Building a Sound Financial Ship

Almost everyone is familiar with the tragic story of the Titanic, but did you know that the Titanic wasn’t the first “unsinkable” ship to meet disaster on her maiden voyage?

On August 10, 1628, nearly 300 years before the Titanic disaster, the mighty Swedish warship Vasa set sail from Stockholm harbor. The recently completed ship was one of the largest warships ever made. Equipped with 64 bronze cannons the Vasa was the most powerfully armed ship in the world.

Only twenty minutes into her maiden voyage, after sailing less than a mile, the ship was hit by two strong gusts of wind. The wind caused the Vasa to list to port, take on water, and quickly sink.

The beautiful but fatally flawed ship was recovered in 1961 and is now housed in the Vasa Museum, one of Sweden’s most popular tourist destinations, where it is seen by over 1 million visitors a year. The ship is a work of art but clearly defective in either its design, construction, or both. Fred Hocker, an archaeologist at the Vasa Museum, has spent years studying the ship trying to solve the mystery of its untimely demise.

Hocker reports, “We have, over the last three years, measured every single piece of wood in the ship.” His perseverance has paid off as his meticulous measurements have revealed that the ship was not symmetrical. Hocker states, “There is more ship structure on the port side than on the starboard side.” This explains why the ship so easily heeled to port when hit by the wind, and was a definite factor in its sinking.

But what caused the ship to be lopsided? Hocker also found some clues to explain this. On board they found four rulers that had been used in building the ship. Two of the rulers were based on the Swedish foot, which was divided into 12 inches, but the other two rulers were based on the Amsterdam foot, which was divided into only 11 inches.

The reason the ship was lopsided is because it was built using inconsistent measurements. Although there were other contributing factors, this was one of the reasons the mighty ship sank in such tragic and embarrassing fashion only a few minutes into its first voyage.

To have a seaworthy ship you have to build it using accurate and consistent measurements. The ruler used has to be appropriate for the task you are doing, and it has to match the rulers others are using that are doing similar work. Inconsistent or faulty measurements can end in tragedy.

Of course, the Vasa sunk almost 400 years ago. There is no way a similar measuring error could be made today, is there?

The Mars Climate Orbiter Fiasco

We lost our Martian rocket ship, the high paid spokesman said. Looks like that silly rocket ship just lost its cone shaped head. We spent ninety jillion dollars, trying to get a look at Mars. I hear universal laughter ringing out among the stars. – Jimmy Buffett from his song, “Fruitcakes”

On September 23, 1999, after years of development and over 9 months of travel, NASA’s Mars Climate Orbiter approached the red planet. The spaceship was designed to enter a low orbit around Mars to gather data about its atmosphere and climate.

As it was about to enter orbit NASA suddenly lost contact with the spacecraft. The orbiter had drifted closer to Mars than it should have and was burned up in the planet’s atmosphere.

A study was commissioned to determine what had gone wrong. It turns out that different teams had designed the computer software on the ground and the software on the spacecraft. The software on the ground was programmed using English measurements while the software on the spacecraft was programmed using the metric system.  

This resulted in the computer on the ground sending instructions to the orbiter’s thrusters in pound-seconds, but the orbiter interpreted the data using newton-seconds. This small inconsistency caused the orbiter to be closer to Mars than it should have been, which turned out to be a fatal error. All of the technology that went in to building the sophisticated spacecraft was not enough to overcome a simple human-caused measuring error.

The sinking of the Vasa and the burning up of the Mars Orbiter were separated by hundreds of years and involve completely different types of ships, and yet the ultimate cause of the two catastrophes are eerily similar. Both disasters were caused by measuring inconsistencies and errors during the building process. This is vital to remember as you construct your financial ship.   

Building Your Financial Ship 

One of the most important things you need to measure to build a sound financial ship is investment risk. Indeed, the accurate and consistent measurement of investment risk could be as important in building your financial ship as the accurate measurement of length is in ship building and force is in creating the software to control space ships.  

The standard tool that Wall Street provides for measuring investment risk is volatility, but is this really the correct measurement to use? It turns out that volatility is very useful for measuring risk in the short term, but useless, or even harmful, in measuring long-term risk. Speaking on this subject David Dreman, in his excellent book Contrarian Investment Strategies: The Psychological Edge, writes:

“The major risk is not the short-term stock-price volatility measurements….Rather, it is the possibility of not reaching your long-term investment goal through the growth of the funds in real terms. It is counterproductive for investors with investing time horizons of thirty, twenty, ten, or even five years to focus on short-term fluctuations. Shorter-term volatility measurements provide an illusion of safety while derailing the higher returns that are provided by holding equity…over time.”

James P. O’Shaughnessy, in his outstanding book What Works on Wall Street, provides an example of how this short-term “illusion of safety” can be very risky in the long-term:

“Had you been an extremely conservative investor and kept your portfolio in U.S. T-bills, your 1927 $10,000 would have grown to only $16,256 by the end of 2009 [after inflation] a real average compound return of just 0.59 percent. In essence, you would not be much better off than you were in 1927, since your portfolio earned virtually nothing in 82 years. T-bills appeal to conservative investors over the short-term because there is no possibility of short-term loss. Yet look at what inflation did to the hapless T-bill investor – the maximum decline of the inflation-adjusted T-bill portfolio was 49 percent [over the worst 5-year period] the result of holding cash in an inflationary environment.

T-bills are often referred to as providing “risk-free returns,” but James Grant, of Grant’s Interest Rate Observer, notes that over the long-term you are more likely to get “return free risks.”

Robert G. Allen put the case succinctly when he stated, “How many millionaires do you know who have become wealthy by investing in savings accounts? I rest my case.”

Volatility is the correct risk standard for money you need in the short-term, but using it to measure the risk of your long-term investments is just as dangerous as using the wrong length standard to build parts of a ship or using English instead of metric measurements when developing the software of a spaceship. Just as with the Vasa and the Orbiter, using the wrong standard to measure risk in your financial ship can eventually lead to disaster.   

So whether you are building your financial ship to safely take you through the storms of life to a safe retirement harbor, or building a financial spaceship to shoot for the stars, be careful and consistent in how you measure risk.