Friday, April 18, 2008

Portfolio Complexity: The toxic cake!

Wow, do you ever wonder how an industry with so many smart people can get itself into such a huge mess? Having met Purdy Crawford, I know he is extremely bright and experienced and a great choice to sort out the ABCP issues in Canada. So is it not amazing when he takes months working with a hand picked selection of bright minds, and then acknowledges they have no idea what the ABCP is worth today! I guess that qualifies as complex!

Asset Backed Commercial Paper is one of the best examples of smart people outwitting themselves. It all starts with simple assets like a mortgage, but a straight mortgage can only generate so much profit for the smart folks. So from the mortgage comes mortgage backed securities, then comes a complex bundling process that is like baking a cake. When the recipe is right, the individual ingredients cannot be easily distinguished but the finished product looks and smells great! Unfortunately, as with baking, a little of the toxic stuff can be mixed into the investment bundle and perhaps not be fatal. Maybe we use a few ingredients that are past there "best before dates", who will know or care, right. Well, in a great kitchen the chef would notice and of course in the investing world the rating agencies would know. Quick comment: trust your chef before your rating agency, the chef is not paid by the flour mill!

Not surprisingly, it would appear that there is a limit to how much of the ingredients can be toxic before the cake is poisonous. And to bring this long analogy to an end; the cakes have all been baked, nobody knows how much of the ingredients are toxic, and there are very few investors lined up to sample the outcome! The smart guys in the kitchen can't tell the good cakes from the bad and it would appear the bakeries sold enough cake to feed the world!

So what have we learned: The old adage still holds can't have your cake and eat it too!

As for complexity in your portfolio....beware the advisor selling baked goods! Check the ingredients before you scoop up the icing! For a more rational and clear understanding of portfolio complexity, check out the 3rd issue of the Second Opinion Newsletter .


Simplifying Your Investment Portfolio Ken Hawkins
“Perfection is achieved, not when there is nothing more to add, but when there is nothing left to take away”Antoine de Saint-Exupery
IntroductionA well diversified and uncomplicated portfolio is almost always better than one that is overly diversified and too complex. This is especially true for individual investors with limited time, analytical tools and expertise. Despite this, many investors find themselves with portfolios that are too complicated to understand, hard to manage, and difficult to make changes with confidence. This is especially true for investors that hold too many mutual funds and invest in too many complex structured products


Anonymous said...

So if I get this right, I can lose a lot of dough if a few crumbs poison the batter! So what role does the advisor play...waiter?


Anonymous said...

Hearing about those chefs baking a dangerous cake makes me think of the 17th century medical experts. They bled their patients and applied treatments that we now know did more harm than good.
I think that 20 years from now we'll look back and realize that most 'financial' chefs and financial advisors also did more harm than good.