Portfolio Management – Page 18

One Dozen Reasons Why the Average Person Underperforms In Investing, Part 2

Posted on 23 April 201523 April 2015 by David Merkel

You can catch part 1 here, where the first six reasons were:

Arrive at the wrong time
Leave at the wrong time
Chase the hot sector/industry
Ignore Valuations
Not think like a businessman, or treat it like a business
Not diversify enough

On to the last six reasons:

7)?Play around with pseudo-stocks

ETFs are simple. ?Perhaps they are too simple, allowing people to implement their investment views very rapidly, when have not done sufficient due diligence on the target of their investing.

As a quick example, consider the CurrencyShares series of ETFs. ?You know that if you use these, you are making an unsecured loan to JP Morgan, right? ?Well, you might be bright, but most people think these funds are collateralized.

ETFs are complex, particularly if you use any that are short or levered. ?They attempt to mirror the price move of a day, and typically underperform if held over longer periods. ?Again, you might know this, but most people don’t. ?Personally, I would ban them on public policy grounds.

Commodity ETFs and Bond ETFs have their own issues, as do ETNs with their credit risk, etc., etc. ?How many people actually look through the prospectus, or at least the information sheet provided by the fund? ?Precious few, I think.

If you use ETFs, stick to the good ones. (Article one, Article two)

8) Gamble

This one should be obvious. ?Most good investing focuses on avoiding losses, and compounding gains in a predictable manner. ?Taking chances, like speculating on the short-term direction of markets through puts and calls is a way to lose money predictably. ?(I leave out covered calls and married puts.) ?It is hard enough to get a good idea of where a stock is going in the long run. ?Getting it in the short run is much harder.

9) Ignore Balance Sheets and Cash Flow

Those who follow the fundamentals of most companies pay attention to the most manipulated of the three main financial statements — the income statement. ?Companies often try to make their earnings numbers, and compromise their accounting in the process.

Accrual entries depend on assumptions and can be tweaked to favor management’s view of profitability. ?Cash for the most part is a lot harder to fake, and most companies wouldn’t consider faking it, because few look there.

Looking at the change in net worth per share with dividends added back is often a better measure of financial progress than earnings per share. ?Beyond that, investing is not just about earnings, but about the margin of safety in the company. ?Many things look very cheap that have a significant risk of failure. ?Analyzing the balance sheet can keep you from many situations that will result in losses.

10) Try a little of this and a little of that ? No strategy / No edge

It takes a while to become good at a method of investing. ?Read about different methods and settle on one that fits the whole of your life. ?I gave up on certain methods because they took up too much time, and I had a family to tend to.

I rarely short assets, because to do it right would require large changes to the way I do risk control. ?(The same applies to options.) ?Good risk control is easy when the choice is between long assets and cash only. ?It gets a lot harder when you can short or go leveraged long, because you no longer have full control over what you are doing — the margin clerks will have some say over your assets.

Also, understand your circle of competence. ?What is your edge, and where does it apply? ?I avoid investing in biotechnology because I can’t tell a good idea from a bad one there, aside from estimating how long the company has before it needs to raise more capital. ?I do more with insurance than most do, because I intuitively understand how the companies work, and what a good insurance management team is like.

That doesn’t mean you can’t broaden your strategy or increase your circle of competence. ?But it does mean that you will have to study if you want to do it well. ?This is a business if you are going to make active bets in a big way. ?You will need to spend time equivalent or greater than that of a significant hobby.

11) Trade Aggressively

In general, you don’t make money when you trade. ?You make it while you wait. ?Most ideas in investing take time to work out, unless you are gambling on a short-term event, or speculating on a move in the stock price.

Most of the studies that I have done on investment in mutual funds of all sorts, including ETFs, show that buy-and-hold investors typically do better than the average investors in the mutual funds. ?On average, the losers are the ones who do the trading. ?That’s not to say there aren’t some clever traders out there. ?There are, but you are not likely to be one of them. ?Frequent trading, unless carefully controlled, is more likely to result in a lot of losses, and few gains, because fear causes many to panic in the short-run.

Even if successful, most aggressive traders get taxed more heavily than those with long-term gains. ?Most of my investment income qualifies for the lowest tax rates, and since I use big gains for charitable giving, my effective rates are lower still.

12) Short incautiously

This may affect the fewest number of my readers, but I have seen even professionals struggle with making money from shorting, particularly when they think an asset is worth nothing ultimately.

Shorting is a difficult way to make money, because your downside is unlimited, and your upside is limited to 100% if the asset goes to zero. ?Another way to say it is that your risk gets larger with shorting as the position moves against you. ?The risk gets smaller when long positions move against you.

if you must short, then treat it like a business and do it tactically.

Diversify shorts much more than longs.
Be tactical, and go for lots of little wins rather than a few big wins.
Set a time limit on your short positions at inception, and close out the positions no later than that.
Be aware that you are likely embedding factor bets on steroids, which can blow up in the wrong market environment. (E.g., short size, long value, short quality, short liquidity, short momentum, etc., would be common for a value oriented hedge fund)

Conclusion

Be aware of the foibles that exist in investing. ?There are many of them, as described in this article and the last one. ?If you want to profit over the long haul, act to avoid the traps that derail most retail investors. ?If you get knocked out of the game, and no longer invest as a result of a trap, you forgo all of the gains that you might have otherwise gotten with more diligence and patience.

On Negative Interest Rates

Posted on 21 April 201521 April 2015 by David Merkel

Photo Credit: Alcino || What is the sound of negative one hand clapping?

As with many of my articles, this one starts with a personal story from my insurance business career (skip down four paragraphs to the end of the story if you want):

25 years ago, when it was still uncommon, I wanted?to go to an executive course at the Wharton School for actuaries that wanted to better understand investment math and markets. ?I went to my boss at AIG (a notably tight-fisted firm on expenses) and asked if the company would pay for me to go… it was an exclusive course, and very expensive compared to any other conference that I would ever go to again in my life. ?I tried not to get my hopes up.

Lo, and behold! ?AIG went for it!

A month later, I was with a bunch of bright actuaries at the Wharton School. ?The first thing I noticed was aside from the compound interest math, and maybe some bond knowledge, the actuaries were rather light on investment knowledge, and I would bet that all of them had passed the Society of Actuaries investment course. ?The second thing I noticed were some of the odd investments described in the syllabus: it was probably my first taste of derivative instruments. ?At the ripe old age of 29, I was learning a lot, and possibly more than the rest of my classmates, because I had spent a lot of time studying investments already, both on an academic and practical basis.

I had already studied the pricing of stock options in school, so I was familiar with Black-Scholes. ?(Trivia note: an actuary developed the same formula for valuing optionally terminable reinsurance treaties six years ahead of Black, Scholes and Merton. ?That doesn’t even take into account Bachelier, who derived it 73 years earlier, but no one knew about it, because it was written in French.) ?At this point, the professor left, and a grad student came in to teach us about the pricing of bond options. ?At the end of his lesson, it was time for the class to have a break. ?I went down to make a comment, and it went like this:

Me: You said that we have to adjust for the fact that interest rates can’t go negative.

Grad student: Of course.

Me: But interest rates could go negative.

GS: That’s ridiculous! ?Why would you ever lend money and accept back less than you gave them, and lose the time value of money?!

Me: Almost of the time, you wouldn’t. ?But imagine a scenario where the demand for loanable funds leaves interest rates near zero, but the times are insecure and violent, leaving you uncertain that if you stored your cash privately, you would run too large of a risk of having it stolen. ?You need your cash in the future for a given project. ?In this case, you would pay the bank to store your money.

GS: That’s an absurd scenario! ?That could never happen!

Me: It’s unlikely, I admit, but I wouldn’t say that you can never have negative interest rates.

GS: I will say it again: You can NEVER have negative interest rates.

Me: Thanks, I guess.

Well, so much for the distant past. ?Here is why I am writing this: yesterday, a friend of mine wrote me the following note:

Good evening.? I trust you had a blessed Lord’s Day in the new building.?

Talking bonds today with my Econ class.? Here’s our question. Other than playing a currency angle why would anyone buy European debt with a negative yield?? The Swiss and at least one other county sold 10 year notes with a negative yield.? Can you explain that?? No interest and less principle [sic] at the end.

Now, I didn’t quite get it perfectly right with the grad student at Wharton, but most of it comes down to:

Low demand for loanable funds,?with low measured inflation, and
Security and illiquidity of the funds invested

The first one everyone gets — inflation is low, and few want to borrow, so interest rates are very low. ?But that doesn’t explain how it can go negative.

Things are different for middle class individuals and large financial institutions. ?Someone in the middle class facing negative interest rates from a checking or savings account could say: “Forget it. ?I’m taking most of my money out of the bank, and storing it at home.” ?Leaving aside the inconvenience of currency transaction reports if the amount is over $10,000, and worries over theft, he could take his money home and store it. ?Note that he does have to run a risk of theft, though, so bringing the money home is not costless.

The bank has the same problem, but far larger. ?If you don’t invest the money, where would you store it? ?Could you even get enough currency delivered to do it? ?if you had a vault large enough to store it, could you trust the guards? ?Why make yourself a target? ?If you don’t have a vault large enough to store it, you’re in the same set of problems that exist for those that warehouse precious metals, but with a far more liquid commodity.

Thus in a weak economic environment like this, with low inflation, banks and other financial institutions that want certainty of payment in the future are willing to pay interest to get their money back later.

Part of the problem here is that the fiat currencies of the world exist only to be?units of account, and not stores of value. ?Thus in this unusual environment, they behave like any other commodity, where the prices for futures are often higher than the current spot price, which is known as backwardation. ?(Corrected from initial posting — i.e. it costs more to receive a given cash flow in the future than today, thus backwardation, not contango.) ?The rates can’t get too negative, though, or some institutions will bite the bullet and store as much cash as they can, just as other commodities get stored.

To use another analogy, a while ago, some market observers couldn’t get why anyone would accept a negative yield on Treasury Inflation Protected Securities [TIPS]. ?They did so because they had few other choices for transferring money to the future while still having inflation protection. ?Some people argued that they were locking in a loss. ?My comment at the time was, “They’re trying to avoid a larger loss.”

Thus the difficulty of managing cash outside of the bond/loan markets in a depressed economy leads to negative interest rates. ?The financial institutions may lose money in the process, but they are losing less money than if they tried to store and protect the money, if that could even be done.

Index Investing is not Inherently Socialistic

Posted on 18 April 201519 April 2015 by David Merkel

How does capital get allocated to the public stock markets? ?Through the following means:

Initial Public Offerings [IPOs]
Follow-on offerings of stock (including PIPEs, etc.)
Employees who give up wage income?in exchange for stock, or contingent stock (options)
Through rights offerings
Company-issued warrants and convertible preferred stock, bonds, and bank debt (rare)
Receiving equity in exchange for other claims in bankruptcy
Issuing stock to pay for the purchase of a private company
And other less common ways, such as promoted stocks giving cheap shares to vendors to pay for goods or services rendered. ?(spit, spit)

How does capital get allocated away from?the public stock markets? ?Through the following means:

Companies getting acquired with payment fully or partially in?cash. ?(including going private)
Buybacks, including tender offers
Dividends
Buying for cash?company-issued warrants and convertible preferred stock, bonds, and bank debt
Going dark transactions are arguable — the company is still public, but no longer has to publish data publicly.

I’m sure there are more for each of the above categories, but I think I got the big ones. ?But note what largely does not matter:

The stock price going up or down, and
who owns the stock

Now, I have previously commented on how the stock price does have an effect on the actual business of the company, even if the effects are of the second order:

My initial main point is this: capital allocation to?public companies does not in any large way depend on what happens in secondary market stock trading, but on what happens in the primary market, where shares are traded for cash or something else in place of cash. ?When that happens, businessmen make decisions as to whether the cash is worth giving up in exchange for the new shares, or shares getting retired in exchange for cash.

In the secondary market, companies do not directly get any additional capital from?all the trading that goes on. ?Also, in the long run, stocks don’t care who owns them. ?The prices of the stocks will eventually reflect the value of the underlying claims on the business, with a lot of noise in the process.

My second main point is this: as a result, indexing, or any other secondary market investment management strategy does not affect capital allocation much at all. ?Companies going into an?index for the first time typically have been public for some time, and do not issue new shares as a direct consequence of going into the index. ?The price may jump, but that does not affect capital allocation unless the company does decide to issue new shares to take advantage of captive index buyers who can’t sell, which doesn’t happen often.

The same is true in reverse for companies that get kicked out of an index: they?do not buy back?and retire shares as a direct consequence of going into the index. ?They may buy back shares when the price falls, but not because there aren’t indexers in the stock anymore.

So why did I write about this this evening? ?I get an email each week from Evergreen Gavekal, and generally, I recommend it. ?Generally it is pretty erudite, so if you want to get it, email them and ask for it.

In their most recent email, Charles Gave (a genuinely bright guy that I usually agree with) argues that indexing is inherently socialist because you lose discipline in capital allocation, and allocate to companies in proportion to their market capitalization, which is inherently pro-momentum, and favors large companies that have few good opportunities to deploy capital.

I agree that indexing is slightly pro-momentum as a strategy, and maybe, that you can do better if you remove the biggest companies out of your portfolio. ?Where I don’t agree is that indexing changes capital allocation to companies all that much, because no cash gets allocated to or from companies as a result of being in an index. ?As a result, indexing is not an inherently socialistic strategy, as Gave states.

Rather, it is a free-market strategy, because no one is constrained to do it, and it shrinks the economic take of the fund management industry, which is good for outside passive minority investors. ?Let clever active managers earn their relatively high fees, but for most people who can’t identify those managers, let them index.

If indexing did lead to misallocation of capital, we would expect to see non-indexed assets?outperform indexed over the long haul. ?In general, we don’t see that, and so I would argue the indexing is beneficial to the investing public.

I write this as one who makes all of his money off of active value investing, so I have no interest in promoting indexing for its own sake. ?I just agree with Buffett that most people should index?unless they know a clever active manager.

On Being A Forced Seller in a Panic

Posted on 17 April 201517 April 2015 by David Merkel

No one wants to be a forced seller in a panic. So how does anyone get into that situation? ?Two things: bad planning and a bad scenario.

Let’s start with the obvious stuff: the moment you start using leverage, there is a positive probability of total failure, and more leverage increases the probability. ?Other factors that raise the probability are lack of diversification of assets, a short term for repayment on the leverage, a run on the bank, or restrictive rules on what happens if your assets decline too much in value.

For the big guys, I think that covers most of it. ?With little guys, there is one more painful way that it happens, with insult added to injury.

Assume the man in question has no formal leverage, except maybe a mortgage on his house. ?He has a stock portfolio, and like many, has bought popular stocks that everyone thinks will do well. ?Then a?significant panic hits the market because enough corporate or banking debts are incapable of being repaid.

The value of his portfolio falls a lot, but he doesn’t sell or worry immediately, because he has a solid job and has a buffer of a few months expenses set aside. ?Then the shock hits. ?In the midst of the panic he faces one of the following:

The loss of his job (or severe trouble in his business)
Disability with no insurance
An uninsured casualty of some sort
Divorce
Health problems not covered by insurance
Death (and his wife has to pick up the pieces)
Etc.

Guess what? ?Even though he planned ahead, the plan did not consider true disasters, where two things fail at the same time. ?His buffer runs out, and in order to live, he has to sell stocks at a time when he thinks they are undervalued.

This happens to some degree in the depths of bear markets, because unemployment and credit panics are correlated. ?Other contingencies may not be correlated, but a certain number of them happen all the time — the odds of them happening when the stock market is down is still positive.

What can be done? ?Here are a few ideas:

Hold a bigger buffer. ?Maybe toss in some high quality long bonds, as well as cash.
Reduce fixed commitments.
Insure most reasonably possible large insurable contingencies — death, disability, health, liability, etc.
Keep a rolling hedge of protective puts (costly)
Increase portfolio quality and diversification to lessen the hit.

The time plan for a flat tire is before you have one. ?As an example, I keep wrenches that are better than what the automakers put in their tire changing kits in my cars. ?The same is true for financial disasters. ?The planning is best done in the good times, like now. ?Consider your financial and personal risks, and adjust your positions accordingly, realizing that no one can survive every panic. ?Eventually you have to trust in God, because no earthly security system is comprehensive.

From Stream to Shining Stream

Posted on 11 April 201512 April 2015 by David Merkel

There’s one thing that is a misunderstanding about retirement investing. It’s not something that is out-and-out wrong. It’s just not totally right.

Many think the objective is to acquire a huge pile of assets.

Really, that’s half of the battle.

The true battle is this: taking a stream of savings, derived from a stream of income, and turning it into a robust stream of income in retirement.

That takes three elements to achieve: saving, compounding, and distribution.

What’s that, you say? ?That’s no great insight?

Okay, let me go a little deeper then.

Saving is the first skirmish. ?Few people develop a habit of saving when they are relatively young. ?Try to make it as automatic as possible. ?Aim for at least 10% of income, and more if you are doing well, particularly if your income is not stable.

Don’t forget to fund a “buffer fund” of 3-6 months of expenses to be used for only the following:

Emergencies
Gaining discounts for advance payment (if you know you have future income to replenish it)

The savings and the “buffer fund” provide the ability to enter into the second phase, compounding. ?The buffer fund allows the savings to not be invaded for current use so they can be invested and compound their value into a greater amount.

Now, compounding is trickier than it may seem. ?Assets must be selected that will grow their value including dividend payments over a reasonable time horizon, corresponding to a market cycle or so (4-8 years). ?Growth in value should be in excess of that from expanding stock market multiples or falling interest rates, because you want to compound in the future, and low interest rates and high stock market multiples imply that future compounding opportunities are lower.

Thus, in one sense, you don’t benefit much from a general rise in values from the stock or bond markets. ?The value of your portfolio may have risen, but at the cost of lower future opportunities. ?This is more ironclad in the bond market, where the cash flow streams are fixed. ?With stocks and other risky investments, there may be some ways to do better.

1) With asset allocation, overweight out-of-favor asset classes that offer above average cashflow yields. ?Estimates on these can be found at GMO or Research Affiliates. ?Rebalance into new asset classes when they become cheap.

2) Growth at a reasonable price investing: invest in stocks that offer capital growth opportunities at a inexpensive price and a margin of safety. ?These companies or assets need to have large opportunities in front of them that they can reinvest their free cash flow into. ?This is harder to do than it looks. ?More companies look promising and do not perform well than those that do perform well.

3) Value investing: Find undervalued companies with a margin of safety that have potential to recover when conditions normalize, or find companies that can convert their resources to a better use that have the willingness to do that. ?As your companies do well, reinvest in new possibilities that have better appreciation potential.

4) Distressed investing: in some ways, this can be?market timing, but be willing to take risk when things are at their worst. ?That can mean investing during a credit crisis, or investing in countries where conditions are somewhat ugly at present. ?This applies to risky debt as well as stocks and hybrid instruments. ?The best returns come out of investing near the bottom of a?panic. ?Do your homework carefully here.

5) Avoid losses. ?Remember:

Margin of safety. ?Valuable asset well in excess of debts, rule of law, and a bargain price.
In dealing with distress, don’t try to time the bottom — maybe use a 200-day moving average rule to limit risk and invest when the worst is truly past.
Avoid the areas where the hot money is buying and own assets being acquired by patient investors.

Adjust your portfolio infrequently to harvest things that have achieved their potential and reinvest in promising new?opportunities.

That brings me to the final skirmish, distribution.

Remember when I said:

You don’t benefit much from a general rise in values from the stock or bond markets. ?The value of your portfolio may have risen, but at the cost of lower future opportunities.

That goes double in the distribution phase. The objective is to convert assets into a stream of income. ?If interest rates are low, as they are now, safe income will be low. ?The same applies to stocks (and things like them) trading at high multiples regardless of what dividends they pay.

Don’t look at current income. ?Look instead at the underlying economics of the business, and how it grows value. ?It is far better to have a growing income stream than a high income stream with low growth potential.

Also consider the risks you may face, and how your assets may fare. ?How are you exposed to risk?from:

Inflation
Deflation and a credit crisis
Expropriation
Regulatory change
Trade wars
Etc.

And, as you need, liquidate some of the assets that offer the least future potential for your use. ?In retirement, your buffer might need to be bigger because the lack of wage income takes away a hedge against unexpected expenses.

Conclusion

There are other issues, like taxes, illiquidity, and so forth to consider, but this is the basic idea on how to convert present excess income into a robust income stream in retirement. ?Managing a pile of assets for income to live off of is a challenge, and one that most people?are not geared up for, because poor planning and emotional decisions lead to subpar results.

Be wise and?aim for the best future opportunities with a margin of safety, and let the retirement income take care of itself. ?After all, you can’t rely on the markets or the policymakers to make income opportunities easy. ?Choose wisely.

Opinions on the Market, Redux

Posted on 31 March 2015 by David Merkel

Here’s the second half of my most recent interview with Erin Ade at RT Boom/Bust. [First half located here.] We discussed:

Stock buybacks, particularly the buyback that GM is doing
Valuations of the stock market and bonds
Effect of the strong dollar on corporate earnings in the US
Effect of lower crude oil prices on capital spending
Investing in Europe, good or bad?

Seven minutes roar by when you are on video, and though taped, there is only one shot, so you have to get it right. ?On the whole, I felt the questions were good, and I was able to give reasonable answers. ?One nice thing about Erin, she doesn’t interrupt you, and she allows for a few rabbit trails.

Opinions on the Market

Posted on 24 March 2015 by David Merkel

I was on RT Boom/Bust yesterday with Erin Ade, and got to talk about:

Apple
The “Tech Bubble”
The “Bond Bubble”
Different sectors of the stock market, and their prospects.

This was the first half of the interview. ?If they run the second half, I will post it. ?Note my modest confusion on the tech bubble as I forget the second thing and try to recall it, while vamping for time. ?I don’t often glitch under pressure, but this was a bad time to have a foggy memory (on something that I wrote myself). ?Sigh. 🙁

Full disclosure: positions in sectors mentioned, but no positions in any specific securities mentioned

Simple Stuff: On Bid-Ask Spreads

Posted on 28 February 2015 by David Merkel

This piece is an experiment. ?A few readers have asked me to do explanations of simple things in the markets, and this piece is an attempt to do so. ?Comments are appreciated. ?This comes from a letter from a friend of mine:

I hope I don?t bother you with my questions.? I thought I understood bid/ask but now I?m not sure.

For example FCAU has a spread of 2 cents.? That I understand – 15.48 (bid) ? that?s the offer to buy and 15.50 (ask) ? that?s the offer to sell.

Here?s where I?m confused.? How is it possible that those numbers could more than $1 apart? EGAS 9.95 and 11.13.? I don?t understand.? Is the volume just so low? ?And last price is 10.10 which is neither the ask nor bid price.? Can you please explain?

You have the basic idea of the bid and ask right. ?There is almost always a spread between the bid and the ask. ?There can be occasional exceptions where a special order is placed, such as an “all or none” order, where the other side of the trade would not want to transact the full amount, even though the bid and ask price are the same. ?The prices might match, but the conditions/quantities don’t match.

You ask why bid/ask spreads can be wide. ?I assume that when you say wide, you mean in percentage terms. ?Here the main?reason:?many of the shares are held by investors with a long time horizon, who have little inclination to trade. ?Here is a secondary reason: the value of the investment is more uncertain than many alternative investments. ?I believe these reasons sum up why bid/ask spreads are wide or narrow. ?Let me describe each one.

1) Few shares or bonds are available to trade

Many stocks have a group of dominant investors that own the stock for the longish haul. ?The fewer the shares/bonds that are available to trade, the more uncertainty exists in where the assets should trade, because of the illiquidity.

Because few shares are available to trade, price moves can be violent, because it only takes a small order to move the price. ?Woe betide the person who foolishly places a large market order, looking to buy or sell at the best price possible. ?I did that once on a microcap stock (the stock of a very small company), and ended up doubling the price of the stock as my order was fully filled, only to see the price fall right back to where it was. ?Painful lesson!

As a result, those that make markets, or ?buy and sell stocks tend to be more cautious in setting prices to buy and sell illiquid securities because of the difficulty of trading, and the problem of moving the market away from you with a large order.

I’ve had that problem as well, both with small cap stocks, and institutionally trading illiquid bonds. ?You can’t go in boldly, demanding more liquidity than the market typically offers. ?If you are buying, you will scare the sellers, and the ask will rise. ?If you are selling, you will scare the buyers, and the bid?will fall. ?There is a logical reason for this: why would someone come into a market like a madman trying to fit 10 pounds into a 5-pound bag? ?Perhaps they know something that everyone else does not. ?And thus the market runs away, whether they really do know something or not.

In some ways, my rookie errors with small cap stocks helped me become a very good illiquid bond trader. ?For most bonds, there is no bid or ask. ?Some bonds trade once a week, month, or year… indicative levels are given, maybe, but you navigate in a fog, and so you begin sounding out the likely market to get some concept of where a trade might be done. ?Then negotiation starts… and you can read about more this in my “Education of a Corporate Bond Manager” series… I know most here want to read about stocks, so…

2) Uncertainty of the value of an asset

Imagine a stock that may go into default, or it may not. ?Or, think of a promoted penny stock, because most of them are in danger of default or a dilutive stock offering. ?Someone looking to buy or sell has little to guide them from a fundamental standpoint — it is only a betting game, with volatile prices in the short run. ?Market makers, if any, and buyers and sellers will be cautious, because they have little idea of what may be coming around the corner, whether it is a big news event, or a crazy trader driving the stock price a lot higher or lower.

For ordinary stocks, large enough, with legitimate earnings and somewhat predictable prospects, the size of the bid-ask spread reflects the short-run volatility of price. ?In general, lower volatility stocks have low bid-ask spreads. ?Even with market makers, they set their bid-ask spreads to a level that facilitates trade, but not so tight that if the stock gets moving, they start taking significant losses. ?And, as I experienced as a bond trader, if news hits in the middle of a trade, the trade is dead. ?You will have to negotiate afresh when the news is digested.

As for the “Last Price”

The last price reflects the last trade, and in this era where so much trading occurs off of the exchanges, the bid and ask that you may see may not reflect the true state of the market. ?Even if it does reflect the true state of the market, there are some order types that are flexible with respect to price (discretionary orders) or quantity (reserve orders). ?Trades should not occur outside of the bid-ask spread, but many trades happen without a market order hitting the posted bid or lifting the posted ask.

And though this is supposed to be simple, the simple truth is that much trading is far more complex today than when I started in this business. ?I disguise my trades to avoid alarming buyers or sellers, and most institutional investors do the same, breaking big trades into many small ones, and hiding the true size of what they are doing.

Thus, I encourage all to be careful in trading. ?Until you know how much capacity for trading a given asset has, start small, and adjust.

All for now, until the next time when I do more “simple stuff” at Aleph Blog.

Advice on Organizing Asset Allocations and Managers

Posted on 26 February 2015 by David Merkel

I was reading an occasional blast email from my friend Tom Brakke, when he mentioned a free publication from Redington, a UK asset management firm that employs actuaries, among others. I was very impressed with what I read in the 32-page publication, and highly recommend it to those who select investment managers or create asset allocations, subject to some caveats that I will list later in this article.

In the UK, actuaries are trained to a higher degree to deal with investments than they are in the US. The Society of Actuaries could learn a lot from the Institute of Actuaries in that regard. As a former Fellow in the Society of Actuaries, I was in the vanguard of those trying to apply actuarial principles to risk management, both when I managed risks for insurance companies, worked for non-insurance organizations, and manage money for upper middle class individuals and small institutions. Redington’s thoughts are very much like mine in most ways. As I see it, the best things about their investment reasoning are:

Risk management must be both quantitative and qualitative.
Risk is measured relative to client needs and thus the risk of an investment is different for clients with different needs. ?Universal measures of risk like Sharpe ratios, beta and standard deviation of asset returns are generally inferior measures of risk. ?(DM: But they allow the academics to publish! ?That’s why they exist! ?Please fire consultants that use them.)
Risk control methods must be?implemented by clients, and not countermanded if they want the risk control to work.
Shorting requires greater certainty than going long (DM: or going levered long).
Margin of safety is paramount in investing.
Risk control is more important when things are going well.
It is better to think of alternatives in terms of the specific risks that they pose, and likely future compensation, rather than look at track records.
Illiquidity should be taken on with caution, and with more than enough compensation for the loss of flexibility in future asset allocation decisions and cash flow needs.
Don’t?merely avoid risk, but take risks where?there is more than fair compensation for the risks undertaken.
And more… read the 32-page publication from Redington if you are interested. ?You will have to register for emails if you do so, but they seem to be a classy firm that would honor a future unsubscribe request. ?Me? ?I’m looking forward to the next missive.

Now, here are a few places where I differ with them:

Caveats

Aside from pacifying clients with lower volatility, selling puts and setting stop-losses will probably lower returns for investors with long liabilities to fund, who can bear the added volatility. ?Better to try to educate the client that they are likely leaving money on the table. ?(An aside: selling short-duration at-the-money puts makes money on average, and the opposite for buying them. ?Investors with long funding needs could dedicate 1% of their assets to that when the payment to do so is high — it’s another way of profiting from offering insurance in of for a crisis.)
Risk parity strategies are overrated (my arguments against it here:?one, two).
I think that reducing allocations to risky assets when volatility gets high is the wrong way to do it. ?Once volatility is high, most of the time the disaster has already happened. ?If risky asset valuations show that the market is offering you significant deals, take the deals, even if volatility is high. ?If volatility is high and valuations indicate that your opportunities are average to poor at best, yeah, get out if you can. ?But focus on valuations relative to the risk of significant loss.
In general, many of their asset class articles give you a good taste of the issues at hand, but I would have preferred more depth at the cost of a longer publication.

But aside from those caveats, the publication is highly recommended. ?Enjoy!

A New Exercise in Industry Rotation

Posted on 17 February 2015 by David Merkel

At Abnormal Returns, over the weekend, Tadas Viskanta featured a free article from Credit Suisse called the?Credit Suisse Global Investment Returns Yearbook 2015. ?It featured articles on whether the returns on industries as a whole mean-revert or have momentum, whether there is a valuation effect on industry returns, “social responsibility” in investing, and the existence of equity discount rate for the market as a whole.

There are no surprises in the articles — it is all “dog bites man.” ?They find that:

Industry returns exhibit momentum
There is a valuation component in industry returns
Socially responsible investing doesn’t necessarily produce or miss excess returns
There is an overall equity discount rate, which is levered about 20-25 times, i.e., a 1% increase in the rate lowers valuations by 20-25%.

The first two are well-known for individual stocks, so it isn’t surprising that it happens at the industry level. ?The third one has been written about ad nauseam, with many conflicting opinions, so that there is little effect is no big surprise. ?The last one resembles research I saw in the mid-90s, where the effect of changes in real interest rates has about that impact on stocks. ?Again, nothing new — which is as it should be.

But now some more on industry returns. ?They found that industry return momentum was significant. ?Industries that did well one year were likely to do well in the next year. ?The second finding was that industries with cheap valuations also tended to do well, but it was a smaller effect.

So, using one-year price returns as my momentum variable and book-to-market as a valuation variable (both suggested in the article), I divided industries for companies trading in the US into quintiles (also suggested in the article) for momentum and valuation. ?(Each quintile has roughly 20% of the total market cap.) ?Here is the result:

Low valuations are at the right, high at the left. ?Low momentum at the top, high momentum at the bottom. ?Ideally by this method, you would look for industries in the southeast corner.

To me, Agriculture, Information Technology, Security, Waste, Some Retail, and Some Transportation look interesting. ?One in the far southeast that is not so interesting for me is P&C Insurance. ?Yes, it has done well, and compared to other industries, it is cheap. ?But industry surplus has grown significantly, leading to more competition, and sagging premium rates. ?Probably not a great time to make new commitments there.

Anyway, the above table should print out nicely on two sheets of letter-sized paper. ?Not that it would be a substitute for your own due diligence, but perhaps it could start a few ideas going. ?All for now.