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Tuesday, November 18, 2008

You Can't Invest in an Average

There is an interesting interview with Howards Marks, Chairman of Oaktree Capital, over at Barron's (hat tip Infectious Greed) explaining how innovation, leverage and risk-taking all lead to the problems the financial community is currently experiencing (bold navy is mine).

So there must be some risks in the overall proposition that are not captured merely by the yield curve. And those risks are that on a bad day, you could be asked to repay your borrowings, or you could be unable to roll over your borrowings. So to repay your borrowings, you have to sell assets. But assets could be either not sellable or only sellable at losses or prices well below what you think they are worth or what they are really worth.

You look at this and say: "OK, I can borrow money short-term at 3%, and I can buy 30-year bonds at 6%. I'm going to make 3% a year forever." That will work in the long run, if you can survive to enjoy the long run. It reminds me of one of the greatest adages in this business:

Never forget the six-foot-tall man who drowned crossing the stream that was five feet deep, on average. It is not sufficient to get through on average. You have to get through every day.

As Howard points out, if you can borrow at 3% and invest in something that year in and year out returns more (equities have returned 8% on average over the past 20 years), you can make an absolute killing. The problem lies when you've borrowed at that 3% and then have a period like we've had over the past twelve months, one in which after dividends has seen the S&P 500 return -36%.