Archive for August, 2006

Paul Notari on confronting the Oil crisis

If you’re wondering about how the US should deal with the looming oil crisis, Paul Notari wrote an excellent overview on RE Insider this week.   His prescription for the US is exactly what we need.

High oil prices are starting to move us in the right direction, but not nearly fast enough.  We need to take action before Adam Smith’s invisible hand forces action on us, through demand destruction.  Demand destruction is a nice way of saying that when gas hits $20 a gallon, people will start taking their bikes to work because they can’t afford to do otherwise. 

Economists who pooh-pooh peak oil becase “demand destruction will take care of the problem” are forgetting the human element: demand destruction is incredibly painful.  We need to take proactive steps to solve the problem, such as those outlined in Paul’s article, or the problem will be solved for us… and it will hurt.  A lot.

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Green Energy Stock Challenge

It’s official; I’m not the “Ultimate green tech investor.”  That’s according to, who ran a fantasy stock trading game from mid June to mid August this year.  I participated, and did end up being one of the winners (I turned my fictional $200,000 into an equally fictional $775,000 in the two months the contest ran.)  I think I won a book.

For readers expecting a sour-grapes rant, yes, I would have liked to have won the electric car.  What green-blooded techie wouldn’t?  But that’s not what I want to talk about.  I want to use this stock trading game as a cautionary tale:

Stock trading games are not the real world.  They are games.  Please, do not let success in trading games make you think that you know how to deal with the real, live, stock market.  If you do, you are just begging to lose money.

Returns like mine, and the ultimate winner, Russ Michaud, are not achieved through investing skill.  I achieved my returns by manipulating flaws in the trading game, and I believe he did as well.  In the real world, the best investors may have returns of 20% to 100% in a single year, depending on how much risk they take on, but over the long term, this can never be sustained.  The only person in Forbes top ten list of the wealthiest people in the world to have made his money by investing is Warren Buffett (number two), and his average returns over time have been around 20%.  At 20% annual returns, it would have taken over seven years to turn $200K into $775K, which I did in 2 months in the trading game, and I wasn’t even in the top five players.  Buffett, on the other hand, is the top player in the real investing world.

Stock trading games are not like the real stock market.

Here’s how they differ:

  1. In stock trading games, no matter how much of a stock you trade, it goes through at the most recent price.  In the real world, you buy at the ask (which is higher) and sell at the bid (which is lower), and if you are making a big trade, the price will probably get worse for you (higher when you’re buying, lower when you’re selling) in the middle of your trade
    1. In the game, I was frequently trading over 1,000,000 shares of stocks with average daily volume of just a few thousand shares.  I probably traded more shares of several stocks than had traded over the entire life of the company.
    2. Russ, who won the electric car, said in an interview “My winning strategy keyed on playing the smaller ‘penny stocks’”—penny stocks are very low volume, so it would have been impossible for him (as it was for me) to replicate his trades in the real world.
    3. The reason we were both trading penny stocks is that the lack of trading means that penny stocks are often mispriced by a large margin.  Mispricings are what allow investors and traders to make excessive returns.  The difficulty in trading these stocks means that it is not very profitable to try to trade on these mispricings in the real world.
  2. It’s not real money.  The hardest part of investing successfully is the psychological element.  Human nature is to get out when things look very bad, and pile in when they seem good.  An investor who wants superior returns needs to get in when most people are (wrongly) too scared to invest, and get out when everyone else is euphoric.  This is emotionally very hard to do, and it becomes much, much harder when getting it wrong means your child isn’t going to go to college, or you’re never going to be able to retire.

Take-home message: Stock trading games may be fun, and you may win an electric car (or a book) if you know how to manipulate the system, but it’s lousy training for the real world of investing.

9/19/06: Collision or Convergence  (Wiley Finance)  My book showed up.  This is it:

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Water and energy

Last month, several nuclear power stations in Europe had to shut down during a heat wave (and consequent period of extreme electricity demand) to avoid releasing overheated water back into the environment.  As many other astute observers have pointed out, this pokes another big hole in the arguments that nuclear is our best choice of carbon-neutral generating technology.  A power plant that goes down precisely when you need the most power is almost useless for the current grid.

It also brings up the broader point of the role of water in electricity generation.  Nuclear is not the only technology that uses water for cooling.  Coal plants, including “next generation” IGCC plants mostly use water for cooling (air cooling can be used, but it makes them less efficient, and hence more expensive to run, and is seldom used in practice.)

This is a problem because water, in most countries is under-priced.  Resources that are under-priced tend to be overused, since the user does not have to bear the full cost of supply.  This is the cause of a large number of ills, such as the drying up of the Aral sea due to irrigation for cotton farming.  It is not only poor countries who don’t have enough water.  In the US, mispricing means that almost every aquifer is being pumped at much faster than sustainable levels.  In this context, it seems certain that power plants are also paying too little for the water they use for cooling.

 With a looming need to increase farming to supply biofuels, it is more important than ever that water be priced appropriately, especially in planning scenarios for power plants.  When water is under-priced, generation technologies which use more water are likely to be inappropriately favored in comparison to technologies which use little or no water for generation.

 Like nuclear, thermal electric systems are usually water cooled.  Fossil-fueled power plants account for approximately 39 percent of the water used in the United States, second only to agriculture. For coal plants, this typically amounts to 3 gallons of water (Texas study) or 0.5 gallons (NREL study) for every kWh produced (25 gallons are used for cooling, but only 3 evaporate in the process).  Nuclear, Biomass, and Oil fired plants also require large amounts of water lost as steam in the cooling process.   Some Solar thermal technologies also require significant water for cooling.

Water use by large hydropower projects is more complex, since water in reservoirs is more useful for some purposes (recreation) but often less useful for wildlife.  However, there is no question that reservoirs increase evaporative losses.  An NREL study quantifies these losses in the US.  Overall, in the US evaporative losses average over 18.2 gallons per kWh of hydroelectric power generated.  These numbers vary widely depending on the reservoir, from 2-3 gallons per kWh in cool northern states, up to over 100 gallons per kWh in KY, OK, SD, and WY.  Keep in mind that a lot of these reservoirs have other uses besides power generation, such as storing water for dry seasons, but the numbers can be mind-boggling.

Technologies which use little water include gas turbines (both natural gas and gas from renewable sources such as landfill gas), and geothermal (the water is typically re-injected into the ground).

Wind, photovoltaic, and wave power require no water to generate electricity. 

Energy efficiency, by its nature, uses no water.  Readers will recognize that as an ongoing theme: Given the choice, it is better to avoid using a kWh than it is to generate a kWh (regardless of source… even renewables have environmental impact.)

Renewable energy advocates should also be advocating for more rational water pricing, especially in planning scenarios.  Water use in generation will eventually come to be recognized as a significant cost (and source of uncertainty, as France found out last month).  The sooner this happens, the better for everyone.  Pricing water properly will not only save water, it will help move us to renewable energy technologies.

Investors may do well by concentrating their investments on low water use technologies, especially in parts of the world where water is (or will soon be) scarce.

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Contrarian Investing is Hard

I just came across an apparently defunct blog (no posts since June.)  It’s called Big Mike’s contrarian investing blog, and it seems that he advocated a lot of the same things I was recommending to clients.  The difference is that my clients are still in them… I have my doubts about Big Mike and the readers of his blog.

 [9/4/06 Note: It seems like my guesses about Big Mike were off the mark…  see his comment below.  Regardless, I stick by what I say about investor psychology… the best time to buy is often when things are most discouraging.  And that is precisely when it’s hardest to buy… or  recommend someone else buy.  ]

 For those of us who were commodity bulls in this spring, times seemed tough.  To be a successful contrarian, you need to keep the long perspective.  As Jonathan Graham said, “In the short run, the market is a voting machine, in the long run, it is a weighing machine.”  If you invest based on fundamentals, you have to be ready for the market to turn against you for months or years.  I’m get the feeling that Big Mike, despite his MBA, BS in economics, and 6 week stint as a broker, did not have the financial or emotional resources to stick it out when the votes started going against him.

John Maynard Keynes once said “The market can stay irrational longer than you can stay solvent.”  Big Mike seems to be a case in point.

The moral of the story is that you should never invest money that you need to fund your current expenses.  If you place money into an investment because you know that the long term prospects of that investment are good, you have to be willing and able to leave that money there for the decade it might take for the market to stop voting and start weighing again.

Gold’s nowhere near the $730 an ounce it hit in May, and Oil is not much better (ditto for alternative energy stocks), but for those of us who feel certain that the US$ is headed for the trashcan, and uncertainty and fear are only going to increase (which will be good for gold), and that Peak Oil is already showing its effects in the energy markets, the volatility this spring and summer were easy to bear.

Rules to keep in mind:

  1. Don’t invest on a hunch.  You have to have conviction.
  2. Don’t lose your conviction just because prices move against you.
  3. If the reasons you became convinced in the first place change, get out!

One last quote from Keynes: “When the facts change, I change.  What do you do, sir?”  (but don’t change unless the facts change.)

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High stakes decisions: Where to put your money, and mistakes to avoid

I’ve recently read two articles about the state of healthcare in the world today, one by speculator and libertarian Doug Casey, with a somewhat paranoid (but perhaps justified) view of the state of cancer treatment, and another in Business Week, about the lack of evidence based decision making in medicine today.  The underlying theme in both these articles is that medicine, as it is practiced today, shows a remarkable hostility in the medical establishment towards rigorous evaluation of therapeutic alternatives.


I see a parallel here between medical treatment and investment advice.  In both cases, the choice of expert is an extremely high-stakes decision: if your landscaper does a lousy job, you may have to replace a few dead shrubs.  If your doctor prescribes the wrong course of treatment, you may not wake up the next day.  An incompetent investment advisor may leave you unable to ever retire.


The extreme high stakes of these decisions can lead to us making worse decisions in the first place.  Combine that with the fact that, when it comes to expert services, it is very difficult for the customer to determine the value of what they are getting.  When we visit a doctor, we have no way to know if they are prescribing unnecessary tests or prescriptions, we only know our ongoing state of health, and as we often do not even know what the other alternatives are, we can’t compare the outcome from the particular course of treatment.


Similarly, we don’t know how good our advisor’s recommendation for portfolio allocation is until it’s too late.  He can show us fancy charts about how the portfolio has performed in different historical market conditions, but in the same breath, he’s obligated to tell us that “past performance is no guarantee of future results.”  Investing is more an art than a science, because it is impossible to perform a repeatable experiment; financial markets constantly change and adapt to new information, including to the results of past experiments.


That is not to say that superior investors do not exist, but the sad fact is that most investors and advisors truly believe themselves to be better than average.  The sad fact is, that even if everyone were honest with each other, we still wouldn’t know if we were competent investors ourselves, or if the people offering their advice were, either.  Worse, the only measuring stick we have is past results, which, I’ll repeat, are no guarantee of future returns.


It’s enough to make you throw up your hands in frustration and go home.  Which is exactly what people who advocate index investing suggest.   Indexers basically ascribe to the theory that if you don’t know if you’re buying rotten fruit, buy the fruit that you know is only lightly bruised, and pay discount prices.


I’m a great fan of discount prices, but most people do not have enough saves that they can afford to accept the slightly-below-market (because of fees) returns promised by index funds, especially since we have very little idea what those market returns might be.  Historically, stocks have returned around 10% depending on how you count, over the long haul.  However, current valuations look more like those typically seen at market peaks, and investors who buy at market peaks typically have to wait a decade or more to get their money back.  With this perspective, slightly-below market returns look much less appealing.


I feel that the biggest mistake we can make with our investments is to believe that we deserve a particular return, because that is what we need to reach our retirement goals.  This belief leads to chasing returns; moving money to a new manager/stock/fund/asset class because it has had the returns that we thought we were going to get in the manager/stock/fund/asset class we thought we were in.  This usually makes our problem worse.  Recent performance is just about the worst reason to choose an investment or manager.


What is a good reason to choose an investment or investment manager?

  • Because you are getting a good value: you should have an idea of what you are buying is worth, and be paying less than that.  This should be an absolute valuation (“apples are worth $1 a pound”), not a relative valuation (“apples cost less per pound than oranges”,) because relative valuations lead to us buying the least rotten apple on offer, when we should just keep our money in our pocket and look at the oranges.  When it comes to investment managers, most, in my opinion, are rotten apples.  If you do not have the time and patience necessary to decide if a manager is as good as he thinks he is, you’re better off indexing your investments in a low fee, no-load life cycle fund.  This is essentially what you’d be getting from most planners, and the bells and whistles some add on almost never justify the fees they charge.  As far as I’m concerned, with most financial planners, you’re essentially paying for hand-holding.  Following this logic, I first got into investing because I thought I could so better saving the 1-2% fees I would have been paying with an advisor and doing it myself.  

When should you switch investments or managers?

  • When the reasons you got in in the first place have changed.  If you chose an investment manager because you thought he had a methodology that would beat the market over the long term, if you later found out that he was picking stocks that he heard recommended on Mad Money (I actually think Jim Cramer’s a very smart guy- if a bit hyper for my taste- but even the best guru’s picks cease to be useful when too many people follow them… and Cramer’s worse than most in this regard because he makes stock picking fun… The best investments tend to be ones it’s hard to get excited about… because that means no one else is excited, either.)  On the other hand, if you chose a mutual fund because it has low fees, the time to switch is as soon as you find one with lower fees.

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Green REITs

I just read an article in Jetson Green where he talks about Wells Fargo’s recent investments in LEED certified buildings, and advocates more bank lending for green buildings.  This would be wonderful, but I don’t think banks are the best vehicle for pushing green building… their business tends to be too diffuse, and not concentrated enough in the real estate sector.

The companies who can really make a difference, and quickly, are Real Estate Investment Trusts(REITs), which allow individual investors to pool their money and invest in property under professional management. 

I don’t currently advocate investing in the real estate sector; I feel the real estate market is peaking or has peaked.  Better to wait a few years, and buy when property is cheap.  That said, here are some REITs I’ll be looking at when I feel it’s time to get back in to real estate:

Arden Realty, and Equity Office Properties, both of which have been singled out by Innovestas green REITs.  Trizec Properties, Inc., which is also becoming more vocalabout its green record.   According to Innovest, REITs which were active partners in DOE’s Energy Star program outperformed non-active partners and non-partners by 18% over the period from June 2000 to June 2002, so another good place to look would be an attempt to determine which REITs are corrently or are becoming active partners in Energy Star.

Related article about Trizec.

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What does all this environmental stuff have to do with investing?

Question: What do all these long postings about Ethanol, Biodiesel, Global warming, and CFLs have to do with investing?

TK: Superior investing arises out of having a deeper understanding of the companies and industries you’re investing in than other market participants. 

Global warming is not just an impending ecological disaster, it is an economic disaster as well. Understanding global warming, energy efficiency, and renewable energy are the first steps to protecting our financial assets from the effects of global warming and peak oil.   

Many consider it immoral to profit from disasters.  That is a recipe for going broke when the disaster hits.  When there’s a drought, I want to be able to pay my water bill.  If the water system shuts down, I want to be able to come up with whatever it takes to buy a few gallons wherever I can find them.

It’s sensible to use our investments to mitigate the problems we see on the horizon, and make a profit which we can use to help shield ourselves and those we care about from those problems when they arrive.  To do that, we have to understand the nature of those problems, and the possible solutions.

Causing disasters is immoral.  Preparing is the right thing to do.

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Global warming picture pairs, coastal erosion.

Take a look at this global warming pictorial from the BBC.  Not just pictures of disappearing glaciers, but some interesting coastal erosion pictures as well.  Coastal erosion is aggravated by increasingly frequent severe storms and the slight rise (so far) in sea levels.

Just as we cannot attribute any particular storm to global warming (and there is still some argument about the trend), it is also impossible to attribute any instance of coastal erosion, such as the one above, to global warming. 

Coastal erosion has been going on throughout history, as have intense storms, droughts, and heatwaves.  The trends of all these things, along with atmospheric CO2 levels well above any that have ever been seen, together form a preponderance of evidence in support of climate change.

As an investment manager, I make my living by acting when the evidence is sufficient, not by waiting until all the evidence is in.  That doesn’t mean new evidence won’t make me change my mind later, but the whole point is to take action before other investors decide to act.  In the case of global warming, I feel we (as a planet) have already waited longer than we should before taking meaningful, large-scale action. 

As a mathematician who studied chaos theory, I know that a small difference in initial conditions, such as an 8 inch rise in sea levels, can cause a completely different outcome (a coast being unharmed, or completely washed away.)

I’ve greatly modified this post in response to a conversation with Lars Smith, see the comments below, and his post in his Conservation Finance Blog.

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Over the limit on ethanol?

What are the limits on ethanol production? 

According to NREL’s John Sheehan, at this months Energy Analysis Brown Bag, ethanol production from corn is set to reach 4 billion gallons this year, and 7.4 billion gallons per year by 2011, based on current and planned production capacity.  (As an aside, on August 10, the Douglas County News-Press published a very pointed editorial from him on the travesty of IREA funding disinformation about global warming.)   Given that a bushel of corn will produce 2.8 gallons of ethanol, that will make ethanol demand for corn in the
US 1.4 billion bushels in 2006, and 2.6 billion bushels in 2011.  Since the annual corn production in the
US is around
11 billion bushels, ethanol production is already having a significant impact on the price of corn for food.

As Lester Brown, President of the Earth Policy Institute pointed out in the Aug 21 issue of Fortune(the particular article I’m referring to does not seem to be available online), the market is already setting the price of agricultural commodities at their oil equivalent value.

Unlike Lester Brown and John Sheehan, I think this will be a good thing for the world’s poor.  Yes, food prices will go up, but the poor are not only consumers of food; they are also producers and potential producers.  In the
US, the percentage of poor rural residents has been
consistently higher than the percentage of poor urban residents throughout the last 50 years.   In
Africa, the world’s poorest continent, farmers can often not make a living because they
cannot compete with subsidized first-world farmers.

If world food prices rise because of demand for biofuels, this may at last reverse a great injustice, where subsidies for first world farmers have prevented third world development.  Allowing myself to get wildly optimistic for a moment, if fuel demand permanently boosts agricultural commodity prices (which seems very likely), that might even open the way to removing subsidies for European and North American farmers.  The Doha round of world trade talks failed in large part because of rich world unwillingness to cut agricultural subsidies, which is a great shame, because cutting subsidies would be a great boon to first world taxpayers, as well as third world farmers.

I think the best way to play the biofuels boom as an investor is by betting on the trend of rising agricultural prices.  While large agricultural companies like ADM have already seen the benefits of this trend, the currencies of third world agricultural based economies should benefit, as well as the price of agricultural land in the US.  Much US farmland may benefit twice from renewable energy, since land in windy areas also has the opportunity to gain income from wind leases.  This was a large part of the theme of the Intermontain Harvesting Energy Summit I attended this spring.

On the downside, stimulating agricultural production can lead to deforestation.  Greenpeace can push for all the moratoriums it wants on soy from deforested areas, but that won’t keep soy oil or ethanol from deforested areas going into our tree-hugging gas tanks.  Global commodities, such as soy, corn, soy oil, and ethanol will just go to countries and companies who don’t participate in the boycott, removing their demand from the world market, and lowering the world price for everyone else.  This is the same principle we use in our favor when we buy Green Power: the actual electrons running my laptop are probably from a coal fired plant, no matter if I pay for green power or not.  What I’m actually purchasing with green power (in theory… may green power markets still have kinks that need to be worked out) is the fact that I’m stimulating green power production as much as I would if all my power actually did come from green sources.

Another worry about the rapidly rising biofuels capacity is distribution.  John Sheehan’s estimate of 7.4 billion gallons of ethanol in 2011, and 700 million gallons per year of biodiesel would amount to a around 5% of gasoline consumption and less than 2% of diesel consumption.  Since the current fleet of engines can run with no problem on 10% ethanol (in
Brazil “gas” typically contains
25% ethanol.), we would not need to use any E85 to use all the planned ethanol production.  Similarly, B20 can be used in all but the coldest parts of the country year round, so converting just 2% of diesel consumption to biodiesel could also be accomplished through existing distribution.

I find it likely that the constraints on biofuel production will come in the form of the price of the feedstock, which will be driven by oil prices.

While ethanol and biodiesel will be necessary parts of weaning us off our dependence on oil, current technologies cannot go very far to getting us there without a much greater push towards more efficient automobiles.  Raising average fuel economy by just 10% would reduce fuel use and greenhouse gas emissions over twice the amount the flat-out biofuels production we’re seeing will. 

We can easily double the fuel efficiency of our current fleet with a combination of plug in hybrids (powered by cheap wind) and more efficient engines.  Only when we’ve done that can we hope that cellulostic ethanol and biodiesel can start to supply our remaining fuel needs. 

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Wave power squatters

According to Verdant Power, Oceana Energy Co is blocking wave power development at as many as 12 prime sites in US waters.   An article in Cape Cod Online also makes this accusation.

 This is an example of teething problems in regulation for an new industry.  The Federal Energy Regulatory Commission’s (FERC) procedures allow anyone to apply for a preliminary permit, which effectively ties up a site for 3 years while the applicant studies the feasibility of using the site.  If this process is being used, like late-90s Cyber Squatting to effectively hold prime sites for ransom with no real intention of ever developing them, the regulatory system needs fixing.

 The good news is that now is the time to be fixing the regulatory system for ocean power, where the technology is still in its infancy.  Imagine if all the prime sites were taken up not by squatters, but by real ocean power farm using poor technology.  If the best sites have to wait 5 years to be developed, and the regulatory system gets fixed in the meantime, that will probably end up being a good thing: all the best sites will then be available for much better, more resilient, higher power producing technology.

According to a lawyer and family friend who did legal work for early wind farms, there are still wind turbines in Tehachapi Pass from the early 80’s which are no longer functional, never produced much electricity, but can’t be taken down, because the original investors would be hit with gigantic back taxes if they were decommissioned.  Maybe a little wave squatting will keep much of that from happening for wave power.

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B5 Grand Cherokee

I just saw a news report on that Jeep will be fueling their new Grand Cherokee CRD with B5 at the factory.  Has Dr. Z been reading my “Why I Bought a Jeep”  article?

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John Turner’s Renewable Energy Future; renewable technologies compared.

When you want an informed, but unbiased opinion, it’s usually best to ask someone John A Turnerwhose livelihood does not depend on coming back with the “right” answer.  When it comes to comparing different renewable energy technologies, one of the best experts I’ve heard from is John Turner.   Dr. Turner is a principal scientist for the Center for Electric & Hydrogen Technologies & Systems at the National Renewable Energy Laboratory (NREL), in Golden, Colorado.

The Hydrogen economy is that long hoped for world in which one day our cars will fill up at the corner hydrogen station, and combine that fuel with oxygen in the air, a process which will create electricity for the car’s motor, and with the only emissions being water.  It all sounds wonderful, but to reach that nirvana of zero emissions, the hydrogen itself needs to be produced with non-emitting technology.  That is because, contrary to oversimplified hype from politicians, hydrogen is not an energy source, but rather an energy carrier.  Like a battery, it has to be produced (charged) before it can be used.

Dr. Turner’s goal is to guide us to the hydrogen economy with as few missteps as possible, with missteps in his mind being the used of unsustainable technologies to get there.  Since he wrote his visionary 1999 article in Science, outlining a path to a “Renewable Energy Future” in which hydrogen serves as portable energy storage for an economy fueled solely by renewable sources of power.  The weak link in this chain is fuel cell technology.  Fuel cells are used to efficiently convert hydrogen and oxygen to electricity and water.  They have been around for well over a century, but are still too expensive for use in cars, although they are practical in some military and larger scale civilian operations.  A similar problem exists for hydrogen storage.

In contrast, hydrogen as a storage medium for electricity from intermittent power sources such as wind is a technology whose time has come. Norsk Hydro is currently doing a trial run of a wind/hydrogen combination system on a small Norwegian island, powering 10 homes.

What is most interesting to me about his presentation, is his unbiased comparison of different renewable technologies, along with nuclear, and Internal Gasification Coal Combustion (IGCC) with carbon sequestration.

He compares these technologies for robustness: the ability to meet our future energy needs; for expense, and for Energy Payback.  Energy payback and the related measure EREOI (Energy Return on Energy Invested) give us an idea of how much of our energy will have to be devoted to making more energy.

Here’s the run-down (with some additions of my own):


Energy Payback/ EROEI Robust? Price per kWh (approximate 2003 prices) Long term?

3-4 months; 20-30x


5-8 cents


Solar PV

3-4 years; 8x


21-24 cents


Concentrating Solar

5 months; 40x


8 cents





7 cents



varies by source


4-7 cents



1 year, not counting waste disposal. <20x


13-18 cents


Coal (w/ carbon sequestration)

16% of energy required for sequestration.

For now

5-6 cents

70 yrs, at current growth rates.

Energy efficiency

months; 50x +

Can never get all energy from efficiency

1-2 cents


(Items with links are from linked sources)

We’ll need all these energy sources, but Wind and concentrating Solar (CSP) stand out as near-term, robust, economical solutions, while Energy Efficiency and Geothermal will give us the most bang for our buck as we try to get started down the road.

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The Wisdom of Crowds and Selecting an Investment Manager

The Wisdom of CrowdsI just read James Surowiecki’s The Wisdom of Crowds.   The provocative title refers to the idea that, given the right circumstances, a group of people will consistently reach decisions which are better than the decisions that the smartest people in the group would be able to reach on their own. 

As someone who considers himself an investing expert, it might be surprising that I like this book.  After all, he frequently cites examples from investing as to how bad the “experts” are.  For instance, a vast majority of mutual fund managers under-perform their benchmarks in any given year, as well as over longer periods. 

Surowiecki’s conclusion is that the crowd (in this case, the market as a whole) is smarter than most mutual fund managers, and even if there are managers who are smarter than the market (The namesake of my cat, Warren Buffett, being a prime example), the amount of effort necessary to distinguish a superior manager (if it is possible to do at all, since past performance is not a guarantee of future results) is far in excess of the possible reward.

Why are most money mangers so bad at the job they are paid to do?  Because it is more risky for them to take non-consensus positions, than it is for them to buy the same stocks everyone else is buying, even if they know those stocks to be overvalued.

Surowiecki concludes that, while there may be superior investment managers who can consistently outperform the market, the effort necessary to identify those managers is likely to be prohibitive.  After all, past performance is no guarantee of future results, and we are as likely to be fooled by randomness into choosing a manager who is lucky as we are to choose a manager who is killed.

I disagree.  I feel it is possible to identify superior managers, and Surowiecki has laid out the tools to do so, even if he does not realize he has done so.  He shows quite convincingly that stock markets can be very efficient when the participants are diverse, and reach decisions independently.   As he also shows, most money managers fail on all counts.

Markets are efficient at finding the best prices for stocks when the participants are diverse and independent.  Since that is often not the case in the stock market, there will be opportunities for individuals to outperform the market.When looking for such an individual, what are the clues?

  • Any manager whose holdings mimic the entire market (i.e. are extremely diversified) can be ruled out.  His returns will also mimic market returns, and will likely even under perform, due to fees and commissions.
  • His choices should not be random; they should be based on private information or research that is not available to (or is being ignored by) the entire market.
  • There should be some reason to believe that this private information or research gives him some true insight into the value of his investments: a portfolio of five companies chosen at random will not perform the same as the market as a whole, but there is no reason to believe it will outperform, either.

If you believe, as James Surowiecki does, that the necessary effort is prohibitive to find a manager like this, the best investment strategy would be to index, that is try to mimic the entire market’s return for the lowest possible fees. 

To me, the possible gains from above-average performance seem well worth the effort necessary to find the few superior managers. Over a period of 20 years, the difference between a 7% annual compounded return and an 8% annual compounded return is about 25%.  In other words, you would get the same effect by starting with $100,000 and earning 8% for 20 years, as you would by starting with $80,000 and earning 7% over the same period.

 The trick is not to give too much weight to past performance, but instead concentrate on the factors which might allow a manager to acheive superior performance in the future.  As an example, here is how I would go about selecting a mutual fund based on the above criteria.  The same approach would apply to a hedge fund or private account manager, except for the fact that in this case, the search for such a manager might truly be outside the ability of most individuals, since the relevant data is not readily available in a searchable form.

  1. Have a small number of positions (since these are less likely to mimic the market,) or changing emphasis on particular industries or sectors which vary significantly from market weighting.
  2. Have low turnover (private information is hard to come by, and given the effort involved, it is not likely to lead to rapidly changing strategies.)
  3. Have a methodology that emphasizes independent research, and is easy to explain.  Black box approaches based on computer models can work for a time, but the market has a tendency to make them go rapidly obsolete.  This is a large part of the reason past performance is such a bad predictor of future results.  “Fundamental” investment strategies tend to pass this test, so long as they are based on deeper research than plucking various ratios from a company’s financial statements.
  4. Look for funds that don’t fit well into any one “Style” or capitalization category.  Independent and diverse thinkers will be hard to categorize.
  5. Funds with less than $1 billion under management.  When assets under management get too high, it becomes difficult to act on what private information you have without greatly moving the market.
  6. Look for low “Beta” compared to the fund’s category. Beta is a measure of correlation with the market as a whole, and can be a proxy for diversity.
  7. Make sure that the fees you are paying are justified by the excess returns (in comparison with the risk involved) the strategy is likely to yield.

Using the Yahoo! Mutual fund screener, with the following criteria: manager tenure > 5 years; no load; expense ratio < 1%, assets < $1 billion, turnover < 30%, is a good place to start.  This yields a reasonable number of funds to sort through, and the choices can be further narrowed by ignoring the index funds, and by checking Beta under “Risk.”

Happy Hunting!

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