapped around the face of humanity, relentlessly jamming its blood funnel into anything that smells like money.”

In the past couple years, however, Goldman appears to have greatly improved its public image, according to a new report by research firm YouGov’s Plan & Track:

New data shows that slightly more US adults would be proud to work for the firm than embarrassed

General impression of Goldman Sachs during the financial crisis and subsequent recession was not good. Public perception of the investment bank as a potential employer plunged as its share price sank.

Now that 10 years have passed, however, and the firm is getting a fresh start with incoming CEO David Solomon, who begins his new role on October 1, things are looking much better.

Indeed, new data from YouGov Plan & Track shows that slightly more American adults would now feel proud to work for Goldman Sachs, as opposed to embarrassed. This comes after the firm’s Reputation score — which gauges how open US consumers aged 18+ are to being employed at a particular brand — spent years emerging from negative territory following the crash. Even when the bank’s Reputation score returned to neutral in the latter half of 2015, disparaging comments made during the 2016 presidential campaign seem to have pushed it back down again.

Workplace Reputation: Investment Banks
Read the full article on Forbes.

The “Nastiest, Hardest Problem in Finance”

Should retirees own any stocks? It seems ridiculous to ask that question. Of course, they should. People are living longer than ever before and need higher returns on their assets to see them through an extended retirement. And many target date funds are responding by maintaining elevated amounts of stocks through at least the early years of retirement.

How else to get those returns than from stocks?

Not so fast, says economist Allison Schrager who wrote a recent article for Quartz asking the provocative question:

“If you’re about to retire, should you pull out of the stock market?”

After all, weeks such as the last one remind investors that stocks are far from a sure thing, and can vaporize wealth quickly.

It’s true that most people haven’t saved enough to retire easily, and stocks – or the returns they’ve historically provided — may be a way to overcome savings shortfalls. But there are two problems with this argument. First, stocks may not deliver the returns we have grown accustomed to receiving from them. The best indicator of long term – say, future ten-year – returns is the Shiller PE, which is the current price of the market relative to the past decade’s worth of inflation-adjusted average earnings. That metric is over 30, despite last week’s correction. It’s two highest readings previously have been 34 in 1929 and 44 in 2000. And stocks did poorly from those two peaks over the next decade. Basically, it’s very hard for stocks to perform well for the next decade starting from this valuation.

Because of their high valuations, stocks may not outpace bonds. The 10-Year US Treasury is now yielding around 2.8%, and investors can own an index of investment grade corporate bonds that pays nearly 3.6% in the form of the iShares Investment Grade Corporate ETF (LQD). And if investors can get a highly probable return of over 3% from bonds, it’s not clear that domestic stocks will outstrip that by a lot or even at all.

Moreover, the volatility stocks often deliver can destroy retirement plans, even if stocks eke out higher average annual returns than bonds. This is because of something called “sequence of return risk.” That basically means that ,during distribution phase, when and how returns are delivered matters at least as much as the average annual return itself. I did a study of two portfolios – one all domestic stocks, and one balanced – starting in 2000 using the famous “4% retirement rule.” That means the retiree is taking 4% of the portfolio as income in the first year and boosting the first year’s dollar payment by 4% every year thereafter.

Retirement Allocation Chart 4% Retirement Rule

Source: Morningstar, Yahoo!Finance

The results are ugly for the all-stock portfolio, which reduced the account by nearly 80% after 18 years at the end of 2017. The balanced portfolio, by contrast, was reduced by only 20% of the original balance after 18 years of applying the 4% rule. The starting point for the test is admittedly random, and it includes two big stock market drawdowns. But it shows how an unfortunate starting date combined with a lot of stock exposure can hurt a retiree.

None of this is to argue that retirees should eliminate their domestic stock exposure altogether. Stocks may outpace bonds over the next decade, after all; we’re just saying the chances of that happening are low. Also, foreign stocks, especially emerging markets stocks, present better valuations, and their likely future returns are at least somewhat higher than what their domestic counterparts are offering.

Although many mutual fund families have target date funds that contain more than 50% stock exposure at the time of retirement, Schrager says the average target date fund in Morningstar’s database has 40% of its assets in stocks. That’s meaningfully lower than the classic balanced portfolio, which has 60% in stocks.

There’s a big difference between having 60% stock exposure and 40% stock exposure. In 2008, for example, a portfolio that had 60% in the S&P 500 and 40% in the BloombergBarclays U.S. Aggregate Bond Index lost around 20%, but a portfolio that had the reverse exposure – 40% stocks and 60% bonds – lost around 13%. That’s a big difference for retirees taking 4% or more from accounts in income. There are limits to how much stocks can help savings shortfalls in retirement. Don’t put a burden on them they’re not equipped to handle.

As always, your stock exposure depends on your personal risk tolerance (which is much harder to estimate than you might think), your spending needs, and how well funded you are. But Schrager is correct to note that things are different in retirement than they are when investors are saving or accumulating assets. As Bill Sharpe, whom she quotes, says, investing in retirement is the nastiest, hardest problem in finance.