When Markets Collide

Having read Bill Gross’s useful and breezy book on investing, I turned to When Markets Collide, by Gross’s PIMCO colleague Mohamed El-Erian, whose resume includes the IMF and the Harvard Management Company.

When Markets Collide is very different—so different that it makes you wonder how the authors of two such different books could work well together. Though it has some practical advice for the individual investor (buy lots of non-US stock, and manage your own risk) it is most useful for anyone who wants to understand the big picture: global trends in economics and investing, and what governments, international organizations, and institutional investors should be doing about them.

There’s a lot of technical language here, but it is deployed because it is needed and not to impress. Throughout the book I felt that El-Erian was striving to follow Einstein’s rule that everything should be made as simple as possible but not simpler. Again and again, I felt that El-Erian was shedding light on corners of the investment world that had never been clear to me before.

A few more or less random examples:

* The “market for lemons”: If buyers don’t know which cars on the market are lemons, the price of the good cars will be driven down by the presence of the bad ones. In the same way, lack of information about the safety or volatility of investments (like mortgage-backed securities) will drive down prices in the whole sector—providing an opportunity for investors.

* Though stocks are often promoted as the best long-term investment, the benefit investors get from them is heavily influenced by their own behavior, including reluctance to sell at a loss, attachment to an investment because of “sunk cost,” and the “home bias” that leads US investors to invest heavily in US stocks.

* Emerging-market economies are prospering to the point where the IMF is no longer in the business of making (profitable) loans to poor countries and imposing painful structural adjustment programs on them. But the inflow of capital to these economies has some negative effects, driving up inflation (which is bad for the poor) and driving up the value of the local currency (which is bad for the export market).

* Hedge funds, despite the dazzling returns of a few, do no better on average than the S&P 500. Although their reason for being is “alpha” (the value added by fund managers), in reality this is often a “dirty alpha”—contaminated by exposure to more-volatile types of investment in order to boost returns. Finally, the fat fees charged by hedge funds (2% off the top, plus 20% of the fund’s return) give hedge fund managers an incentive to play it safe as the fund gets bigger.

There’s a lot more where that came from, including the Black Swan concept, how Harvard’s investment managers made a killing in timber, and whether we should worry about the moral hazard posed by bank bailouts. But what is really impressive about this book is not the individual nuggets but the way it all fits together into what looks like a coherent, detailed view of where we are and where we’re going.