WALL STREET SMARTS, THE BLOG, IS NOW WALL STREET SMARTS, THE BOOK. FULLY EDITED AND REVISED WITH NEW MATERIAL ON AMAZON
Hunters have the option to use either a rifle or a shotgun, depending on what is being hunted. Similarly, investors have the option to purchase either a specific investment or a mutual fund. In order to diversify a portfolio, the individual stock purchaser must spread his or her money over a number of companies in different industries. You may recall that the collective advice of the value investors we have studied in earlier posts is to purchase between ten and thirty different companies, each in a different industry. For an investor just starting out, the successful assembly of such a portfolio will take both time and effort. Not everyone has the time or the inclination to do this. Once a person starts a career and has the funds to invest, there never seems to be enough time for much more than work, family and friends. Most retirement plans offered by employers offer only mutual funds as investment options. Many individual investors take the shotgun approach and put their money into mutual funds. It would seem that a majority of people in the market do so via pooled investments.
Pooled investing has been around for centuries. Many financial historians point to a Dutch investment trust (called a negotiatie) as the first such investment established in 1774. Its stated purpose was to provide diversification to individual investors at a small cost. Numerous negotiaties were organized in the latter part of the 18th century to invest in the credit of a new country, the United States of America. The organizer of the original trust, Adriaan van Ketwich, organized a second one in 1779 which remained in existence for 114 years. It was dissolved in 1893, the same year that The Boston Personal Property Trust, one of the first American investment trusts, was formed.
The fore bearer of the modern American mutual fund, the Massachusetts Investors' Trust, was established as an open-end fund in Boston in 1924. The Wellington Fund, launched in 1928, was the first mutual fund to specifically invest in both stocks and bonds, a balanced fund. The value investor, Phillip Carret, was one of the organizers of the Pioneer Fund in 1928. Pioneer is still in business today. The number of funds increased over time, but many were wiped out during the 1929 Wall Street Crash. Investigations into these failures revealed a fair amount of chicanery and self dealing on the part of the operators of the failed mutual funds. This led to the passage of The Investment Company Act of 1940 which placed numerous restrictions on the operations of US mutual funds and required certain disclosures to investors. The Act also attempted to reduce the conflicts of interest revealed in the investigations.
Over the years, the popularity of mutual funds has waxed and waned. Mutual funds grew rapidly during the 1960s, but the number dropped precipitously after the bear market of 1969, with only 360 funds remaining in 1970. Later, two tax law changes gave the industry a big boost. The Individual Retirement Account (IRA) and a form of retirement plan known by the tax section which authorized it, 401 (k), provided large platforms for the sale of mutual funds to millions of Americans saving for their golden years. Interest in mutual funds dropped again in 2003 with the revelation of wide spread scandals in which a number of funds were alleged to have allowed their large hedge fund customers to engage in abusive trade timing practices at the expense of their smaller customers.
Memories are short on Wall Street, and the mutual fund industry has recovered since 2003. It is reported that there were approximately 14,000 mutual funds, including money market funds, in existence in 2011. The funds offer every sort of investment strategy in stocks, corporate bonds, government debt, gold, oil and any other investment asset you can think of. The irony is that, year in and year out, a large percentage of the funds (some say as high as 80%) fail to meet or beat the annual performance of their respective markets as a whole.
We will look at mutual fund investing in the next post.
Comments are always welcome.
Monday, July 15, 2013
Monday, July 8, 2013
Are We There Yet?
WALL STREET SMARTS, THE BLOG, IS NOW WALL STREET SMARTS, THE BOOK. FULLY EDITED AND REVISED WITH NEW MATERIAL ON AMAZON
Every parent has heard this complaining question from the back seat of the car at one time or another. Usually, it is a daily chorus as the family's summer road trip plays out. Many times, the question is followed with another old standard, "Why is Daddy so crabby?" Children just do not comprehend the distance and time involved in reaching vacation destinations.
Some investors approach their investments in a similar manner. They fail to identify their destination and formulate a realistic time frame in which to reach it. They forget to tailor specific methods of investing to specific goals. For some, the goal is just making money. There is nothing wrong with that. Making money is a good goal; but then what? Long term goals, such as meeting college tuition for the children or investing for a comfortable retirement, are best reached with long term investments. Years of short term trading with its ups and downs is probably not an appropriate way to achieve retirement security. The risk of suffering a crippling loss shortly before reaching retirement age is just too great.
In Rediscovering the Wheel: Contrary Thinking & Investment Strategy, Bradbury K. Thurlow discussed the interplay between goals, strategy and time as follows:
A prime ingredient in any investment strategy must be a considered time frame, which will be directly related to major, intermediate, or minor price objectives. How long is one willing to wait in anticipation of an x percent move? What happens to one's calculations if the stock moves the wrong way? Should one sell automatically, regardless of time, if a goal is reached? or protect the position with puts?*
Once a person sets a goal and establishes the amount of time needed to achieve it, the next step is to consider and adopt the appropriate investment strategy or philosophy. The investor or trader needs to develop basic ideas on which their way of investing is based. Aswath Damodaran, a Professor of Finance in the Stern School of Business at New York University summed this up in his book, Investment Philosophies, as follows:
An investment philosophy represents a set of core beliefs about how investors behave and how markets work. To be a successful investor, you not only have to consider the evidence from the markets, but you also have to examine your own strengths and weaknesses to come up with an investment philosophy that best suits you. Investors without core beliefs tend to wander from strategy to strategy, drawn by anecdotal evidence or recent success, creating transaction costs and incurring losses as a consequence. Investors with clearly defined investment philosophies tend to be more consistent and disciplined in their investment choices.**
Although most of the advice given above would seem to apply to long term investors, traders also need a goal, a strategy and a time frame. The most famous trader, Jesse Lauriston Livermore, followed the basic tenet of quickly selling losers and letting profits ride. He had a strategy for identifying and selling stocks which were not performing to his standards:
Hope is the villain here and it has ruined millions of speculators over the course of time -- take your losses right away they are real whether you sell the stocks or not.
To put this in another way I have two stops in mind when I enter a trade I have a "PRICE STOP" and I have a "TIME STOP." I will not stay with any trade more than a few points if it moves against me and I will not stay with a stock position for more than a few days if the stock does not perform as I expect it to perform.***
It would seem that he did not always follow his own advice. Livermore is reputed to have made and lost four multimillion dollar fortunes over his forty year trading career.
Aimlessly wandering from place to place without a plan and a map is a recipe for a bad family vacation. Likewise, aimlessly bouncing from one investment to another without a goal and a strategy is a recipe for financial disaster.
* Excerpt from Rediscovering the Wheel: Contrary Thinking & Investment Strategy, Bradbury K. Thurlow, ©1981, published by Fraser Publishing Company, is used by permission of the current copyright holder
** Excerpt from Investment Philosophies, Aswath Damodaran, ©2003, published by John Wiley & Sons, Inc., page 13
*** Excerpt from How to Trade in Stocks, Jesse Livermore, ©1940, updated edition in 2001 with comments from Richard Smitten, published by McGraw-Hill, page 108
Comments are always welcome.
Every parent has heard this complaining question from the back seat of the car at one time or another. Usually, it is a daily chorus as the family's summer road trip plays out. Many times, the question is followed with another old standard, "Why is Daddy so crabby?" Children just do not comprehend the distance and time involved in reaching vacation destinations.
Some investors approach their investments in a similar manner. They fail to identify their destination and formulate a realistic time frame in which to reach it. They forget to tailor specific methods of investing to specific goals. For some, the goal is just making money. There is nothing wrong with that. Making money is a good goal; but then what? Long term goals, such as meeting college tuition for the children or investing for a comfortable retirement, are best reached with long term investments. Years of short term trading with its ups and downs is probably not an appropriate way to achieve retirement security. The risk of suffering a crippling loss shortly before reaching retirement age is just too great.
In Rediscovering the Wheel: Contrary Thinking & Investment Strategy, Bradbury K. Thurlow discussed the interplay between goals, strategy and time as follows:
A prime ingredient in any investment strategy must be a considered time frame, which will be directly related to major, intermediate, or minor price objectives. How long is one willing to wait in anticipation of an x percent move? What happens to one's calculations if the stock moves the wrong way? Should one sell automatically, regardless of time, if a goal is reached? or protect the position with puts?*
Once a person sets a goal and establishes the amount of time needed to achieve it, the next step is to consider and adopt the appropriate investment strategy or philosophy. The investor or trader needs to develop basic ideas on which their way of investing is based. Aswath Damodaran, a Professor of Finance in the Stern School of Business at New York University summed this up in his book, Investment Philosophies, as follows:
An investment philosophy represents a set of core beliefs about how investors behave and how markets work. To be a successful investor, you not only have to consider the evidence from the markets, but you also have to examine your own strengths and weaknesses to come up with an investment philosophy that best suits you. Investors without core beliefs tend to wander from strategy to strategy, drawn by anecdotal evidence or recent success, creating transaction costs and incurring losses as a consequence. Investors with clearly defined investment philosophies tend to be more consistent and disciplined in their investment choices.**
Although most of the advice given above would seem to apply to long term investors, traders also need a goal, a strategy and a time frame. The most famous trader, Jesse Lauriston Livermore, followed the basic tenet of quickly selling losers and letting profits ride. He had a strategy for identifying and selling stocks which were not performing to his standards:
Hope is the villain here and it has ruined millions of speculators over the course of time -- take your losses right away they are real whether you sell the stocks or not.
To put this in another way I have two stops in mind when I enter a trade I have a "PRICE STOP" and I have a "TIME STOP." I will not stay with any trade more than a few points if it moves against me and I will not stay with a stock position for more than a few days if the stock does not perform as I expect it to perform.***
It would seem that he did not always follow his own advice. Livermore is reputed to have made and lost four multimillion dollar fortunes over his forty year trading career.
Aimlessly wandering from place to place without a plan and a map is a recipe for a bad family vacation. Likewise, aimlessly bouncing from one investment to another without a goal and a strategy is a recipe for financial disaster.
* Excerpt from Rediscovering the Wheel: Contrary Thinking & Investment Strategy, Bradbury K. Thurlow, ©1981, published by Fraser Publishing Company, is used by permission of the current copyright holder
** Excerpt from Investment Philosophies, Aswath Damodaran, ©2003, published by John Wiley & Sons, Inc., page 13
*** Excerpt from How to Trade in Stocks, Jesse Livermore, ©1940, updated edition in 2001 with comments from Richard Smitten, published by McGraw-Hill, page 108
Comments are always welcome.
Monday, July 1, 2013
Trading Platforms & Slot Machines
WALL STREET SMARTS, THE BLOG, IS NOW WALL STREET SMARTS, THE BOOK. FULLY EDITED AND REVISED WITH NEW MATERIAL ON AMAZON
One sure sign of the market's getting "frothy" is the number and silliness of TV commercials for on line trading from brokerage firms. My all time favorite is an ad aired in the late 1990s during the dot com bubble which featured a plumber driving his truck to a job and talking about the island he had just purchased with the money he had made trading on line with a brokerage firm. It seems that as the market rockets upwards, TV ads increase proportionately, promising easy, quick profits. As with most advertising, this message must be taken with a grain (or tablespoon) of salt.
On line brokers tout their trading platforms and low trading costs. The platforms offer computerized technical analysis with moving averages, volume and price charts, breaking news services and whatever other indicators a trader might want to see on the screen. Some people make small trades and use leverage (margin loans) to increase profits. Given the costs, many traders give most of their profits, and more, to the broker in interest expense and trading costs.
Traders have different trading periods. Position or trend traders can hold their positions for several months to several years. The goal is to find a stock which is trending upwards and hold onto it for the duration of the run. A second type of trading is called swing trading (the new name for the old strategy of momentum trading) with near term time frames of several days to several weeks and intermediate terms of up to six months. The shortest time frame is the day trade in which the trader holds a position for anywhere from several minutes up to a day. The day trader will close out all of his or her positions at the end of the day. They avoid losses they might otherwise incur if their positions remained exposed to the action of after hours markets. Markets now follow the sun and are open for trading twenty-four hours a day around the world.
The look and feel of trading screens is similar to that of slot machines with flashing lights and beeping alerts. In my opinion, the similarity is not coincidental. The gaming industry has spent a considerable amount of time and money determining what sort of display will keep a person feeding coins into a machine. I believe that on line trading on your home computer and playing the slots in a casino share many characteristics, the fundamental one being that both activities are just gambling.
The Securities and Exchange Commission has posted comments about day trading. Their advice included several statements, two of which I will share with you: Be prepared to suffer severe financial losses and Day trading is an extremely stressful and expensive full time job. Granted, these are from a regulatory agency, but they should give pause to anyone interested in those supposed easy and quick profits touted by the brokerage firms.
If it were that easy and profitable, why would they share their secrets with you for just $7.95 a trade? One advantage of slot machines - you need not pay a fee to pull the lever or hit the button. You just drop in your coin and play.
Comments are always welcome.
One sure sign of the market's getting "frothy" is the number and silliness of TV commercials for on line trading from brokerage firms. My all time favorite is an ad aired in the late 1990s during the dot com bubble which featured a plumber driving his truck to a job and talking about the island he had just purchased with the money he had made trading on line with a brokerage firm. It seems that as the market rockets upwards, TV ads increase proportionately, promising easy, quick profits. As with most advertising, this message must be taken with a grain (or tablespoon) of salt.
On line brokers tout their trading platforms and low trading costs. The platforms offer computerized technical analysis with moving averages, volume and price charts, breaking news services and whatever other indicators a trader might want to see on the screen. Some people make small trades and use leverage (margin loans) to increase profits. Given the costs, many traders give most of their profits, and more, to the broker in interest expense and trading costs.
Traders have different trading periods. Position or trend traders can hold their positions for several months to several years. The goal is to find a stock which is trending upwards and hold onto it for the duration of the run. A second type of trading is called swing trading (the new name for the old strategy of momentum trading) with near term time frames of several days to several weeks and intermediate terms of up to six months. The shortest time frame is the day trade in which the trader holds a position for anywhere from several minutes up to a day. The day trader will close out all of his or her positions at the end of the day. They avoid losses they might otherwise incur if their positions remained exposed to the action of after hours markets. Markets now follow the sun and are open for trading twenty-four hours a day around the world.
The look and feel of trading screens is similar to that of slot machines with flashing lights and beeping alerts. In my opinion, the similarity is not coincidental. The gaming industry has spent a considerable amount of time and money determining what sort of display will keep a person feeding coins into a machine. I believe that on line trading on your home computer and playing the slots in a casino share many characteristics, the fundamental one being that both activities are just gambling.
The Securities and Exchange Commission has posted comments about day trading. Their advice included several statements, two of which I will share with you: Be prepared to suffer severe financial losses and Day trading is an extremely stressful and expensive full time job. Granted, these are from a regulatory agency, but they should give pause to anyone interested in those supposed easy and quick profits touted by the brokerage firms.
If it were that easy and profitable, why would they share their secrets with you for just $7.95 a trade? One advantage of slot machines - you need not pay a fee to pull the lever or hit the button. You just drop in your coin and play.
Comments are always welcome.
Monday, June 24, 2013
If The Cook Leaves For Lunch
WALL STREET SMARTS, THE BLOG, IS NOW WALL STREET SMARTS, THE BOOK. FULLY EDITED AND REVISED WITH NEW MATERIAL ON AMAZON
A cook who is paid for quantity not quality and does not have to eat his own cooking will probably not follow the recipe all that carefully. A mortgage lender in the same position will have little concern for the quality of the loans being made. This was the situation during the last years of the US housing bubble of 2001 through 2005.
Anyone who has seen Frank Capra's Christmas classic, It's a Wonderful Life, knows how a bank operates. Back then, if a person wanted to buy a house, he or she would go to the lending institution and apply for a mortgage loan. The banker would carefully check the applicant's credit rating, job history and stability, get an appraisal of the property and decide whether to make the loan. The bank lent money and expected to be repaid since the lent money came from the collective deposits of the bank's customers. The bank recycled one person's savings into another person's home loan and made money on the spread between the interest rate it paid on the savings account and the interest rate it charged for the loan. The bank had to be conservative in its lending practices since it still had to meet the daily withdrawals of its customers regardless of the borrower's repayment of the home loan.
In 1938, late in the Depression, the government established the Federal National Mortgage Association (Fannie Mae) to stimulate the moribund economy and to support the national policy of encouraging home ownership by making it easier to get a home mortgage. The Federal Home Loan Mortgage Corporation (Freddie Mac) was chartered in 1970 to expand the government's efforts to provide funds for home loans. These agencies would purchase billions of dollars worth of mortgage loans from lenders across the country, repackage them into pools of securitized bonds which were then sold to debt investors. The bond proceeds would then be used to buy yet more mortgage loans from the banks. The theory was that the availability of this money would lower the cost of home loans.
Wall Street copied the Fannie/Freddie models and got into the mortgage backed securities game during the housing bubble years in a big way. Earlier, Congress had passed laws to make home loans affordable for many people whose credit was not strong enough to qualify them for a home loan. These were referred to as subprime mortgage loans which provided very low "teaser" rates of interest for the first two years before the interest rate jumped to a market rate. This increase would almost double the rate. Mortgage lenders offered what were called "low doc" and "no doc" loans, i.e., loans made without credit checks or other traditional lending considerations and documents. These loans were cynically called "liar loans" since the information on the credit applications was rarely, if ever, verified. In an effort to keep them "honest," the mortgage brokers were required to keep a small percentage of their loans on their books. Despite this exposure, most brokers saw no reason to worry about repayment and creditworthiness.
Repackaging subprime mortgages into bonds became a huge money machine for the investment banks. In his book, The Big Short, Michael Lewis explains how billions of dollars in fees were earned by the mortgage companies and the investment banks by recycling money between American home buyers and bond investors worldwide. The goal was booking loans, earning fees and converting the mortgage debt into bonds for sale around the world. With those bonds went the risk of default. Bond buyers were lulled by Triple A credit ratings for the bonds despite the subprime quality of the mortgages backing the bonds. The poster child for this lending orgy, according to Lewis, was the California farm worker making $14,000 per year who received a home loan of over $700,000. The underpinning of this debt debacle was the belief that home values would continue to rise, allowing otherwise unqualified borrowers to either refinance the debt or sell the property at a profit in less than the first two years. When the teaser rates increased after the first two years, the loans became unaffordable. Since the mortgage brokers and investment bankers had only a fractional interest in the loans and bonds or they had laid off the risk with credit default swaps, they did not believe they would suffer any loss. What they failed to appreciate was the fact that a even a small fractional interest in hundreds of billions of dollars is still a large number.
The results of this played out when the housing bubble burst and an unexpectedly large percentage of the loans went into default. The other part of this perfect storm was the rapid decline in home values. Mortgage debt exceeded the value of the collateral with the obvious result - billions of dollars in losses for the holders of the mortgage backed bonds around the world. As the music started to slow down in 2007, several very large publicly traded mortgage companies went out of business.
Two signs that the party was truly over were the failures of the venerable Wall Street firms, Bear Stearns and Lehman Brothers in 2008. Lehman's September 15, 2008 bankruptcy filing, considered the largest in history, foretold the credit crisis to come. The exposure of both Bear Stearns and Lehman to the subprime mortgage market played a significant role in their failures.
Comments are always welcome.
A cook who is paid for quantity not quality and does not have to eat his own cooking will probably not follow the recipe all that carefully. A mortgage lender in the same position will have little concern for the quality of the loans being made. This was the situation during the last years of the US housing bubble of 2001 through 2005.
Anyone who has seen Frank Capra's Christmas classic, It's a Wonderful Life, knows how a bank operates. Back then, if a person wanted to buy a house, he or she would go to the lending institution and apply for a mortgage loan. The banker would carefully check the applicant's credit rating, job history and stability, get an appraisal of the property and decide whether to make the loan. The bank lent money and expected to be repaid since the lent money came from the collective deposits of the bank's customers. The bank recycled one person's savings into another person's home loan and made money on the spread between the interest rate it paid on the savings account and the interest rate it charged for the loan. The bank had to be conservative in its lending practices since it still had to meet the daily withdrawals of its customers regardless of the borrower's repayment of the home loan.
In 1938, late in the Depression, the government established the Federal National Mortgage Association (Fannie Mae) to stimulate the moribund economy and to support the national policy of encouraging home ownership by making it easier to get a home mortgage. The Federal Home Loan Mortgage Corporation (Freddie Mac) was chartered in 1970 to expand the government's efforts to provide funds for home loans. These agencies would purchase billions of dollars worth of mortgage loans from lenders across the country, repackage them into pools of securitized bonds which were then sold to debt investors. The bond proceeds would then be used to buy yet more mortgage loans from the banks. The theory was that the availability of this money would lower the cost of home loans.
Wall Street copied the Fannie/Freddie models and got into the mortgage backed securities game during the housing bubble years in a big way. Earlier, Congress had passed laws to make home loans affordable for many people whose credit was not strong enough to qualify them for a home loan. These were referred to as subprime mortgage loans which provided very low "teaser" rates of interest for the first two years before the interest rate jumped to a market rate. This increase would almost double the rate. Mortgage lenders offered what were called "low doc" and "no doc" loans, i.e., loans made without credit checks or other traditional lending considerations and documents. These loans were cynically called "liar loans" since the information on the credit applications was rarely, if ever, verified. In an effort to keep them "honest," the mortgage brokers were required to keep a small percentage of their loans on their books. Despite this exposure, most brokers saw no reason to worry about repayment and creditworthiness.
Repackaging subprime mortgages into bonds became a huge money machine for the investment banks. In his book, The Big Short, Michael Lewis explains how billions of dollars in fees were earned by the mortgage companies and the investment banks by recycling money between American home buyers and bond investors worldwide. The goal was booking loans, earning fees and converting the mortgage debt into bonds for sale around the world. With those bonds went the risk of default. Bond buyers were lulled by Triple A credit ratings for the bonds despite the subprime quality of the mortgages backing the bonds. The poster child for this lending orgy, according to Lewis, was the California farm worker making $14,000 per year who received a home loan of over $700,000. The underpinning of this debt debacle was the belief that home values would continue to rise, allowing otherwise unqualified borrowers to either refinance the debt or sell the property at a profit in less than the first two years. When the teaser rates increased after the first two years, the loans became unaffordable. Since the mortgage brokers and investment bankers had only a fractional interest in the loans and bonds or they had laid off the risk with credit default swaps, they did not believe they would suffer any loss. What they failed to appreciate was the fact that a even a small fractional interest in hundreds of billions of dollars is still a large number.
The results of this played out when the housing bubble burst and an unexpectedly large percentage of the loans went into default. The other part of this perfect storm was the rapid decline in home values. Mortgage debt exceeded the value of the collateral with the obvious result - billions of dollars in losses for the holders of the mortgage backed bonds around the world. As the music started to slow down in 2007, several very large publicly traded mortgage companies went out of business.
Two signs that the party was truly over were the failures of the venerable Wall Street firms, Bear Stearns and Lehman Brothers in 2008. Lehman's September 15, 2008 bankruptcy filing, considered the largest in history, foretold the credit crisis to come. The exposure of both Bear Stearns and Lehman to the subprime mortgage market played a significant role in their failures.
Comments are always welcome.
Monday, June 17, 2013
Markets and Birds of a Different Feather (2)
WALL STREET SMARTS, THE BLOG, IS NOW WALL STREET SMARTS, THE BOOK. FULLY EDITED AND REVISED WITH NEW MATERIAL ON AMAZON
Dr. Taleb described his trading philosophy as one in which he limited his losses and left open the possibility of large gains if and when an unusual event should take place. He complimented traders who bought options, which meant a loss was limited to the option fee paid, but which provided the trader with the opportunity to reap an out sized profit if something unexpected were to occur. Taleb's investment strategy was to always look for a Black Swan even if he was not sure in what form it might appear.
He likened the unknown risks inherent in the strategies of many investors/traders to the dangers of inductive reasoning noted by the philosopher Bertrand Russell and symbolized by the life of a chicken. Inductive reasoning begins with observations which lead to inferences, then to perceived patterns which lead, ultimately, to theories to address an issue or problem. Dr. Taleb retells Russell's story from the perspective of a turkey:
Consider a turkey is fed every day. Every feeding will firm-up the bird's belief that it is the general rule of life to be fed every day by friendly members of the human race "looking out for its best interests," as a politician would say. On the afternoon of the Wednesday before Thanksgiving, something unexpected will happen to the turkey. It will incur a revision of belief.
(Author's emphasis in bold)
I have heard two stories which illustrate the same point.
In the first anecdote, an individual returned from the west coast to his small Midwestern hometown after both his parents had passed away. He had decided to live in his childhood home. He deposited his savings in the local bank in which he had opened his first Christmas Club savings account as a child. The very next day, the bank failed and was taken over by the Federal Deposit Insurance Corporation (FDIC). This was his Black Swan. The FDIC guaranties that, in the event of a bank failure, the depositors will be refunded their money (with some limitations). Although he ultimately received his deposit back, he was heard to complain about the bank officer who had gladly taken his deposit less than twenty-four hours before the bank closed for good.
In the second one, a widow owned a small amount of stock in her local bank. The shares had been purchased by her husband years before. The local bank was purchased by a larger bank in the area, which in turn was purchased by a regional bank, which was itself purchased. With stock splits, several subsequent bank mergers and a steadily rising price for her shares in the larger, publicly traded institutions along the way, she had accumulated a substantial number of shares worth a significant amount of money. At one point, she sold enough stock to buy a new car. The downside was that those holdings represented a fairly large percentage of her portfolio. Aside from the car purchase, she refused to sell any more shares since the capital gains tax would have been substantial. Things went well until the day the financial institution failed due to "accounting irregularities." The market price of her shares dropped to less than a dollar per share within days of the public announcement that management had been "cooking the books." Another Black Swan.
Although there are typically over a hundred bank failures throughout the US every year, there was no reason why the depositor should have anticipated the failure of a bank that had served his hometown for more than sixty years. Given the years of increasing share price and the conflicting market proverbs to (i) let profits ride and (ii) diversify a stock portfolio, the widow saw no reason to sell shares and increase her taxes. In the final analysis, she let the tax tail wag the investment dog.
Both stories, if true, are apocryphal examples of Black Swans.
Excerpt from The Black Swan The Impact of the Highly Improbable, Nassim Nicholas Taleb, copyright 2007, published by Random House, page 40.
Comments are always welcome.
Dr. Taleb described his trading philosophy as one in which he limited his losses and left open the possibility of large gains if and when an unusual event should take place. He complimented traders who bought options, which meant a loss was limited to the option fee paid, but which provided the trader with the opportunity to reap an out sized profit if something unexpected were to occur. Taleb's investment strategy was to always look for a Black Swan even if he was not sure in what form it might appear.
He likened the unknown risks inherent in the strategies of many investors/traders to the dangers of inductive reasoning noted by the philosopher Bertrand Russell and symbolized by the life of a chicken. Inductive reasoning begins with observations which lead to inferences, then to perceived patterns which lead, ultimately, to theories to address an issue or problem. Dr. Taleb retells Russell's story from the perspective of a turkey:
Consider a turkey is fed every day. Every feeding will firm-up the bird's belief that it is the general rule of life to be fed every day by friendly members of the human race "looking out for its best interests," as a politician would say. On the afternoon of the Wednesday before Thanksgiving, something unexpected will happen to the turkey. It will incur a revision of belief.
(Author's emphasis in bold)
I have heard two stories which illustrate the same point.
In the first anecdote, an individual returned from the west coast to his small Midwestern hometown after both his parents had passed away. He had decided to live in his childhood home. He deposited his savings in the local bank in which he had opened his first Christmas Club savings account as a child. The very next day, the bank failed and was taken over by the Federal Deposit Insurance Corporation (FDIC). This was his Black Swan. The FDIC guaranties that, in the event of a bank failure, the depositors will be refunded their money (with some limitations). Although he ultimately received his deposit back, he was heard to complain about the bank officer who had gladly taken his deposit less than twenty-four hours before the bank closed for good.
In the second one, a widow owned a small amount of stock in her local bank. The shares had been purchased by her husband years before. The local bank was purchased by a larger bank in the area, which in turn was purchased by a regional bank, which was itself purchased. With stock splits, several subsequent bank mergers and a steadily rising price for her shares in the larger, publicly traded institutions along the way, she had accumulated a substantial number of shares worth a significant amount of money. At one point, she sold enough stock to buy a new car. The downside was that those holdings represented a fairly large percentage of her portfolio. Aside from the car purchase, she refused to sell any more shares since the capital gains tax would have been substantial. Things went well until the day the financial institution failed due to "accounting irregularities." The market price of her shares dropped to less than a dollar per share within days of the public announcement that management had been "cooking the books." Another Black Swan.
Although there are typically over a hundred bank failures throughout the US every year, there was no reason why the depositor should have anticipated the failure of a bank that had served his hometown for more than sixty years. Given the years of increasing share price and the conflicting market proverbs to (i) let profits ride and (ii) diversify a stock portfolio, the widow saw no reason to sell shares and increase her taxes. In the final analysis, she let the tax tail wag the investment dog.
Both stories, if true, are apocryphal examples of Black Swans.
Excerpt from The Black Swan The Impact of the Highly Improbable, Nassim Nicholas Taleb, copyright 2007, published by Random House, page 40.
Comments are always welcome.
Monday, June 10, 2013
Markets and Birds of a Different Feather (1)
WALL STREET SMARTS, THE BLOG, IS NOW WALL STREET SMARTS, THE BOOK. FULLY EDITED AND REVISED WITH NEW MATERIAL ON AMAZON
Dr. Nassim Nicholas Taleb has been described as "part literary essayist, part empiricist and part no-nonsense mathematical trader." He received his MBA from Wharton and his PhD from the University of Paris. He was a successful derivatives trader on Wall Street, but his real talent is as a writer. He is most famous for his books, Fooled By Randomness, The Hidden Role of Chance in Life and in the Markets, published in 2004, and The Black Swan, The Impact of the Highly Improbable, published in 2007. Both books, which take on conventional financial theory, are best sellers.
In his Prologue to Fooled By Randomness, Dr. Taleb, a self described Levantine (born in Lebanon), explains that his book is about luck, which is mistakenly perceived by those lucky souls as evidence of their personal skills, and about randomness which is mistakenly seen as a surprising event which might have been, but was not, anticipated. Something unusual (good or bad) happens in the market, shocking everyone, and market professionals immediately reach for explanations. The response "We don't know why." is an unacceptable answer in the public media. That would make for a fairly short television broadcast or newspaper story with a concomitant loss of advertising dollars.
Taleb criticizes economists, journalists, financial television analysts and others for refusing to acknowledge that the one-in-ten billion (or higher) possibility really can happen. Their statistical analyses and Gaussian distribution (bell curve) charts do not take such extremely rare probabilities into account. Although armed with reams of data based on computer analysis of vast numbers of probabilities, they do not know that they do not know. Or, viewed more cynically, if they do know that they don't know, they won't admit it.
All swans were thought to be white until in 1697 the Dutch explorer, Willem de Vlamingh, discovered a black one in Australia. One ugly bird destroyed a belief previously held by everyone in the ornithological world at that time. Dr. Taleb uses the term Black Swan to identify an event with three characteristics. First, the event is an outlier, which means that it is beyond the expectations of most, if not all, people. It will not be revealed in a standard bell curve distribution. Second, it will have a significant effect or impact (think September 11, 2001 or the market crash of October, 1987). Finally, it is an event in the wake of which people immediately demand an explanation. The phrase "Sh_t Happens." is not an acceptable answer to "How could this happen?" for most on Wall Street.
One of the premises of the Black Swan is that events of this type actually happen with greater frequency than previously imagined. It might be that, as a species, we humans need to perceive that we have order in and control over our lives. Black Swans serve to remind us that we are not in total control, a terrifying thought for many. The implications of this for the stock market are significant. Taleb provides two rates of return in a single graph. One line shows the return in the US stock market over the past fifty years. The second one charts the return without the ten most volatile days (up or down) over that same fifty year period. The reduction in return without those ten days is dramatic. Individual investors should bear this in mind when formulating their investment strategies.
We will continue our look at Dr. Taleb's ideas in the next blog.
Comments are always welcome.
Dr. Nassim Nicholas Taleb has been described as "part literary essayist, part empiricist and part no-nonsense mathematical trader." He received his MBA from Wharton and his PhD from the University of Paris. He was a successful derivatives trader on Wall Street, but his real talent is as a writer. He is most famous for his books, Fooled By Randomness, The Hidden Role of Chance in Life and in the Markets, published in 2004, and The Black Swan, The Impact of the Highly Improbable, published in 2007. Both books, which take on conventional financial theory, are best sellers.
In his Prologue to Fooled By Randomness, Dr. Taleb, a self described Levantine (born in Lebanon), explains that his book is about luck, which is mistakenly perceived by those lucky souls as evidence of their personal skills, and about randomness which is mistakenly seen as a surprising event which might have been, but was not, anticipated. Something unusual (good or bad) happens in the market, shocking everyone, and market professionals immediately reach for explanations. The response "We don't know why." is an unacceptable answer in the public media. That would make for a fairly short television broadcast or newspaper story with a concomitant loss of advertising dollars.
Taleb criticizes economists, journalists, financial television analysts and others for refusing to acknowledge that the one-in-ten billion (or higher) possibility really can happen. Their statistical analyses and Gaussian distribution (bell curve) charts do not take such extremely rare probabilities into account. Although armed with reams of data based on computer analysis of vast numbers of probabilities, they do not know that they do not know. Or, viewed more cynically, if they do know that they don't know, they won't admit it.
All swans were thought to be white until in 1697 the Dutch explorer, Willem de Vlamingh, discovered a black one in Australia. One ugly bird destroyed a belief previously held by everyone in the ornithological world at that time. Dr. Taleb uses the term Black Swan to identify an event with three characteristics. First, the event is an outlier, which means that it is beyond the expectations of most, if not all, people. It will not be revealed in a standard bell curve distribution. Second, it will have a significant effect or impact (think September 11, 2001 or the market crash of October, 1987). Finally, it is an event in the wake of which people immediately demand an explanation. The phrase "Sh_t Happens." is not an acceptable answer to "How could this happen?" for most on Wall Street.
One of the premises of the Black Swan is that events of this type actually happen with greater frequency than previously imagined. It might be that, as a species, we humans need to perceive that we have order in and control over our lives. Black Swans serve to remind us that we are not in total control, a terrifying thought for many. The implications of this for the stock market are significant. Taleb provides two rates of return in a single graph. One line shows the return in the US stock market over the past fifty years. The second one charts the return without the ten most volatile days (up or down) over that same fifty year period. The reduction in return without those ten days is dramatic. Individual investors should bear this in mind when formulating their investment strategies.
We will continue our look at Dr. Taleb's ideas in the next blog.
Comments are always welcome.
Monday, June 3, 2013
From Essays to Equations (2)
WALL STREET SMARTS, THE BLOG, IS NOW WALL STREET SMARTS, THE BOOK. FULLY EDITED AND REVISED WITH NEW MATERIAL ON AMAZON
Another financial author known for writing ability, not equations, is Peter L. Bernstein. He received his degree in economics from Harvard, but is known as a financial historian. Several of his ten books became best sellers. In 1992 he wrote Capital Ideas - The Improbable Origins of Modern Wall Street. In this work, he chronicled the evolution of modern investment theories. Starting with Louis Bachelier's 1900 Doctoral dissertation, The Theory of Speculation, Bernstein traces the evolution of Bachelier's dissertation with its formulas, which was "discovered" by later economists about sixty years after its publication, into the Modern Portfolio Theory (MPT). Using MPT and its supporting mathematical equations, investment professionals try to assemble a portfolio of assets to either maximize return at a certain level of risk or minimize risk while achieving a desired rate of return. It should come as no surprise that the use of equations in financial investing came at the same time as computers capable of executing those complex equations became the financial weapons of choice on Wall Street.
Bernstein summarized investment by equation as follows:
There is Louis Bachelier in 1900, holed up in the Sorbonne scratching out eternal verities about the behavior of speculative markets.....Fischer Black, Myron Scholes, and Robert Merton change the whole world of finance by staring at differential equations. Through it all, the only sound we hear is the clanking of primitive computers...The clatter of the computer and the roar of the trading floor are the sounds of a great battle in which investors compete with one another to determine who can buy at the lowest and sell at the highest....If the final product of the efforts of the financial theorists was only an assemblage of abstractions, those abstractions are the essential insights into how people do act and how people should act as they engage in the competitive battle.*
One of a growing number of critics of formulaic financial theories is the Wall Street veteran and author, Nassim Nicholas Taleb. In his 2004 best seller, Fooled By Randomness -- The Hidden Role of Chance in Life and in the Markets, Taleb takes economists to task for their reliance on equations as follows:
What has gone wrong with the development of economics as a science? Answer: there was a bunch of intelligent people who felt compelled to use mathematics just to tell themselves that they were rigorous in their thinking, that theirs was a science.....Indeed the mathematics they dealt with did not work in the real world, possibly because we needed richer classes of processes -- and they refused to accept the fact that no mathematics at all was probably better.**
Criticism of computerized, equation driven investing has grown after several highly publicized investment disasters. It has spawned a new branch of economic study called Behavioral Finance.
* Excerpts from Capital Ideas / The Improbable Origins of Modern Wall Street, Peter L. Bernstein, copyright 1992, published by The Free Press, a division of Macmillan, Inc., page 305. A new edition of the book was published in 2005 by John Wiley & Sons, Inc.
** Excerpts from Fooled by Randomness, Nassim Nicholas Taleb, copyright 2004, published by Random House, page 177.
Comments are always welcome.
Another financial author known for writing ability, not equations, is Peter L. Bernstein. He received his degree in economics from Harvard, but is known as a financial historian. Several of his ten books became best sellers. In 1992 he wrote Capital Ideas - The Improbable Origins of Modern Wall Street. In this work, he chronicled the evolution of modern investment theories. Starting with Louis Bachelier's 1900 Doctoral dissertation, The Theory of Speculation, Bernstein traces the evolution of Bachelier's dissertation with its formulas, which was "discovered" by later economists about sixty years after its publication, into the Modern Portfolio Theory (MPT). Using MPT and its supporting mathematical equations, investment professionals try to assemble a portfolio of assets to either maximize return at a certain level of risk or minimize risk while achieving a desired rate of return. It should come as no surprise that the use of equations in financial investing came at the same time as computers capable of executing those complex equations became the financial weapons of choice on Wall Street.
Bernstein summarized investment by equation as follows:
There is Louis Bachelier in 1900, holed up in the Sorbonne scratching out eternal verities about the behavior of speculative markets.....Fischer Black, Myron Scholes, and Robert Merton change the whole world of finance by staring at differential equations. Through it all, the only sound we hear is the clanking of primitive computers...The clatter of the computer and the roar of the trading floor are the sounds of a great battle in which investors compete with one another to determine who can buy at the lowest and sell at the highest....If the final product of the efforts of the financial theorists was only an assemblage of abstractions, those abstractions are the essential insights into how people do act and how people should act as they engage in the competitive battle.*
One of a growing number of critics of formulaic financial theories is the Wall Street veteran and author, Nassim Nicholas Taleb. In his 2004 best seller, Fooled By Randomness -- The Hidden Role of Chance in Life and in the Markets, Taleb takes economists to task for their reliance on equations as follows:
What has gone wrong with the development of economics as a science? Answer: there was a bunch of intelligent people who felt compelled to use mathematics just to tell themselves that they were rigorous in their thinking, that theirs was a science.....Indeed the mathematics they dealt with did not work in the real world, possibly because we needed richer classes of processes -- and they refused to accept the fact that no mathematics at all was probably better.**
Criticism of computerized, equation driven investing has grown after several highly publicized investment disasters. It has spawned a new branch of economic study called Behavioral Finance.
* Excerpts from Capital Ideas / The Improbable Origins of Modern Wall Street, Peter L. Bernstein, copyright 1992, published by The Free Press, a division of Macmillan, Inc., page 305. A new edition of the book was published in 2005 by John Wiley & Sons, Inc.
** Excerpts from Fooled by Randomness, Nassim Nicholas Taleb, copyright 2004, published by Random House, page 177.
Comments are always welcome.
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