Ray Unger: Don't be too surprised by the next sneak attack

Ray Unger  —  12/07/2007 8:59 am

Today is Pearl Harbor Day. As Franklin Roosevelt said, "A date which will live in infamy." But has this experience taught us anything? Can we grasp those perilous threads of nefarious encroachment that presage disaster? The attack on Pearl Harbor ushered us into a world war; the sneak attacks I'm referring to are the ones that badly damage our retirement nest eggs.

Recently I read a great article about the qualities of leadership ("Judgment Trumps Experience," Wall Street Journal, Nov. 29, by Warren Bennis and Noel Tichy). It's about political leaders, but the story line could easily refer to investment managers. The article reminded me of a John F. Kennedy quote, "Good judgment comes from experience. Experience comes from bad judgment."

Coincidently after I read this article, my partner Greg Jones challenged me to a seemingly innocent investment question. He showed me the annual returns of various hedge funds compared to some of our mutual fund selections. Some hedge funds routinely logged 15, 20, even 30 percent annual returns. "So which one would you choose?" he asked. Then he revealed that a number of these same hedge funds that routinely beat the pants off the stock market suffered that magic three-digit loss number of 100. That's right: TOTAL LOSS.

Now I'm sure some of those hedge fund investors thought that such a sneak attack could have been averted. Perhaps a closer look at the technical tea leaves or a failure of their funds to meet certain performance benchmarks could have steered them out before the fall? They could also be thinking that it's their fault for not watching their managers more closely. If that's the case they'll probably suffer another such "sneak attack" down the road.

Agree with me or not, but I don't think there are any mystical indicators that foreshadow such events, except one: good judgment.

Plainly put, investment managers -- and investors -- need to exercise good judgment. So how do you recognize good judgment? That's a tough one. Perhaps it's best to ask what isn't good judgment. Is betting the ranch on a whimsical spin of the roulette wheel using good judgment? Or how about borrowing three, four, may five times your investment, and betting the whole bundle on which way volatile instruments like derivatives, futures, currencies, options or commodities will squiggle?

Now some investors will say, "Yes, I understood what they were buying and selling, but the technical strategies they used actually reduced their risk." What these managers, and investors forgot is the unassailable law of random events. In non-statistical terms, that means something can come out of the blue and blow up the best laid technical strategy.

For example, do you know what happened to those smart currency hedgers who borrowed Japanese yen at low interest rates (roughly 1 percent), converted the yen into U.S. dollars and invested in high yielding corporate bonds? You guessed it. The high yield bonds got clobbered on the subprime mortgage news, the dollar fell relative to the yen, and after they unraveled their positions, they lost a bundle.

So don't be overly impressed by technical strategies or arcane formulas. When you bet the ranch every day on short-term moves in the market, you'll make lots of money -- if you guess right. But just one zig when you should have zagged, and poof, all the money's gone.

The lesson we learned on Dec. 7, 1941 was never to take our security for granted. That's been our strategy ever since -- vigilance. Likewise, never forget the security of your nest egg. Be vigilant about where that nest egg resides (have a strong custodian), vigilant about how much risk you're exposed to (how much in stocks, bonds, etc.), and vigilant about your expectations (if past returns are too good to be true, the risks are probably too high to assume).

Ray Unger is chairman of Unger Capital Management in Madison. He can be reached at 833-9400; e-mail: rayu@ungercap.com

Ray Unger  —  12/07/2007 8:59 am