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Now, a clever man would put the poison into his own goblet, because he would know that only a great fool would reach for what he was given. I am not a great fool, so I can clearly not choose the wine in front of you. But you must have known I was not a great fool, you would have counted on it, so I can clearly not choose the wine in front of me.

~ Vizzini, from the movie The Princess Bride

The Princess Bride DVD

As I was writing about biflation and the various investment approaches we might take this week, I couldn't help but think about how difficult these choices are. For every good argument for a certain course of action, there is an equally valid reason why the opposite might be true. I can make a very reasonable argument why neither stocks nor bonds are attractive right now. The Reformed Broker did so a few weeks ago with more wit and clarity than I could hope to achieve. The post was entitled Stock Are from Mars, Bonds Are from Venus and it's a great read.

Every time I hear the stocks vs. bonds debate, I can't help but feel that both sides are missing something important. It reminds me of a scene from the movie The Princess Bride. For this reason, I chose that scene to provide the foundation for today's Friday Food for Thought. In the scene, a self-proclaimed genius examines every angle of a decision based on his assumptions about human nature, resorts to a schoolyard trick, and fatally overlooks an outlier in the end.

Pour the Wine. The Battle of Wits Has Begun . . .

For those of you who are not familiar with Rob Reiner's The Princess Bride, it‘s a movie that was based on a novel by William Goldman. In it, there is a scene where the hero, Westley, is trying to free the princess from Vizzini, the villain. Westley proposes a battle of the wits for the princess. He pours two glasses of wine, claims to poison one with iocane powder, and asks Vizzini, who fancies himself a genius, to choose which glass is poisoned.

Today's opening quote goes through some of the dizzying logic Vizzini undertakes to make his decision. In the end, he distracts Westley in order to switch glasses with him. He then chooses his own glass and they both drink. Westley reveals that both were poisoned, but that he had spent years developing an immunity to iocane powder. Vizzini falls over dead, and Westley wins.

8 Financial Lessons from Vizzini

There are a few financial lessons we can take from this scene:

  • Look for the Third Way: If neither of two options is attractive, you're allowed choose neither. Instead, look for a better option and be ready to wait until the right one comes along.
  • People in Masks Cannot Be Trusted: This is a quote from Fezzik the giant, another character in the movie. There is always elevated risk when people with vested interests and hidden agendas make the rules.
  • Never Put More at Risk Than You Can Afford to Lose: Vizzini wagered his life, so that's pretty extreme, but the lesson holds for money at risk as well. Always understand exactly how much you have at risk.
  • Make Contingency Plans: Vizzini accepted Westley's challenge without even considering changing the rules or offering an alternative. He never considered what would happen if he were wrong.
  • Anything Can Happen: Sometimes we just have to admit that we cannot anticipate every risk and make the best choices we can with the information we have. (“Get used to disappointment” is another great line from the movie.)
  • Conventional Wisdom Isn't Always That Wise: Vizzini accuses Westley of falling “victim to one of the classic blunders . . . Never go against a Sicilian when death is on the line!” Vizzini drops dead as he is laughing at Westley. I'm sure all of you can come up with some interesting financial parallels. If you're stuck, you might try starting with the old “subprime is contained” mantra.
  • Overconfidence Can Kill You: Your mother was right: It really is better to be safe than sorry. Be on the lookout for outliers no matter how confident you are in your investment thesis.
  • Intelligence & Logic Do Not Guarantee Success: This is particularly true in the financial management realm. I have heard many anecdotes about financial planners whose personal finances are a mess and of highly intelligent professionals and academics who know a great deal about the stock market and economics, but can't seem to manage a positive return in their own portfolios.
  • Cheaters Never Prosper – at Least Not Forever: I guess we have seen a few cheaters leave with pay packages containing more money than most of us can hope to save in a lifetime. Vizzini thought, for a brief moment, that he had outsmarted Westley by tricking him. Justice was served swiftly. The cases of Madoff and others show that justice is sometimes a little slow. Better late than never.

Outliers, Caveats and Iocane Powder

Prior to the financial crisis of 2008, many analysts, investors, politicians, and central bankers exhibited a lot of the complacent attitudes outlined above. Investors and consumers were told not to worry about skyrocketing housing prices or emerging problems with derivatives related to mortgages or the fact that millions of people had bought homes that they were never going to be able to afford. Instead, many blustered on about historic stock market returns, about how housing prices hadn't fallen since the Great Depression, and about the sheer lunacy of the idea that a large U.S. financial institution could fail.

These faulty assumptions, and many many more, were the iocane powder that poisoned our economy. Of course, we know that the stock market has not been a great investment for over a decade now – unless you've traded it very well. U.S. housing prices did fall; they did so quite precipitously, and they continue to fall over a year after the recession supposedly ended. As for large U.S. financial institutions, let's take attendance: Bear Stearns, Lehman Brothers, Merrill Lynch, Fannie Mae, Freddie Mac, Washington Mutual, Wachovia, Countrywide Financial, and AIG have all either gone bankrupt, merged with other banks, or remain under taxpayer protection to this day.

Iocane is a fictional poison that is colourless, odourless, and dissolves instantly in liquid. If we continue the financial metaphor, perhaps it has some sensitivity to gold. Maybe the gold price is telling us that there are pockets of trouble gathering, like iocane powder, in our economic system. Where will they turn up? Will it be more trouble in Europe, Chinese bubbles popping, a U.S. dollar currency crisis, or something we haven't yet considered?

Do you see increasing risks in the system, or do you think gold is sending a false signal?

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