INVESTING: Complexity of investments is a big part of problem

I recently visited the town of Concord, Mass., known not only as the site of the “shot heard ’round the world,” but also as home to many influential authors during the 1800s.

Just outside town is Thoreau’s Walden Pond, and in Concord you can visit the homes of other writers of the era, including Emerson, Alcott and Hawthorne.

If any of these literary transcendentalists were around today, it is doubtful they would care much, if anything, about the evolution of our country’s financial system. Yet today’s market participants and regulators would be wise to adopt one of Thoreau’s most enduring creeds: “Simplify, simplify.”

The root of the severe problems in the bond market can be traced to the home mortgage-whose straightforward terms were tinkered with to (falsely) appear more affordable to borrowers.

Then Wall Street’s financial engineers went about the lucrative business of creating complex securities out of these newfangled mortgages that (falsely) appeared to provide investors with a safe high yield.

And, finally, the new “masters of the universe”-hedge fund managers-borrowed gobs of money from the investment banks to magnify their investment returns (and fees). The result is that investors and investment banks will be busy recording losses on these transactions for the next couple of years.

Another convoluted financial strategy has Jefferson County, Ala., home to the city of Birmingham, on the brink of bankruptcy. In 2002, local government officials and investment bankers devised a complex plan to convert the county’s borrowings from fixed rates into variable rates and then used interest-rate swaps to hedge against rising rates.

As it turned out, nobody understood these financial gymnastics, not the local government officials or even the investment bankers who sold them the stuff.

Many states and municipalities are dealing with a meltdown in the auction-rate bond market. In Indiana, auction-rate bonds were used to finance projects like Lucas Oil Stadium. Recently, the periodic auctions of many of these bonds failed, causing the interest rates to soar and liquidity to vanish, proving once again that there is no free lunch in the financial markets.

Elsewhere, the Fed-assisted rescue of Bear Stearns was most likely deemed necessary because of Bear’s derivatives exposure. Derivatives make up a massive $450 trillion interconnected market of arcane securities, where the failure of one firm could trigger a domino effect throughout financial markets, causing untold damage.

In the end, a rational investor can thrive on the advice Thoreau advocated 170 years ago-keep it simple. Successful investing requires a type of thinking that requires an investor to act counter to the pervasive mood of the market. Today, as stocks go down in value, they become more attractive long-term investments-be greedy when everyone else is fearful. Buy a few good businesses at attractive prices, hold them, guard against over-diversification and keep your costs down.