Other Blogs I Can Recommend

It’s time I acknowledged some other bloggers, all of whom provide interesting and thoughtful material. I can strongly recommend each of these.

David Miller – Diary of a Fund Manager


Christian Hunt – The Human Risk Blog


Daniel Ross – A Load of BS


Both Ends Against the Middle

In late 1880’s the celebrated (is that the right word?) arms dealer and speculator Sir Basil Zarahoff pulled off one of his greatest coups – he managed to sell the same submarine designs on an exclusive basis, to both Greece and Turkey convincing the bitter rivals it would ensure their naval superiority over one other. Just to add into the mix he worked the same trick with the Russian government convincing them the submarines could ensure Russian command of the Black Sea and the Eastern Mediterranean. In the event all the submarines proved to be very inferior, and none saw active service, though Zarahoff of course made huge selling commissions.

This is the classic example of the middleman being a big winner and with limited risk. In this case the middleman actually created the market for the arms. Clearly Zarahoff understood 1970s marketing guru David Abbott’s maxim; “There may be a gap in the market, but is there a market in the gap?”

This story set me thinking about how we play different roles in life (and by extension) markets, and why the distribution curve might be a nice guide on occasions. In this blog I’m not delving into the world of fat tails et al., but rather a general look at how “averages” can help and hinder. We probably become aware of distributions very young in life, perhaps in our class one kid is very tall and another very short with the rest of us somewhere in the middle, just being average. Most of us seem to be average at most things most of the time, well of course we must be!

The media and financial markets are interested in extremes, “Man bites Dog” and “Crash wipes off billions of dollars” are news. This makes sense (despite the sensationalism) as most new information is found in the tails of a distribution not in the data clinging to the average. We may dream of being in the tail, as a rock star, world class athlete, tycoon, or captain of industry but we are resigned to failure in such fields, as we are still stubbornly just average. On occasions an exceptional person will try hard to be average, the field of espionage or fraud usually calls for those with unusual talents but their stock in trade method is to be “Hidden in plain sight”.

Thinking in this simple way can help in our understanding of risk. Too much risk management ends up being just risk measurement, whereas the key to success is in identifying risk, in particular new risks. This is a dynamic approach, whereas risk measurement is often static if not just a formulaic box ticking exercise. By questioning constantly and thinking about new information and whether its unusual or doesn’t ring true, is the real skill in risk management. We need to watch the tails for new information, whilst still keeping an eye on the average group for any sudden unexpected behaviour that reveals hidden deeper information that is being concealed.

A final thought, well an old joke; My head is in the oven and my feet are in the freezer, on average my temperature is just fine!

Sherlock Holmes, The Grain of Wheat, and The Snowball

The great fictional detective Sherlock Holmes was a frequent user of cocaine, and his companion Dr. Watson disclosed that the great man preferred a 7% solution, to ease his mind and let him relax to ponder various complex cases. Perhaps slightly obliquely, the phrase “7% solution” immediately made me think of long term investment strategies. A compounded return of some 7% annually (well 7.2%) will see a sum double every ten years, and somewhat strikingly in a period of 100 years, the capital will have grown by over a thousand fold. Quite a “solution”!

This idea of the enormous power of compounding was nicely illustrated by the great Islamic scholar Ibn Kallikan in 1256 (though its origins are almost certainly far older), when he considered the simple task of putting grains of wheat on a chessboard. The puzzle asks you to put one grain of wheat on the first square and double the amount on each subsequent square thereafter…so two grains on square two, four grains on square three etc…until all sixty four squares of the board are covered. So how many grains of wheat will be on the board overall?

Perhaps somewhat astonishingly, on the entire chessboard there would be no less than 18,446,744,073,709,551,615 grains of wheat, weighing about 1,199,000,000,000 metric tons. This is about 1,538 times the global production of wheat (780.8 million tonnes in 2019).

So, doubling is a hugely powerful force, but away from wheat on chessboards, how realistic is this in long-term investment? Interestingly 7% average returns are not that impossible, over many different time horizons global equity markets have delivered those sort of total returns. Detailed information across various asset classes can be found in the Annual Credit Suisse Global Investment Returns Yearbook (see reference below) and for example US equities in real terms (i.e., after inflation) between 1900 and 2019 returned on average 6.5% p.a., and in the last ten years global equites generated 7.6% p.a. (Though it should be noted returns across a wider portfolio of all stock markets for the last 120 years produces a lesser return of 5.2% p.a.) So our desired 7.2% cannot be guaranteed but investment returns can still be a powerful creator of wealth.

Now on to the snowball – this is a simple way to think of the effect of re-investing any investment income – in time it starts to act like a snowball. This analogy was used in a well-known book on the celebrated investor Warren Buffet, The Snowball: Warren Buffett and the Business of Life by Alice Schroeder.

All of these examples point to two simple investment precepts, invest early (or at least regularly throughout your savings life) and always re-invest any income. In forty years at 6.5% p.a. a £1,000 racks up nicely to around £12,500.
Whilst we may not quite get to Holmes’s 7% solution, we will get wealthier and stay somewhat healthier than the great detective.