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Archive for November, 2010

Against Ayn Rand

Tuesday, November 30th, 2010

There is one main reason why I have never been tempted to read any book by Ayn Rand.  Her disciples are monomaniacs that if they were anything more than a tiny minority of society, would make life miserable for most people.  I have never met one that I would want to have as a neighbor.  They have the zeal of a religious cult, and twice the negative wisdom.

I write this as one who is a libertarian, but with a sense of ethical values, and a belief in regulating financial promises.  Selfishness is never a virtue.  Anyone who has raised children would know that.  Anyone familiar with what it is like to work in an office with one who is selfish would know that.  Anyone who is the child of a selfish person would know that.  And, surprise, most political scandals involve someone who has been selfish in the use of their office.

Selfishness makes life hard on those nearby, who have to live with the backwash of the actions of the selfish one.  We have seen in corporate America the actions of selfish people who run corporations, and goose their own pay to the detriment of shareholders and employees.  It leads to losses for all, when leaders more farsighted might earn more in the long run than asset-strippers and body-cutters.

Business is a cooperative game, and those that can motivate people to work efficiently and creatively can create a lot of value for many.  But that means sharing the value, not being selfish.

Recently, I have reviewed two books: Secrets of the Moneylab, and Priceless.  One major conclusion of the books indicates that people are not rational profit maximizers.  They care for status and their own sense of ethics.  They don’t want to promote greedy people, and they want to see their own relative status in society preserved.  They care what others think about them.

In one sense, followers of Ayn Rand are no better than Communists because they have the wrong model of man.  Instead of trying to create The New Communist Man, they try to create the New Selfish (Randian) Man.  Both are unrealistic for anyone caring about treating people fairly.

To the man who only has a hammer, everything looks like a nail.  In my own life, I have found that the more I act honestly, and look out for the good of others, the more I get rewarded.  I have known people who try to be tight in every transaction, and they don’t get done what I could, because they aren’t trusted like me.

Trust.  We trust those who are altruistic far more than those who are selfish.  I earned a lot more for my clients by being altruistic to Wall Street than being combative.  I got Wall Street to trust  me, and it yielded dividends for my clients.  Cooperation leads to more benefits than competition.

I have little respect for a woman who wrote a bunch of boring books, partially to justify her immoral life.  I don’t care if she favors free markets or not.  It is far better to consider whether ethical behaviour is present in the markets.

Ayn Rand was an intellectual lightweight, and a moral failure.  Following her is akin to intellectual suicide.

Thanksgiving Thoughts

Saturday, November 27th, 2010

My main reason for blogging is not to develop a business, make political points, or earn money off of book reviews, advertising, or anything else, but to give something back.  I have a gift of sorts, which means that I should do some “pro bono” work for the good of all.

My work is an expression of me, with all of my idiosyncracies, biases, contrarian views, and as my wife would say, “Merk Quirks.”  I love my wife.  We just celebrated our 24th anniversary.  She doesn’t understand much about money and finance, but she supports me in all that I do — as I support her in our efforts in homeschooling our children.  She works as hard as I do; we both work 12-16 hours/day, 6 days per week, and we love it.

What I write here is an expression of who I am, and how I interpret the world.  My experience has shown me that so far I do better than most at anticipating future problems.  That said, I usually can’t get timing or severity right.  But if I make things easier for people to understand, I consider that a victory.

I am healthy, but I don’t know how long I will live.  True for most of us.  While I have the chance, I try to write articles that will have longer validity than most.  I view my role as not telling you what to do, but trying to teach you how to think, so that you will do better.  I don’t want to die without recording what I think are my best thoughts.  I think I have done most of that, but there is more to do before I am done.

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With that, I want to comment briefly on Thanksgiving.  To me, it is more than family around a meal, though I cooked an excellent spread for my family and in-laws.

The next time I visit my in-laws house, I need to get the title of a book that I read there, which purports that the Pilgrims worked exceptionally hard to pay off their debts to the merchant adventurers who funded them.  The Pilgrims were idealists who risked life and limb for religious liberty.  I have no Pilgrim blood in me, but my kids have ~10% of their ancestry there through their Mom.

How hard did the Pilgrims work?  Consider this piece from my friend Caroline Baum, which she publishes annually, with small changes each year.  The Pilgrims, who suffered huge losses in their first year, would not have survived as a colony if they had not privatized agriculture.  Once they did that, they had plenty to eat and to trade for other goods.

Caroline comments, “Their good fortune had little to do with God.”  I would disagree. The Bible commends personal property rights and diligent labor through the eighth commandment.  Obedience to what God commanded brought blessing.

But to take another angle on this, the Pilgrims had quite a debt to pay off, and their agents in London did not negotiate well for them.  It took them ~20 years to pay off the merchant adventurers, who earned a return of ~40%/year off of the idealists who could not do the math, but who did love God.

Considering how well the merchant adventurers did, I would still say the Pilgrims were the victors.  They flourished in their faith, and having more wealth would not have brought them much in the new world.

Bradford, on the other hand, was not as pleased by the end of his life.  In a pattern that would repeat in US history, by the end of his life, Plymouth was almost deserted, because the descendants of the settlers had moved further west, seeking earthly prosperity.  Did they put the ideals of the original Pilgrims first?  No.

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In my own life, I could have earned a lot more money had I sacrificed my family and church.  There are tradeoffs in this life, and often the better things get sacrificed for monetary goals.  But to what end?

As for me, I am grateful for my family, my congregation, my church, my nation, and all the blessings that come from God to support them.  May God bless you, my readers, richly as well.

On Investment Modeling, Part 4

Wednesday, November 24th, 2010

I thought part 3 would be the end, but I ended up with one huge and good comment from a friend.  A real friend, not a Facebook friend.  I will respond to it in pieces.

Good article and series. A few comments and/or questions for you. First, there is no doubt that both value and momentum work. And while I happen to personally be a big believer in (certain) trend-following approaches, the way in which Covel interacts with people is childish at best. There is room for professional discourse and disagreement, but he has little interest in being professional about anything…at least in the blogosphere/twitterverse world. So, keep at it…be a gentleman and let the other chips fall where they may. Now, a few other areas:

I try to stay polite.  Sometimes I fail, but thankfully, it is not common.

1. First, I’d be interested to have you elaborate a bit further (or point me to a different post) on your views of the Carhart factors. In my mind, there is no doubt that they are betas…but at the same time, there is also no doubt that those betas can and should be used (carefully) as alpha factors as well. Much as my brain has been trained to think about them as simply betas, I’m more than willing to think about them in both ways. They aren’t mutually exclusive, are they?

I have no other post on this.  This series was meant to bring this idea buried in me to the surface.

I think the thing that set me off here is the value factor.  Value is regarded as a risk factor, when if you own enough stocks with the value factor, you will outperform over the intermediate term.  The same applies to momentum, it is a risk factor, but it tends to outperform.  The same can be said for size, small is usually a winner because of neglect.  Beta tends to be negatively correlated with outperformance.

If the factors were neutral, having zero expectation of future performance, they would be betas.  But that is not true even of “beta.”  Thus, most of the time one can make money by tilting to the moneymaking sides of these factors.

Recently, there was an analysis of Berkshire Hathaway for the last decade, showing Buffett had no alpha.  But if you looked at Berky versus the index, Berky beat it by 6%/year.  Buffett asks whether companies are cheap.  If he buys a company because it is specially cheap, or because its associated “risk” factors are cheap, that should be measured as skill, not taking risk.

If we add enough “risk” factors to the analysis, most alphas disappear.  But the ability of managers to buy when a risk factor is cheap does not go away, as does their ability to be “late followers” and lose money as so many retail investors do.

2. Second, and importantly, I don’t believe that every investment strategy can be boiled down to a fairly simple mathematical/quantitative approximation. Therefore, not every strategy can be tested in a purely academic sort of fashion. Take Covel’s trend-following, for instance. There are obviously many ways to do trend-following, but few are so simple as to easily do an historical test. It’s NOT simply momentum (as you well know!), and while momentum and trend-following certainly have some correlation, it would be a disservice to the TF crowd to view one as a proxy for the other. The buy and sell rules, timing of entry points, level of stop loss, etc. are hugely crucial to the success of the strategy.

You are right here, mostly.  What we test are only the quantifiable aspects of the strategy.  We don’t test, we cant test nuances.  Nuances will get lost in the noise.  We are out to test the first approximation of a strategy, not the strategy itself.

Most managers have an initial screen that winnows down the universe of stocks that they will then use their abilities to analyze.  Managers think that only a subset of stocks are worth their time, because that pool is likely to outperform, now let’s get the best of those.

In this sense, we are not testing the fullness of a manager’s processes, but only his initial quantitative screen.  Processes beyond that are alpha, whether positive or negative.

As one who has sat through many dog-and-pony shows (and you, friend, more than me), most managers fall into buckets off of their screens.  What is their investable universe?  We test that.  We can’t test the fine gradations beyond that — the law of small numbers interferes.

But what I will argue regarding trend following is that there is some measure of momentum that explains over 70% of the results of a wide number of trend followers, much as Buffett could point to the “Superinvestors” and claim that they were all one tribe, though the details differed considerably, much as Covel has done with trend following.  The first approximation of the group element is the important part tested.  Maybe we need to use principal component analysis to tease it out, but we do need to simplify the broad parts of the strategy for testing.  We can test the broad stuff.  Beyond that we are stuck.

3. So with #2 as an assumption, the only way to analyze TF is as a group of investors. Is there survivorship bias? Yes, but you have that with value guys, too. Is it enormously dependent on sticking with the system, even when it’s not working? Yes. Is there a good sample of auditable accounts out there? No…not so far as I’m aware. I think the issue that Covel has is that the majority of the best investment returns people have ever put up are from the momentum/TF crowd. However, one should very clearly separate investing from trading. The trading crowd has the ability to put up ginormous returns, but at what cost? Huge volatility, gigantic turnover, etc. that most people are not willing to live with.

Let Covel and his friends try to raise money from the institutional investment community.  We may admit that momentum works, but not the ability to consistently make money off of price/volume action when managing a large amount of money.  If they do have that skill, we need to explore it, and let the behavioral investors analyze it so that we get a first approximation, a factor, to explain it.

Survivorship bias? You bet that is there.  That is why we test mechanized first approximations to a strategy, not the strategy itself.  We test tribes, we don’t test families, much less individuals.

So in the end, as you’ve said before, it comes down to finding a system/approach that has shown the ability to work well for others and sticking with it through the tough times. No approach to investing/trading will be absolutely perfect every month, and most people lack the discipline to actually make it work over time. They switch from system to system, at the most inopportune times.

Thanks for the good work…keep it up!

You would know better than most that though I am generally a value investor, my own strategies are different because I use industries as my primary screen in investing.  And it is nonlinear — I look at those that are running, and those that are dying, but not the middle.  I consider macro factors that many do not, whether I am right or not.

I am one of those managers that would be hard to measure, if one wanted to measure things precisely; I don’t screen, as most managers do.  But I consider value, momentum, and mean-reversion effects to be givens, while I try to analyze what industries and companies will do well.

And that is a reason why I have not fared well with fund management consultants.  Like Covel, I do not fit their paradigm.  Unlike Covel, I would like to fit their paradigm.

But no, I am happy for the present to attract individual investors who want to outperform on a risk adjusted basis over a 5-year  period.  That is my forte, and I will pursue it with investors as my firm goes live at the beginning of 2011.

Book Review: The Last of the Imperious Rich

Tuesday, November 23rd, 2010

This is a great book for those that love economic history, as I do.  It describes the fortunes of the Lehman clan, Jews having emigrated from Germany, to antebellum Montgomery, Alabama, and later New York City, and what they did as a commodity trading firm that morphed into venture capital, and then investment banking.

As a family firm, it lasted for three-four generations.  There was less than one generation as a private company outside of family control.  Stagnation, and a need to allow for liquidity led to a need for a broader capital base, which led to the sale to American Express.

The title stems from the life of Bobbie Lehman, who was the last family member to lead the company, who as a financier, had such a commanding position that he struck fear in the hearts of those he would talk to, though he was a gentleman in many regards, and a patron of the arts to a high degree.

History is Messy

How did three immigrant brothers manage to create a behemoth, particularly with the original leader dying early?  Hard work; they were in the right places at the right times.  Their family structures held together well enough against increasing wealth, at least until the third generation.

They were pragmatic, and sometimes cut against their principles.  There is some evidence that the brother bought at least one slave.

The commodities that they traded in were in hot demand.  They built that into a big business.  That they had a presence both in the agricultural areas for commodities, and in the financial capital, New York City, was an ideal plan to have information from both sides of the market, supply and demand.

But the messiness of history is what makes this an interesting tale, and the author tells it well.

Quibbles

It’s a really good book.  I think it is best paired with A Colossal Failure of Common Sense: The Inside Story of the Collapse of Lehman Brothers, because it tells the end of the story better.  But the beginning of the story is rich, and had a few alternative decisions been made, Lehman might not have failed.

Who would benefit from this book:

I think most investors could benefit from the book, mainly because I believe that economic history is valuable.  History doesn’t repeat but it rhymes, and this gives us more than a few new poems to consider.

If you want to, you can buy it here: The Last of the Imperious Rich: Lehman Brothers, 1844-2008.

Full disclosure: This book was sent to me, and I don’t think I asked for it.  I’m  glad they sent it, though.

If you enter Amazon through my site, and you buy anything, I get a small commission.  This is my main source of blog revenue.  I prefer this to a “tip jar” because I want you to get something you want, rather than merely giving me a tip.  Book reviews take time, particularly with the reading, which most book reviewers don’t do in full, and I typically do. (When I don’t, I mention that I scanned the book.  Also, I never use the data that the PR flacks send out.)

Most people buying at Amazon do not enter via a referring website.  Thus Amazon builds an extra 1-3% into the prices to all buyers to compensate for the commissions given to the minority that come through referring sites.  Whether you buy at Amazon directly or enter via my site, your prices don’t change.

On Investment Modeling, Part 3

Saturday, November 20th, 2010

This is the last piece intended in this series, but I know that I will get a some abuse for it.  One small request to those who agree with me on this issue: if I get flames as a result of this piece, and you disagree with the flames, please comment in my favor.  Thanks.

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Warren Buffett once wrote a piece that is in one the editions of Ben Graham’s The Intelligent Investor, called The Superinvestors of Graham-and-Doddsville.  Buffett chooses nine investors that learned from Ben Graham, including himself, and shows how they outperformed the market averages over many years.

Very nice.  Another win for value investing.  I live in Graham-and-Doddsville for the most part, and have admiration for my neighbors.  No envy here.  I do well enough.

But, even though Buffett knew these investors long ago, and they were all students of Ben Graham, what I don’t know is whether Buffett culled only the best of Graham’s students for his essay.  I think the best of Buffett; I generally think he is an honest guy, but I don’t know for sure.  I write this as a convinced value investor.

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Far better to try to do a general study.  The trouble is that it is difficult to segment the market into value investors, and everyone else.  The category is squishy.  Even if we could define the category well, we would have a hard time aggregating all of the data from all of the brokerage accounts.

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So, what are we left with?  We boil down strategies into their quantitative essences, and measure the performance of the quantitative strategy versus the index.  The result is bloodless, and accurate to the first degree, in analyzing an investment strategy.

This is what the academics do.  Though I disagree with the Carhart factors, because I view them as alphas and not as betas, the basic idea of testing a strategy over the whole of the market is valid, if they take into account a full accounting for transaction costs.

See if the strategy is valid from the first approximation of turning it into a mathematical formula.  For value investing, it has worked.  Value factors have outperformed.  I love being a value investor, and I have been better than most of my competitors.

But that is not enough.  Price momentum factors have also outperformed.  Which brings me to my final point: Michael Covel hand-picked many successful trend followers in the his book, Trend Following.  He had more freedom to pick trend investors than Buffett did to pick value investors.  I give Michael Covel a choice:

  • Are you willing to recognize that value investing works, even as momentum investing works?
  • Or, do you end up a narrow-minded man who only sees one way to make  money in the markets?

Though I am mainly a value investor, I do not abhor momentum investing.  I incorporate it where I can.

But when Michael Covel chose other trend followers to demonstrate the value of his theory, he was less restrictive than Buffett was, and Buffett’s method was less than scientific.

I am not trying to pick a fight with Michael Covel.  On October 1st, we had a “discussion” over Twitter that he started, and I finished, where we discussed this topic.  Anyone who can re-assemble the full details of the topic please e-mail me, and I will post it.

I tried to be a gentleman, but Covel interpreted me as being a wimp.  I hate that.  A gentle answer discourages wrath, and that is what I aimed for, but he did not perceive it.

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Much as I am not crazy about academics in finance, the way that they analyze strategies is the only fair way of analysis, because it allows for no discretion.

There are two choices for doing an economic analysis in finance:

  • Segment investors, and analyze their performance
  • Describe the distinct strategies of investors in easy quantitative terms, and show how they perform versus the index.

There are a large number of studies that show that price momentum is a winning strategy.  I agree with those, and let Michael Covel agree with me.  I am not looking for a debate, but an agreement.

With that, I leave it in the hands of my readers.  Why not incorporate both value and momentum into your investing?

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Update: here is a transcript of the discussion with @Covel:


Covel: @AlephBlog You get grief because you don’t understand the subject and ignore the performance.

Merkel: @Covel As you wish sir.

Covel: @AlephBlog http://www.michaelcovel.com/2009/04/25/david-merkel-defending-a-wrong-view-to-the-bitter-end/

Merkel: @Covel I don’t bear grudges, do you?

Covel: @AlephBlog Is this seriously how you debate? Everything is an emotional counter?

Merkel: @Covel No, I still stand by what I wrote.  There are five parts, and you would do well to read them carefully.  My opinion is expressed.

Covel: @AlephBlog If you were serious about the subject you would examine the blind spots in your argument. You don’t and wise people see why.

Merkel: @Covel I responded in detail to your statements; you did not. Your use of “ad hominem” argumentation was without basis. Compare me w/Cramer?

Merkel: @Covel Look, I am fair. Please write a piece that shows pt-by-pt where I am wrong, or affirm that your last piece was that. I will +

Merkel: @Covel re-examine my “prejudices” and write a follow-up.  But, are you willing to be as fair? It’s your ball, run with it.

Covel: @AlephBlog If you are truly intellectually curious write a cogent argument for trend following performance. Don’t be lazy like your review.

Merkel: @Covel I have written many times on the value of using price momentum in investing.  I mentioned that in my reviews a number of times.

Merkel: @Covel Try this, then: http://alephblog.com/2009/01/21/a-different-look-at-industry-momentum/

Covel: @AlephBlog No banana. Explain the decades of trend following performance generated by the traders mentioned in my book. Let’s see it.

Merkel: @Covel In any strategy, those who do the best survive and get known. Using hindsight, they get picked to show that the strategy works.

Merkel: @Covel Buffett used the same argument for value investing in his essay The Superinvestors of Graham and Doddsville http://bit.ly/9IKsDf

Merkel: @Covel My answer to you is that cherry-picking is not analysis. Please do a study of all trend followers to prove your argument.

Merkel: @Covel Comprehensive article on the value of momentum and mean-reversion. http://bit.ly/cCzx2p This is what I think is careful research.

Covel: @AlephBlog Who are failures? Name them. Describe why they failed. Let’s see it. Don’t hide behind “Covel it’s only survivors!”

@edwardrooster @alephblog His argument is idiotic. He is trying to say thousands of trades over decades is luck. That is foolish.

Merkel: @Covel Selection of high performing investors does not prove that a method works. I am not saying anyone’s performance is luck. Momo works.

Covel: @AlephBlog I am out. Even if you read my book, there is no comprehension. Typical bias. Wrong, but unable to accept. You must protect self.

Merkel: @Covel Happy trails. Come back when you want to talk reasonably.  If you get to Baltimore, lunch is on me.

Book Review: Buying at the Point of Maximum Pessimism

Friday, November 19th, 2010

This book is misnamed.  The subtitle should have been the title, or, the author should have entitled it “The Financial Crisis and the Aftermath: Six Ways to Make Money Now,” because that is what the book really is.

I asked the publisher for the book partly because the title is one of the maxims of Sir John Templeton, a value investor that I respect.  One of his nieces is an investor, and wrote an introduction to the book that her husband wrote.

The sad thing is that the book doesn’t relate to the title much at all.  How to have the fortitude to buy at the point of maximum pessimism is quite a gift.  The book does not address that topic in any significant way.

This is the way the book is designed: the first half of the book talks about the financial crisis, and the second half talks about six different themes that the author thinks are promising:

  • China
  • Agriculural Proteins
  • Energy
  • Green Technology
  • Education
  • Rare Earth Metals

I find this to be an odd set of themes.  I am on board with agricultural proteins and energy, but the other themes have issues.  China is like Japan in the late ’80s.  Lots of growth, but is it growth that will beget more growth?  Green Technology has yet to prove its usefulness; often it is not as resource conservative as conventional technology.  Education is a good idea, but for-profit educators are not the best in terms of quality, and may not be a great investment.  Product quality matters.  As for Rare earth metals: yeah, great idea, would that you had said this earlier.  Most investments in stocks involved in rare earth metals are quite expensive.

That’s a metric that anyone involved in thematic investing should use.  What is the price versus the promise?  The book gives no guidance here.  As such, I find the book to be fundamentally flawed, and a stain on the good name of Sir John Templeton.  Better the authors had not tried to cash in on his name.

Quibbles

I have no quibbles with the book.  The book is flawed for the reasons listed above.  If the book had had a different title, I might have liked it, or not.

Who would benefit from this book:

Those wanting to read about the six trends could benefit from the book, but I would hardly call them “value investing.”  That said, the book is long on theory and short on practice.

If you want to, you can buy it here: Buying at the Point of Maximum Pessimism: Six Value Investing Trends from China to Oil to Agriculture.

Full disclosure: I asked the publisher for a copy, and they sent one to me.

If you enter Amazon through my site, and you buy anything, I get a small commission.  This is my main source of blog revenue.  I prefer this to a “tip jar” because I want you to get something you want, rather than merely giving me a tip.  Book reviews take time, particularly with the reading, which most book reviewers don’t do in full, and I typically do. (When I don’t, I mention that I scanned the book.  Also, I never use the data that the PR flacks send out.)

Most people buying at Amazon do not enter via a referring website.  Thus Amazon builds an extra 1-3% into the prices to all buyers to compensate for the commissions given to the minority that come through referring sites.  Whether you buy at Amazon directly or enter via my site, your prices don’t change.

On Investment Modeling, Part 2

Thursday, November 18th, 2010

Before I begin tonight’s piece, one small thing that I want to point out from my last piece was that though my models were a few years ahead of the life insurance industry, the two most important things that I did were:

  • Not optimize for best return, even if risk adjusted.  I gave extra weight to avoiding the downside.
  • Added in the details.  My models were entirely home-grown, and took advantage of my programming abilities to come to a sharper result.  I am not a good theoretical mathematician, but I am good at using math to solve practical problems.

The idea is model completely, and don’t ignore scenarios that could not happen.  My interest rate model had scenarios that mimicked what we actually got, though what we got was not a high probability.

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One of the themes that I came away with from the Denver conference last week was look through the windshield, not the rearview mirror.  But much of the investment industry, and retail investors are destined to  look through the rearview mirror.  I, as an actuary, have been unfairly accused of driving life insurance companies through the rearview mirror, look at this and say that we can look through the windshield, but we have to be more than the common shlubs who are the majority of the market.

To do that we have to adopt an independent disposition, and not care about raising funds, but only earning returns for clients.  If we build it, they will come.  In one sense, it is like someone who has a beautiful singing voice, but who avoids pride, and admires his voice as if it were someone else’s voice. (Apologies/Credit to C. S. Lewis)

The main point here is to look through the windshield, and exercise intelligent independent judgment.  Analyze the situation, and figure out where there is an advantage as a businessman.  The tools of modern portfolio theory will be useless here, so ignore them.  They only sharpen/obscure our understanding of the past/present by calculating parameters that are not stable or predictive.

The only positive thing about Modern Portfolio Theory is that it sidelines a bunch of bright guys who would otherwise be competitors in the markets.  Sun Tzu would admire this tactic — getting a large portion of the opposition to become peaceniks because the expected value of the war is zero or negative.  It’s as if an economic Tokyo Rose is broadcasting that competition in financial markets is futile — in aggregate, everyone will get average performance, so why fight to get better performance?  It’s futile; give up; go home.

I would simply say there is always a decent amount of lazy investors in the market. Smart investors can get better returns through paying careful attention to what seems to offer the best returns on a forward-looking basis.

Part of looking through the windshield is avoiding noneconomic constraints.

1) Do I care where a company is located? Yes. I want a place where the rule of law is honored.  As many have commented at my blog, does that include the US?  Yes, for now.  Global diversification is important.  That said, it will be interesting to see what will happen to investments should we see tariffs, foreign exchange controls, and expropriation.  At least in you own home country you only have to deal with the “devil you know.”

2) Do I care whether a company has a large or small market capitalization?  Not now.  Even if my asset management firm grows, I will adjust my strategy to include attractive small caps at lower target percentages.  If my buying begins to affect the stock price, I will take smaller positions.

3) Do I care if a stock is “a growth stock” or a “value stock?”  No, I care more about industry and firm prospects relative to price.  I will pay up on occasion.  Still, mostly I try to buy them cheap, and it biases me toward “value stocks.”

4) Do I care about whether a stock is volatile or not?  Yes.  Stock price volatility is a sign of low creditworthiness, and usually I only buy higher quality stocks.

5) Do I care about price momentum?  Yes.  Typically, I buy companies that have strong current momentum, or poor momentum over 3-5 years.  Is it what I focus on?  No.

6) Do I care if I have an “undiversified” portfolio?  No.  I want to be in the right place at the right time on average.  Mimicking the index is a recipe for mediocrity.

7) Do I care if I am holding cash?  Yes.  I’d rather be in stocks, but will build up cash if I have to.  Cash moderates volatility in a concentrated portfolio, and allows for opportunistic purchases.

8 ) Do I care if I underperform?  You bet.  It burns a hole in my gut.  But it doesn’t make me change my methods.  It will make me sharpen my analyses.

A large part of the idea is to focus on risks, not risk.  Academics focus on univariate risk, with its simplistic math — beta, standard deviation, skewness, and all of the half-measures and ratios that stem from them.  I can’t model my methods in full, but I look at the risks in particular for each of my investments.  Every investment has to justify its existence in my portfolio independently.  I don’t do correlations; they are not reliable.

I also don’t go in for the four Carhart risk factors — beta, size, value/growth, and price momentum.  I don’t think of them as “betas,” but as “alphas.”  These are factors that can be taken advantage of when they are cheap or rich.  They are not risk factors, they are simply factors.

In closing, there has been a shift in the environment from inflation to deflation.  How does that affect investment choices?  My guess: buy well-financed companies with a low price to tangible book.  Stagflation?  In the ’70s the answer was low P/E with pricing power.

The closing segment of this series will focus on how to do statistically valid studies of investment performance.  I know at least one person who may be annoyed by what I say, but it is important to try to be fair in investment analysis, lest we lead others astray.

On Investment Modeling, Part 1

Tuesday, November 16th, 2010

Investing is a battle between the past, present, and future.

The past tempts all to look and see what has happened, and extrapolate, or assume mean-reversion.  It tempts academics to use simplistic math, and calculate alphas, betas, standard deviations, R-squareds, and more.  They consider the past to be prologue.  They estimate assumptions for asset allocation off of averages of past returns, sometimes even making the error of arithmetic averages, rather than geometric averages.

But the past is the past.  It happened, and it usually has little bearing on the future, aside from momentum effects when few are following momentum.  Those who calculate models off of historical data describe the past in a stylized way.  The past is a historical accident; generalizing from it in precise terms is difficult.  In some ways I think that analogies from the more distant past have more validity, partly because they are less known by the average market participants.

Those who use the past for asset allocation are doomed for failure.  The past is the past.  Bonds returned well in the past, but the best estimate of a bond’s return over its maturity is the YTM now.

The present intrudes on the past that way. With stocks, the same thing happens measuring current P/Es, P/Bs, P/Ss, versus long term average returns.  It is far better to be a buyer when a stock is out of favor, but not dying.

In the present we can estimate implied volatilities from options, and even implied correlations in certain cases.  Real-time as those are, they give the knife-edge of the estimate of how things react presently.

But as for the future?

We have precious little in the way of clues.

Yes, value and momentum may give us some guidance when they are underfollowed, but they are poor and weak guides to the future.

The truth is that we just don’t know.  Our models are often regime-dependent, because data has been collected over a limited period of time.  I smiled at the Denver conference that I recently attended, as models were trotted out that were based on 20 years of data or fewer.

Now, I don’t blame the researchers, including myself, much.  We all look for the biggest, longest set of clean data we can find.  We realize there are things that we aren’t testing.  We should know that there are hidden variables that haven’t varied much during a regime, that might our results quite different when the regime shifts, but for the most part those are Rumsfeldian “unknown unknowns.”

=-=-=-=-

Excursus: I once did a seemingly hopeless project to try to estimate withdrawal sensitivity to interest rate movements on deferred annuities.  I completed it in 1998, with 16 years of data, on hundreds of thousands of policies.  Big known problem: interest rates had fallen over the whole period.  But the need for the project was evident, because interest rates had nowhere to go but up, right?  With a little clever modeling, though, I teased out the statistically significant result that a one percent rise in the difference between competing and our deferred annuity yields would lead to additional withdrawal of 2%/yr.

At first, I thought 2% was too small, but then I realized it was an option not efficiently exercised.  So I left padding  in my analysis, assuming that if the market ran away and we couldn’t keep up, that withdrawal levels would be far higher than a ratio of 2.  I built my asset-liability model, which had the capacity of running multiple scenarios developed from my multivariate mean-reverting lognormal interest rate model, built from my homegrown quasi-monte carlo multivariate random number generator.

I did not set the model to optimize investment policy.  Instead, I set it to do well on two criteria that I weighted: minimize losses in the lowest 5% of the tail, and best average result.  When I got the results, they looked wrong; but the more I looked at them, I realized they were right.  I did two versions, one that allowed for the use of interest rate options, and one that didn’t.  Knowing  that my investment department had no quants, I realized the options would be a tough sell — indeed, they chose the option without them.  But then they asked me, “Dave, these are deferred annuities; crediting rates vary annually.  You’re telling us to invest three years longer than we are currently in duration terms — that’s huge.  And why 20% in 30 year bonds?”

My answer was a simple one.  We were all concerned about rates rising and withdrawals that would occur from that.  We missed the other issue, because interest rates can only go up from here, right?  Floor guarantees.  If rates continued to fall, we would have no ability to lower rates further on an increasing amount of the policies; those policies also would have low lapse rates.  When I explained how close we were to the floor we were they caught on, and realized that we had a rare “free lunch.”  Limit risk and improve returns all at once.

Actually, it meant we had mismanaged the business previously, because it was the first withdrawal study in the history of that line of business, but at that point it increased the profits of the company significantly.  What’s more — rates didn’t rise as we all knew they would.  The change in investment policy saved the insurer that merged/acquired the company a lot of headaches.

=–==-=-=-

So, with whatever our results seem to be, we have to take caution and not overdo what our results seem to prove.  Risk control should be the order of the day.  Buffett said that all he wanted in life was an unfair advantage, but with our limited knowledge of how markets work, we have to realize that we probably have less advantage than we think.

I have more to say here, but I have to hit the publish button — too long already; more coming in part 2.

Ethics and Investment Writing

Saturday, November 13th, 2010

There are three things that I am happy with when it comes to writing about investments:

  • I am glad that Jim Cramer invited me to write for RealMoney seven years ago.  Motown Josh Brown put together a great piece on the influence that TSCM has had on the financial media.  I heartily agree, and I don’t think we know the half of it.  I interacted with a lot of young TSCM staffers, and it amazed me what an education they got in the markets working for TSCM.  TSCM blended respect and skepticism for the markets, and though you couldn’t have done it without Cramer, the effect on the financial media exceeds him, and for that we can all be grateful, because the financial media is a lot sharper than it was 15 years ago.  (Okay, leave out much at CNBC.)  And who knows, maybe I will return to TSCM someday in some capacity; the door is open.
  • I’m glad I started my blog.  I still think that financial bloggers are the conscience of Wall Street.  There is a need for knowledgeable people to write about economic/investing/finance issues.  It does not replace journalists, but supplements them.  Intelligent commentary complements “neutral” reporting on a topic.  Journalists learn from area experts, playing them off against each other to get a fuller picture of the debate.  (As an aside, the motive to start the blog began on one of the comment boards at TSCM for Cramer.  Readers were fascinated that I would post there, and told me I needed to develop my voice.  A few called me the anti-Cramer, but I never took up that moniker.)
  • I am grateful that I am a CFA Charterholder.  Harry Markopolos recently spoke to the Baltimore CFA Society, mainly about his uncovering of the Madoff scandal, but he spent a decent amount of time explaining why the CFA Institute and our ethics code can make a huge difference in reforming Wall Street.  I was impressed; his beliefs in honesty and fair dealing drive his actions.  (I talked with him afterward, and we realized we must have met seven years before, at a regional meeting of the Northeastern CFA societies, when I was sent by the Baltimore CFA Board to represent us in a ticklish issue regarding the leadership of AIMR.  He had helped lead the effort to replace the existing leadership.)

But that’s not my major reason for writing tonight.  I want to comment on two pieces in the Wall Street Journal that comment on shady practices.

The first one is entitled Shining a Light On Murky 401(k) Fees.  The Department of Labor has the dubious distinction of being less effective than the SEC on investment regulation.  A lady I sat next to at the Denver conference regaled us with how her daughter’s 401(k) plan had expenses equal to 12%/year of assets.  I hope she made a math error, but she is a Ph. D; it’s not likely.

From my own experience at Provident Mutual in the nineties, it was easy to see how expenses could get layered.  We tried to be among the more ethical in that business, but the temptation to pay a lot in order get more business was dangled in front of us regularly, and we refused.  We had a rule that if comp was not disclosed, agents had to disclose that comp was not disclosed. And if they took nondisclosed comp, they could not have additional disclosed comp, because it would give the illusion of “That’s all I am paid.”

Do we need limits on 12b-1 fees?  I would prefer a full disclosure of fees — who and how much, poking through relationships to explain who ultimately is giving services to the 401(k) plan, and who is collecting rents as “gatekeepers” for the plan.

There is a lot to be done here.  Would that the DOL would invest a little money in buying skeptical experts, and really grasp the complexity of what is going on there.

The second one is entitled Structured Notes: Not as Safe as They Seem.  When I (along with others) was taking a demo of a custodian recently, the rep of the custodian went out of his way to show the area of the website that offered structured notes.  I commented, “Those are evil. They offer yield, but they make people short expensive options.”  After an embarrassed pause, the rep said, “Let me demonstrate an area of bonds that is not evil,” and he moved onto Agencies.  I didn’t have the heart to tweak him twice.

I wrote a piece a while ago called “Yield, the Oldest Scam in the Books.”  Structured notes offer above market yield, while that yield, or some of the capital, could be negatively affected if events perceived to be unlikely would occur.  The investment banks can hedge those risks more effectively than the Structured Noteholders can, and they pocket large profits.

The concept of “contingent protection” annoys me.  The odds of triggering such protection are much higher than the average person expects.

Do not buy structured notes.  The investment banks know far more than you.  Do not buy what others want to sell you.   Use your good mind, and buy what you like.

There is no one on Wall Street looking to do you a favor, so view your broker with skepticism.

Book Review: That Thing Rich People Do

Saturday, November 13th, 2010

That Thing Rich People Do

If you know anything about investments, this is not the book for you.  This is the book for your relative or friend that doesn’t have the barest idea about how to manage money.

This was another book that I thought I would not like after the first few chapters.  Too cutesy.  Too certain.  As the book moved on, it broadened out and gave the sort of advice that I would give to neophytes, with a few exceptions.

The book’s title derives from the show “30 Rock,” where the character played by Tina Fey says, “I have to do that thing rich people do, where they turn money into more money.” (Sigh.  I am so glad I don’t own a television.  Hey, let me give you some unsolicited advice: get rid of your television.  You will become far more rational and productive, and then, you will have more opportunities “to do that thing rich people do, where they turn money into more money.”  Sorry, turning rant mode off.)

This book gives the basics:

  • Saving
  • Stocks
  • Bonds
  • Asset allocation
  • Warnings on insurance and annuities.
  • Diversification
  • Avoiding Fear and Greed
  • Avoiding Expenses
  • Avoiding Taxes
  • Passive Investing (best for neophytes)
  • Further Reading — if a neophyte needed a book list to expand his knowledge, the author gives a good list.

The book is clearly written, and sometimes engaging, sometimes humorous.  But it gets the job done for neophytes, and that is what counts.

Quibbles

It would have been a benefit to the average reader to point them to Vanguard, especially for bonds, when expenses eat up so much of the returns.

Who would benefit from this book:

Only neophytes will benefit from this book.  It’s not long at ~140 pages; the chapters are easy to read at an average of 6 pages.

If you want to, you can buy it here: That Thing Rich People Do: Required Reading for Investors.

Full disclosure: I asked the publisher for a copy, and they sent one to me.

If you enter Amazon through my site, and you buy anything, I get a small commission.  This is my main source of blog revenue.  I prefer this to a “tip jar” because I want you to get something you want, rather than merely giving me a tip.  Book reviews take time, particularly with the reading, which most book reviewers don’t do in full, and I typically do. (When I don’t, I mention that I scanned the book.  Also, I never use the data that the PR flacks send out.)

Most people buying at Amazon do not enter via a referring website.  Thus Amazon builds an extra 1-3% into the prices to all buyers to compensate for the commissions given to the minority that come through referring sites.  Whether you buy at Amazon directly or enter via my site, your prices don’t change.

Disclaimer


David Merkel is an investment professional, and like every investment professional, he makes mistakes. David encourages you to do your own independent "due diligence" on any idea that he talks about, because he could be wrong. Nothing written here, at RealMoney, Wall Street All-Stars, or anywhere else David may write is an invitation to buy or sell any particular security; at most, David is handing out educated guesses as to what the markets may do. David is fond of saying, "The markets always find a new way to make a fool out of you," and so he encourages caution in investing. Risk control wins the game in the long run, not bold moves. Even the best strategies of the past fail, sometimes spectacularly, when you least expect it. David is not immune to that, so please understand that any past success of his will be probably be followed by failures.


Also, though David runs Aleph Investments, LLC, this blog is not a part of that business. This blog exists to educate investors, and give something back. It is not intended as advertisement for Aleph Investments; David is not soliciting business through it. When David, or a client of David's has an interest in a security mentioned, full disclosure will be given, as has been past practice for all that David does on the web. Disclosure is the breakfast of champions.


Additionally, David may occasionally write about accounting, actuarial, insurance, and tax topics, but nothing written here, at RealMoney, or anywhere else is meant to be formal "advice" in those areas. Consult a reputable professional in those areas to get personal, tailored advice that meets the specialized needs that David can have no knowledge of.

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