Dirty Words of Finance

A little before my time, comedian George Carlin did a bit called ‘seven dirty words’ that were unsuitable for television. Although the words are fairly commonplace now, I’m glad that the networks and basic cable keep them off of the air until my kids are in bed.

Finance has a few dirty words as well, but unlike Carlin’s list, I can use them here to describe how we mostly, but not entirely, keep clean of these items.

  1. Derivatives
  2. Leverage
  3. Concentration
  4. Short-Selling

Derivatives are securities whose price is derived from the price of something else. For example, when a farmer hedges his wheat crops, the price of the futures contracts that he trades is derived from the price of wheat.

Although we avoid classic derivatives like options, futures, or swaps, we do buy derivatives when we buy a collateralized mortgage obligation (CMO), which is a pool of mortgage bonds whose price is derived from the price of the underlying mortgage bonds in the pool.

Unlike the derivatives that we usually hear about in the financial press (like the London Whale at JP Morgan), the CMOs that we buy are very conservative, partly because they don’t have any embedded leverage.

With traditional derivatives, you often don’t have to put down all of the money to buy the contract, which means that you are implicitly or explicitly borrowing money to finance the trade. That’s not the case when we buy a CMO – no leverage is applied.

We avoid leverage, or more simply, borrowing money, in our investment strategies. That said, we occasionally use borrowed funds on behalf of clients to finance a short-term loan in the form of margin and pay it off relatively quickly.

And, not all leverage is bad – most people have leveraged exposure to the local real estate market in the form of a home with a mortgage.

The third dirty word, concentration, is something that we avoid, but, paradoxically, is something that a lot of clients are comfortable with. Routinely, new clients arrive with a large concentrated position in a stock that they don’t want to sell because of the tax consequences.

We tend to think that anything over 10 percent of a portfolio is nearly an emergency and aren’t really comfortable unless a single exposure is less than five percent of a portfolio. When we invest from scratch, no single stock position has more than one percent exposure.

We’re strong believers in diversification and believe that there is no special compensation for holding what is often called ‘idiosyncratic risk’ and therefore avoid it.

Clients often feel comfortable with their concentrated positions because they worked at a company or inherited the position from grandma, but you never know what will happen, so we diversify and avoid concentration.

The last dirty word, short selling, is a transaction where an investor sells a security that he doesn’t own in the hopes of buying it back later at a lower price. While we don’t engage in short selling, we’re glad that other investors do.

Some people think that short sellers are evil, down on America or a bunch of perma-bears. That last one might be right, but this group of investors serves two important purposes.

First, short sellers scour financial statements and uproot a lot fraud and financial chicanery. The very existence of short-sellers keeps CEOs and CFOs a little more honest than they probably would be otherwise.

Second, short sellers provide liquidity to the market and make it more efficient. If you have a negative view on a stock and can’t sell it short, you simply don’t trade. We prefer more people in the market buying and selling for liquidity and price discovery purposes rather than investors sitting on the sidelines.

Unlike Carlin’s seven dirty words, the dirty words of finance can have some benefits, provided that they are managed appropriately and aren’t as dirty as they may sound at first. That said, I still don’t imagine seeing them at the seven o’clock hour on the broadcast networks.