Monday, May 30, 2005
Analysis - The Good and Bad
Those market participants that come to rely on technical and/or fundamental analysis of a company's stock justify their methods with a the very shaky idea that understanding the past dynamics of a company and it's stock will help one anticipate future movement. The belief that tomorrow's risks can be inferred from yesterday's prices and volatilities has prevailed at virtually every investment bank and trading desk. Modern finance's approach to mitigating risk by preparing for scenarios experienced in the past is simply an extension of the folly perpetrated by the common trader who feels that he/she can predict a future movement based on the theory that "history repeats itself", as Mark Twain said quite well, history does not repeat, it rhymes. With a countless number of market factors changing every instant, one can not rely on the market's past reactions to similar situations as any kind of useful indicator of future direction.
So if one can conclude that predicting future direction is not a reliable method to extract profits from a market, the question arises as to whether it is possible and if so what one should do. What many simply don't realize is that the correct approach to trading is one where the market pays the trader for a service. This service can take the form of many actions undertaken by the trader to the benefit of the market, many taking the form of various "levels" of arbitrage. The idea is that profit potential exists where markets lack efficiency. This can range from the extremely simple true riskless of arbitrage between two fungible securities - such as by buying identical shares on one exchange and selling them on another when a divergence exists - to the complex problem of pricing volatility in warrant and options markets.
The analysis a real trader must go through is the many times daunting task of uncovering inefficiency in a market and then devising a method in order to eliminate it - thereby earning a profit. This is complicated by the fact that many other intelligent traders are competing for the same opportunity, usually resulting in the quick elimination of the truly low/no risk opportunities. In future writings, I hope to go more into more depth on past, current, and future opportunities presented by our financial markets and how to approach them.
Wednesday, May 18, 2005
The Movement of Price
However, before I enter into an examination of why so many fail at both investing and trading, I feel a quick and dirty overview of asset pricing is due. The simple fact is that in all open markets, the forces of supply and demand, working unbridledly, will find the price equally beneficial to both buyers and sellers. And, even though it is perhaps possible (although unpractical) to gauge the entire supply and demand of a good at various prices, it is impossible to accurately and consistently predict the supply and demand of a good at various prices into the future. What may influence millions (or even a handful, the number really doesn't matter) of market participants at one point, may be moot at another. The fact is, with practically an infinite number of changing conditions, needs and sentiments, one can not reliably forecast much of anything.
The stern believers of market forecasting rely on the theory that market behavior exhibits [no matter how slight] a dependency on the past - i.e. the past affects the future. Forecasters use this idea in an attempt to divulge future market paths from past behavior. This is the reasoning applied to the idea of the existance of "trends", which I definately do believe in. A trend can be depicted by a time period in which increases of an asset price cause market participants to be more likely to purchase said asset, or vice versa. Just like in price, however, some market participants claim to see trends in numerous other factors and measures of market activity such as volatility, NYSE sentiment indicators, etc. What I do not believe in is the ability to forecast the beginnings and endings of these trends due to the fact that what appears as a "trend" to humans is simply a perfectly normal statistical artifact. As an example, while many would consider the movement below an "up-trend", it is simply a random walk - at any given point the probability of an increase or decrease is equal, 50% each.
Now, it is important to understand that even though it is quite possible that market movements follow a random walk, ipso facto making them as impossible to forecast as the flip of a coin, there are definite and specific money-making opportunities available to the keen market participant - more later, as you might imagine. For a good look into the dynamics of price movement, random walk, EMH (efficient-market hypothesis), as well as a good introduction into the possibilities behind market inefficiences and Mandelbrot's own view of things, I suggest The (Mis)Behavior of Markets. For a more focused look into the random-ness of markets, as well as a similar approach as Mandelbrot to popular models of risk, Taleb's Fooled By Randomness is a strong read.
Tuesday, May 17, 2005
Investor or Speculator?
What many fail to realize, including this author, is that any investment is a speculation. Personally, I place equal weight on a professional analysts ability to predict the future performance of a company as my ability to predict the price of crude oil in 5 years - pure luck with consistency coming as an illusion. The author makes the important acknowledgement of the place of emotion in the life of the speculator, further hurting the odds of success for the aspirer.Excerpt from "Investor or Speculator?" by Henry To:
The purpose of this article is to address the old debate between investment and speculation, specifically in the area of stocks, and to spark thought on which approach your capital accumulation philosophy falls under. So what is meant by investment and speculation? I prefer Keynes' definitions in The General Theory of Employment, Interest, and Money: in it, he defines "enterprise", which I interpret to be investment, as "...the activity of forecasting the prospective yield of assets over their whole life..." and "speculation" as "...the activity of forecasting the psychology of the market."
Speculation and investment are obviously not mutually exclusive, although, I do believe that most people with money in the game fundamentally fit into one bucket or the other - they may speculate in one part of their portfolio and invest in another, but when it comes down to it, I believe that most of us do not evenly straddle the line between those two approaches. Regardless, the key rule, that every investor and speculator in stocks needs to remember is that investors and speculators in a business, in the aggregate, can get no more out of a business over its lifetime than the business produces in cash flow to the owners. The prices will go up and down, but at the end of the day over the long-run, aggregate experience will approximate business performance (Warren Buffett has discussed this in numerous writings).Unfortunately, the concept of investing is not, in my opinion, necessarily encouraged by every business that deals with financial assets. My favorite is online brokers - almost daily I see ads, whether on TV, radio, newspaper, etc. that beckon you to join the 'revolution' and trade, trade, trade! Note the conspicuous absence of the words 'invest, invest, invest' from that mantra! In my opinion, these businesses have no incentive to encourage you to invest for the long run, because commissions would likely decline (assuming long-term investing involves less frequent trading).
Speculation, on the other hand, is obviously not without its rewards. However, pure speculation, without consideration of any macro or micro fundamentals, is a breeding ground for a dangerous thing: Emotion. If you can speculate but avoid the emotional baggage that permeates most minds when rolling the dice, then I would guess you have a leg up on most speculators. And you must maintain this emotionless activity for the long-term if you are speculator. And the long-term is what matters - the long-term is where the magic of compound interest picks up the economic football and runs for 100-yard touchdowns. So, to really grow your money, you have to work hard at plugging your dollars into opportunities with a high probability of a favorable outcome, after fees and taxes and do it year, after year, after year.
So, what about those chartered with investing the public's dollars: mutual fund managers. Are they investing? We all know that a significant proportion of mutual fund portfolio turnover rates are north of 100%, which, assuming they are investors, seems to imply that they see fundamentals (mostly micro-economic) changing so dramatically every year that they must completely change their portfolios annually to adjust to the changing fundamentals. I don't believe things change this quickly. To be fair, though, the mutual fund business does place a strangle-hold on those managers and impede their ability to make sound long-term high-probability bets on financial assets with solid economics. They are constrained by the negative perception of inactivity and the myopia of a constantly shrinking time horizon where investors are force-fed quarterly performance results (these are supposed to be perpetuities, right?) to cast judgment on relative performance. This is not the healthiest environment for fiduciaries of investors' money to operate under. (For a good read on mutual fund investing, read John Bogle's book Common Sense on Mutual Funds). I do believe, however, that most mutual fund managers intend to operate as investors, although I also believe that the modus operandi of the mutual fund industry does occasionally place certain handcuffs on the managers to make sound investing bets.
So, both investing and speculating can work. Warren Buffett and George Soros are fine evidence of that. The bottom line, though, is to know which game you are playing, play by the rules and risks of that game, and don't let emotion corrupt your decision-making framework. Benjamin Graham laid this out cleanly in The Intelligent Investor (fair disclosure: Graham's definition of speculation differs slightly from Keynes', in that Graham defines it as any "operation" that does not provide "...safety of principal and an adequate return."):
"Outright speculation is neither illegal, immoral, nor (for most people) fattening for the pocketbook. More than that, some speculation is necessary and unavoidable, for in many common-stock situations, there are substantial possibilities of both profit and loss, and the risks therein must be assumed by someone. There is intelligent speculation, as there is intelligent investing. But there are many ways in which speculation may be unintelligent. Of these are: (1) speculating when you think you are investing; (2) speculating seriously instead of as a pastime, when you lack proper knowledge and skill for it; and (3) risking more money in speculation than you can afford to lose."
So, the challenge here is to compound your money, year-after-year-after-year at a high after-tax rate of return after fees and taxes. How will you do it? If you are a speculator, understand that there are hurdles that must be cleared every year to make it work (e.g., transaction costs, taxes, and emotional recklessness) which are significant and impact the long-term growth of your corpus. If you are an investor, as Warren Buffett discusses in his preface to The Intelligent Investor (can you tell I'm a fan?), you will need the confidence to let your analysis guide your decisions and, as in speculation, the emotional fortitude to stick by those decisions.
To wrap up, I can't resist one more quote regarding this debate and, specifically the potential impact of the interaction of speculation and investment. This one is Keynes again in The General Theory of Employment, Interest and Money:"Speculators may do no harm as bubbles on a steady stream of enterprise. But the position is serious when enterprise becomes the bubble on a whirlpool of speculation."
Suitable commentary on the bubble we just experienced, even though it was written over 60 years prior.
However, it seems as though he fails to realize that even with the absence of emotion, success is no where near assured for speculation nor for investing. Finally, towards the end of the article he seemingly subconsciously blurs the two terms when discussing the importance of a lack of emotional interference in speculation as well as in investing by paraphrasing Mr. Buffet's words.
To conclude, even the author himself eventually, perhaps even unbeknownst to him, acknowledges the lack of differentiation between the two terms "investor" and "speculator". This article will hopefully serve as a good transition into a discussion of speculation (read: investing), the myth of technical/fundamental analysis as useful tools for predicting, and in time, how to profit from the markets from real edge. Stay tuned.
Sunday, May 15, 2005
Stocks - Investing
The power of being able to own a part of a corporation instantly and fairly transparently is undeniable, as well as the fact that the stock market - unlike derivatives or commodities markets - actually creates and destroys wealth. It is important to understand why stocks are so touted as an investment vehicle - the fact that since the U.S. stock market's inception, it has averaged a positive yearly return. Of course, whether it will continue to do so in the future is unclear. A major factor in stock market/index performance is the fact that failing companies are removed while strong companies remain - leading to a clear bias. I personally do not see the stock market as a reliable investment vehicle, only as one of wealth redistribution, to the majority of public interests.
Dow Jones Industrial Average (Log Scale)
The two most important things to keep in mind when investing for the long term in the stock market is the equity risk premium and the effects of inflation/taxation. By seeking the chance at higher returns offered by the stock market as compared to the risk free rate of return (a U.S. Treasury), you consequently assume a greater amount of risk. As a result, not only is there a strong chance that you will make less than the risk free rate but that you will lose money in your investment - people sometimes forget this. Second comes inflation, it's effects can not be ignored when considering any investment. Moreso affecting stocks would be taxes, however, as gains from investments (unless in a tax-exempt or deferred account such as 401k) are considered capital gains.
Ok, now I will try and tackle the big question of what to invest in. Most sensible people, although there are exceptions, will agree that when investing it is better to strive for lower risk (and consequently lower returns) for the long run. As a result, these people will target the blue chips, assuming that since these large companies have done well in the past they will continue to not only continue to rise in price but perhaps more importantly continue to pay high dividends. As we all know, however, big corporations can and do fall (see: WorldCom, Enron, etc) and consequently the current consensus on low-risk reliable return investing is the ETF or index fund. With an ETF you get the benefits of a mutual fund which invests in a variety of companies or even sectors to spread risk around as well as higher liquidity, lower costs and freedom to get your cash whenever you please, unlike a mutual fund. Personally, I find the risks associated with keeping my funds vested in any company for the long term (typically over a few months) as unbalanced to the possible returns - it is simply too difficult to have a good understanding of a company's (and especially the entire market's, in the case of an index ETF like the Qs) health nor the development of factors that may influence it's stock price.
While I'm not a strong believer in value investing, it is also unwise to purchase assets simply because they have risen in the recent past. Trying to time an entry is most likely fruitless unless you find yourself privy to insider information; you won't beat the market. As a rule of thumb, it is best to simply invest as funds become available. This can be applied to almost any asset, the fact is you will most likely lose money in the long run (or the opportunity for more money) by leaving your assets in cash rather than investing. Both fundamental and technical analysis, harolded by many to contain the holy grails of trading and investing are ironically worthless as they rely on the future being influenced by the past to forecast the behavior of assets. While this may be the case under some very specific situations, in general the market and even a particular stock is affected by entirely too many factors for the past to play any significant role in the future direction. As a result, fundamental and technical forecasting is rendered worthless, I will touch upon this in later articles.
Finally, always keep in mind that stocks (or a particular ETF) is not the end-all-be-all of investing. I suggest against trying to predict the future, instead make sure to expose your portfolio to various asset classes as well as sectors of all levels of recent performance - but this is an entirely different matter, asset allocation/diversification. Also, for one of my personal favorite books on the investment/saving psychology, check out Rich Dad, Poor Dad under the books section on the right.
What and why?
Why?
In my daily perusal of various financial and trading forums, I gradually became appalled by the level of ignorance present by not only potential investors and traders but by people claiming to make a good living "at the expense of Wall Street".The fact is, too many people simply do not understand first and foremost what they are getting themselves into, and in the fruitless search for riches fail to recognize that they will most probably lose (whether it be real money, time, or even opportunity). Hopefully, I will be able to keep the content flowing - the fundamentals as well as specifics of various asset classes, keys to investment success, the myth of EMH (efficient market hypothesis), trading a real edge and more. I encourage readers to e-mail me with any suggestions or questions regarding anything finance or trading related - there is simply so much to talk about it's difficult to stay focused so I will allow the readership to lead me as they see fit in this noble and perhaps hopeless cause to educate the world.
Note: I will not be publishing any conspiracy theories here, only the facts.
