online discount brokers, part 2: costlier ones, and why I eschew them

I 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.

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.

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).

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.

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.

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!-).

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?

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.

Why should one diversify and differentiate?

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

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

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

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

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

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

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

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

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

Benjamin Graham's "The Intelligent Investor"

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

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

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

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

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

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

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

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

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

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