When it Pays to Lose Money


August 2012
Ivan Obolensky

Stock Markets are made up of the shares of many different companies. Normally prices reflect earnings expectations because markets look towards the future.

Money, or cash, has a built-in expectation, too. It has a time value.

Suppose one has a choice between receiving $10,000 now, or in one year? Which should one choose?

There would be no point in waiting, so receiving $10,000 now seems the better choice. But suppose one wanted to invest for a year.

How much return should one demand? One thousand dollars? How about a 300-dollar loss?

Any one of the above answers could be appropriate depending on the circumstances.

Economics is context-driven.

In scientific experiments, one attempts to isolate the experiment from external factors that might compromise results. In economics this is not always possible.

A business may be viewed in isolation but specific handlings and decisions must be viewed against the environment in which they are made. Context matters.

Economists work with models in an effort to handle this contextual difficulty.

One useful stock market model has been the Capital Asset Pricing Model (CAPM).

It attempts to answer: How much return should an investor demand from an investment?

The model does this by pricing individual securities according to their asset class and in relation to the market as a whole. This allows the investor to compare the current price with the model price and know whether he is overpaying.

An earlier article I wrote (The Story of Modern Finance) explained that combining several assets that trend differently over time can decrease the overall volatility, or up and down, of the total. CAPM is the theory behind diversification, and it works—up to the point when all assets drop in value simultaneously. Diversification can reduce individual asset risk, but cannot get rid of systemic risk: the risk inherent in an overall system.

The human body is made up of many diversified systems. But regardless of how diversified it is, the fact that humans are born, live, and eventually die is a systemic risk. It cannot be avoided.

Economies and stock markets also contain systemic risk.1

In finance, systemic failure would be a freezing (and subsequent collapse) of the entire economic system. This almost happened in 2008.

One of the reasons for the near shutdown was due to the disappearance of the Commercial Paper market in the U.S.

The commercial paper market is how large corporations handle their short-term financing needs.

Supposing General Electric sold one billion dollars of industrial equipment to another manufacturer. It may not receive that sum for some time. Rather than wait for the money to pay employees, GE enters the commercial paper market to borrow the payroll amount. It does this by offering paper (in the form of short-term interest-bearing notes) to various banking institutions that will be paid back within a maximum of 270 days.

Banks use commercial paper to create interest for savings accounts. The amount of U.S. commercial paper outstanding at any given time is around one trillion dollars.

During the Lehman Brothers meltdown in 2008, lending between institutions became almost nonexistent and hardly any bank wanted (or was able) to lend for any reason. There was a distinct possibility that even large companies that would normally borrow for their short-term needs (such as payroll) had insufficient cash and no means of borrowing the amount.

To have sufficient cash would mean having the payroll amount in one’s checking account, ready to send to a payroll disbursement company such as ADP. This type of checking account is called a “demand account” and has no restrictions as to disbursement.

Many companies (as well as individuals) keep excess cash in interest-bearing accounts such as savings or money management accounts. The fine print covering these accounts often states that the bank can refuse to pay out these funds for a period that can extend from several days to several weeks, even if the money shows in the account as a positive balance. This is not the case with a “demand account”.

I recall the day when the rumor circulated that the U.S. was hours away from a complete system shutdown because payrolls were not able to be funded. The commercial paper market had disappeared. The Paulson bailout (The Emergency Economic Stabilization Act of 2008) at the time saved the day.

This was the medical equivalent of a body no longer being able to pump blood, and would have resulted in a systemic failure. Which is why current central bank policy is concentrated on liquidity and keeping money flowing through the system, whether it is in Europe or in the U.S.

The Capital Asset Pricing Model estimates the amount of return an investor should demand of an investment. One factor in the calculation is called the “Risk-Free Rate of Return”.

This is the theoretical rate of interest for an investment that has no possibility of financial loss. It is synonymous with ultra-conservative and is usually represented by the interest rate of short-term government bonds. Historically this rate has been around 3%.

Short-term bonds are usually bought at a discount.

For example a short-term bond might sell for $950 when issued and in six months the buyer receives the face value of $1,000. The fifty-dollar discount to the face value is the interest one earns.

Using the $10,000 example, we are going to assume a very conservative profile and seek the risk-free rate of return. This rate can be either positive or negative depending on the overall state of the economy.

In Japan the risk-free rate of return has been negative off and on for some time. The country has been in a long-term deflation due to the gradual writing down of large numbers of bad loans and import/export imbalances.

In Japan, conservative investors have often purchased short-term government bonds (that matured in a year) for more than their value at maturity. In other words rather than buying the bond for $950 as in the example above, they would buy it for $1,030 and receive back $1,000.

They deliberately lost money. If the prices for goods drop 5% during this time while their government bond investment lost only 3%, they gained two percent in terms of purchasing power. Deliberately buying a losing investment makes sense in that context.

In our example, a return of minus three hundred dollars on the $10,000 might be fine if the transaction occurred in Japan.

In another country such as Argentina (which has a high inflation rate) the two-year bond yields 8.93%2 which reflects a combination of the risk-free rate of return and an inflation factor. (If the historical risk-free rate is 3%.) This would mean inflation is running at around 6%.

In an inflationary environment, money is worth less in the future.

In our example, we see that the amount of return we should demand on our $10,000 depends on the current economic environment.

In the U.S. the one-year treasury rate is 0.19%3. Historically this is low. It is being held there by the Federal Reserve in an effort to force investors to take more risk to stimulate economic growth.

Since our profile is very conservative we should demand this rate on the $10,000.

Because it is so low, it is almost not even worth the trouble.

We are thinking like the Federal Reserve wants us to think, which explains the current low interest rate environment: the central banks want investors to take more risk to stimulate economic growth.

We have to be careful we are not taking on more risk than we should.

To handle one’s finances smartly in today’s world requires that one assess whether the economy we hold money in is in a deflation as with Japan, in an inflation as with Argentina, or whether we are being pulled in both directions simultaneously, as with Europe and to some extent the U.S., where it might be better to hold cash until it is clear which one will win out.

Which scenario fits the country you invest in?

1 Bernstein, P. L. (1996). Against the Gods: The Remarkable Story of Risk. New York, NY: John Wiley & Sons.

2 ForexPros (n.d.) Argentina 2-year Bond Yield. Retrieved August 7, 2012, from http://www.forexpros.com/rates-bonds/argentina-government-bonds

3 U.S. Department of the Treasury. (n.d.). Daily Treasury Yield Curve Rates. Retrieved August 7, 2012, from Resource Center: http://www.treasury.gov/resource-center/data-chart-center/interest-rates/pages/textview.aspx?data=yield

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© 2012 Ivan Obolensky. All rights reserved. No part of this publication can be reproduced without the written permission from the author.

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