Saturday, October 30, 2010

How important to investing is trading?

I didn't provide any specific pointer for my contention that George Soros, in his great book "The Alchemy of Finance", says his trading (in the glorious year he chronicles throughout part III as "The Real Time Experiment" -- 1985-86) was poor. Fortunately, thanks to Google Books' search ability, it's really very easy to check: just go to the book and search for trading, and you'll find as the top two hits of the search:
  • p. 308: "The record shows that my trading was far from flawless even in Phase 1. I was too late in buying bonds and too early in selling them" (&c).
  • p. 207: "In short, my trading was poor".
and more hits such as
  • p. 160: "On balance, my trading has been poor"
not to mention other choice (not fully germane, but irresistible to quote;-) tidbits such as (p. 278) "At present, the stock market is dominated by program trading and portfolio insurance schemes. These schemes are fundamentally unsound. They virtually assure a loss for exchange for peace of mind in a declining market."

Isn't George Soros, among the legendary investors, primarily a trader (as opposed to, say, Warren Buffett, notoriously more of a buy-and-hold type)? And, if so, how can he make money while repeatedly bemoaning his own trading? Read the book for the detailed answers, but, in short: overall, through the year, he was directionally right. E.g., wrt the first search hit above: he did buy bonds cheap (though definitely not as cheap as he might have bought them in hindsight had he timed the bottom in that market perfectly) and sold them dear (though not as dear as he might have sold them in hindsight had he timed the top in that market perfectly).

Nobody can time the market perfectly in the sense of accurately calling the bottoms and tops -- but it doesn't matter as much as our hindsight-based perfectionism screams in our inner ear: as long as we buy cheap and sell dear, we're still making good money. Making good money, just a bit less than you"might" have on the same trade in hindsight, had you timed it perfectly, is not losing money, and framing it as a loss is deleterious to our best judgment since it triggers strong "loss aversion" impulses in our brain.

Even in a dynamic, strongly trading-based investment style like Soros', what matters is being mostly right, most of the time -- that's even more so, of course, in a diametrically opposed (call it Buffett-like) investment style, where the trading part (the buying and the selling) is merely instrumental to the real money making, which is obtained by holding (or, being short of) the right securities at roughly the right time.

Friday, October 29, 2010

More on "The ABC of Stock Speculation" - part 2: "get rich quick" schemes vs patience and prudence

disadvantage of the small operator in following this policy is that he seldom provides sufficient capital for his requirementsContinuing the idea I started here, I'll keep irregularly doing some posts based on quotes from Nelson's 1902 book -- all the quotes in this and other posts of this ilk are from Google Books' scans, except for typo corrections I'm making along the way.
It is an old saying in Wall Street that the man who begins to speculate in stocks with the intention of making a fortune, usually goes broke, whereas the man who trades with a view of getting good interest on his money, sometimes gets rich.
This is only another way of saying that money is made by conservative trading rather than by the effort to get large profits by taking large risks.
Nelson's core idea for this "conservative trading"
starts with the assumption that the operator knows approximately the value of the stock in which he proposes to deal. It assumes that he has considered the tendency of the general market; that he realizes whether the stock in which he proposes to deal is relatively up or down, and that he feels sure of its value for at least months to come.
Suppose this to exist: The operator lays out his plan of campaign on the theory that he will buy his first lot of stock at what he considers the right price and the right time, and will then buy an equal amount every 1 per cent. down as far as the decline may go.
This systematic "averaging down" procedure, of course, when compared to simply buying your whole position (whatever total amount you're comfortable investing in the stock) when the stock reaches "the right price and the right time", saddles you with far more in commissions (and that was even truer in Nelson's time, when commissions were more substantial -- nowadays, depending on your broker &c, you may get a number of commission-free operations, or pay a very small amount even for non-commission-free ones).

More importantly, it makes the overall size of your position highly dependent on Mr Market's whims -- after all, as Nelson says, "Any operator proposing to follow a stock down, buying on a scale, should make his preparations for a possible fall of from 20 to 30 points. Assuming that he does not begin to buy until his stock is 5 points down from the top, there is still a possibility of having to buy 20 lots before the turn will come" (!). So, if you're prepared (say) to invest a total of $10,000 in stock X, you must do it in $500 increments... and may end up owning only $500 or $1000 of it if the decline on which you start buying lasts but a short time!

Whether these substantial strategic disadvantages are compensated by reducing your overall cost basis by up to 10% downwards (buying 20 lots "on a scale" at price points decreasing by 1% each time) may depend on individual tastes... to me, though, this sounds like a procedure for trading, not one for investing. I'm definitely not a great trader -- and I find it heartening to read in George Soros' fascinating book "The Alchemy of Finance" (highly recommended, BTW) that he disparages his own trading (short-term market-timing, &c) skills in even less-uncertain terms (!). Maybe (said he self-soothingly) there's a negative correlation there...?-)

Nevertheless, net of specific procedures, I think that the core messages -- "money is made by conservative trading rather than by the effort to get large profits by taking large risks", and "don't over-trade!" -- or, as Nelson puts it, that the

disadvantage of the small operator in following this policy is that he seldom provides sufficient capital for his requirements
(i.e., he over-trades, over-margins himself, and so forth) -- remain, after more than a century, immortal principles to live by.

Monday, October 25, 2010

The "stop-loss" controversy: Fisher, Nelson, Montier and me

One of Ken Fisher's entries in "debunkery" which I do agree with is the one summarized pithily on the book jacket as "stop-losses should be called stop-gains" -- though in this case I'm not sure whether I agree with his main reason for saying so (i.e., that "stock prices aren't serially correlated" -- Stein and DeMuth have shown that 10-years running average of price measures for the real [inflation corrected] S&P500 _are_ predictive enough of the market's returns over the next 20 years that a long-term investor using those prices is much better off than one doing "buy and hold" instead, for example; yet this example of extreme long-termism is as contrary to the popular myth of the perfectly efficient, aka "not serially correlated" market prices, as any other bit of chartism, from the venerable Dow Theory, to the "momentum" craze, &c... I'm as intuitively averse to the chartism/technically mumbo-jumbo as clearly Fisher is, but definitely not because of dogmatic adherence to "efficient markets", which I find just as unconvincing... so, I'm studying up and refreshing on all sorts of such theories, of both ilks, to try and fight my own confirmation bias on the matter).

Rather, I think S.A. Nelson has it right in his "ABC of Stock Speculation" masterpiece. There are two main ways of speculating in stocks (in 1902, when Nelson's book was written, all trading and investing in the stock market was also called "speculation"): the only way that's ever made really great fortunes, based on deep study (and continuous re-checking) of firms' actual values -- and short-term, pure trading/gambling approaches where the underlying firm is hardly considered, and everything hinges on "what the market will bear"... the market price (which of course a lot of theorists, from Dow himself all the way to dogmatic "efficient market" theorists, will and do at times claim embodies all there possibly is to know about a firm). In the second case, stop losses are not a bad idea (though Nelson justifies them, essentially, by a model of the grand-scale stock manipulation that the short-term trader is trying to coattail-ride on).

If I get into a stock because I'm gambling that it will rise a lot soon, and it goes down substantially instead, then the stop-loss may indeed reduce (though never of course eliminate) my losses on the losing gamble. But if I get into a stock because I'm convinced after thorough study that it's really worth 50 and it's now priced at 35, then, if the stock's market price further decreases to 25 (and, re-checking carefully all my reasoning as to why it's really worth 50, I'm confirmed in that opinion), then the stock is now even more of a bargain, and quite possibly some funds that were previously otherwise employed should be freed to purchase more of the stock in question. While perhaps not "efficient", the market will eventually sync up with a firm's real value -- the patient value investor counts on that! In this approach to investing, stop loss orders make absolutely no sense!

The old saw "ride your winners, cut your losers" only makes sense in a pure trading, not investing, perspective, as "winners" are intrinsically defined here as "stock which increased in price after I purchased them" and vice versa for "losers". That's what makes it particularly sad to see the very worst piece of advice in Montier's "Little Book of Behavioral Investing" -- that "stop losses may be a useful form of pre-commitment that help alleviate the disposition effect in markets that witness momentum". Only for a pure trader, somebody who needs to accept the current market price as the total determinant of the underlying firm's overall worth -- which is really very contradictory with most else that Montier is saying in that otherwise decent book...!

Ken Fisher's "Debunkery"

50 "myths" (or "bits of bunk") exposed and debunked in 4-5 pages each -- I suspect that's a good format for many readers with short attention spans or busy lifes full of interruption, though I personally like good old-fashioned reading and in-depth analysis and explanation, so I found myself somewhat annoyed by the glib, facile, over-simplified tone of each short "bunk". However, while I do have many objections to the format, exposition, and style, somewhat surprisingly to me (while reading critically and in a somewhat annoyed/peeved mindstate from the above issues;-), I found myself more or less in substantial agreement with 49 of the 50 points (far more than I would have expected a priori) though not necessarily with the slant the author gives to his "debunking" explanation.

Let me give an example of me disagreeing with the slant...: Fisher's debunking of beta's mythical status (bubk #19, "Beta measures risk") entirely focuses on the fact that it's backwards-looking, because, he spouts, "past performance is never indicative of future results" -- now that is unadulterated bunk. (Or would Mr. Fisher like to get me to perform surgery next time he needs some? I have no "past performance" while he could get a surgeon with extremely good past performance, but if he truly believed what he so stupidly spouts, that should count for nothing at all with him... harder to think of a more stupid attitude to life: past performance is no guarantee of future results, but to jump from "no guarantee" to "never indicative of" is, truly, totally absurd).

No, the #1 reason to debunk beta is what he himself erroneously states (100% wrong, but similar to what most people just as wrongly believe -- I'm still angry with Fisher because I'm sure he knows better, and just lets "glib and facile" overwhelm "correct and precise"!): that an equity with a beta "Lower [[than 1]] ... was less volatile than the market" (!). False! Bunk!

What β<1 means is that the covariance of that equity with the market is less than the market's variance: in other words, that the equity's volatility (which per se may be high, low, or middling) tends to be less correlated with the market's volatility, than the market itself. You can perfectly have an equity with extremely high volatility and a very low beta (even negative!) -- all it takes is for that equity's peaks and troughs to tend to coincide more with the overall market's throughs and peaks rather than viceversa.

Adding some of that equity if the rest of your portfolio is "the whole market" (e.g. via a S&P 500 index, as that's usually what beta's computed with respect to) will lower your total portfolio's volatility... in as much as the correlation of that equity with the market doesn't change drastically in the future. But unless you bother to compute beta with respect to your specific portfolio (and hardly anybody ever does), even that is not much use.

Other perfectly valid (and important) objections to beta as a measure of risk include the fact that it's based on variance -- which treats the "risk" of outperforming the market exactly as severely as the risk of underperforming it, at total variance with the psychological impact of "risk" and the way everybody uses the word in question in real life (including investing); semivariance, alas much harder to treat mathematically!, while still imperfect, would be much closer to people's understanding of, and psychological reaction to, "risk". And many others... but focusing exclusively on the "backwards looking" aspect, and capping that with that absurd proclamation claiming the past has nothing at all to teach us (as if half of the book itself wasn't about looking at historical information...!!!) is really objectionable.

Of course, the one point of the 50 I think is total bunk is the one ferociously attacking covered call writing, where not only is the argument objectionable, but the implied conclusion is totally absurd and unwarranted. But, I guess that will have to be explained in some future post!

Sunday, October 24, 2010

More on "The ABC of Stock Speculation" - part 1: investors' overall incredible underperformance

I've found more "quotable quotes" in that book than usual, and having it available as pure text in Google Books makes the temptation of sharing some of the quotes hard to resist (as copy and paste is SO easy;-)... the fact that it was written in 1902, when my beloved (and now long-deceased) grandparents were small kids, and yet so much of it feels as fresh and applicable today as ever ("timeless" comes to mind!-) tips the balance!-).

So, I'll irregularly do some posts based on quotes from Nelson's book -- selectively, of course, but I do think they'll be worthwhile. All the quotes in this and other posts of this ilk are from Google Books' scans, except for typo corrections I'm making along the way.
The maxim "buy cheap and sell dear" is as old as speculation itself, but it leaves unsolved the question of when a security of a commodity is cheap and when it is dear, and this is the vital point.
The elder Rothschilds are said to have acted on the principle that it was well to buy a property of known value when others wanted to sell and to sell when others wanted to buy. There is a great deal of sound wisdom in this. The public, as a whole, buys at the wrong time and sells at the wrong time.
Nelson then goes on to explain the reason for this as he sees it...:
The reason is that markets are made in part by manipulation and the public buys on manipulated advances and after they are well along. Hence it buys at the time when manipulators wish to sell and sells when manipulators wish to buy.
While I entirely agree with the core observation, I disagree with Nelson's explanation.
I know my son Lucio -- a financial economist, freelance trader, and poker champion -- would in fact agree with Nelson: Lucio handles the "family money" (I left it all in his care as I moved to the US 5.5 years ago, taking from it only a modest interest-free loan so I could get a car, plonk down a security deposit on a residental lease, &c, without needlessly incurring debt for the purpose, and repaid that loan entirely in about 18 months, i.e., as soon as my savings allowed me to) and he never has any substantial part of it in the stock market, exactly because he thinks that it's a shell game run by insiders for the insiders' own benefit (much like what Nelson depicts throughout most of his great book).
Now maybe that was true 120 years ago or so (I have no personal experience of those times to base an opinion on!-), but having been personally involved in the market -- as a businessman, a manager, an investor -- throughout my adult lifetime, I've seen the market's workings (to some limited extent) "from an inside viewpoint", and I'm convinced that, while there may be manipulation attempted (and sometimes successful), it's nowhere like a primary driver of the market's movements.
In addition, there's no need for such a hypothesis to explain the clearly-true fact that the many-headed, as a whole, "buy dear and sell cheap" -- human psychology on its own is plenty sufficient to account for this (and therefore, Occam's razor urges us not to introduce additional, unneeded hypotheses!-). Consider the measurement of returns over the last 20+ years published by Dalbar: summarizing, while the S&P500 was showing annualized returns of 8.2%, mutual funds investors got annualized 3.2% returns -- a shockingly large difference. Now maybe 1-2% of this can be accounted for by the fees, commissions (through over-trading, AKA churning) and other semi-hidden expenses routinely charged by most mutual funds, but where does the rest of the 5% underperformance come from?!
Easy: it comes from investors' psychology -- invariably, inevitably, doomedly chasing the "latest hottest trend" -- last year's highly performing fund, manager, industry, sector, whatever. Over and over again, investors en masse are systematically selling the "underperforming" fund (or security, or sector, &c) when it's cheap, in order to buy the "outperforming" one when it's dear -- that's known (by its heartiest supporters, no less!-) as "momentum investing" (or "trend following"), and that's the core reason why I named this blog "mutnemom"... because that (made-up) word is the reverse of "momentum" (and a great summary of my overall investing philosophy;-).
I believe human psychology hasn't changed at all deeply in the course of the last 100 years (or 1000, or 10000, for that matter, though social and cultural conditions do change -- on those, and even faster, timescales -- and do make a difference at some level), so the "chasing the latest hotness" mistake is plenty sufficient, IMNSHO, to account for Nelson's 1902 observation, no less than for investors' woeful underperformance of the markets in the 1989-2009 time span (plenty of other human-psychological issues, such as over-trading, panics, &c, help out -- but even if you rebalanced your portfolio just once a year, but every single time to the last year's "hottest stuff", I'm convinced that you'd manage to underperform the markets, if not by 5% yearly, surely at least by 3-4% in the long run.
BTW, once you contemplate the fact that investors as a whole heavily underperform the market, I hope it's clear that theoretical arguments about the impossibility to outperform the market can't hold: if you have a negative oracle (an oracle that invariably gives the wrong answer to every question), that's just as useful as a perfect oracle, once you know about it...: just do the reverse of whatever it's suggesting!-). Ben Stein and Phil DeMuth have written a good, if dry, book, "Yes, you can time the market!", showing extensively that getting into the market only when it's cheap compared to its own moving averages (and out again when it's dear) vastly outperforms "buy and hold" over the decades, for example. But, I guess, that's a subject for another post, as this one is plenty long enough already;-).

Saturday, October 23, 2010

"The ABC of Stock Speculation"

Few investors would consider reading a book written in 1902, but in the specific case of Samuel Nelson's "The ABC of Stock Speculation" I think they might be losing something thereby. I am admittedly fascinated by old, great classics, but this one is a real find -- so much of the advice sounds just as fresh and applicable today, over 100 years later.

I'm really happy I got the Kindle edition (just $9.57 -- it's essentially an image scan of some sort, not very readable to me on my Android phone with the Kindle reader program, but just fine on my Kindle for Mac; the paperback's cheap too, $11.48 also from Amazon). Google Books also has it -- for free, and with a plain-text version that makes it a joy to copy and paste (which the Kindle editions -- and the paper ones -- don't;-). So, consider, for example (from the end of chapter XII)...:
If people with either large or small capital would look upon trading in stocks as an attempt to get 12 per cent. per annum on their money instead of 50 per cent. weekly, they would come out a good deal better in the long run. Everybody knows this in its application to his private business, but the man who is prudent and careful in carrying on a store, a factory or a real estate business seems to think that totally different methods should be employed in dealing in stocks. Nothing is further from the truth.
Isn't this condemnation of the "get rich quick" approach to the stock market just as true and fresh today, as it was when written, over 100 years ago?-)

Nelson's analysis of stop-loss orders (essentially: a good idea if you're wildly speculating on a stock you actually know little about, based on "stock tips" [[which he calls "points"]] and/or overtrading compared to the amount of capital you can really afford to risk -- very bad idea if you have an investment position in a stock of a company you know well, and are trading well within your means... IOW, a bad idea if you're investing as you SHOULD be, rather than just gambling!-) is also pretty much immortal. I can't recommend this book highly enough!

Thursday, October 21, 2010

Fighting confirmation bias

As humans, we all prefer hearing things we already more or less agree with... depending on your politics, you'll probably intuitively prefer to listen to left-wing, right-wing, or "sensible center" speakers, for example. In addition (the actual "confirmation bias") if we hear some things confirming our previous beliefs, and some contradicting them, we're more impressed and likelier to retain the agreeing (and thereby agreeable!) ones.

As an investor, that's not the attitude that's going to prove most helpful to you (unless you're so psychologically fragile that you desperately need confirmation... but then, maybe you shouldn't be an investor in the first place!-). If you've already decided to invest in XYZ (and even more if you are already invested in it, since the "endowment effect" makes you value more what you already own), hearing one more good pitch about why XYZ is a great investment isn't going to help your decision-making that much. The most helpful thing would be hearing a pitch against XYZ: maybe the author makes some points you hadn't thought about, points out some iffiness in the financial statements that you might have overlooked and can prompt you to re-check them in a focused way, and the like.

Hearing your beloved XYZ praised to the heavens reinforces your self-worth and makes you feel happier and more self-assured, but in general it doesn't help your investment strategies and tactics anywhere as much as the painful task of hearing XYZ dragged to the floor and trampled upon. So, fight your confirmation bias! If you have limited amounts of time and attention (and, who doesn't?!), they're better invested in trying to puncture your tentative investment thesis than in looking for psychologically-satisfying confirmation that, yes!, you are a genius (as you always suspected, after all) for thinking of putting some money into XYZ in the first place.

This goes for strategies (how do I generally regulate my investment choices and timing) as well as for tactics (what do I buy, when do I sell, &c). Me, I'm essentially a "value investor" at heart, focused on fundamentals and on getting bargains that Mr Market is currently down upon -- so, I owe it to my portfolio to research and ponder the contrary theses of momentum investing and other technicals and market-timing oriented approaches, as well as the "pure growth" enthusiasts for which "price is no object", differentiation is "diworsification", and so on. Whether such study will turn my whole strategy and character on their heads is iffy, but if I set myself to the task with a critical and dutiful attitude, it can at least give me ways to correct some excessive enthusiasm for a "too pure" approach.

And, what do you know, it has -- just like pondering Graham's ideas about balanced allocation turned me away my initial enthusiasm for an "all stocks, all the time" Peter Lynch-ish approach (so I now stick with a no-worse-than-25/75-allocation rule), so did sufficient focus on Lynch, Motley Fool, &c, convince me to "pepper" my mostly-defensive stocks portfolio with 1/4 to 1/3 of carefully selected "growth" bets, for example (more of that anon...).

I still have to grok the charm of the technicals, though... and, I decided Investors' Business Daily is not worth the bother (I loathe their politics, but then I don't like the WSJ's ones any more... but, the latter I read, as the politics is easily skippable and what I get from what's left is not technoblabbering on stocks -- it's information, facts, pointers and opinions about businesses, a much better value for my money and time!-). I'm still at it (starting with the "Dow Theory", which, whether it works or not;-), at least makes more sense to me than most other chartisms... maybe only because it's been around for over a century!-).

If you're a technical/momentum &c trader by instinct, let me suggest you similarly owe it to yourself and your portfolio to get good, continuing exposure to "the other side(s)" -- value investing, mostly. Start with Graham...!-)

Tuesday, October 19, 2010

Options: investing or gambling?

Most people associate "options" with sheer gambling -- just read the rousing condemnation of them in Peter Lynch's generally excellent book "One Up on Wall Street", for example. Yet -- pause for a moment and think about it -- each option trade has two counterparts, a buyer and a seller... can they both be "gambling"?

Option trading is a zero sum game, after all (net of commissions -- and, on a deep-discount brokers today, those aren't too terrible): if one party is taking a likely small loss in the unlikely chance of scoring a large gain, doesn't it stand to reason that the other party must be accepting a likely small gain in the unlikely chance of giving up a large loss (or, more precisely, the unlikely chance of missing out on the possibility of a large gain)?

The way I like to look at it is: options (covered calls, specifically) are somewhat like lottery tickets. The buyer of a lottery ticket pays a small price and usually gets nothing in return, but once in a while "might" walk off with a jackpot; the seller of a lottery ticket has no chance of thereby making a fortune, but pockets with certainty the ticket's small price and, by repeatedly selling many tickets, makes a pretty steady income. Once in a while the ticket just sold will have been a winning one -- this is not "a large loss" to the seller, unless said seller incorrectly "frames" it mentally in that way;-), but it can be seen as having "missed out on the possibility of a large gain".

A lottery seller who was terrified of one day selling the jackpot-winning ticket and thereby hoarded all tickets himself, never selling any, would nullify the small but steady and certain income they might have realized by selling the tickets to the public. If anything, this is the "gambling" attitude -- never sell a ticket because it just "might" be the big winner -- really similar to buying tickets with a similar hope, after all.

And this, believe it or not, is what most conservative investors end up doing, without realizing it: by not selling covered call options on their stocks, they're unknowingly turning into gamblers!-)

OK, this is put somewhat paradoxically, mostly to whet your appetite for more discussion of options, but more and more writers are getting convinced of that and making a good job at explaining and evangelizing this strategy. I'll have much more to say about it, too, but, for now, you could start e.g. with this site, which seems to do quite a decent job getting you started, or many of the excellent books on the subject.

I recommend Ron Groenke's books and site (if you don't mind the idea of paying 150+ $/year for his Windows-only software) and Paul D. Kadavy's "Covered Call Writing" and "Put Option Writing" books (his software, actually just several simple and useful Excel spreadsheets, is free -- you just have to write to ask for a copy at the address given in the books -- but differently from Groenke's it doesn't get info such as stock prices and option premiums from the net, you have to look it up and enter it manually).

For better-explained theory (no sw though!-), Thomsett's "Options Trading for the Conservative Investor: Increasing Profits Without Increasing Your Risk" is, I think, still best. (Haven't read Wolfinger's "The Short Book on Options: A Conservative Strategy for the Buy and Hold Investor", but I believe it supports the same core ideas and strategy).

Sunday, October 17, 2010

Why should one diversify and differentiate?

A respectable minority of the brightest investors are no friends of the classical recommendations to diversify and differentiate one's investments -- they prefer, in Mark Twain's (or maybe Andrew Carnegie's, check that link;-) great phrasing, to practice and preach the injunction "Put all your eggs in the one basket and --- WATCH THAT BASKET."

I disagree, because I consider avoiding losses to be somewhat more important than achieving gains -- a very widespread preference, actually more extreme in most people (and maybe most monkeys), known as loss aversion.

Suppose that through your thorough, careful research you've identified two promising micro-caps, in any or both of which you could invest. Each, you assess, uncorrelated from each other, has two chances in three of doubling its market price at your time-horizon of interest -- and, alas, one chance in three of going bust (because that's the way life IS -- no matter how good a small, starting-up business, adverse winds still have a substantial chance to scupper it).

Assuming your probability estimate is accurate, your mathematical expectation for each dollar you invest is to get 4/3 dollars, $1.33, so (if your time-horizon is short enough;-) any of them is a good investment, and an equally good one net of loss aversion considerations. Your expectation doesn't change whether you put all your available-for-this-investment money into a single one, or spread it around the two of them.

However, if you focus all your money on a single one, your probability of loss is 33%. If you split it between the two businesses, if one succeeds and one fails, having split your money 50-50 between them, you'll break even (no loss, no gain) -- so you end up with a loss only if both fails, 11%. Your chance of a _gain_ is also similarly reduced (since the expectation is left the same by any kind of differentiation, if you're reducing your chance of loss you must also be reducing your chance of gain!-), but if you have any level (no matter how small) of loss aversion, then with expectation being constant you will prefer the mix with a lower risk of loss (even though inevitably that means a lower best-case chance).

In a nutshell, this is the case for differentiation -- and while the numbers change, their overall import doesn't even if you're considering investments of a very different nature (say with only a 5% chance of losing all your money and a proportionally reduced chance of doubling, or a more continuous distribution of possible gains and losses, and so forth). Diversification (spreading investment around diverse asset classes &c) has a similar mathematical basis, though focused on more strategic overall-markets consideration rather than firm-specific ones.

If you're supremely over-confident that you're a genius, or inherently blessed by Lady Luck, you'll be scoffing at this, and "go for all the marbles" nevertheless -- good luck, and Lady bless. Me, as Jefferson (or somebody else, but I like Jefferson for this one), I'm a firm believer in Luck, and I've found that, the harder I work, the luckier I get; so, the hard work of picking and choosing my stocks and carefully diversifying my investments is part of the ritual propitiations to Signora Fortuna that I've found out in the course of a long and lucky life work very well for me!

I doubt any high-rollers, go-for-all-the-marbles types are wasting time reading this blog (what with all the penny stocks, exotic commodity plays, and abstruse options strategies just waiting for their blessedly-lucky attentions!-) -- if anything, I suspect my readers may be shaking their heads and sadly wondering why I waste so much energy rather than just buying low-cost, S&P500 index funds for maximum differentiation.

Well, a personal compound annualized performance (over many recent years, including dividends but not any options or shorting possibilities) of +12.2%, vs the S&P 500's annualized +1.7 over the same span of years and with identical constraints, has a little bit to do with it... but part of it is, in Charlie Munger's great, recent words, what amounts ultimately to a philosophical, or maybe religious, core belief: "I like understanding what works and what doesn't in human systems. To me that's not optional; that's a moral obligation. If you're capable of understanding the world, you have a moral obligation to become rational.". I feel very much that way, too.

Investing vs Gambling

In current, unfortunate parlance, anybody who buys stocks or other securities is often called "an investor" (and the term easily spreads to such purchases as fine arts, ancient rare wines, gold coins, pure-breed horses...!). Back when Benjamin Graham was getting started, about a century ago, just about anybody operating in the stock market was often called "a speculator" -- indeed, the title of Samuel Armstrong Nelson's excellent 1903 book about stock investing was... "The ABC of Stock Speculation"!

Neither terminological confusion -- the traditional one, where stocks are inherently "speculation", and the modern one, where just about anything is "investment" -- is helpful. Much better, IMHO, to think of "investment" as being focused mostly on the patient, business-owner-like attitude I've been sketching in recent posts (summarizing part of Graham's great "Intelligent Investor" book), "speculation" as most of what is called "investment" today;-), and "gambling" for quite a bit of it.

In these terms, Graham has priceless advice...:
Speculation is always fascinating, and it can be a lot of fun while you are ahead of the game. If you want to try your luck at it, put aside a portion - the smaller the better - of your capital in a separate fund for this purpose. Never add more money to this account just because the market has gone up and profits are rolling in. (That's the time to think of taking money out of your speculative fund). Never mingle your speculative and investment operations in the same account, nor in any part of your thinking.
This has been precious practical advice to me, and I think it may be to you unless you're the exceptional kind of person who's really totally and utterly indifferent to the lure of gambling and "the madness of crowds" under all circumstances.

I'm not quite that good and wise (yet;-), so, had I tried to practice the ascetic optimum of "no gambling at all", I might well have succumbed to the excitement of some of the many small and large bubbles that the markets (plural, considering the international nature of investing, the many kinds of securities, commodities, futures, &c) typically are showing to some prominence or other at most times, and compromised my main investment funds and operations.

Thanks to Graham's advice, instead, I keep no more than 1-2% of my net worth in a small, separate "mad money" account, actively play with it, often over-trade with respect to what I know I should be doing (not a defect I'm entirely free from even in my "real" investment, but, going wild with it in the "play" account saves me from doing worse in the "real" one!-), trade naked options, use margin, short some stocks or commodities, and so forth. The 1-2% level is kept by occasional rebalancing -- in my case, not on a "timed" basis, but considered every time the total worth in the "mad money" account falls much below 1%, or rises anywhere above 2% (the latter trigger helps me intrinsically "get" the "time to think of taking money out of your speculative fund" that Graham mentions in passing;-).

As an extra, practical tip -- I've recently found options house quite suitable for this purpose -- low commission rates, decent execution, decently usable platform all around especially for complex options plays. As an added bonus, they even offer a free "virtual account" where you can simulate trading, speculating and gambling without actually putting any real money at risk (at least it helps learning their platforms and trying out weird options plays, though I admit that for the actual purpose of "getting the gambling craving out of my system" I'd rather have some -- albeit small -- amount of real money at stake... just like, differently from, say, bridge, poker is really no fun when played for beans!-). Having a completely different and separate platform for the small "mad money" account as compared to the larger "serious money" ones helps me psychologically, I think, to keep them completely "disjoint" in my mind, avoiding the "mingling" that Graham's great advice warns against!

Benjamin Graham's "Mr. Market"

Chapter 8 of Graham's book "The Intelligent Investor", "The Investor and Market Fluctuations", is a core one in the work, especially since most "investors" today take a stock's price as the sum total of the information that's needed about it, and thereby are totally enslaved to the market's fluctuations (one might partly blame the EMH for that, but the germ of that specific idea was widespread well before Fama reprised Bachelier's thesis in the '60s -- see point three of six in the classic Dow Theory, first elaborated by Dow in the 19th century, "The stock market discounts all news"... and of course Dow Theory, as an early form of Technical Analysis, is totally incompatible with the fully developed EMH!).
Graham's overall philosophy has become the core of what today is called the value approach to investing -- focused first and foremost on the value of the business whose part-owner you become by buying common stock (its underlying financial situation, its business model and competence in executing it, its investments and research and preparation for the future, its competitive "moats", and so forth), only secondarily on the stock's market price.
"Only secondarily" does not mean "no attention to price at all": a "price is no object" attitude, when buying securities, is neither sensible, nor at all "intelligent" (nor "prudent"!-). Rather, as Graham puts it, the simplest form of "pricing" "is the simple effort to make sure that when you buy you do not pay too much for your stocks", which represents "an essential minimum of attention to market levels". It's also OK to focus on the other side of the equation, possibly buying a so-so business if the market price is so ridiculously low that, despite its mediocrity, the business (and therefore the stock) is a bargain anyway... but that's nowhere as important as never, ever overpaying. The market's enthusiasm for a good business, even when fully justified, often goes way overboard and prices that business's common stock so high that -- despite the business's excellence -- not even in the rosiest, most optimistic scenario could buying or holding at today's price ever be a long-term win.
At the end of the chapter, Graham's introduces "something in the nature of a parable" -- an incredibly useful metaphor, because it's so vivid that it will easily stay in your mind and help fortify your willpower against unwise reactions to the market's inevitable fluctuations.
Imagine that in some private business you own a small share that cost you $1,000. One of your partners, named Mr. Market, is very obliging indeed. Every day he tells you what he thinks your interest is worth and furthermore offers either to buy you out or to sell you an additional interest on that basis. Sometimes his idea of value appears plausible and justified by business developments and prospects as you know them. Often, on the other hand, Mr. Market lets his enthusiasm or his fears run away with him, and the value he proposes seems to you a little short of silly.
If you found yourself in this situation, obviously a good strategy is to mostly ignore your friendly partner's babblings, except that, when he offers to sell you an interest for a ridiculously low price, if you have cash available to invest, it's a good idea to accept the offer, and buy from him, and, vice versa, when he offers to buy you out for a ridiculously high price, it's a good idea to sell to him.
Of course, to form your own judgment on when prices are ridiculously high or low, you need a sound judgment about the business's "fair" value -- but then, as a part-owner, you would be supposed to have some sensible ideas about that, no? Your general attitude as an investor should be no different... because, as an investor in common stock, you are exactly a part-owner of a business (with an obliging partner, Mr. Market, who's always ready to buy you out or sell you more, sometimes at sensible prices and sometimes at crazy ones).
To me, this simple fable, or parable, always proves helpful and soothing in fortifying my emotions somewhat against the natural herd responses of collective fear and greed -- to, instead, "be fearful when others are greedy and greedy when others are fearful", to quote one of Warren Buffet's best-crafted soundbites.

Friday, October 15, 2010

Benjamin Graham's "The Intelligent Investor"

My "investing philosophy" begins (though it doesn't quite _end_;-) with Benjamin Graham's popularization masterpiece, The Intelligent Investor (incredibly to me, I see the paperback edition is only $8.99 on Amazon as I write!-).

Unfortunately, the author who curated this "Revised Edition", Jason Zweig, is no Ben Graham -- I appreciate much of the work he's done to bring the work up to date for 2003 (Graham's own editions went from the first one in 1949, to the fourth one in 1973), but I object to a lot of what he adds to the text (I'm particularly fuming about his unthinking and wrong-headed condemnation of covered call writing in his sidebar at the end of his commentary on Chapter 16 -- but, that's a specific technical subject for another post somewhat in the future). Fortunately, he does leave Graham's text substantially alone, only adding footnotes and commentary -- some helpful, some, not so much, but, worst case, a reader _can_ just skip them!-)

I can't summarize this masterpiece within a post, but, if 600+ pages are too much for you, get it anyway and read just one chapter -- Chapter 20, "Margin of Safety" as the Central Concept of Investment (p. 512-524 in the paperback).

As for practical tips, start with the "General Portfolio Policy" discussed in Chapter 4 -- forget "Modern Portfolio Theory" and the utter idiocy of modern theories dictating your stocks/bonds split based on your age, or when you want to retire (totally ignoring the prices and yields of stocks vs bonds at any given time -- eep!-), and, instead, follow "the investor should never have less than 25% or more than 75% of his funds in common stocks, with a consequent inverse range of between 75% and 25% in bonds" (investments in other than negotiable securities -- real estate, commodities, art masterpieces, etc -- are totally outside the bounds of Graham's interests, as they are of mine in this blog; as are obvious but crucial considerations such as, pay off high-interest debts before you dream of "investing" anything, keep in ready cash any money you need -- or would need in an emergency -- for at least the next six months; and so on).

Graham makes extremely convincing points to support this simple rule -- convincing enough, that they easily convinced me (before reading and pondering them, I was convinced that I should have all in bonds when stocks are in a bubble, and vice versa; now, I'll never again stray outside the 25-75 boundaries). You should read and ponder the arguments yourself, but it boils down to two key points: no matter how accurately and closely you've analyzed the markets to convince yourself that stocks or bonds are in a bubble, still (a) you could be wrong, and, if that's unthinkable, nevertheless (b) the market might stay crazy for more and more years to come (before finally coming to its senses as it always does eventually) making you really sad about your timing; softening the most extreme allocation to 25-75 instead of 0-100 will proportionately soften the consequence of either issue, though it proportionately softens the gains from being right and "on time". Avoiding or reducing overall big losses is, in the long run, more important than achieving or enhancing overall big gains, and, you know that "the markets can stay crazy longer than you can stay liquid"...!-)

Case in point: by late '96, I had convinced myself that Mr Market (in stocks) was high into one of its manic periods, so I got entirely out of stocks and into bonds -- with the S&P500, as I recall, somewhere below 800. I wasn't too bad off in diagnosing the bubble... I was just way early in so doing, as S&P500 kept rising back up all the way to peaks over 2000 four year later (!). Had I kept 25% of my securities in stocks, and rebalanced once or twice a year, I would have been substantially better off, even though the S&P500 then crashed badly again to a low of 800 or so after another couple of years. Similarly, I've been convinced for a while that the bonds market is now in a bubble... but, nevertheless, keeping 25% of my securities in bonds (and rebalancing once or twice a year) lets me benefit from the fact that the market can (and often does) keep being crazy for years after dispassionate observers have called it out as being mad!-)

As for the details of how to invest in bonds -- I really can't be bothered much with the details, except for the obvious advantages (for US citizens or residents) of US Savings Bonds, which Graham already pointed out (they're the only bonds I know that are "callable by the lender" with little penalty, so if interest rates spikes you can sell your existing ones at essentially no loss and buy new and higher-yielding ones) -- each person can get about 5 or 10 thousand dollars' worth a year, so they won't fill your quota for bonds unless your overall holdings in securities are modest, and like all tax-advantaged investments make no sense in an IRA or 401K.

If, to reach your desired total of bonds, you need more than the amount of US Savings Bonds you can hold, or you need to keep some in an IRA or 401K, then reach for the bond ETFs (Exchange Traded Funds) of your choice to get the overall mix or differentiation you desire (US vs foreign advanced countries vs emerging countries, dollar-denominated vs other currencies, government vs investment-grade corporates vs junk bonds, mix of maturities, munis if you need to hold some in a taxable account, inflation-protected ((but never those in a taxable account!))... -- those choices depend too much on your personal situation and opinions; e.g., I want more exposure to foreign currencies than the typical US investor probably does, simply because I may decide after retirement to move back to Europe again... after all, I do retain my EU passport and citizenship, in the US I'm only a permanent resident).

With these investments, as well as any other "differentiation/diversification" plays you make in ETFs, I recommend a "set and forget" policy -- look at them only every 6 months or so when you consider rebalancing your whole portfolio of securities. Churning into and out of ETFs (or, for that matter, old-style mutual funds) makes no more sense than it does for common stocks -- even if your IRA and/or taxable account are with one of the growing number of firms that let you trade commission-free with respect to ETFs underwritten by the firm itself (e.g., my accounts with Vanguard have that feature). "Fund churning" is responsible for a huge loss for the many investors who practice it: many studies show that, while mutual funds overall way underperform a S&P500 index, individual investors in funds, in turn, way underperform "mutual funds overall" by an even worse margin: simple reason, too much fund churning in chasing the high-gaining fund of yesterday (which, by mean reversion, is unlikely to be the one you care about... the high-performing one of tomorrow!-).

My philosophy and approach is quite different for stocks, than it is for funds. But, more about that, and (separately;-) more about allocation, diversification, differentiation, and wonderful little tidbits or tips from Graham's masterpiece (as well as other books), in many future posts to come.

Wednesday, October 13, 2010

Mutnemom: the reverse of Momentum

I'm a personal investor (kind of a mix between a hobby and a serious endeavor to enhance my future retirement income) -- wrt my actual job(s), see wikipedia.

More and more often I find myself moved to share some thoughts on some aspect of the matter with the world at large, and I usually end up doing so on comments on other people's blogs, which of course are pretty hard to put together into a semi-consistent whole;-)

Finally, reflecting on what was recently telling me, I think I've come up with a good name. Take a look at this report...:

Portfolio's Performance1w1m3mYTD
DOW JONES1.63%5.20%7.93%5.55%
S&P 5001.65%5.01%8.09%4.49%
See? If I was managing OPM (Other People's Money), I'd probably have been fired, after underperforming the market on the last week, the last month, AND the last three months (though this somewhat understates performance all the way 'round, since it ignores dividends, and small steady profits from writing call options, and the ability to reinvest them, such understatement applies to all the rows;-).
But, since I only answer to myself and my wonderful wife, I'm allowed to follow the somewhat-contrarian "Mutnemom" strategy -- AKA "Buy Low, Sell High" (AKA "Buy when there's blood on the Street", AKA "Be fearful when others are greedy, be greedy when others are fearful") -- and underperform in the short run but outperform the market over longer time span.
That I've outperformed in the year-to-date is actually somewhat fortuitous -- the time horizon I aim at is actually 3-5 years, as used in Value Line's superb service, and I know -- thanks to the "track vs S&P500" feature of the excellent site -- that over the last such timeframe I did +9.6% (compound annual returns, including dividends assumed to be reinvested but ignoring profits from writing call options) vs S&P 500's +1.8% (over the same time and conditions).
But anyway, that's way plenty for an introduction -- I'll try to stay focused mostly on philosophy and strategy in future posts and not get too distracted by current events and refined technicalities!-)