tag:blogger.com,1999:blog-35871688019994719662024-03-12T17:44:23.191-07:00MutnemomInvesting musings, reviews of books, brokers, strategies, tactics, &c, by a somewhat conservative and somewhat contrarian individual investor applying his "reverse of Momentum" general idea.Alexhttp://www.blogger.com/profile/05338312873524129257noreply@blogger.comBlogger28125tag:blogger.com,1999:blog-3587168801999471966.post-40485932390241453582010-12-03T21:22:00.000-08:002010-12-03T21:22:23.850-08:00Buybacks to avoid dilutionTwo more reasons (that I hadn't mentioned in my last post) why giving your CEO options (besides being a bad idea in general) will also give him or her strong incentives to prefer buybacks to dividends (if any "return cash to shareholders" action is contemplated).<br />
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First, as a ("call") options holder, the CEO receives no benefits from dividends declared today -- call owners don't accrue dividends, holders of <i>stock</i> do. For the identical decrease to the firm's enterprise value (due to the departure of cash), buybacks should at least increase the options' present value (by the amount the buybacks increase the value of common stock, times the options' "delta" -- the latter can be pretty close to 1 if the option is, at this time, substantially in-the-money).<br />
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Second, the very granting of options produces likely risk of stock dilution -- those options are going to be exercised if they are in the money at some time between when the vest and when they expire, creating new stock in addition to what current stock-holders presently own. Just as buybacks should increase the value of common stock, so dilution should decrease it -- and, the market is a forecasting device, so, <i>impending</i> dilution (dilution that's reliably forecast to happen in the future) should also reduce the value of common stock (by some fraction of what it would be reduced by as and when the options get exercised, multiplied by the probability that options will expire out of the money -- roughly equal to delta -- and further diminished by the discount rate to apply due to the delay between now, and the time of the options' exercise).<br />
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Decrease in common stock value also decreases the value of the options the CEO holds (again, by the amount the dilution decreases the value of common stock, times the options' "delta") -- again, this is incentive for the CEO to have the firm do the buybacks.<br />
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If options are to be granted at all, buybacks (one grudgingly has to admit), in about the amount needed to avoid dilution, have reasonable returns to shareholders (mostly due to the tax treatment of various possibilities -- which, of course, is a very volatile thing;-).<br />
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And, in fact, there are industries where it's just about mandatory to give your employees options if you want to retain the top talent -- mostly industries in which your likely competitors for said top talent are likely to try to lure them away by dangling wads of options at them.<br />
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Employee options are relatively cheap to the firm granting them (and in particular, differently from just about any other form of compensation, require no outlay of cash by the firm at this time... nor at any future time either, necessarily, except that if and when the options are exercised buybacks costing cash will become desirable... but, still, not mandatory!).<br />
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Since call options give great leverage compared to owning stock (esp. restricted stock), they're particularly attractive to optimistic, "high-roller", "top talent" employees who are particularly desirable.<br />
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<i>And</i>, the crazy accounting treatment (by GAAP) of granting employees options is yet another motivation for the company to employ them in industries where they're culturally common. Note that each of the three points makes granting options as compensation <i>particularly</i> rewarding to start-up companies (who desperately need to preserve cash today, desperately need to attract and motivate over-performers, <i>and</i> really need accounting help to make their statements look decent in the difficult early times of low revenues, high outlays, and negative-if-any earnings;-). So, options are most commons in industries with large numbers of start-up companies, such as high tech; in those industries, options are usually found as part of compensation even in larger and more established companies, who'd otherwise risk having their best performers lured away by startups.<br />
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In addition, it's become customary to award options, in just about every industry, to at least the "cream" of top management (though often not to rank-and-file employees or even to middle management). This one new cultural trait I really deplore... it's certainly desirable to give top management a strong incentive to behave like stockholders, but, options don't do that -- stock does, even restricted stock (e.g. stock that cannot be sold for years after vesting -- enough years to hopefully allow the market to properly evaluate the company's value resulting from management's strategy, vision, and execution). Only startups (where volatility <i>is</i> desirable -- and the firm's not publicly quoted yet, so there are no shareholders to be damaged;-) should generously award options to top management (and all other employees... and suppliers, too, if they will take some reasonable amount in lieu of cash... remember, a startup's first commandment is to <b>conserve cash</b>!-).<br />
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Restricted stock, like options, would also require buybacks to avoid dilution, of course... but typically much less actual cash than needed to compensate for options of equivalent value when granted (the premium, or value, of a call options that is at the money when acquired -- as typically done for options granted to management or other employees -- is invariably lower than the underlying stock's price... except maybe for companies so wildly volatile they had <i>better</i> be startups!-). Accounting-wise, seeing that at an expense at time of granting -- or, at worst, of vesting -- rather than delaying it to exercise time, makes a lot of sense (but of course that's in part because it makes a company's financial statements a better match for reality, rather than "pretty them up" a bit... which no doubt is exactly why most companies dislike that!-).<br />
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Beyond the amount needed for dilution avoidance, buybacks are really a lottery at best, and in my view they're really undesirable for stockholders as a general rule -- as I hope to show in a future post. Absurd tax and accounting rules making buybacks (or options) "look good" should really be reformed, to avoid having the tax system provide distorting incentives to firms and their top management!Alexhttp://www.blogger.com/profile/05338312873524129257noreply@blogger.com0tag:blogger.com,1999:blog-3587168801999471966.post-72068147358105014442010-11-29T22:46:00.000-08:002010-12-03T20:38:16.289-08:00The problem with buybacks... and, with granting options to CEOs!<a href="http://en.wikipedia.org/wiki/Peter_Lynch">Peter Lynch</a> -- an investor whose historical realized performance we should all be hoping to emulate! -- was just gaga about stock buybacks: i.e., he just loved being long companies who used some of their accumulated earnings to buy back some of their stock. So, if I admire Lynch, and he was the hottest fan of buybacks... why am I so, overall, "meh" about owning stocks of firms that do a lot of buybacks...?<br />
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"Anno Domini", my dear sir... the eternal problem of time!-). Lynch's great books, and great performance, are from the 1990's... it's now the 2010's, 20 years later. Companies' management has had plenty of time to figure out that stock buybacks are "costly signals" to the market, and therefore ones with a lot of intrinsic credibility... but the cost, if any is to be paid, is not from their pockets, but, the shareholders'. (Agent-principal issues potentially emerging again;-).<br />
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When a company buys back its own shares it clearly signals (costly, thus credibly) it believes shares are undervalued - contrarywise, stopping or delaying a buyback plan would signal it believes shares are fairy valued, or overvalued. CEOs typically hold far more in ("call") options than in shares -- a terribly badly designed incentive that makes them participate fully to the upside, but not at all to the downside.<br />
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Let me expound simply on why options (vs, e.g., restricted stock) are a terrible way to provide incentives to top management. Suppose you owned stock of ABC, currently trading for $100 a share. A certain move has 50% probability of moving ABC stock to $90, 50% probability of moving it to $110. As a shareholder, would you <i>like</i> that move?<br />
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Surely not -- it leaves you with the same expected returns while increasing your volatility, AKA risk... a crazy tradeoff! Normally, you'd demand <b>higher</b> expected returns to withstand an increase in risk (volatility).<br />
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But -- say you didn't own the stock itself, but a call option at strike 100 close to expiry. What would you think of the 90-or-110 move <i>now</i>?<br />
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You should be all in favor -- going down from at-the-money 100, to out-of-the-money 90, for the underlying, doesn't decrease the value of your expiring options... it stays at 0 either way. <b>But</b>, should the underlying soar to 110, you're making a 10% profit. "heads I win, tails I break even" is a superb bet, so of course you'll just love such a move which increases risk but not (shareholders') expected returns!<br />
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If you give your firms' CEOs options (rather than restricted stock), you're giving them strong incentives to increase the stock's volatility. Increasing future expected value would be great, too, of course... but, increasing risk with no increase in expected returns is clearly way easier... and by granting the CEO who works for you options rather than restricted stock, that (increase volatilily) is exactly the incentive you're giving him or her.<br />
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So that's problem #1 with buybacks (and acquisitions too): if they increase volatility but not expected returns, they're a great idea for your options-incented CEO... yet a bad bargain for you, the shareholder.<br />
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This is a general problem with giving top management options-centered bonuses. Buybacks have more specific issues, too... but, I guess that's a theme for a <i>future</i> post!-)Alexhttp://www.blogger.com/profile/05338312873524129257noreply@blogger.com0tag:blogger.com,1999:blog-3587168801999471966.post-85104796820183979202010-11-29T21:21:00.000-08:002010-11-29T21:21:21.686-08:00How would you like your cash back, sir?We have examined how, despite Modigliani-Miller's theorem, in the real world we should prefer most firms, under most circumstances, to return to their shareholders some (a sustainable fraction) of the free cash flow resulting from operational earnings -- not to the point of incurring avoidable debt (except in cases where some debt can be had under very favorable conditions, and be wisely used to leverage the firm up in sectors requiring high capex but with a very steady and predictable cash flow as the result -- regulated utilities being the prime, classical example of this situation), but also avoiding excessive accumulation of cash hoards which yield very little (except in rare cases where a company has a proven track record of profitable acquisitions, with successful integration of the acquired firms, and requires substantial cash reserves to continue on that strategy going forward).<br />
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If you're still a Modigliani-Miller fan, I'd recommend taking a look at <a href="https://www.aaii.com/investing/article/the-dividend-puzzle-the-relationship-between-payout-rates-and-growth?acc=o">this article</a>. By the way, as an aside, I do strongly recommend the <a href="http://www.aaii.com/">aaii.com</a> site -- it's very cheap and really chock-full with interesting and directionally-right information, even if you're a more experienced investor than they aim to. (if you're a <i>beginning</i> investor, AAII membership is really, truly, seriously, I-mean-it a <b>must</b>, BTW;-).<br />
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So anyway, back to the AAII article I just pointed to, which summarizes and discusses Arnott's and Assness's immortal 2003 article in "Financial Analysts Journal". To summarize the summary of the summary: companies that pay dividends have <i>better</i> (not <i>worse</i>, as M-M would predict) capital gains returns, too.<br />
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One of the possible explanations is that "high earnings retention and a low dividend payout may signal an attempt at empire-building by current management" -- in other words, such a high retention with low dividends is a negative signal, pointing at the risk of out-of-control acquisition spreads.<br />
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Some companies (a very few, with a proven historical track record) can retain earnings and use them to fund acquisitions in a way that's accretive of value to shareholders; by far the greatest majority just can't, and history proves that clearly. Arnott and Assness's "screen" may screen out companies likely to go on shareholder-negative acquisition binges -- and that may explain a lot of why it's predictive.<br />
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So, let's accept (for the sake of discourse) the overwhelming evidence that companies who do return some (reasonable, sustainable) fraction of earnings to shareholders, overall (i.e., always excepting many possible exceptions, which, in real-life, do abound), outperform those who hoard that cash.<br />
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There remains a problem -- per the title of this article: as an owner of some part of the company, accepting that it should return <b>some</b> of its cash to you, <b>how</b> would you rather get it back?<br />
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The main possibilities are, share buybacks, and dividends (which can take many forms). Dividends are "all the rage", lately... and, as a contrarian, I'm always especially wary when I find myself agreeing w/the hoi polloi... but in this one case I have to admit I can't really, credibly, <i>dis</i>agree, either;-).<br />
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So, I'll follow on with posts on buybacks (when are they good, when are they a problem) and dividends (and the various forms they can take... though today's typical US investors may not realize dividends' multifarious possibilities and their pros and cons!-).Alexhttp://www.blogger.com/profile/05338312873524129257noreply@blogger.com0tag:blogger.com,1999:blog-3587168801999471966.post-31263599735376651972010-11-27T17:34:00.000-08:002010-11-27T17:34:04.875-08:00are acquisitions good for you?If you're a shareholder in the company being acquired, probably so; if in the company doing the acquisition, usually, not so much. Why is that? Because acquiring a company generally requires the acquirer to pay a "control" premium over the market's stock price -- that premium goes right into the pockets of the acquiree's stockholders (good for them!)... but it requires justification from the viewpoint of the acquirer's stockholders.<br />
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Say company BUY wants to buy out company SEL -- SEL's market cap just before the bid, $2 billions -- bid value, $2.5 billions (a pretty modest premium of 25%). What's SEL actually <b>worth</b>? If it's worth more than 2 billions, why was Mr Market silly enough to be happy to sell us shares at a $2 billions valuation? Well, Mr Market undoubtedly <i>is</i> prone to temporary follies, no doubt about it... but, if I'm the one supposed to finance this buyout (i.e., a BUY shareholder), you still have to <b>show</b> me that this is indeed the case in this specific instance.<br />
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If SEL's own assets (book value) are worth $1 billion, the remaining $1.5 billion of the acquisition price will go in BUY's asset account as "goodwill" -- always something worth looking out for: an intangible asset which just means "we paid so much more for some acquisitions than we can prove the acquired assets are worth"... not usually a good sign from my skinflint, value-oriented viewpoint.<br />
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From the viewpoint of optimistic, aggressive BUY's management (the kind of people you probably <i>do</i> want in charge of companies you own, overall), acquiring SEL is undoubtedly going to be a triumph -- it will grow their little empire, increasing their power (and likely their compensation in proportion), and it's just sure to work out great as their superior strategic vision strengthens SEL's direction (BUY's managers are of course totally certain that they're better than SEL's... and everbody else;-).<br />
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You could see this as a principal-agent incentive conflict problem, I guess, because there <b>are</b> cases in which the acquisition will benefit BUY's managers (increase their power and compensation) but not BUY's shareholders (reduce their overall returns on equity). However, I think that (for the typically forthright and honest -- but often overconfident! -- people who end up in top management) this is not a major consideration -- such cases are somewhat marginal. Normally, when the acquisition's a flop, BUY's management will not be happy either -- and when it's a triumph, both BUY's management <i>and</i> shareholders will benefit thereby... maybe not <i>quite</i> in the same proportions (in either case, win or lose), but that's a second-order consideration.<br />
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Rather, I think the natural "can-do" optimism (and, likely, overconfidence) of BUY's management is more likely to skew their vision in favor of acquisitions that would be better avoided (from BUY's shareholders' perspective) than any seriously distorted incentives.<br />
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That being said, the way-overused word, "synergy", <i>sometimes</i> <b>does</b> apply. Maybe SEL's bursting with brilliant people and ideas but just can't get capital enough to fund their projects, for example, while BUY can get abundant capital cheap, just because it's bigger and financially sounder. Maybe SEL, being a smaller company, suffers avoidable amount of overhead in supporting functions (such as, say, HR), which can be saved by merging the companies (maybe with some layoffs). Maybe SEL's wonderful products just can't get enough distribution, while BUY's excellent access to distribution channels can help those products make a real impact on the merged companies' top and bottom lines.<br />
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All of these situations (and more) are <i>possible</i>... just <b>very</b> hard to evaluate (in terms of probability of playing out, and likely returns if they do) for anybody who's not deeply enmeshed in the specific industry (as management of course will be, but many shareholders, even the "investor types" like me who do tons of due diligence, usually won't).<br />
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So, my own rule of thumb is to let past performance be predictive of future results -- I know everything about there being no <i>guarantee</i> there, but, hey, surely there <i>is</i> <b>some</b> correlation!-) I look at some companies and see a great track record of successful acquisitions over years and decades -- whether acquisitions play a supporting role in their overall company strategy (like, say, for AAPL), or a more central one (like, say, for MDT, or, even more, ORCL), they've repeatedly shown that they <i>can</i> successfully integrate newly acquired companies, and regularly <b>do</b>. I look at <i>most</i> companies and I see a track record of disaster, or, at best, a <i>very</i> mixed picture -- e.g., look at EBay's acquisition of Paypal (now arguably the brightest part of the company, with the very best growth prospects)... but also that of Skype (with the huge write-downs of goodwill and the need to hive that part off again in just a few years)...!-)<br />
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So, if I was a shareholder or considering buying into AAPL or EBAY (neither is true at this time, nor have I been in either company's stock for years), and a proposed acquisition by said company was announced, I'd react very differently. In AAPL's case, based on past performance, I'd give management enough credit to assume the acquisition won't be a bad hit against the firm's performance, and just <i>might</i> work out awesomely well. In EBAY's, again based on past performance, I'd be <i>much</i> more skeptical -- unless the underlying business logic is crystal-clear enough even to a duffer like me (in which case I'd dig deeper into the financials' entrails), like, say, Paypal's acquisition was, I'd be prudentially assessing the likelihood that management's about to play another Skype on me... and looking for an opportunity to get out of the stock (or just avoid getting into it in the first place).<br />
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The fact that the vast majority of mergers and acquisitions don't work out, is part of why I'm dubious about the possibilities of most companies hoarding big treasure troves of cash -- they enable management to perform more and more acquisitions that I, as a BUY shareholder, would rather see not happen. All of this applies to acquisitions in cash, BTW -- if you have incredibly overvalued stock, and can acquire real value in that weirdly inflated currency (like AOL did to Time Warner a few years ago), hey, more power to you (and then I'd be more worried as a shareholder of SEL!-). But, cash <i>is</i> still worth $1 per buck (despite the Fed's best attempts to the contrary;-), so, as a BUY shareholder, I'd usually rather see that cash in my own pockets, than in those of SEL's shareholders!-)Alexhttp://www.blogger.com/profile/05338312873524129257noreply@blogger.com0tag:blogger.com,1999:blog-3587168801999471966.post-20030421005771329352010-11-23T20:33:00.000-08:002010-11-29T21:22:44.153-08:00Paper money: a Faustian bargain?-)I've been enjoying Weatherford's delightful <a href="http://www.amazon.com/History-Money-Jack-Weatherford/dp/0609801724/ref=sr_1_1?ie=UTF8&qid=1290571190&sr=8-1">History of Money</a> as an audiobook (that's the one plus of having to commute by car, now that I've moved to Sunnyvale so can't really walk to work in Mountain View as I used to -- in the 20+ minutes of drive each way, instead of radio which at any time might be speaking about interesting things <i>or</i> inane ones [or playing ads -- or thanking sponsors or hustling for donors, if it's NPR;-)], you <b>can</b> listen to cool audiobooks of your choosing!-).<br />
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Among its many charming details is a sound "monetary" (and literary) analysis of Goethe's Faust (Part Two) -- remember the immortal verses (in Lange's popular translation to English, cfr <a href="http://books.google.com/books?id=fF7Mh9EIP94C&lpg=PA160&ots=qTJNJ-T-uv&dq=faust%20gold%20paper&pg=PA160#v=onepage&q=faust%20gold%20paper&f=false">Google's version</a>) in which Faust, alternating with Mephisto, pleads to the Emperor in favor of paper money...?<br />
<blockquote>The excess of treasure frozen in your lands,//Deep in the soil awaiting human hands,//Lies there unused. The furthest range of thought//Cannot define such riches as it ought</blockquote>...and therefore the Emperor should solve his monetary problems by issuing abundant paper money backed by all the yet-unextracted gold, silver and gems in the land belonging to the Empire? I had always taught of that as the typical "Faustian bargain" -- a devil-inspired one. However, Weatherford's reading is different: Mephistopheles' ends are of course evil (it's definitely possible, even easy, for paper money to be abused to evil, greedy, selfish ends by the State's rulers)... but, <b>not</b> Faust's own!<br />
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What <i>Faust</i> does with the newly abundant paper money is -- try to drain marshes, build roads, propel the Empire to new, real prosperity, which the scarcity of species previously held back. And (in W's reading) that is why the Angels in the end shield Faust from the devil "for his unending striving"... because that's what the economy <b>is</b>, whether it's held back by scarcity of species or propelled forward by abundance of paper money -- an unending striving to make things better (albeit beset by rogues and Madoffs...), to build <b>real</b> prosperity. The great Poet is not <i>just</i> sounding a worried, backwards-looking alarm against the easy excesses of paper money, as he's usually read -- he's <i>also</i>, in the same breath, pointing to the positive, creative "unending striving" it makes possible (despite all the selfish rogues), for those who really <b>do</b> want to "unendingly strive" to build a better world for all.<br />
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In other words (and that's my own parallel, thinking of the "news of today") -- Bernanke is Faust. The superficial observers (most of us) only see the "pact with the Devil" aspect, and want to take away the original part of the Fed's mandate (the one about full employment) to make it focus entirely on keeping the currency sound (as it did in 1929... fat lot of good it did back then, hm? only as nations, including the US, <b>dropped</b> the gold standard, and roughly in the same chronological order as they did so, did each of them manage to start the monumental task of draining the swamp of Depression -- only paper money enabled that, just like only it, the understandably maligned Continentals, enabled the thirteen colonies to finance their terrible wars against England...!). But -- Bernanke's fighting to promote the "unending striving" that's the only possible path to prosperity. In the end, even though the Devil may prevail, the Angels will come in to defend him and save him!-)Alexhttp://www.blogger.com/profile/05338312873524129257noreply@blogger.com0tag:blogger.com,1999:blog-3587168801999471966.post-81188154241887594512010-11-17T08:54:00.000-08:002010-11-17T08:54:13.595-08:00Firms' debts and cash: Modigliani-Miller vs the real worldMy considerations about "holding cash" in <a href="http://mutnemom.blogspot.com/2010/11/should-you-be-in-cash.html">Should you "be in cash"</a> were entirely focused on what an <b>investor</b> should to about it -- my ideas are very different about what a <b>firm</b> (that the investor part-owns: remember that I consider it crucial to think about <i>investing</i> as <i>owning</i> a part of a firm!) should do about it are very different.<br />
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The <a href="http://en.wikipedia.org/wiki/Modigliani%E2%80%93Miller_theorem">Modigliani-Miller theorem</a> shows that (under totally idealized conditions) it makes no difference at all what a firm does about its finances -- retain earnings or distribute them in whatever way (dividends, share buy-backs, &c), incur debts or sell more equity, whatever -- the theorem is often known as the <b>capital structure irrelevance principle</b>, exactly because it shows that, <i>under certain assumptions</i>, all of these details about a firm's capital structure and financing are just that, irrelevant.<br />
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However, much as the maths in question may fascinate me (and much as I may be personally biased towards this theorem by Modigliani being Italian;-), I consider the beautiful theoretical result in question pretty much irrelevant to the real world -- after all, among those "certain assumptions", it assumes efficient markets (which I consider a myth), no taxes (don't you just <i>wish</i>;-), no asymmetric information (ha!-), no agent-principal issues, and more.<br />
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In real life, a company's decision to incur debt (and in what form -- long term vs short, bonds vs bridge loans, intermediate forms now a bit out of favor like preferred stocks and convertible bonds) or hoard cash or both, and of whether, how much, and in what form, return "extra" cash to shareholders, does make a huge difference.<br />
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In particular: capital markets can and do "just freeze up", as the recent "great recession" amply proved -- making it risky to hold (especially) short-term debt in excess of the liquid assets available to repay it if needed. Acquisition opportunities do emerge, and being able to make a buy-out offer that's mostly or all cash (as opposed to acquiring-company shares) does make a difference (especially in credit-straitened times) to the chance that the offer will be successful. These considerations push many companies to hold a veritable treasure-hoard of cash and cash-equivalents (to the point where I believe that recently many otherwise-excellent companies, today, have gone overboard in this respect, holding far too much cash in their coffers -- mostly an understandable over-reaction to what the credit markets did over the last three years, I believe).<br />
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On the other hand, taxes are, of course, a reality, and have long encouraged companies (weirdly, in my opinion) to hold debt -- interest charges can be deduced from taxable earnings, while dividends, owners' capital gains, &c, cannot -- so, if a company needs a certain amount X of working capital to keep producing its earnings, and people who can supply it with capital require a certain remuneration (yield -- including interests for lenders, and dividends and capital appreciation for shareholders), it's cheaper for a certain fraction of X to be debt (up to the point where potential lenders become nervous about the company being over-leveraged and start demanding higher interest rates) than it is for it to be all equity.<br />
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The optimal debt-to-equity ratio, BTW, depends on the specific firm (and, in large measure, on what industry the firm is in): regulated utilities, in particular, have steady, predictable, "boring" income flows (and "boring" is a good thing for a lender), so they may leverage up with very substantial amounts of debt and still pay decent rates of interest -- while their lack of substantial growth prospects makes potential shareholder demand higher dividend yields than they do from firms in other industries (shareholders in utilities aren't looking for prospect of big capital gains). So, the assessment of whether a certain firm (that you're considering investing in) may be over-leveraged (a big risk to shareholders) or under-leveraged (holding too much cash -- not a risk, but depressing to prospective returns on equity), must depend on analyzing these factors.<br />
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And then sometimes there's a bubble in bond markets (we've been going through one of those for a while now!), and solid companies (ones where nobody's worrying about their going bankrupt) can sell bonds at ridiculously low interest rates (like MSFT's recent bonds that pay less than 1% interest!) -- when (for a company with no real risk of bankruptcy, and still <i>some</i> hope of future growth though quite possibly well beyond the "early tumultuous growth" phase of its life cycle) bonds pay much less yield in interest than stocks do in dividends, it's no doubt prudent and responsible for management to "take the near-free cash" by selling such bonds (as long as the resulting increase in the cash hoard <i>is</i> returned to shareholders in some way, or at least used <i>responsibly</i> to fund reasonably-profitable growth, rather than held entirely in sterile cash or squandered in wasteful acquisitions, perks, &c).<br />
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Of course, that parenthetical "as long as" condition can be quite a problem (and that's where agent-principal problems can emerge...), but, that's a discussion well worth its own post. The gist of this one is, rather, that whatever the theory (Modigliani and Miller's theorem) has to say about it, there are proper, prudent and profitable ranges of debt/equity ratio for a firm (depending on its industry sector, credit-market conditions and prospects, and other such considerations) and a prospective investor (or lender) would be well advised to take them into due consideration (carefully avoiding "gut" reactions about firms having "too much" debt, or "too much" cash -- either condition is quite possible, and occasionally even <b>both</b> are observed together!, but each such case must be weighed on its individual merits).<br />
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In future posts I plan to discuss acquisitions, and the issue of <i>how</i> (as well as <i>whether</i> and <i>how much</i>;-) to return "excess cash" to shareholders rather than hoard it (and/or use it to pay down some debt prematurely) -- dividends (regular and special) and stock repurchases. All of these issues are enmeshed with potential problems that can be couched in principal-agent terms (i.e., potential conflicts of interests and incentives between the firm's owners and its management), and indeed one could say that the <a href="http://en.wikipedia.org/wiki/Principal-agent_problem">agency dilemma</a> is at or near the core of each and every one of them...Alexhttp://www.blogger.com/profile/05338312873524129257noreply@blogger.com0tag:blogger.com,1999:blog-3587168801999471966.post-10680750475219287842010-11-14T19:36:00.000-08:002010-11-14T19:36:41.428-08:00Should you "be in cash"?Of <i>course</i> you should have some portion of your wealth in cash (or cash-equivalent, but make sure the "equivalence" <b>does</b> hold: many thought of the weekly-auctioned muni bonds as such, and the crisis showed them they were wrong...) as a buffer against emergencies (no-penalties CDs, and ones with very small pre-withdrawal penalties like 60 days' worth of interest, may be a good way to keep most of that buffer -- I've seen that these days the best such offers, esp. from online-only banks, surpass 1.5% APYs, which sure beats the tiny-fraction-of-a-percent you can get from treasury bills and the like; just make sure you're fully covered by FDIC insurance!). That's the part of your wealth, a small or big fraction as you may decide to make it, that's <b>not</b> "investable" (not with any safety and peace of mind, that is -- and those qualities are just priceless!-). That's not what I'm talking about -- nor is the obvious fact that repaying any high-interest debt you may owe is probably a better use of any money you can spare than just about any other "investment" (with the <i>possible</i> exception of a <i>good</i> low-cost 401k with generous employee-matching of your contributions).<br />
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No, I'm talking about the "investable" portion of your wealth -- whatever's left <i>after</i> repaying high-interest debts, if any, and keeping a "safety cushion" in cash sufficient to give you whatever amount of surety and peace of mind you prefer. Is there ever any case for keeping some fraction of your <i>investable</i> funds as <b>cash</b>?<br />
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A controversial topic, to be sure -- some are horrified at cash's low or even (in real terms) negative yields, other (typically with more experience) are adamant about "always having some dry powder" (readily investable cash) to take advantage of whatever weird opportunity batty-though-likeable Mr Market might be presenting them with next. And (what a contrarian would I be otherwise?-) I agree with <i>neither</i> extreme position.<br />
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Let's start with a Warren Buffett quote (you can never go wrong with those!-), one which doesn't mention cash but is actually very relevant to this issue...:<br />
<blockquote>The stock market is a no-called-strike game. You don't have to swing at everything--you can wait for your pitch. The problem when you're a money manager is that your fans keep yelling, 'Swing, you bum!'.</blockquote>"Not swinging" (because the right pitch, i.e., investment opportunity, hasn't come <i>yet</i>) means "staying in cash" (with that fraction of your funds) rather than using them for inferior investments that don't meet your own personal criteria for margin of safety, probability of success, and potential returns. "Keeping some dry powder" no matter what means <i>never</i> "swinging" (again: for that specific fraction of your funds) no matter how perfect for you the pitch is. Clearly, neither can be right: you should swing when the right pitch comes, but, not before!<br />
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At times in history when cash-equivalent holdings were (in real terms) devaluating in double digits (remember the '70s, anybody...?-), holding cash was a really serious ongoing cost... but, at times like this one, when the real rate for holding cash-equivalents is so close to zero, that doesn't really matter.<br />
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The only real cost of holding cash is the <i>opportunity</i> cost, which would occur if good investment opportunities occurred (with strong safety margins, probabilities of success, and expected returns) and were not taken. But that's balanced by the opportunity cost of <i>not</i> having investable cash, "dry powder", to take advantage of a good investment opportunity should one occur tomorrow -- the two considerations should just about balance each other out, removing any bias <i>against</i> "holding some dry powder" as well as any bias <i>towards</i> <b>always</b> holding some.<br />
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So, the decision should always depend on the case-by-case, bottom-up analysis of the actual pitches Mr Market is pitching at you all the time; if none are attractive enough to meet your criteria for margin of safety, probability of success, and profit potential, keep waiting (but don't keep waiting if and when the good pitches <i>do</i> come, just based on a fetish for always "holding some dry powder" -- if you never actually <b>invest</b> it, it's not really <b>investable</b> cash anyway, right?-).Alexhttp://www.blogger.com/profile/05338312873524129257noreply@blogger.com0tag:blogger.com,1999:blog-3587168801999471966.post-44080623070566195302010-11-13T21:51:00.000-08:002010-11-13T21:51:42.616-08:00Own, or own not: there is no 'hold'"!I realize "hold" -- an advice between "buy" and "sell" -- is a very old concept: "don't initiate a new position (or add to an existing one), but don't exit (or reduce) your current position, either, if you have one". However, except in a long-past world of very high commissions, it has never made sense to me!<br />
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Maybe it does to traders... I wouldn't know: I'm an investor, not a trader. Say I either already own a portion of P% a business, and I'm extended an offer of $X if I will sell that portion; OR, I don't already own any part of the business, but I'm extended an offer of $X if I want to buy such a portion (IOW, assume no commissions -- with various super-discount online brokers offering commissions in the very low single digits for stock trades, you might as well, if you're buying or selling any significant amount). Mr Market is making you such offers to either buy or sell all of the time, of course.<br />
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Surely, either offer makes sense for you to accept (if you do understand the business well enough to be in it <b>at all</b>, so you can give a reasonable estimate of whether the business as a whole is, or isn't, worth $X/P%, or some amount above it, or below it -- if you have no such understanding, then, of course, it's absurd for you to even consider being involved in owning that business at all!). So what is that "hold" business, where apparently <i>neither</i> offer is worth your consideration?! The business is not worth any <b>more</b> than $X/P%, either you'd accept the offer to <i>buy</i> it; but neither is it worth any <b>less</b> than that, or else you'd accept the offer to <i>sell</i> it. If the offer is "exactly at the money" and happens to match precisely the business's value, then I guess even a one-penny commission, or a cost of a penny for your time executing the transaction, would make both offers best rejected -- but surely such accidental perfect match is an incredibly rare coincidence, no?<br />
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It makes perfect sense for you not to want to <i>add</i> to your <i>existing</i> position because of differentiation considerations -- you may sensibly have boundaries on what % of your portfolio you're going to allocate to a specific stock, or sector, and accepting an offer to buy <i>more</i> might put you over (then, unless the bargain's absolutely irresistible and you may get your desired balance again by selling something else that's good but not <i>awesomely great</i> value, it's proper to regretfully reject). But such situations are very specific to an individual portfolio -- and that's <b>not</b> the context in which "hold" recommendations are most usually issued.<br />
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There may be tax issues, such as wanting to ensure a certain profit or loss is taken in a given tax year, or turning a capital gain into a long-term one -- but that's even more specific and out of the context in which "hold" assessments are pronounced by analysts and other Solons.<br />
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I think that "Hold" is just, at some level, an institutionalization of human defects like inertia (AKA laziness: it's microscopically less effort to not trade than to trade!-) and the "Endowment Effect" (what I already own magically becomes worth more just because <i>I</i> own it, which makes it special -- aka "Divestiture Aversion", and one of Thaler's key contributions to the field of behavioral economics). Except, of course, where "hold" is used as an euphemism for "sell, but I can't use the `Sell` word because then I, as an analyst, would be shunned and cut off by the management of this company which I need to keep covering because that's my <i>job</i>"!-)<br />
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I was happy to finally hear somebody agreeing with me, after all these years -- specifically, <i>very</i> happy because he "somebody" is the manager of a fixed-fee advisory hedge-fund-like service I've just joined, "Motley Fool Alpha". The way he put it was "if a position is worth being held, it's worth being initiated anew. To think/act otherwise, is slightly irrational" -- <b>hear, hear</b>!<br />
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If Yoda was an investor, he'd no doubt put it something like I used for this post's subject...: "Own, or own not: there is no 'hold'"!-)Alexhttp://www.blogger.com/profile/05338312873524129257noreply@blogger.com2tag:blogger.com,1999:blog-3587168801999471966.post-68575328422733193192010-11-13T12:28:00.000-08:002010-11-13T12:28:38.804-08:00the "cult of growth" and why it's all wrongO'Shaughessy's <a href="http://www.amazon.com/Predicting-Markets-Tomorrow-Contrarian-Investment/dp/1591841089/ref=sr_1_1_oe_1?s=books&ie=UTF8&qid=1289678604&sr=1-1">book</a> "Predicting the Markets of Tomorrow : A Contrarian Investment Strategy for the Next Twenty Years" is "on fire sale pricing" at Amazon -- the specific offer I pointed to is at $3.99 (with the advantage of fast free shipping if you're on Amazon Prime), others are as low as $2.53 (plus shipping, though). Anyway, for anywhere around that price, it's definitely worth getting!<br />
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The author's a guru in top-down, long-term strategies based on picking large-ish numbers of stocks based on capitalization, style (growth vs value), sector, &c; he claims that the last 20 years (1986-2006) have been historically "incredibly good" for large-cap growth stocks, and that markets revert to the mean so value stocks and small caps are much better choices for the <i>next</i> 20 years (he's got centuries of data to back up his contentions, too).<br />
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Of course, investors tend to think that the <i>last</i> 20 years "define" what's "normal, expected" behavior -- like the proverbial generals, always preparing to win the <b>last</b> war, most investors pick strategies that might have served them well had they been in place for the last 20 years... and are going to be woefully disappointed by applying them from here on. Whatever's least loved and appreciated now (because it underperformed recently) is going to be underpriced (exactly because unloved) and thus outperform going forwards -- that's the root of the "contrarian" in the book's title.<br />
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But but but... don't we all know that growth is <b>the</b> key determinant of a stock's value (through the computation of the latter as present value of the stream of all future earnings)? Nope -- that's a widespread fallacy. Growth may create value, but it may just as well (perhaps more often) <i>destroy</i> value -- because the pursuit of growth does not generally come for free, but rather costs capital, sacrifice on margins, and the like.<br />
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The best book I know to show this in analytical, accounting-popularization detail is Bruce Greenwald's recent but truly immortal classic <a href="http://www.amazon.com/Value-Investing-Graham-Buffett-Finance/dp/0471463396/ref=sr_1_1?s=books&ie=UTF8&qid=1289679381&sr=1-1">"Value Investing: From Graham to Buffett and Beyond"</a> -- really an incredibly good book (and far from costly!-) which I strongly recommend to every reader for many reasons, but what's really unique about it is exactly its cold-headed, precise analysis of growth and how much, exactly, is it worth to me as an investor.<br />
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You really have to read the book for all details and persuasive, worked-out examples, but, let me try to summarize. Growth can be indifferent, positive, or <b>destructive</b> of value -- it all depends on whether a company his growing "within its franchise" (with competitive barriers to competitors), in which case growth can indeed be good for the stockholder (but the amount of growth of this kind that is at all possible is delimited by the franchise's boundaries!); on a level playing field (no competitive barriers), in which case growth can at best be indifferent (negative whenever an acquirer overpays for an acquisition, negative whenever there's the slightest execution defect, ...); or against competitive barriers (against a strong and awake entrenched competitor), in which case growth destroys value for the stockholder (since the cost of capital to pay for and maintain that growth is higher than the growth's returns).<br />
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For the <b>management</b> of a company, growth is always great, as it enhances their power, builds up their little empires, increases their compensation (esp. the value of their generously awarded stock options): for the <b>owners</b> of a company, though (and that's the way you should think of yourself if you want to be a real investor, not "a trader"!-), one needs to be much more critical and selective about, which <i>kind</i> of growth you're buying! You can frame this as typical "agency problem": what's best for the agents (management) isn't necessarily so for the principals (stockholders).<br />
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Growth has its place -- both organically, i.e. "within the franchise", and by acquisition, should it ever happen that the acquirer doesn't wildly overpay for the acquiree (has that <i>ever</i> happened in the history of the world?!-) -- but nowhere as much as currently popular valuation mythology posits. (The "discounted stream of future payments" valuation model, no matter how neat and indisputable it may appear on its face, has this misconception to mark among its many other problems... but I guess that's a topic for another, future post!-).Alexhttp://www.blogger.com/profile/05338312873524129257noreply@blogger.com0tag:blogger.com,1999:blog-3587168801999471966.post-52272201785974825242010-11-08T20:41:00.000-08:002010-11-08T20:41:38.241-08:00online discount brokers, part 6: OptionsHouseSo as I mentioned a few times in the previous parts of this series, among the online discount brokers I checked out thoroughly was <a href="http://www.optionshouse.com/">OptionsHouse</a> -- and I'm leaving them for last because (spoiler...!-) they're the one I ended up with.<br />
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Their user interface, while nowhere as complex as Interactive Brokers', is definitely not as slick and neat-looking as Zecco -- and, alas, it's all clunky old Java, not spiffy new Web 2.0 - ish Javascript, HTML, and CSS... no use of multiple browser tabs the way a pure Web solution offers -- a session is one separate browser window with "simulated" pop-ups on it.<br />
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The harshest criticism I could offer of OH is that their UI looks a lot like what it might if <b>I</b> had designed it: full functionality, working pretty solidly (except that occasionally a pixel or two at the borders may go missing...), but pretty "bleah" looks, and especially a surfeit of information that can feel overwhelming at times (besides mediocre graphical aesthetics, that's part of why I've never been and never will be a good UI designer: no intuition for what information the user might want at a certain time and an "when in doubt, show more large tables of numbers" attitude;-). Alas, I don't even <i>like</i> using interfaces I designed <b>myself</b>, even less ones designed by <i>others</i> in the same engineery, un-designy spirit!-). [[On the plus side, I'm now going to be part of a beta test phase for a new generation of interface intended to be more customizable and usable]].<br />
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Other minor criticisms I can extend to OH include the peculiar limitations of their separate "tools" -- the profit analysis one seems to only deal with simple options (the ones you <i>don't</i> need a tool to help check, in other words -- none of the fancy combinations!-), the ones for exploring put spreads and call spreads only deal with a very small set of ETF rather than arbitrary optionable stocks, &c. (I can do such analysis myself on a spreadsheet or the like of course, but why bother to offer tools that look like they might be useful and then hobble them like that...?-).<br />
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I personally don't miss the social networking approach that Zecco focuses on so much, because I do my investment-related social networking on fool.com (including paid services -- actually, after years as a satisfied customer of various Motley Fool paid services, I've just upgraded to the Motley Fool's "all you can eat" "Duke Street" premium offer which gives me access to <i>every</i> service on the site); but I know that my wife Anna does miss it (as well as the Twitter support offered by Zecco but not OH).<br />
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But -- this is just about <b>all</b> that I can criticize about OptionsHouse after trying them pretty intensively recently. Their sign-up forms and procedures are, overall, the simplest, and their customer service the <b>most</b> courteous and efficient, that I had <i>ever</i> yet met in a lifetime of having to deal with brokers, banks, &c; the site's functionality, while (as mentioned above) not attractively presented, I've found complete and quite satisfactory; their training materials (webinars &c) quite useful.<br />
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I like their commissions (it would be nice if it was easier and faster to switch between the two rates of options commissions, the one that's optimal up to 10 contracts and the one that's optimal for 10 contracts and up [[they both end up as $10 commission for trading exactly 10 contracts!-)]], or even better if the two were merged into one with a seamless switchover at the 10-contracts point... but, I so rarely trade more than 10 contracts at a time, that it doesn't really matter much to me!) -- maybe not <i>quite</i> as low as Interactive Brokers' in many cases, but lower than Zecco's, Merrill Edge's, and just about anybody else (I did spot a few offerings that came in even lower, but <a href="http://www.brokerage-review.com/">http://www.brokerage-review.com/</a>'s cover of those definitely doesn't make them attractive -- none get the 5 stars there that OptionsHouse, Zecco, and a few costlier brokers, do!).<br />
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And, OH's commissions are very simple to figure out (the reverse of IB's, where you may have to worry e.g. about orders that add liquidity versus ones that drain it (???), and even simpler than Zecco's and Merrill Edge's "X free stocks trades per month <i>if</i> you meet a set of conditions, otherwise Y but Z if T unless U..."...;-). Stocks at $2.95; options (on the cheap-up-to-10 schedule) at $5 (plus $1 per contract over five). That's all, and it really <b>is</b> refreshing (OK, there's a "first 100 trades free" special offer to further sweeten the pot for newcomers, but if you trade very actively you know from the start that said quota won't last you all that long -- it's just a nice little extra bonus for newcomers, as are the alternatives of getting reimbursed for wire or ACAT fees, or getting a free year of the Wall Street Journal... I picked the "100 free trades" special offer over the others, simply because, at $295 in savings, it's worth more than the alternatives;-).<br />
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Now that one of the new Motley Fool paid services I've just subscribed to ("MF Alpha") focuses on a balanced long-short portfolio (kind of like a hedge fund, but you do your own trading and there's no 2-and-20 nonsense, just a fixed yearly fee whatever size portfolio you're trading!-), I was worrying about OH's ability to find stocks to borrow for a short sale -- I had never done shorting before (even though I know all about the theory, and how long-short mixes are supposed to statistically outperform!), and the discussion boards for MF Alpha and MF Big Short are full of stories of people having trouble borrowing shares from shorting, from such big-name brokerages as, say, ETrade (MF Alpha recommends IB because of that -- plus, I suspect, the fact that the people doing the recommendation <i>are</i> professional, full-time investors and traders!-).<br />
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So I checked this out with a few example short sales (drawn from MF Big Short's recommendations) -- specifically a couple of firms that others had had trouble shorting recently on other brokers -- and I'm much less worried now, since everything went as smoothly, seamlessly, and trouble-free as it possibly could. (Looking forward to actively shorting for the first time in my investing life, actually!-).<br />
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So anyway, I'll be sure to let you all now if there are any further developments -- for now, I feel really satisfied about OptionsHouse (and if you don't hear anything for me for a while you can take it as meaning that the satisfaction level remained constant!-).Alexhttp://www.blogger.com/profile/05338312873524129257noreply@blogger.com0tag:blogger.com,1999:blog-3587168801999471966.post-88511051051578952102010-11-07T21:03:00.000-08:002010-11-07T22:10:40.631-08:00online discount brokers, part 5: ZeccoOn reading reviews such as <a href="http://www.brokerage-review.com/stock-broker-reviews/zecco-review.aspx">this one</a> and <a href="http://www.brokerage-review.com/compare/zecco-vs-optionshouse-review.aspx">this comparison</a>, and looking how spiffy <a href="http://zecco.com/">zecco.com</a> is as a site with very Web 2.0-ish features and supporting apps like ZapTrade, I was pretty happy to try out Zecco -- my wife Anna, in particular, really looked forwards to the social networking features of the site, Twitter &c. Opening a joint account was fast and easy, though strangely the sequence only had a way to indicate <b>one</b> userid for the joint account -- what part of "joint" don't they understand...?! Ah well, we proceeded anyway, and figured out that customer support would be able to link both of our userids to the account later, as we immediately proceeded to request.<br />
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Wrong, and an <i>incredible</i> design bug in their software architecture: they offer <b>no</b> way to have more than one userid on one account, even if that account is a "joint" one. So the part of "joint" they don't understand is: 100% -- they are absolutely, incredibly, totally, infinitely clueless about what a <b>joint</b> account is all about. Especially with their social networking features, Anna having to log in as me, or vice versa, in order to access our <b>joint</b> account, is obviously unacceptable. Suddenly I started having huge doubts about putting any of my money in the hands of people so incredibly clueless about application architecture -- what <i>else</i> had they "oops, forgotten" (or mis-designed) that we'd only find out about later, at some painful and unfortunate moment...?<br />
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I can't believe this mis-feature hasn't raised a hue and cry among the users and would-be users of Zecco yet -- hey, even flipping <i>Merrill Lynch</i> (hardly the top technology dog in the online brokerage arena;-) obviously offers the clearly mandatory feature of having two userids co-owning a joint account! I guess most Zecco users must be using individual accounts, not joint ones (or else they're joint just in name, and one spouse actually does all the trading -- but that's <b>not</b> how Anna and I work, thanks be!).<br />
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We pushed ahead anyway, figuring the other advantages could maybe make us deal with this one for a while, while we lobbied to have this absurd restriction removed.<br />
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Disappointment number 2 was, no foreign exchanges allowed, only American ones. I guess I must have misread some review or other, because I was under the mis-apprehension that they did support trading on non-US exchanges. Ah well, guess that's a rare feature for US brokers, and you really need to go with Interactive Brokers (and brave their fearful complexity) if you're keen to do some foreign trading (which for a permanent-resident alien like me isn't really that "foreign" -- e.g., I might have liked to try getting some of Enel Green's IPO stock at the Milan bourse... Milan doesn't really sound "foreign" to an Italian citizen, even though he may be currently residing in the US;-). Guess I shouldn't really charge this one against Zecco in particular, but it did disappoint me at the time (no doubt because of my misreading from a review somewhere that they did support foreign trading).<br />
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Disappointment number 3, and the killer, came the first time we tried to trade options -- and found out that, despite filling all the required fields in the initial application (including trading experience, total income and wealth, the fact that we've read the mandatory brochure on options, &c) and being under the strong impression that we therefore <b>were</b> approved for options trading... we were not! To get approved for options you need to fill out a paper form, fax it in, and wait -- standard operating procedure for most brokers (and not as bad as ones like Merrill or Vanguard that require snailmail and plenty of phone calls for the purpose), but their initial signup procedure (the one that was so slick, fast and inviting) was definitely misleading in the matter.<br />
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Moreover, and worse, to get approved for the "highest levels" of options trading, you need hefty account minimums, like $150,000 for some and $250,000 for others, or the like -- so we couldn't even <b>try</b> option trading on Zecco before <i>fully</i> funding the account with the highest amounts we ever planned to move there. Worse still, like most brokers, they seem totally convinced that selling cash-secured puts is a very risky, very high-level kind of option trade -- while everybody knows, or should, that it's mathematically equivalent to selling covered calls (which they, and most other brokers, consider the safest kind of option trade). See Ken Fisher's Debunkery book, point 13, about this idiocy (though Ken wrongly says that it's the options <i>fans</i> that don't get the mathematical equivalence, when it's really the brokers such as Merrill and Zecco!-).<br />
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At this point, we were already fully options-approved on OptionsHouse (which we had started at the same time as Zecco -- but OH's signup process, while a tad less fast and slick, had made it perfectly clear from the start what all you needed to get options trading approval at the various levels, so we had faxed the needed forms and docs right from the start and they had processed them expeditiously -- plus, OH had no weirdly high account minima to get approved for, e.g., cash-covered put writing). Plus, this was the third disappointment, and I'm told that (in the US, and especially in California where it's actually a state law;-), "three strikes, you're out".<br />
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So we decided to transfer the balance back to our bank account... and were aghast to see the transferable balance marked as $0 (two-plus weeks after we had originally funded the account, and well after Zecco had let us trade stocks based on that very substantial balance). We immediately contacted customer service and got some mild handwaving about some bug in their system, and how we'd need to get in touch with them on the phone to get our money back (!) -- by this time, this was starting to smell strongly like a mini-sized Madoff case to me... what broker or bank has ever essentially refused to transfer out cash that's available in your balance, except a fraudulent one?!<br />
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Of course, the times during which you can actually talk to human beings about your account are always incredibly inconvenient for people who work (almost independent of who's your broker or bank), especially when it's a joint account so both husband and wife need to be on the call, and they work at pretty separate places during the working day -- not to mention the huge delays always involved (again, not Zecco-specific, they're <b>all</b> terrible -- Merrill probably the worst, as in slowest, in our recent experience). That's a good part of why requiring phone calls (rather than online transactions) is idiotic and hateful (Vanguard is even worse at this than Zecco).<br />
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Fortunately the next morning when I tried the transfer again it <i>did</i> go through -- so apparently the customer service person was <b>not</b> lying about there being a bug in their system: looks like there was indeed a horrible, gaping bug making it impossible at random times to get your money out. If we hadn't already decided to go away, this experience on its own would have been way plenty to convince us to: I just can't work with a bank or broker whose systems, while spiffy-looking, are so incredibly buggy as to stop me from getting my money at times, depending on the systems' whims, and I just can't believe that anybody else could possibly choose to do so, if they realized this possibility.<br />
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Maybe one day they'll fix this bug, and at least some many others they have (for example, they say they're entirely reworking their options trading platform, which apparently has many problems today -- I wouldn't know, since as I mention I <i>wasn't</i> allowed to trade options there, but I imagine that if even they admit it needs to be redone from scratch, it must be pretty lousy indeed... and they've been open <i>how long</i>, only deciding to finally fix their options trading platform by 2011?! jeez...).<br />
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But I most certainly will not be waiting around for such a time, just as I am not waiting for Merrill to get their act together and at least get me back to the level of service I got back when I did my trading directly on Bank of America (which booted me out, forcing me onto the MerrillEdge platform as they shut their own, in the summer of 2010) -- rather, I want to take my business to competitors who <b>do</b> have their act a little bit more together.<br />
<br />
Fortunately, at the same time as Zecco, I was trying OptionsHouse -- and, while perfection is not of this world, I found myself much better there, as I'll tell about in my next post in this series (where I'll also mention what details on OH I found to be not perfect, and what prospects are there to see them improve soon), so that's going to be my main broker going forward (right now I'm gradually liquidating positions on Merrill and moving cash to OH -- generally much easier and faster than transferring an account as a whole; fortunately I'm not adverse to take my capital gains right now, before taxes perhaps go up on Jan 1 unless Congress manages to get its act together to avoid that, though for the same tax reason I'd rather take most of the capital losses next year instead -- that will slow things down a bit, but fortunately I have many more capital gains than losses so most of the account will be moving this year).<br />
<br />
Meanwhile, if you're looking for an online discount broker, I recommend the <a href="http://www.brokerage-review.com/">http://www.brokerage-review.com/</a> site -- I don't agree with all their reviews (e.g., they give five stars to Zecco, as well as OptionsHouse, Scottrade, TradeMonster, OptionsXpress, TradeKing, QuesTrade -- like a rating agency slapping AAA's on every mortgage-backed derivative, a review site granting the highest stars to seven different brokers is clearly not as selective, and thus not quite as useful, as it could be;-), but they do give many details and mostly well-considered opinions. I do find t<a href="http://www.brokerage-review.com/stock-broker-reviews/optionshouse-review.aspx">heir OptionsHouse review</a> to be mostly on-target, though;-).Alexhttp://www.blogger.com/profile/05338312873524129257noreply@blogger.com0tag:blogger.com,1999:blog-3587168801999471966.post-50911742593930189402010-11-06T21:53:00.000-07:002010-11-07T22:10:40.633-08:00online discount brokers, part 4: Interactive BrokersIf you're a trading professional, I'm sure you've already heard of <a href="http://www.interactivebrokers.com/en/main.php">Interactive Brokers</a> -- no other brokerage service I've ever heard about comes even close to matching them for depth and breadth of offerings (including, in particular, powerful Application Programming Interfaces -- APIs -- to let you design and implement your own interactive or automated trading platforms -- if, of course, you can afford to hire a few good Java or C++ programmers, otherwise, don't bother:-).<br />
<br />
As a kind of a "side line", they <i>also</i> support individual investors... though most of the time it kind of feels like a "second thought" (it probably was, come to think of it) glued on top of their main business model of serving extremely sophisticated professional needs with a dazzling variety of possibilities and the most complicated (even though probably the cheapest in most cases) array of pricing models I've ever heard of in my life.<br />
<br />
I have to admit -- in the end, they intimidated me; just picking and choosing the specific set of options that I wanted to buy (including for example various kinds and levels of more or less real-time information on their site, each priced in complex ways...: <b>nothing</b> is really simple and bundled in their worldview!-) scared me off, not to mention the lurking issue of "how will I figure out how much I'll be paying in commission each time I trade -- am I enhancing or depleting liquidity, does that matter to pricing depending on what exchange or set of exchanges I'm trading on, etc, etc...?".<br />
<br />
I may have missed out on a good thing -- maybe. I've just joined <a href="http://www.fool.com/">Motley Fool</a>'s new "Alpha" service (I've long been a happy customer of some subsets of the Fool's services, and this one eventually convinced me -- a hedge-fund-like long-short real-money portfolio service, open for a very limited time to a small set of high-net-worth [[but perhaps not qualifying for an actual hedge fund]] investors, but with a fixed yearly fee [[no 2-and-20 nonsense there!-)]] and complete disclosure of the trades and their rationale, for you to replicate yourself in your own portfolio -- worlds apart from the typical hedge-fund advisors that just want you to blindly trust them with investing your own hard-earned, hard-saved cash!-)... and now I wonder if I should have signed up with IB.<br />
<br />
You see, though decades of experience as an investor, I had actually never placed one short sale in my life -- before today (Saturday), when I tried one on my currently favorite online discount broker, just so I can check come Monday morning if it's triggered properly. But MF Alpha is a long-short portfolio -- a big part of its attraction, of course. I'm quite familiar with all the theoretical results (and practical confirmations) about how long-short strategies can outperform "pure" ones in both good markets and bad ones, as well as with every detail of how short sales are actually handled, margin requirements, and so forth... I'd just never actually put any of this theory into practice (hey, my family kept taunting me for years because, as a kid, before actually trying to <i>make</i> paper planes, I bought and studied a book about their practical and aerodynamical issues...!-).<br />
<br />
So, MF Alpha strongly recommends Interactive Brokers -- not just because of their dirt-cheap commissions and margin interest (my currently favorite broker is almost as good in these respects, as well as really much simpler!-), but specifically because IB appears to excel over all other brokers in actually getting hold of (a loan of) the stocks you're selling short, while even well-known names such as ETrade have had problems with this crucial issue in the past. Alas, not having ever been a short seller before, that is one issue I never thought to check...! (And when I was choosing my new broker, I had no idea yet that I'd be doing some short-selling so soon!-).<br />
<br />
Ah well, let's hope I've been lucky this time. But, if you can deal with the complexity that scared me off, and are really keen on substantial short-selling (or trading on all sorts of weird international exchanges, something Interactive Broker is the only cheap service to offer, that I know of), do give them a try (and let me know how well it's working, though I'm sure plenty of my MF Alpha co-members, currently busy opening their IB accounts, also won't fail to enlighten me;-).<br />
<br />
But I, for once (as I should be more often), was humble, and in the end the choice for me boiled down to two simple, good, cheap online discount brokers: Zecco and OptionsHouse. More about them (and how things ended up for me) in my next couple of posts!Alexhttp://www.blogger.com/profile/05338312873524129257noreply@blogger.com0tag:blogger.com,1999:blog-3587168801999471966.post-77260883897384308352010-11-05T23:22:00.000-07:002010-11-07T22:10:40.635-08:00online discount brokers, part 3: conservative option plays and the importance of cheap commissionsMany risk-takers love options and the huge leverage they can give their gambling -- but a growing number of prudent, conservative investors are acquiring a growing taste for the extra income they can give their conservative portfolio, and I count myself among the latter. Thomsett's classic <a href="http://www.amazon.com/Options-Trading-Conservative-Investor-Increasing/dp/0137042000/ref=sr_1_1?ie=UTF8&s=books&qid=1289020286&sr=1-1"><span class="Apple-style-span" style="font-family: inherit;">"</span></a><a href="http://www.amazon.com/Options-Trading-Conservative-Investor-Increasing/dp/0137042000/ref=sr_1_1?ie=UTF8&s=books&qid=1289020286&sr=1-1"><span class="Apple-style-span" style="font-family: inherit;">Options Trading for the Conservative Investor: Increasing Profits Without Increasing Your Risk"</span></a><span class="Apple-style-span" style="font-family: inherit;">, and simpler, breezier books such as Kadavy's </span><a href="http://www.amazon.com/Covered-Call-Writing-Demystified-Double-Digit/dp/0971551405/ref=sr_1_4?ie=UTF8&s=books&qid=1289020424&sr=1-4"><span class="Apple-style-span" style="font-family: inherit;">"Covered Call Writing Demystified"</span></a><span class="Apple-style-span" style="font-family: inherit;"> (the latter comes, when you email requesting them, with some useful spreadsheet that I had no trouble loading into Google Spreadsheets and customizing to my preferences), blaze the way, as do websites such as </span><a href="http://www.safe-options-trading-income.com/"><span class="Apple-style-span" style="font-family: inherit;">this one</span></a><span class="Apple-style-span" style="font-family: inherit;">.</span><br />
<div><span class="Apple-style-span" style="font-family: inherit;"><br />
</span> </div><div><span class="Apple-style-span" style="font-family: inherit;">BTW, Ken Fisher's new and overall worthwhile book </span><a href="http://www.amazon.com/Debunkery--Seeing-Through-Streets-Money-Killing/dp/0470285354/ref=sr_1_1?ie=UTF8&qid=1289020914&sr=8-1"><span class="Apple-style-span" style="font-family: inherit;">Debunkery</span></a><span class="Apple-style-span" style="font-family: inherit;"> "debunks", in its point 13, the myth that selling naked puts is any riskier than selling covered calls -- though he omits to mention that for that purpose it's crucial to have your put entirely cash-secured [no margin!!!], and strangely seems to think the mathematical equivalence means that selling covered calls is risky, while obviously the reality is that selling naked, cash-secured puts is just as secure and conservative, </span><b><span class="Apple-style-span" style="font-family: inherit;">and</span></b><span class="Apple-style-span" style="font-family: inherit;"> that the people needing to hear about this are conservative-investing options buffs (which is silly, since popular books by and for such readers, such as Groenke's <a href="http://www.blogger.com/goog_1348994522">"</a></span><span class="Apple-style-span" style="font-family: inherit;"><a href="http://www.amazon.com/Show-Me-Money-Covered-Monthly/dp/1934002089/ref=sr_1_1?s=books&ie=UTF8&qid=1289021169&sr=1-1">Show Me the Money: Covered Calls & Naked Puts for a Monthly Cash Income"</a>, show the equivalence quite as clearly and describe it in more detail) -- obviously those who need to hear it said and repeated are the regulators and the majority of brokers that make it <b>so</b> much harder for the investor to qualify to sell cash-secured puts, as to sell covered calls (requiring more experience, a margin account, higher minimum account sizes and/or income and wealth, or any other such silly differentiation between two mathematically identical strategies!!!)</span><br />
<span class="Apple-style-span" style="font-family: inherit;"><br />
</span><br />
<span class="Apple-style-span" style="font-family: inherit;">Anyway, buying a call is like buying a lottery ticket: limited risk (just the ticket's price or the call's premium), potentially huge upside (the jackpot lottery prize, a sudden hockey-stick in an underlying price that owning the call option lets you get for a pittance)... and yet <b>not</b> a sensible choice for an investor, because the probability of winning the big jackpot is just too low, so the expected value of the purchase is definitely negative. But consider that (net of commissions, and we'll come back to that key point!-) the trading of options is a zero sum game: if it's negative for the buyer, it must be positive for the seller. The seller of lottery tickets will once in a while be giving up a huge upside (when he sells the rare ticket that happens to be fated to win the jackpot -- he <i>could</i> have kept it for himself and cashed the jackpot...!-)) -- but gets a steady, modest, secure stream of income through his selling, nevertheless. That, roughly speaking, is what you can get by selling covered calls (or cash-secured puts, but despite the mathematical equivalence I've noticed that selling calls is a bit more lucrative than selling puts: maybe there are more gamblers wanting to buy calls, than ones wanting to buy puts, and option prices after all are set by demand and supply -- the underlying math matters, but doesn't entirely determine the prices in the market).</span><br />
<span class="Apple-style-span" style="font-family: inherit;"><br />
</span><br />
<span class="Apple-style-span" style="font-family: inherit;">But let's get back to that "net of commissions" provision, which is <i>very</i> important. In the previous post I've noticed that for a moderatively active investor/trader on stocks, like me, MerrillEdge's 30 free stock trades a month end up meaning basically free trading (say $50/year for a few trades exceeding the monthly limit out of 200 total yearly ones) while (e.g.) Schwab's commissions could cost me about $2000/year (Fidelity's a tad less, Ameritrade's a tad more, but, same ballpark).</span><br />
<span class="Apple-style-span" style="font-family: inherit;"><br />
</span><br />
<span class="Apple-style-span" style="font-family: inherit;">But now consider that out of (e.g.) the 30 stocks I own, every month I may want to sell calls on about 20 (I'll use another future post to explain why you don't want to sell calls on every stock every month, and why selling monthly options is best -- at least if your commission's low enough), say typically for about 6 contracts (600 shares) each, with a typical expected profit of (again, typical numbers) $200 for the premium and another $400 if exercised (out of the typically 240 calls [out of the money!] that I sell every year, experience tells me that only somewhere between 20 and 30 will be exercised in a typical market -- fewer in serious bear markets, more in crazy bull markets -- call it 25!-); so, expected revenue around 240 * $200 + 25 * $400 = 58,000/year, about 12% of the portfolio's overall value (and _that_ 12% yield is why I'm so keen to sell covered calls!-), <i>gross of commissions</i> (and taxes).</span><br />
<span class="Apple-style-span" style="font-family: inherit;"><br />
</span><br />
<span class="Apple-style-span" style="font-family: inherit;">But -- what about the commissions...? With MerrillEdge's 4.95+0.75/contract (and $4.95 on exercise), they would be: 240 * (4.95 + 0.75 * 6) + 25 * 4.95 = $2391 -- call it 2400 (we're using round numbers anyway!-), reducing profit to 55,600 before taxes. With Schwab's </span><span class="Apple-style-span" style="color: #222222; line-height: 25px;"><span class="Apple-style-span" style="font-family: inherit;">$8.95 + 0.75/contract (as an example, since it's smack in the middle between cheaper Fidelity and costlier OptionsXpress), and $8.95 on exercise, we'd have </span></span>240 * (8.95 + 0.75 * 6) + 25 * 8.95 = $3451, almost 50% higher cost than MerrillEdge's, reducing pre-tax profig to 54,550. I know, no world-changing difference, but, high enough to smell bad to this skinflint!-)<br />
<br />
Whence, the quest for cheap commissions becoming especially important for options trading (and very very frequent trading even just of stocks, of course, but that's not really my case). I'll reveal what broker I ended up choosing a couple posts from now, but, as a foreshadow -- its commissions are $2.95 for stock trades, and $5 for up to 5 contracts (plus $1/contract over five -- there's another possible commissions schedule you can opt into, changing only before the start of the trading day, if you usually trade more than 10 contracts at a time). So in this case we'd have 240 * 6 + 25 * 2.95 -- $1513, a full third <i>less</i> than MerrillEdge, and that kind of saving really gladdens my heart!-)<br />
<br />
The online discount broker I tried next after MerrillEdge, Zecco, has commissions of $4.50 for stock trading, $4.50 + 0.50/contract for options [Merrill gives qualifying customers 30 free stock trades/month, Zecco 10, but in each case I'm assuming the free trades, just like the "first 100 trades free" &c offers of other brokers, are exhausted on trading actual stocks, before options trading and exercise is considered], so the cost would be 240 * (4.50 + 0.50 * 6) + 25 * 4.50 = $1912, only 15% more than the one I ended up with and a good 20% less than MerrillEdge -- so that wouldn't have been so bad, price-wise, it's for other reasons that I found myself really unsatisfied with them... but, I'll go into that in the <i>next</i> post.<br />
<br />
</div>Alexhttp://www.blogger.com/profile/05338312873524129257noreply@blogger.com1tag:blogger.com,1999:blog-3587168801999471966.post-38198970595702095302010-11-05T20:17:00.000-07:002010-11-07T22:17:46.423-08:00online discount brokers, part 2: costlier ones, and why I eschew themI barely looked at anything that would raise my cost of trading substantially above what I get from MerrillEdge (at what they call "Superior" status, which just means I have a good total for the amounts in Merrill and BoA accounts and/or do many trades): commissions of $4.95 to trade stocks or ETFs (with the first 30 trades each calendar month for free), $4.95 plus $0.75 per contract to trade options.<br />
<div><br />
</div><div>I'm a skinflint -- I don't like paying money unless I feel I'm getting full value for what I'm paying, and (ideally;-) then some. So, rates such as Fidelity's (stocks $7.95, options $7.95 + 0.75/contract), Schwab's (stocks $8.95, options $8.95 + 0.75/contract), AmeriTrade's (stocks $9.99, options $9.99 + 0.75/contract), OptionsXpress's (stocks $9.95 up to 1000 shares, a cent per share if more than 1000; options $1.25/contract with a $12.95 minimum, higher unless you're an "active trader" doing at least 35 option trades/quarter), and so on up, turned me right off those popular choices.</div><div><br />
</div><div>Some investors of an ilk quite similar to mine (prudent, conservative, fundamentals-focused) may not care -- they do very few stock trades, and never options. But me, I like for example to "scale into" a position -- buy some stock in a good company that I've decided is substantially undervalued, but not my full intended position at once; buy more if Mr Market gets even more wrongly (I hope;-) pessimistic; and so on down (possibly "filling up" on dips to the full position I always hoped to hold) -- so it may easily take me several smaller trades to build up to a position that could conceivably have been acquired at once (but dearer;-). (Sometimes, but for some psychological reason less often, I do the reverse when a stock becomes fully-valued-and-then-some so that I want to sell it).</div><div><br />
</div><div>Plus, I like differentiation -- sometimes, I guess, I overdo it a bit (say, 50 positions -- no Peter Lynch's portfolio, but a tad too broad for my stock portfolio size, which even for a keen differentiator should be fine at even half that many) -- so the number of trades to build my full portfolio is similarly multiplied.</div><div><br />
</div><div>Then there are little tricks, such as...: say that, researching some particularly interesting idea, I end up deciding that there are, not one, but two or three good companies more or less in that niche, all a bit undervalued by the market. Then, I might buy a "seed position" in each (for a total amount that's, say, about half of the final position I mean to have in that specific play); then follow carefully the market's behavior with respect to the individual companies (as well, of course, as the companies' fundamentals!) and play it by ear.</div><div><br />
</div><div>Say for example that the two companies' (A's and B's) fundamentals are and remain equivalent (for the prospects in the time frame I care most about, say the 3-5 years range typically), but Mr Market in its unending manias raises A's stock 5% (putting it that much closer to a fair valuation) while sinking B's by another 5% -- then I can sell off A, double my stake in B, and end up with a fully position in B (and out of A) substantially cheaper than I would via the "buy the full stake outright" approach. (If Mr Market did exactly the reverse, for whatever passes for "reasons" for his behavior, I'd be just as happy owning A instead -- I'm a skinflint, after all, so I focus on getting a low cost basis!-).</div><div><br />
</div><div>All of this means that doing (say) 20 or 30 stock trades in a month is not at all strange for me, and some months I even go a bit over 30. So, just for the stock, what I get more or less free at Merrill (OK, call it $50 for a few trades exceeding the 30/month quota) would cost me, say, $2000 a year at Schwab -- sorry, but for skinflint me that just doesn't feel good... why toss away every year the price of two superb laptops like Apple's new 11" Air (my wife Anna just got one -- I got the 13" version, but hers is cuter, smaller and lighter, as well as cheaper!-)? What am I getting in return for such a splurge, again?</div><div><br />
</div><div>My penchant for safe, conservative options plays makes this kind of consideration even more important -- but I guess that's better left for another, later post.</div><div><br />
</div>Alexhttp://www.blogger.com/profile/05338312873524129257noreply@blogger.com0tag:blogger.com,1999:blog-3587168801999471966.post-68552100433359447772010-11-04T21:20:00.000-07:002010-11-07T22:28:08.474-08:00online discount brokers, part 1: why I had to start lookingOn this latest spell of my life as a US resident, I started out with Bank of America's "self-directed trading" service -- nothing fancy, but usable, and I did love the 30 free stock trades per month (given that my account size met their threshold).<br />
<div><br />
</div><div>Alas -- this summer they automatically switched my account over to "Merrill Edge", the "Wealth Management Platform" (ha!) they got from their acquisition of Merrill Lynch.</div><div><br />
</div><div>Among many minor inconveniences, I found out I couldn't trade options any more -- had to apply all over again. I did, and found out I was only allowed to sell covered calls -- no options buying any more, no selling cash-secured puts any more (!).</div><div><br />
</div><div>Selling covered calls is my main use of options (since I'm a pretty conservative investor!), but I missed the ability for occasional buying of some puts or calls to temporarily hedge a position, and the somewhat more frequent use of cash-secured puts as an alternative to a buy limit order to perhaps purchase a stock if it goes down enough.</div><div><br />
</div><div>I nevertheless endured, kinda golden-chained by the free stock trades I guess (I'm a <b>real</b> penny-pincher!-), until Merrill mysteriously locked me out of my online accounts for weeks, on varying claims about "funds due" (when I had plenty of cash in the account!) or "sale-not-long" (whatever exactly they mean by that).</div><div><br />
</div><div>Phone customer service was almost invariably good (with the exception of one guy with a strong Brooklin accent who appeared to be looking for a fight, and even though he was totally clueless about what the problem was still kept trying to pin it on me), eventually <i>excellent</i> when we (me and my wife -- we trade usually together and by consensus) were finally escalated to a manager who gave us his direct phone number (saving us the incredibly long waits any normal call to customer support usually involves), online-rate trades ($4.95 for stocks -- he couldn't unfortunately gave us the free trades we would have gotten if actually online) rather than the ridiculous rate for human-assisted trades as long as the mysterious lock-out remained, and really bent over backwards to try to find out about the problem and fix it for us.</div><div><br />
</div><div>Alas, he couldn't -- though it eventually disappeared, as it happens, just after the settling date following the expiration date for some calls I had sold (a couple of which got exercised); so I suspect their bug may be related to the one that recorded me as selling the same covered calls <i>twice</i> at a few minutes' time difference (when I had stock enough to cover only one of the two sales -- and remember, I'm not allowed to sell <i>un</i>covered calls, so, even had I tried -- which I obviously didn't, as I'm not crazy yet;-) -- their SW obviously should have blocked me!-).</div><div><br />
</div><div>That customer-service manager was incredibly good in his follow-through, even offering to waive the fees for account transfer to some other broker, if, given how we justifiably felt after that episode, we just wanted to get rid of Merrill altogether (which we definitely did!-).</div><div><br />
</div><div>So, I had to start looking around -- and I did, and I plan to post one or more follow-on "episodes", in the course of the next few days, about what transpired afterwards...</div><div><br />
</div>Alexhttp://www.blogger.com/profile/05338312873524129257noreply@blogger.com0tag:blogger.com,1999:blog-3587168801999471966.post-76316651857197255222010-10-30T07:20:00.000-07:002010-11-07T22:04:41.021-08:00How important to investing is trading?I didn't provide any specific pointer for my contention that George Soros, in his great book <a href="http://books.google.com/books?id=qxkiYul2wgoC&lpg=PP1&dq=alchemy%20finance&pg=PP1#v=onepage&q&f=false">"The Alchemy of Finance"</a>, 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 <span style="font-weight: bold;">trading</span>, and you'll find as the top two hits of the search:<br />
<div><ul><li>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).</li>
<li>p. 207: "In short, my trading was poor".</li>
</ul><div>and more hits such as</div><div><ul><li><span class="Apple-style-span" style="font-size: 15.9722px;">p. 160: "On balance, my trading has been poor"</span></li>
</ul></div><div><span class="Apple-style-span" style="font-size: 15.9722px;">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."</span></div></div><div><span class="Apple-style-span" style="font-size: 15.9722px;"><br />
</span></div><div><span class="Apple-style-span" style="font-size: 15.9722px;">Isn't George Soros, among the legendary investors, <i>primarily</i> 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 <i>directionally</i> right. E.g., wrt the first search hit above: he did buy bonds cheap (though definitely not as cheap as he <i>might</i> have bought them in hindsight had he timed the bottom in that market perfectly) and sold them dear (though </span><span class="Apple-style-span" style="font-size: 15.9722px;">not as dear as he might have sold them in hindsight had he timed the <i>top</i> in that market perfectly).</span></div><div><span class="Apple-style-span" style="font-size: 15.9722px;"><br />
</span></div><div><span class="Apple-style-span" style="font-size: 15.9722px;">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 <b>not</b> losing money, and framing it as a loss is deleterious to our best judgment since it triggers strong "loss aversion" impulses in our brain.</span></div><div><span class="Apple-style-span" style="font-size: 15.9722px;"><br />
</span></div><div><span class="Apple-style-span" style="font-size: 15.9722px;">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.</span></div>Alexhttp://www.blogger.com/profile/05338312873524129257noreply@blogger.com0tag:blogger.com,1999:blog-3587168801999471966.post-71728414779367783122010-10-29T18:52:00.000-07:002010-11-07T21:53:38.649-08:00More on "The ABC of Stock Speculation" - part 2: "get rich quick" schemes vs patience and prudence<div><span class="Apple-style-span" style="font-size: medium;"><span class="Apple-style-span">disadvantage of the small operator in following this policy is that he seldom provides sufficient capital for his requirementsContinuing the idea I started </span><a href="http://mutnemom.blogspot.com/2010/10/more-on-abc-of-stock-speculation-part-1.html"><span class="Apple-style-span">here</span></a><span class="Apple-style-span">, </span></span><span class="Apple-style-span" style="font-size: 15.9722px;"><span class="Apple-style-span" style="color: #222222; font-size: 15.9722px; line-height: 25px;"><span class="Apple-style-span" style="font-size: medium;"><span class="Apple-style-span">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.</span></span></span><span class="Apple-style-span" style="font-size: medium;"><span class="Apple-style-span"> </span></span></span></div><blockquote><div>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.</div><div>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.</div></blockquote>Nelson's core idea for this "conservative trading" <br />
<blockquote>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.<br />
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.</blockquote>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).<br />
<div><br />
</div><div>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!</div><div><br />
</div><div>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 <i>trading</i>, not one for <i>investing</i>. I'm definitely <b>not</b> a great trader -- and I find it heartening to read in George Soros' fascinating book <a href="http://www.amazon.com/Alchemy-Finance-Wiley-Investment-Classics/dp/0471445495/ref=dp_ob_title_bk">"The Alchemy of Finance"</a> (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...?-)</div><div><br />
</div><div>Nevertheless, net of specific procedures, I think that the core messages -- "<span class="Apple-style-span" style="font-size: 15.9722px;">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 </span><br />
<span class="Apple-style-span" style="font-size: 15.9722px;"></span><br />
<span class="Apple-style-span" style="font-size: 15.9722px;"><blockquote>disadvantage of the small operator in following this policy is that he seldom provides sufficient capital for his requirements</blockquote><blockquote></blockquote></span></div>(i.e., he over-trades, over-margins himself, and so forth) -- remain, after more than a century, immortal principles to live by.Alexhttp://www.blogger.com/profile/05338312873524129257noreply@blogger.com0tag:blogger.com,1999:blog-3587168801999471966.post-74789201393152428152010-10-25T21:40:00.000-07:002010-11-07T21:44:28.332-08:00The "stop-loss" controversy: Fisher, Nelson, Montier and meOne 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 <b>not</b> 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).<br />
<div><br />
</div><div>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 <i>values</i> -- 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 <i>is</i> 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).</div><div><br />
</div><div>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 <i>market</i> will eventually sync up with a firm's real value -- the patient value investor counts on that! In <i>this</i> approach to investing, stop loss orders make absolutely no sense!</div><div><br />
</div><div>The old saw "ride your winners, cut your losers" only makes sense in a pure <i>trading</i>, <b>not </b><i>investing</i>, 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 <i>worth</i> -- which is really very contradictory with most else that Montier is saying in that otherwise decent book...!</div><div><br />
</div>Alexhttp://www.blogger.com/profile/05338312873524129257noreply@blogger.com1tag:blogger.com,1999:blog-3587168801999471966.post-38198379293105524932010-10-25T18:55:00.000-07:002010-11-07T22:07:11.101-08:00Ken 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.<br />
<div><br />
</div><div>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 <b>that</b> is unadulterated bunk. (Or would Mr. Fisher like to get <i>me</i> 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 <i>truly</i> 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 <b>guarantee</b> of future results, but to jump from "no guarantee" to "never indicative of" is, truly, totally absurd).</div><div><br />
</div><div>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 <b>he</b> 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" (!). <b>False! Bunk!</b></div><div><br />
</div><div><b></b>What β<1 <b>means</b> is that the <i>covariance</i> 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.</div><div><br />
</div><div>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.</div><div><br />
</div><div>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); <a href="http://en.wikipedia.org/wiki/Semivariance">semivariance</a>, 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 <i>really</i> objectionable.</div><div><br />
</div><div>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!</div><div><br />
</div>Alexhttp://www.blogger.com/profile/05338312873524129257noreply@blogger.com0tag:blogger.com,1999:blog-3587168801999471966.post-39022490144109676172010-10-24T17:12:00.001-07:002010-11-07T21:43:01.525-08:00More on "The ABC of Stock Speculation" - part 1: investors' overall incredible underperformanceI'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!-). <br />
<div><br />
</div><div>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.<br />
<blockquote>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.<br />
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.</blockquote>Nelson then goes on to explain the reason for this as he sees it...:<br />
<blockquote>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.</blockquote>While I entirely agree with the core observation, I disagree with Nelson's explanation.<br />
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).<br />
Now maybe that <b>was</b> 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 <i>may</i> be manipulation attempted (and sometimes successful), it's nowhere like a primary driver of the market's movements.<br />
In addition, there's no need for such a hypothesis to explain the clearly-true <b>fact</b> 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 <a href="http://www.qaib.com/public/freelook.aspx?activeMenu=GLB-1">Dalbar</a>: 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?!<br />
Easy: it comes from investors' psychology -- invariably, inevitably, doomedly chasing the "latest hottest trend" -- <i>last year</i>'s highly performing fund, manager, industry, sector, whatever. Over and over again, investors <i>en masse</i> 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 <b>reverse</b> of "momentum" (and a great summary of my overall investing philosophy;-).<br />
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 <b>do</b> 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.<br />
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 <b>outperform</b> 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, <a href="http://www.amazon.com/Yes-You-Can-Time-Market/dp/0471679267/ref=sr_1_1?ie=UTF8&s=books&qid=1287968845&sr=1-1">book</a>, "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;-).<br />
<br />
</div>Alexhttp://www.blogger.com/profile/05338312873524129257noreply@blogger.com0tag:blogger.com,1999:blog-3587168801999471966.post-16061724677429466532010-10-23T11:29:00.000-07:002010-11-07T21:42:13.422-08:00"The ABC of Stock Speculation"Few investors would consider reading <a href="http://books.global-investor.com/books/9985/Samuel-Nelson/The-ABC-of-Stock-Speculation/">a book written in 1902</a>, 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.<br />
<div><br />
</div><div>I'm really happy I got the <a href="http://www.amazon.com/ABC-Stock-Speculation-ebook/dp/B001CBK18C/ref=tmm_kin_title_0?ie=UTF8&m=AG56TWVU5XWC2">Kindle edition</a> (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). <a href="http://books.google.com/books?id=8tkZAAAAYAAJ&dq=abc%20stock%20speculation&pg=PR8#v=onepage&q&f=false">Google Books</a> 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)...:<br />
<blockquote>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.</blockquote>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?-)</div><div><br />
</div><div>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!</div>Alexhttp://www.blogger.com/profile/05338312873524129257noreply@blogger.com0tag:blogger.com,1999:blog-3587168801999471966.post-3254170688945842010-10-21T20:10:00.001-07:002010-11-07T21:55:41.207-08:00Fighting confirmation biasAs 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.<br />
<br />
As an investor, that's <span style="font-style: italic;">not</span> 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 <span style="font-style: italic;">be</span> 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 <span style="font-style: italic;">against</span> 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.<br />
<br />
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, <span style="font-weight: bold;">fight</span> your confirmation bias! If you have limited amounts of time and attention (and, who doesn't?!), they're better invested in trying to <span style="font-weight: bold;">puncture</span> your tentative investment thesis than in looking for psychologically-satisfying confirmation that, yes!, you <span style="font-style: italic;">are</span> a genius (as you always suspected, after all) for thinking of putting some money into XYZ in the first place.<br />
<br />
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.<br />
<br />
And, what do you know, it <span style="font-weight: bold;">has</span> -- 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, <a href="http://fool.com/">Motley Fool</a>, &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...).<br />
<br />
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 <span style="font-weight: bold;">stocks</span> -- it's information, facts, pointers and opinions about <span style="font-weight: bold;">businesses</span>, 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!-).<br />
<br />
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...!-)Alexhttp://www.blogger.com/profile/05338312873524129257noreply@blogger.com0tag:blogger.com,1999:blog-3587168801999471966.post-2211027195174436872010-10-19T21:17:00.000-07:002010-11-07T22:13:39.483-08:00Options: 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 <span style="font-weight: bold;">both</span> be "gambling"?<br />
<br />
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 <span style="font-weight: bold;">other</span> 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)?<br />
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The way I like to look at it is: options (covered calls, specifically) are somewhat like lottery tickets. The <span style="font-style: italic;">buyer</span> 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 <span style="font-style: italic;">seller</span> 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".<br />
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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, <span style="font-style: italic;">this</span> is the "gambling" attitude -- never sell a ticket because it just "might" be the big winner -- really similar to <span style="font-style: italic;">buying</span> tickets with a similar hope, after all.<br />
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And this, believe it or not, is what most conservative investors end up doing, without realizing it: by <span style="font-weight: bold;">not</span> selling covered call options on their stocks, they're unknowingly turning into gamblers!-)<br />
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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 <a href="http://www.safe-options-trading-income.com/">this site</a>, which seems to do quite a decent job getting you started, or many of the excellent books on the subject.<br />
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I recommend Ron Groenke's books and <a href="http://rongroenke.com/">site</a> (if you don't mind the idea of paying 150+ $/year for his Windows-only software) and Paul D. <a href="http://www.amazon.com/Paul-D.-Kadavy/e/B001K93F16/ref=ntt_athr_dp_pel_1">Kadavy's</a> "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).<br />
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For better-explained theory (no sw though!-), <a href="http://www.amazon.com/Options-Trading-Conservative-Investor-Increasing/dp/0137042000/ref=sr_1_2?s=books&ie=UTF8&qid=1287549618&sr=1-2">Thomsett's</a> "Options Trading for the Conservative Investor: Increasing Profits Without Increasing Your Risk" is, I think, still best. (Haven't read <a href="http://www.amazon.com/Short-Book-Options-Conservative-Strategy/dp/1403307768/ref=sr_1_3?s=books&ie=UTF8&qid=1287549664&sr=1-3">Wolfinger's</a> "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).Alexhttp://www.blogger.com/profile/05338312873524129257noreply@blogger.com0tag:blogger.com,1999:blog-3587168801999471966.post-6338448501922514402010-10-17T21:28:00.000-07:002010-11-07T22:06:28.778-08:00Why 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 <a href="http://herbison.com/herbison/broken_eggs_watch.html">Mark Twain</a>'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."<br />
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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 <a href="http://www.nytimes.com/2005/06/05/magazine/05FREAK.html?_r=1&pagewanted=all">monkeys</a>), known as <a href="http://en.wikipedia.org/wiki/Loss_aversion">loss aversion</a>.<br />
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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).<br />
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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.<br />
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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 <span style="font-style: italic;">will</span> prefer the mix with a lower risk of loss (even though inevitably that means a lower best-case chance).<br />
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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.<br />
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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 <span style="font-style: italic;">and</span> 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!<br />
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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.<br />
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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 <a href="http://finance.yahoo.com/news/Charlie-Munger-on-Communism-fool-1939650256.html">Charlie Munger</a>'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.Alexhttp://www.blogger.com/profile/05338312873524129257noreply@blogger.com0tag:blogger.com,1999:blog-3587168801999471966.post-74912737443585060082010-10-17T09:27:00.000-07:002010-11-07T21:58:36.626-08:00Investing vs GamblingIn 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 <a href="http://books.google.com/books?id=VAYaAAAAYAAJ&ots=fzfXojvJsX&dq=the%20abc%20of%20stock%20speculation&pg=PA5#v=onepage&q&f=false">book</a> about stock investing was... "The ABC of Stock Speculation"!<br />
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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.<br />
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In these terms, Graham has priceless advice...:<br />
<blockquote>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 <span style="font-style: italic;">out</span> of your speculative fund). Never mingle your speculative and investment operations in the same account, nor in any part of your thinking.</blockquote>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.<br />
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I'm not <span style="font-weight: bold;">quite</span> 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.<br />
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Thanks to Graham's advice, instead, I keep no more than 1-2% of my net worth in a small, <span style="font-style: italic;">separate</span> "mad money" account, actively play with it, often over-trade with respect to what I know I <span style="font-weight: bold;">should</span> 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;-).<br />
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As an extra, practical tip -- I've recently found <a href="https://www.optionshouse.com/">options house</a> 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 <span style="font-style: italic;">simulate</span> 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 <span style="font-style: italic;">real</span> 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!Alexhttp://www.blogger.com/profile/05338312873524129257noreply@blogger.com0