Book Review – Freefall: America, Free Markets, and the Sinking of the World Economy

I decided to read Freefall (by Joseph Stiglitz) after seeing a talk by the author. In the book Stiglitz promises to peel back the layers of causes responsible for the recent financial market collapse. When asked why the collapse happened most people will respond by saying banks were giving out mortgages to people who could not pay back. But Why? Because the incentives of the mortgage originators and bankers were flawed. But then the question is why did the market not respond to those flawed incentives and encourage firms that had the right incentive structure. Stiglitz frames the economic collapse in context of larger debate between Keynesian's and Monetarist's. His central claim is that since late 1970's Monetarist thought has been gaining the upper hand and the current crisis is the result.

The book starts off very crisply. Stiglitz invites you to listen to the story of the crisis and keeps you engaged even while going over parts of the story that you have already heard. He gives a comprehensive account of the crisis and I learned many things even though I considered my self well aware of the events. He castigates the political administrations starting from Regan's for dismantling the regulatory system which was ultimately responsible for the crisis.

While he is extremely critical of the bankers, regulators and politicians he seems to give the homeowners who took mortgages they could not afford a free pass. He never quite gets around to explaining how the american family who took the zero percent down, non recourse mortgage was the victim when they could just walk away from the home that they had no business owning in the first place. He seems to see no difference between the hardworking Americans who save for a down-payment and only buy homes they can afford and those who get the biggest house they can with nary a thought to finances.

He also latches on to ARM's as unequivocally bad and predatory which is not really true. He mentions them multiple times and faults Greenspan for encouraging them in a lecture. In an otherwise crisp and insightful narrative I felt a dissonance reading the simple minded rhetoric on ARM's. In an ARM the borrower takes on the interest rate risk and in return gets a lower cost for the loan. These mortgages are pretty common in many countries (like Canada) and they work as well as the fixed rate mortgages used to in America.

The above faults aside Stiglitz is spot on in his criticisms on how the stimulus has played out. Banks and their shareholders got too sweet a deal. He explains how all the reasons given on why banks and their shareholders are entitled the the tax payer largess are flawed. The Obama administration policies have failed to stop a crisis like this from recurring. The banks are still too big to fail, and thus enjoy the implicit government guarantees.

The only problem with the book is its length. After about half way through, I started feeling that the arguments and examples got repetitive. It felt like someone who has been ignored for years has finally been vindicated and now cannot stop saying "I told you so".

Overall, I would highly recommend the book to anyone who is interested in the financial crisis. It pairs really well with The Big Shot

Managing Your Portfolio.

I have been doing some reading on investment planning. Some great books that everyone should read are "A Random Walk Down Wall Street" by Burton Malkiel and "The Intelligent Asset Allocator" by William Bernstein. Both of them advocate passive investing. Markets are efficient, you cannot beat the market, you most certainly cannot beat the market by being an arm-chair analyst. The most you can hope for is to not lose to the market. Read the first book if you do not believe me. A Random Walk also gives an excellent introduction to various investment vehicles and terminologies. If you do not know about mutual funds, expense ratios, capital gains, turnover rate, rebalancing, PE ratios, alpha, beta, read the first book.

So what is the intelligent investor to do? Decide on how much risk you can take, depends on what you are saving for and your personal appetite when you lose half your portfolio. The most important thing in investing is to stick to your strategy though bear markets, so it is essential that you design your portfolio keeping this in mind. Risk decides bonds to stock ratio in your portfolio, higher the stocks fraction, more the risk and higher the expected rewards. Now further divide each part into various sub components. For example, short term bonds and intermediate term bonds for bond part, and foreign stocks, large cap stocks, small cap stocks, REITs for stocks part. Assign percentage numbers to each of these and buy a index fund that tracks the corresponding asset class. You now have a portfolio! Every time you invest more money, invest in all of them in the proportion you decide. This part is important, you want to keep putting money in even when the prices are falling and you are losing money. Everything reverts to mean, buy low and sell high. The Intelligent Asset Allocator gives excellent advise on how to design a portfolio and analyze its expected return and risk.

Every year, rebalance. Sell off assets that now make a higher proportion of your portfolio and buy those that now make a smaller proportion than the target. This is by far the most important part. More important than the exact composition is disciplined regular rebalancing. Rebalancing essentially means selling your winners and buying your losers. Remember, assets revert to mean. Buy low sell high.

I designed a spreadsheet to track a portfolio, calculate how much off target it is, etc. Its is a very simple sheet, you can check it out here. You only need to fill out the grey cells, rest are all automatically calculated. It is pretty basic, I might add new features from time to time. If you find it useful, let me know. If you add some stuff to it, let me know. (Need less to say the numbers in the sheet are made up, the allocations should not be taken as suggested allocations).


Disclaimer: I am not a financial planner. You can bankrupt yourself by following this advise. All software is provided as it. You can bankrupt yourself by using the linked spread sheet.