Economic Outlook and Metaphysics

February 24, 2018February 26, 2018 / 416Investor / Leave a comment

Prelude
I must admit, originally I intended this post to be strictly about my market outlook and crypto-mania. However, adding my afterthoughts allowed me to recollect my ideas in ways I otherwise couldn’t have; so in a sense, this post has been much more self-serving. I have two goals: to inform and invoke curiosity. If I can encourage the latter, I will have more than succeeded. If not, at least the efforts were valiant.

“Many shall be restored that are now fallen and many shall fall that are now held in honor” – Horace

Time Travelling
In the Fall of 2017, The Economist released an issue with a captivating title: “The Bull Market in Everything”. As the title implies, the sub-article embodied to a great degree the current market conditions: prices in almost every asset class reaching all-time highs, GDP growth seemingly great and investor psychology relatively optimistic. Add in the then-booming price of Bitcoin and cryptos, you really see why “The Bull Market in Everything” fits the headline.

Skyrocketing prices should warrant caution. The immediate reason for worry are basically twofold. For the past decade, the markets have been prompted by near-zero interest rates through quantitative easing. Only now, has the Fed started to unwind its policies. Along with a (hopefully) gradual interest rate hike, it will begin selling its some $11trn bonds it had previously purchased to re-stabilize the economy. The second, perhaps more worrisome reason, is the increasing degree of euphoria, and progressive pro-risk behaviour that has plagued market participants. At the end of the article, the author ends with words from the Godfather of value investing, Benjamin Graham: margin of safety- which many should heed to today and will form the central theme of what’s to follow.

In his time, Graham was concerned with the term “investor” loosely being used. The Godfather of value investing had initially defined the term investing as: “An investment operation is one which, upon thorough analysis, promises safety of principal and a satisfactory return. Operations not meeting these requirements are speculative”. As markets reach new highs- participants have become increasingly imprudent, seeking higher yields and seemingly (and/or unknowingly) accepting higher risk; ultimately eroding their margin of safety. It seems now-again, the word investor is being used to describe any market participant, including and notably, crypto-mania bandwagonners. As we stand near the top of the markets, gazing into the unknown (as we’ve been doing for the past years), Graham’s concern of investor versus speculator should rightfully resurface, and more importantly; re-emphasized.

Only Time Will Tell
Semantics aside, the distinctions between investing and speculating are still debatable-and will continue in the future. Perhaps most distinctions are on the individual level, and include specific characteristics. An investor measures price in relation to intrinsic value and can close the gap between their thoughts and reality. Amazon may be a great company, but that in itself doesn’t warrant a buy. You wouldn’t pay infinite dollars for a share- but how much would you pay at this moment, given a sensible future earnings? Answering this with some degree of accuracy requires extensive intellect, financial knowledge and in-depth qualitative and quantitative analysis. Another notable trait of the investor is, as Buffett mentions, knowing your circle of competence. Other qualities include good temperament, high EQ, and patience. Although much of the rational-linked qualities are required to characterize an investor, it’s not all black and white.
Some degree of leakage occurs between investing and speculating. When facing uncertain measures; the estimation of future earnings, qualitative aspects of a business- some degree of (good) speculation may be required. For the market, benefits to speculation includes increased liquidity. As Graham puts it, theres intelligent investing and intelligent speculation, the latter has more ways of being unintelligent.

http://www.econ.yale.edu/~shiller/data/ie_data.xls

With the S&P500 seemingly blossoming from January 2009 till 2018, it’s hard to distinguish between skill and luck, after all, a rising tide lifts all boats. When the lucky sailors start to believe they have skill; that is when the danger arises- literally and figuratively. Being brutally honest with oneself could help determine if one is an investor, a speculator or a mix of both; the skillful or the lucky. The importance to distinguishing between being an investor and a speculator is essential, it may indeed help avoid financial missteps. As Mark Twain puts it: “It’s not what you know that will get you in trouble, it’s what you know that just ain’t so”. Actually, it’s more fitting to give Graham’s greatest protege, Warren Buffett, the closing act in this section: “Only when the tide goes out do you see who has been swimming naked”.

Past, Present and Uncertain Future
As I’m writing this, the CAPE is at its second all-time high, flirting around the 32 mark. We’ve seen elevated levels just before Black Tuesday (1929) and the dot-com bust (1999-2000) at 30 and 44, respectively. The CAPE’s average is about 16-17. Now these are just indicators- not the gospel truth ordering investors to run for the hills. However, if we are experiencing a market where assets are trading at substantial premiums, and in the past- these levels have been followed by crashes, new participants must directly or indirectly accept that “this time is different”.

http://www.econ.yale.edu/~shiller/data/ie_data.xls

The year-recent natural disasters, Korean tensions, European policies, and political uncertainties haven’t (yet) phased investor’s confidence, in large, due to the Fed suppressing interest rates for nearly a decade. Numerically, the Dow is experiencing the second longest bull market run in history, from the lows of 2009 until present, it has more than quadrupled; breaching the $26,000+ mark from its lows of $6,626. Similarly, the S&P500 has returned near 300%, from its March 2009 lows of around $680 upwards to the present $2,700 mark. The S&P 500 held a CAGR of approximately 15.7% (January 2009 till 2018) and a present price-to-earnings ratio of about 24, with a historical mean of 15. It’s unquestionably easier to double from mid 10s p/e in the early 2010s, then it would be to go 24 p/e today to 40 in the next few years.

The physical constraints of the economic reality required to sustain growth conditions certainly makes doubling the p/e again improbable, at least within the “foreseeable” future. Achieving these results would require unprecedented US and world GDP growth, federal and fiscal policies perfectly in sync with the markets, increased hourly productivity growth, multitudes of miraculous earnings, along with other combinations of inputs that would surely be within the tail ends of the probability spectrum. Climbing the mountain certainly gets harder as we close near the top. When there is upside, downside probabilities should also be addressed. As the axiom goes, there’s only a few ways things can go right, but many ways to go wrong. If Murphy’s law is even half the rule- then as t moves further on the time continuum, the risk of encountering calamities increases. Looking into the many uncertain conditions of future financial markets, and considering that “cheap money” is now a thing in the past, we should steer with greater caution and reduction of risky exposures.

Yin-Yang Outlook
• Interest Rates and inflation: The Fed is eyeing inflation closely and expects 3-4 rate hikes in 2018 to cool the expected rise in inflation. Adding a sudden surprise hike could meddle with asset prices (assuming we’ve already “correctly priced in” for 3-4 hikes). Interest rates have been extremely low, permitting higher asset valuations (in relation to bonds). Cheap debt has allowed inflated earnings and easy debt servicing. As real interest rates “return to normal”, how much will it affect earnings and repayment abilities? The sudden increase in real interest rates could collapse bond prices and simultaneously hit the equity markets. Treasury yields going up sharply (say sudden 10-year moving above 3.3-3.5%+) due to sell-off and/or over-supply (ECB, BOJ, and China slowing down on QE and/or purchasing US bonds) may trigger a turmoil.

• Rising Debt levels, US Budget Deficit and Tax Cuts: Ballooning debt has always been a central characteristic in a financial crisis. The US Total Debt is currently just over the $20 trillion mark, with a debt-to-GDP ratio reaching over 105% (increasing year-over-year since the crisis), and is expected to continue rising as a result of deficit. The increasing US budget deficit for 2018 is projected around $1 trillion. In order to fund its expenditures, Treasury states that the US will need to borrow an additional $440 billion within the next quarter. Although beneficial in the shorter term, the tax cut that decreased corporate tax from 35% to 21% will add an estimated $1.5 trillion deficit over the upcoming years. A higher deficit may constrain GDP growth over the long haul. The effects of rising deficits on the entitlements for baby-boomers remain to be seen. It seems that monetary and fiscal policies are indirectly clashing, one putting on the brakes and the other stepping on the gas in a heated economy.

• Premiums, Optimism and Risk-Appetite: With decade low interest rates, equities are trading at substantial premiums with their elevated p/e levels (along with other financial measures). This implies that future earnings will, with the help of a roaring economy and tax cuts; adequately justify today’s premium prices. The full effects of increasing interest rates on stocks remains to be seen. Wells Fargo Investor Optimism Index are nearing all time highs since the dot-com bubble. Decade long economic growth (recovery) and fiscal policies have aided the optimistic forecasts. Pro-risk behaviour is becoming increasingly common, purchasing premium equities with little to no margin of safety. The margin debt on NYSE has reached all time highs, topping $642.8B at the end of 2017 implying higher leverage and risky behaviour. With such a high margin debt, sell-offs will be amplified due to forced margin selling.

• Party, Unemployment and The Rosy Economy
The bull party, despite the recent blimp, appears to tread upward. Unemployment rate is near all-time lows, reaching and retaining 4.1% for the past few months. World economy has experienced constant growth for nearly a decade, paired with a recently strong quarterly economic report, an economic recession is unlikely within the short term (1-3 years). The recent tax cut will likely help boost short-term earnings for US companies over the next few years, so the music isn’t stopping yet. Increased repatriation is bound to pump cash positions and potential investments of US multinational corporations (within US). Although tax cuts will help artificially prolong, what Ray Dalio describes as the late stage of the debt cycle, the party cannot go on forever. Tax cuts may have short term benefits, but-there is no free lunch; costs remain to be paid in the long run.

Incerto and Amor Fati
The world is full of uncertainties. Even the “best” forecasters cannot be consistently accurate. Although the economy appears to have room to grow in the next upcoming years, there are many obstacles it must overcome, especially rising deficits constraints and rising inflation. Inflation is expected to pick up in the upcoming years, meaning that hurdle rates will increase, ultimately eroding real owner’s earnings. Other worries include political instability, rising foreign debt, war outbreaks, natural and technological disasters and shifts in market psychology that cannot be precisely quantified.
While latter worries are noteworthy, concerns should rather be on the management of payoffs in the face of rare events- negative Black Swans. These events are hard to predict and are evident only after they occur (using hindsight). The trouble with hindsight; we don’t have it until we have it. An effective weapon to combat uncertainty (if any), is not its avoidance but the proper management of risk.
A near decade of optimism warrants rising uncertainty (markets are blindsided when they are most euphoric). The looming questions and dimensions of the next financial crisis naturally begin to surface. Exact timing may be unpredictable, but it may likely include the following characteristics:

• Systematic event that will alter the way market participants (in mass) react to events; ultimately altering animal spirits
• High levels of debt, over-leverage and insolvency issues
• Unrealistic levels of optimism and delusion, a wide gap between the fundamentals of economics and finance and the mass’ perspective

The next financial meltdown may be unavoidable; investors might as well embrace their fate. Equity turmoils have always presented generous opportunities to purchase quality stocks at substantial discounts that will prove rewarding once the dust clears. Graham, should rightfully have the last words: “The intelligent investor is a realist who sells to optimists and buys from pessimists”.

Bitcoin and Crypto Mania
Since my introduction to Bitcoin in 2015 (yes, I was late), I’ve only watched it soar up, taking no trading positions. By and large, I’m a supporter of the development of global economies, notably the incorporation blockchain technology which has the ability to allow individuals in third world countries, whom don’t have enough capital; to participate in the global economy. But we are still, unfortunately, far from that. I truly hope to see a revolutionary operation that will enable participation for those in need within the distant future, not just for the betterment of the economy, but for the advancement of humankind itself.

How do we go about Bitcoin and Crypto(“currencies”)?
A currency, although a man-made concept, has a few core components which makes it valuable and desirable- or at the very least, useful. These components include stability, store of relative purchasing power, a relationship with interest rates and economic growth, which it derives from being under federal bank governance. Within the past century, the floating US Dollar has been relatively stable, especially in comparison to other currencies. The USD’s relation to interest rates (along with the net positive GDP increase) has created continuous demand for the US Dollar (foreign investments into USD). Although there are some theoretical and practical nuances, there’s a substantial benefit for a country/currency in having the ability to perform QE. Logically, there must be some government control over currency, as it can drastically improve the conditions and extensively aid in remedying poor economic growth, as experienced during the recent financial crisis.

Theory and Reality
As of present, Bitcoin, in terms of currency, lacks its core functionality (stable store of value- it’s currently too volatile) along with its convenience as a medium of exchange. The high transaction (and processing) fees makes it a costly medium of exchange. So is everyone actually using it? If cryptos were intended to be used for its intended purpose (money), then the huge influx of new users in crypto exchanges must, in theory, mean an equivalent rise in its use for practical transactions, but the reality is much different.
Do you buy your groceries, pay your utilities and taxes in Bitcoins, or other cryptos, and if you could would you? Or would you wait for someone else to buy them from you at a (hopefully) higher price? If most crypto participants are trading the “so-called-currency”, or intend to get out when it “tops”, while its rarely being used for its intended purpose as a “currency”, then its clear that we can attribute it with the concept of the greater fool. How many Bitcoin “investors” do you know who will actually use it for its intended purpose?

The Good, The Okay and The Fool
There’s a clear distinction between investing, trading, and poor speculation (what has plagued the crypto-markets). There are two main school of thoughts: fundamental analysis and technical analysis. The former embodies the definition of investing; it concerns itself with value in relation to price. Technical analysis (trading) bases itself on price and volume, in addition to other variables such as momentum. The tools required for both schools differ immensely. Fundamental analysis depends on in-depth analysis of financial statements and the comparison of intrinsic value to market price. Technical analysis concerns itself with charts, oscillators and trend analysis, in addition to price payout ratios. The tools required for poor speculation- the kind that has a clear disconnect of reality, although not a sin (yet), is wishful thinking, a four leaf clover and a lucky horseshoe. The danger is when one cannot differentiate between investors, traders and wishful thinkers. Unfortunately, the latter always thinks they’re an investor or a trader.

There are different classes of investments: assets, commodities, rare goods, and currencies:
• Assets: the valuation assets are fundamentals driven. To invest, we must rationally value the asset- a popular measure would be a form of discounted cash flow (that is, the intrinsic value of the discounted cash flow of the company from now till judgement day). Cryptocurrencies don’t produce anything (no earnings), therefore cannot be rationally valued and therefore (by way of logic) cannot be considered an investment.
• Commodities: are complex in their valuations, they derive their price from economic models of supply and utilitarian demand. These goods are essential to daily activities (energy-related commodities; gas, oil, wheat, etc.). An argument for Bitcoin (and some cryptos) is that it is equivalent to gold reserves, making it a commodity/currency (comparable pricing). It shares the same theoretical properties of gold: alternative “store of value”, derives its demand from perceived utility. Although gold has real usage (conductor and jewelry), the aggregate supply of gold does not equate to its aggregate utility; the physical usages are negligible. Gold, like Bitcoin produces nothing; so has no actual intrinsic value. It is true that Bitcoin and gold have abstract similarities, but only in a vacuum. The price volatility of Bitcoin and cryptos renders it an unreliable gold-alternative.
• Rare goods: are priced by its demand which derives from perceived market value and scarcity, think in terms antiques and classic cars. Cryptocurrencies are not rare goods. The argument of its limited supply is fallacious. Bitcoin may be limited in supply, but that in itself doesn’t make it valuable; there’s also a limited supply of 1998 mint-condition Pikachu Pokemon cards.
• Currencies: the price of a currency is determined by supply and demand in relation (as stated earlier) to its relative purchasing power, stable store of value, and medium of exchange. As previously noted, cryptocurrencies do not effectively qualify for the definition of a “successful” currency.

Another argument for the fundamental value of Bitcoin is using Metcalfe’s Law (originally used in telecom). This argument is widely misinterpreted. Metcalfe’s Law states that the value of a network roughly equates to the squared number of users or nodes on the network. The argument is that as more users join the cryptocurrency markets, its price increase may be justified because of utility demand. The application of Metcalfe’s Law on Bitcoin (and other cryptos) is erroneous. A user is defined as an individual who uses the network as intended, in this case, an individual who uses Bitcoin to make transactions. There’s a clear difference between a user and an open account/ speculator/ trader; this is where Metcalfe’s Law breaks down.

It is evident that fundamentals are unclear and much uncertainty remains (how will it be incorporated efficiently into daily activities? What are its impact on the economy and fiat currency?). This is not to say that money cannot be made from the crypto mania. The proper approach is to implore technical analysis. For experienced institutional traders (and the few “good” retail traders), there are merits in trading cryptocurrencies, however, the small-fry crypto fanatics should be discouraged to do so.

It’s not immoral to poorly speculate and bet on something you don’t fully understand, it is however- illogical. Speculating and gambling (in small sums) may, with low probabilities, be rewarding. Bachelier puts it lightly: “the mathematical expected value of a speculator is zero”, for the poor speculators (in aggregate); it’s permanent loss. After all, there are widespread stories of individuals whom have made large sums betting on Bitcoin and cryptocurrencies. Consequently, there are plenty more crypto bets that have ended thinning out the pockets, but are ignored due to selective biases (such as the survivorship bias).
Euphoria, delusion, FOMO have plagued the crypto-markets. In aggregate, many cryptocurrencies today will cease to exist in due time, the practical constraints cannot allow for 1000+ cryptocurrencies to all successfully integrate within society (this is not to say that a few cannot become successful). Consequently, amateur crypto traders will lose money- especially with the widespread fraud and poorly placed exchange regulations (pump and dumps, etc.). To reiterate, there’s a distinction between a professional trader and a foolish speculator. Likewise, there’s difference between skill and luck, if you’re lucky, best admit before you’re caught swimming naked.

Encore:
• Blockchain implementations have the potential to drastically improve lives of those who cannot participate in the current global economy
• Blockchain technology and applications are independent from and not limited to cryptocurrencies
• There’s a disconnect between theory and practice, closing it may move cryptocurrencies closer to its intended use (it needs legitimate users, not traders or gamblers, it needs actual daily activities transaction; it must have utilitarian demand, or else it’s basically worthless)
• For Bitcoin to succeed as a currency, it must be globally accepted, but why not accept other cryptos that have better transaction and superior design (Ethereum’s smart contract, Litecoin’s transaction)? Why pay in Bitcoin when you can pay in Ethereum, or Dogecoin for that matter? Who wants to be paid in Kodakcoin? (Rhetoric).
• Bitcoin and Cryptocurrencies in aggregate cannot be rationally valued; there’s a difference between valuing and pricing
• This is not to say that skilled traders should not trade it- fundamental analysis is inapplicable, but technical analysis may have some success
• Cryptos are a trader’s game, not fundamentally driven; unfortunately, most participants lack technical analysis knowledge and tools (institutional grade algorithms), and without a doubt, suffers from the effects of “the greater fool”

Recommended books: Blockchain Revolution by Alex Tapscott and Don Tapscott, and The Age of Cryptocurrency by Michael J. Casey and Paul Vigna.

After[thoughts]¹ La Vita è Bella
For those who take the time to read my collection of thoughts, I am truly appreciative – thank you. Further, I must apologize for my absence. I still read religiously, now more than ever and I’ve added science, physics and mathematics into my arsenal. Originally, I only took interest in business and investing related-matters, but learning other subjects has profoundly enriched my thoughts and conditioned a more multi-dimensional analysis system. Having the ability of viewing the world through different lenses really enriches the experience that makes life. Seeing the world differently, particularly from a physics viewpoint, helps us appreciate the beauty of reality.
Life is a lot more beautiful, once you realize that the Big Bang had to happen, stars died to form the gas clouds enabling our solar system to rise from it’s cosmic ashes, atoms came together in an exact mixture at the perfect time to form everything we presently know to be life. A mathematical view would indicate that the odds are as close as ever to 0; life truly is the greatest Black Swan event. A thrilling phenomena when you really think about it.

Never would I had viewed the world in such light if I hadn’t stumbled upon Neil deGrasse Tyson’s Astrophysics for People in a Hurry– this sparked my interest in science and physics. It’s an exciting feeling to pick up a book knowing that in some way- you’ll expand you’re circle of competence. Whether it’s finance and its strategic investments, or physics and its journey for truth², learning adds to the aggregate knowledge of mankind. Books allow knowledge to dissipate from one generation to the next. It’s a magnificent learning tool, allowing individuals to absorb the knowledge of an author’s lifetime of laborious work within days. Time travelling of the mind and ideas are all made possible through the vehicle of a book. As Carl Sagan stated: “…one glance at it and you’re in the mind of another person, maybe somebody dead for thousands of years. Across the millennia, an author is speaking clearly and silently inside your head, directly to you. Writing is perhaps the greatest of human inventions, binding together people who never knew each other, citizens of distant epochs. Books break the shackle of time. A book is proof that humans are capable of working magic…”

The pleasure lies not in discovering the truth, but in searching for it.
-Leo Tolstoy

Reflections
Other than exhausting my time scavenging through the markets or pondering about the cosmos, I have abstract thoughts that have occupied my mind; 3 contemplations to be exact.

1. Risk, uncertainty and complex models
2. The disconnect between perspective and reality
3. Evolution of financial theories

1. Risk, Uncertainty and Complex Models
The distinction between risk and uncertainty is crucial. Risk is when the outcomes are known with reasonable precision but remain to be seen. It can be mathematically calculated to a probable number; think for instance rolling a dice. The outcomes are known, picking a number from 1 to 6, the probability of landing on it is 1/6 (16.7%). So, if you bet money on, say number 1, there’s an 83.33% chance you will lose your money. Uncertainty reflects the unknown; some of the outcomes may be known, but the probabilities of occurrences are vague or extensively unpredictable.
Transforming qualitative information to quantitative probabilities entails human error and biases. The dilemma is believing that all uncertainties are known; refining mathematical models which exclude unknown events (or removing outliers) and heavily weighing on them for guidance as seen in financial forecasting.
Under risk, complex models are very useful, as all possibilities are known. In uncertainty, complex models do not provide a good basis for the true value. As Gerd Gigerenzer says “the best decision making under risk is not the best decision making under uncertainty”. Complex problems do not always require complex solutions.
Risk management; decreasing risky exposures and increasing risk absorption abilities, sticking with simple heuristics (ie. index funds), and defining your circle of competence are best practices against uncertainty.
(1) How will true mu be determined under uncertainty? Will it ever? (2) Or will it always be the cosmic standard that one can only profit bearing some degree of uncertainty?

2. The Disconnect Between Perspective and Reality
In 1996, Greenspan pondered: “…But how do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions as they have in Japan over the past decade?”. Four years later, the tech-bubble burst and the NASDAQ came crashing down over the following two years, eradicating nearly three quarters off its peak. Optimism may be good for health, but should be cautioned when paired in decision-making. Robert Shiller, Nobel Laureate describes euphoric phenomenas well (read this paper); “When speculative prices go up creating success for some investors, this may attract public attention, promote mouth-to-mouth enthusiasm, and heighten expectations for further price increases…high prices are ultimately not sustainable, since they are only high because of expectations of further price increases…”.
Financial ruins stem from overly-optimistic predictions but is mainly rooted in a disassociation between perceived views and reality. Blind mass perception can sway the markets into overly optimistic or pessimistic territories, but only for so long; the realistic constraints of economics and finance will readapt and regain rationality over the long run. Optimism overrides caution, suppresses rationality while boosting confidence, pitting investors into what Daniel Kahneman describes as the planning fallacy; when planning we always think we are right and overweight the best case scenarios. A method to detach from possible biases is by reasoning from first principles. This involves breaking down problems to the most fundamental truth and then building solutions and decision-making from these indisputable truths.
For instance, we have many forms of transportation; walking, bicycles, vehicles, helicopters, airplanes and boats. The core function of transportation is to go from point A to B in the safest and most time-efficient manner (aesthetics aside). So what’s the best way of doing that in theory? Teleportation, and since that’s not achievable on a human scale (yet), Elon Musk’s Hyperloop will have to do for now.
Reasoning up from first principles in investing is much more complex; as human-made concept, it strays from physics and mathematical laws (what is universally true- ie. gravity, Pi, etc.). Musk says that most people reason from analogy rather than first principles – this phenomena is especially widespread in finance. Many market participants buy or sell holdings based on someone else’s prediction (think cryptos) or because prevailing market sentiments indicate a bearish trend. They forget that the price is the underlying reflection of the fundamentals of a company. Profit can be made by following trends, but if following is purely based on reasoning by analogy (buying because others are), then it becomes dangerous. This leads to widespread euphoria resulting in the formation of bubbles, and its usually original thinkers, those who reason correctly from fundamental analysis; the first principles of investing, that fare better coming out of meltdowns.

3. Evolution of Financial Theories
The history of finance was heavily shaped by economists, statisticians, and individuals who dedicated their lives to their work which will be forever archived within finance. From Bachelier, to Fisher, Graham, to Black, Fama, Jensen…Shiller, to Thaler’s behavioural economics, there’s been a constant refinement of principles. Many theories built off the work of old ones. For instance Paul Samuelson refined and shed light on Louis Bachelier’s asset pricing model in his thesis “Theory of Speculation”(Théorie de la Spéculation) which serves as the foundation for quantitative finance today (EMH, Black-Scholes, etc.). Even more interesting is the leakage between finance and physics, or the reverse. Bachelier’s model had actual confirmed Brownian Motion, years before Albert Einstein’s paper: Investigation on the Theory of Brownian Motion. Fascinatingly, Bachelier turned to physics and used a function of heat diffusion and central limit theorem principles in the making of his work.
Perhaps in the near future, there will be theories that incorporate physics and current fundamental, technical and behavioural analysis (with less controversy amongst scholars). Perhaps this new pricing model or grand financial theory will be to finance what string theory is to quantum physics.

Fin
And now, reader, it is time to part – thank you again for reading my thoughts. Let me finish by borrowing from The Pilgrim’s Progress as the Old-Valiant-for Truth in his journey; my sword¹, I give to him that shall succeed me in my pilgrimage².

10 Investment Books Everyone Should Read

May 25, 2017May 27, 2017 / 416Investor / Leave a comment

The best investment you can make is in yourself.

-Warren Buffett

The most successful individuals, ranging from Bill Gates to Mark Cuban have always been avid readers, and deeply value learning. It is no secret that the greatest investor in the world, Warren Buffett alongside his partner, Charlie Munger spend the majority of their time reading and thinking. In fact, Buffett contributes a lot of his success to reading, picking up a book at the Columbia library led to a chain of events that forever changed his life. Reading has numerous cognitive benefits; it can improve knowledge, intelligence, increase abstract thinking and creativity.

I constantly see people rise in life who are not the smartest, sometimes not even the most diligent, but they are learning machines.. they go to bed every night a little wiser than they were when they got up.

-Charlie Munger

Here’s a list of 10 must-read investing books:

1. The Intelligent Investor by Benjamin Graham

Benjamin Graham is regarded as the father of value investing. His contributions on margin of safety and financial analysis paved the road for investors. This book has heavily influenced Warren Buffett’s life and is considered one of the bibles of value investing. “Chapter 8 and 2 have been the bedrock of my investing strategy for more than 60 years years. I suggest that all investors read those chapters and reread them every time the market has been especially strong or weak” – Warren Buffett

2. Security Analysis by Benjamin Graham and David Dodd

Graham and Dodd’s Security Analysis is the foundation of The Intelligent Investor. It is widely regarded as the fundamental textbook for analysis of stocks and bonds. It explores numerous topics on analysis of balance sheets, intrinsic value, margin of safety, fixed securities and much more. Many of the greatest financial figures were fascinated by this book, notably Warren Buffett, Jamie Dimon and Seth Klarman. This is an absolute must-have for every serious value investor. Find it: here.

3. A Random Walk Down Wall Street by Burton G. Malkiel

Burton G. Malkiel explores numerous investing topics such as the efficient market hypothesis, castles in the air, “smart” betas, risk management and low cost indexing strategies. It is captivating from the start and the author provides actionable investing plans for individuals in different age groups. Find it: here.

4. The Most Important Thing Illuminated by Howard Marks

With brief segments from his valuable memos, Howard Marks describes the components of successful investing and discusses the mistakes that investors often make. Through 20 important sections (21 including the conclusion), the author emphasizes “second level” thinking, price in relation to value, conservative investing, and numerous crucial factors for successful investing. Additionally, this book includes commentary from four famed value investors, notably, Seth Klarman, Christopher C. Davis, Paul Johnson, and Joel Greenblatt; making it one of the most important books an investor should own. Find it: here.

5. You Can Be A Stock Market Genius by Joel Greenblatt

Joel Greenblatt, successful manager at Gotham Capital explores numerous uncommon investment strategies such as spin-offs, restructuring, bankruptcies, warrants, options and mergers. He explains each strategy exceptionally well, and structures the book so it is easy to follow. Additionally, the case studies in every chapter make this book all-the-better. There are many hidden opportunities in investing, this book will definetly shine light on where to look. Find it: here.

6. Value Investing: From Graham to Buffett and Beyond by Bruce Greenwald, Judd Kahn, Paul D. Sonkin and Michael van Biema

If you ever want to learn the basics of value investing, this is it. Relatively easy read, so just about anyone can pick this up. The book consists of three parts, this includes an introduction to (I) value investing, (II) three sources of value, and (III) value investing in practice. This book provides a wonderful application of the three sources of value (part II) with a case study of WD-40 and Intel, explaining in detail the valuation process. In addition, it profiles 8 of the very best investors, from Graham to Buffett, to Edwin and Walter Schloss and beyond. Find it: here.

7. The Essays of Warren Buffett: Lessons for Corporate America by Lawrence Cunningham

This book is a reorganized compilation of letters from the Oracle himself. Buffett addresses numerous business and investing issues with his personal memos to his Berkshire Hathaway partners every year. The memos are organized to cover specific subjects such as finance and investing, investment alternatives, mergers and acquisitions, valuations, in addition to a numerous financial topics . Buffett’s investing prowess is so great that it takes the spotlight away from his immensely kind and humble character. After reading this book, you will definetly gain an appreciation for his kindness and contributions to the world and infinitely more important, gain a vast array of business and investing knowledge. What better way to learn business and investing than from Warren Buffett himself? A must-read for all investors. Find: it here.

I am a better investor because I am a businessman, and a better businessman because I am an investor.

-Warren Buffett

8. Common Stocks and Uncommon Profits by Philip A. Fisher

Known as a pioneer of Growth Investing, Philip A. Fisher’s contribution to the investing world will not be forgotten. In this book, consisting of 3 parts, he lays out the a general description in what to look for in stocks, and when to buy. He opens the book with his concept of “Scuttlebutt”, then puts in 15 detailed points to look for in common stocks, as well as 10 investor don’ts. In the second part, Fisher outlines his 4 dimensions in which he describes cues to look for in companies. He notes the importance of employees and management, investment characteristics of certain businesses, conservative investments and much more. Fisher closes the book with his philosophy along with its evolution that has made him one of the most influential investors. Find this book: here.

9. Strategic Value Investing: Practical Techniques of Leading Value Investors by Stephen M. Horan, Robert R. Johnson and Thomas R. Robinson

Strategic Value Investing explores the main strategies and valuation techniques in value investing. It consists of three sections: (I) An introduction to value investing and the how to analyze companies, (II) The valuation methods such as Dividend Discount Models, Free Cash Flow Models, Residual Income models, and more, (III) The application of the models, variations of value investing styles. The information is very practical (includes case studies) and detailed, and it emphasizes on core value investing principles such as margin of safety. Different valuation methods are a must-know for investors and the authors do great work shining light on them. A must-read if have not. Find it here.

10. One Up on Wall Street by Peter Lynch

Peter Lynch is without question one of the greatest investors of all time. He is famous for managing the Fidelity Magellan fund from $14 million to $20 billion in 1977 to 1990, greatly outperforming the benchmarks. One Up On Wall Street is filled with investing knowledge and where to search for what the author calls “tenbaggers” (10x your return). Lynch shares his views on the requirements of picking a winner, six categories in which stocks are grouped, in addition to long term aspects. Lynch makes this an easy read with his intriguing and lesson-filled stories, perfect for new investors. Find it: here.

Other mentions include The Manual of Ideas by John Mihaljevic, Margin of Safety by Seth Klarman and The Alchemy of Finance by George Soros.

Happy reading 🙂

The best thing a human being can do is to help another human being know more.

-Charlie Munger

Disclosure: I wrote this article myself and it expresses my own opinions, I am not a financial advisor. This is for educational purposes only. I do not get any compensation from this, other than from Amazon Affiliate links and advertisements.

The Basics of Value Investing

May 22, 2017May 22, 2017 / 416Investor / Leave a comment

The stock market is filled with individuals who know the price of everything but the value of nothing.

– Phillip A. Fisher

*Phillip A. Fisher was one of the greatest pioneers of growth investing. His contributions to investors include Conservative Investors Sleep Well, and notably Common Stocks and Uncommon Profits.

Some investors believe that growth and value are two opposite extremes, be one or the other. But the reality is, as Buffett puts it; value and growth are actually joint to the hip. Growth is always a component in the calculation of value, constituting a variable whose importance can range from negligible to enormous and whose impact can be negative as well as positive. Value Investing: From Graham To Buffett and Beyond written by Greenwald, Kahn, Sonkin and Van Biema greatly captures the framework that is value investing.

The book consists of three parts, this includes an introduction to (I) value investing, (II) three sources of value, and (III) value investing in practice. This book provides a wonderful application of the three sources of value (part II) with a case study of WD-40 and Intel, explaining in detail the valuation process. In addition, it profiles 8 of the very best investors, from Graham to Buffett, to Edwin and Walter Schloss and beyond.

Below I will briefly review some specifics of part II; the three sources of value, as I believe it is critical in investing, and would be highly beneficial for anyone looking into this field. I will generalize the concepts in part II, but I strongly recommend that you give this book a read to truly understand the frameworks and the information it intended to provide.

Greenwald et al. places emphasis on valuation as follows: The value of assets, earnings power value (EPV), and the value of growth, all in that exact order.

The liabilities are always 100% good. It’s the assets you have to worry about.

-Charlie Munger

The Value of Assets:
Using a Graham and Dodd valuation, we begin at the balance sheet and evaluate the company’s assets. This shows us the health of the company: is the firm loaded with cash or debt? What are the shareholders entitled to if all debt was paid? If we are in a declining industry, we value the assets at liquidation cost. In a stable industry, we must value assets at reproduction cost (which is the cost a competitor or new entrant would incur to reproduce all its assets).

Under the asset side of the balance sheet, we find the two main component of current assets and long term assets. Assuming accurate information of the balance sheet, under reproduction cost we would likely value current assets such as cash, marketable short-term securities without any adjustments. Accounts receivables and inventory should be adjusted depending on allowances and turnover ratios. Longer term assets such as PPE should be estimated based on consistent depreciation rate, market value and reproduction of equipment costs. Interesting accounting entries are goodwill, intangibles, R&D (hidden assets); these all require thorough analysis as their value may range significantly. For instance, Coca Cola’s extensive value lies in its Goodwill. Its years of advertising, customer loyalty are ingrained in its intangibles, for a competitor to replicate Coca Cola (or attempt to), it would pay dearly, in money and time.

Moving away from assets to liabilities, Greenwald et al. classifies liabilities in three categories. Applying a reproduction approach to these liabilities, it is likely to take these liabilities as stated. These categories include (I) Operational liabilities (spontaneous): which include liabilities such as accounts payable to suppliers, wages, accrued taxes and expenses related to operations, (II) Past circumstances liabilities (circumstantial): one time or uncommon charges that would not be pertinent to new entrants, these include deferred tax liabilities and legal liabilities (breaking the law), (III) Outstanding debt: includes long term debt.

Now with the value of asset reproduction and value of total liabilities, we subtract the latter from the first (asset reproduction value – total liabilities) and assess the potential for investment. Clear examples along with accounting entries are provided in Chapter 4.

Earnings Power Value:
The EPV formula is as follows:

EPV = Adjusted Earnings x 1/ R
R = Current Cost of Capital (usually measured in terms of WACC)

Adjustments to earnings include resolving discrepancies between depreciation and amortization, taking into account business cycle, and applying other reasonable modifications in specific situations. The reason for adjustments is to smooth out one time outlier expenses to arrive at distributable cash flow; money that the shareholders are entitled from the firm while keeping operations intact. This method assumes that earnings are constant (so, there must be a relatively sustainable competitive advantage) and no growth.

There are 3 identifiable cases after applying the formula: (I) If your calculated EPV is lower than the value of asset reproduction, then the assets are not being used efficiently, (II) when your calculated EPV equates (or is close) the value of asset reproduction, it may be because the industry has no competitive advantage (perhaps no one has a significant “upper hand”), (III) when your calculated EPV relatively exceeds the asset reproduction value, the evaluated firm may have some form of competitive advantage. Chapter 5 discusses EPV, while later chapters will walk you through its application.

Growth Value:
As previously stated, we begin by valuing asset reproduction value, then earnings power value, and lastly growth; in that specific order. The reason the value of growth is prioritized last, according to Greenwald et al. is because it is most difficult to estimate. A conservative value investor is concerned about not losing money, and projections entail a great deal of uncertainty, especially long future projections which are prone to error. Growth itself has to be supported by in increase in assets, sales, accounts receivables or equipment. In order to do so, it must be funded through either new borrowings, retained earnings, or issuing new shares; all which cut into the cash and value to be available for shareholders. For this reason, growth value is not the primary concern for conservative value investors. Chapter 3 and 7 details growth value.

I highly recommend this book to anyone looking to start with a value investing approach. I liked that it illustrates valuation in a conservative order, starting with the balance sheet, moving onto earnings power (although perhaps free cash flow should be considered too- JMO) then growth. Greenwald et al. thoroughly applies the three valuation process in Chapter 6 and 7 using WD-40 and Intel as case studies, making it clear and understandable. The study of some of the greatest value investors is a valuable plus. You can find this book on Amazon: here.

Thank you for reading 🙂

The most important investment you can make is in yourself.

-Warren Buffett

Must Read: Deep Value Investing by Jeroen Bos

December 15, 2016May 22, 2017 / 416Investor / Leave a comment

A cynic is man who knows the price of everything but the value of nothing.

– Oscar Wilde

In 1934, Benjamin Graham and David Dodson paved the road for all value investors with their contribution of “Security Analysis“. Graham went on to publish “The Intelligent Investor“, the book that heavily shaped Warren Buffett’s life. Some decades later, a short practical book on value investing, “Deep Value Investing” by Jeroen Bos strongly compliments the classics by Graham and Dodd.

Deep Value investing is also known as the cigar-butt investing style that Buffett had famously, and successfully practiced during his earlier days. To begin, we compare the stock’s price with its net asset value (NAV), or in other terms, a stock that is selling for less than its working capital. The focus of deep value investing is on assets, particularly liquid assets. Deep value investors look for stocks whose current assets minus its total liabilities are worth more than its current stock price or market capitalization. The logic is that if the company were to shut down, liquidate all its assets, repay debtors and redistribute all wealth to its shareholders; you would still walk away with some profit, leaving you with a substantial margin of safety.

To make things better, we know that the current assets minus the total liabilities is still worth more than the market price. This means that the long term assets (equipment, long term investments, etc.) are essentially “free”. Of course, deep value stocks are rare, and falling prey to value traps is always possible. Therefore, deep value investors must evaluate every detail of the company’s information along with possible catalysts.

Author and fund manager at Church Investments, Jeroen Bos provides 15 exceptional case studies of his own investment ideas in this book. He walks the reader through not only his successful, but equally important, his failed cases of investments allowing readers to learn from his mistakes. For each of the 15 companies explored, Bos provides a company background, an investment case and the outcome of his decisions. He further provides exit reasoning for his stocks; an added value for the reader.

In his writings, Bos explains the benefits of service-based sector stocks. Service firms are flexible, they can contract and expand alongside its economic environment. Well managed service firms are likely to sustain recessions (by nature; unlike manufacturing and machine-heavy firms, their expenses are not fixed, so they just lay off workers to cut their expense in order to survive through economic storms).

Moreover, Bos augments the prioritization of assets (balance sheet), as earnings (income statement) and its expectations can be manipulated (quite legally) which may result to poor valuations. Other interesting aspects the reader will appreciate is Bos’ unique style of deep value investing: occasionally, he holds deep value stocks even after its gone up past its fair value (and he explains his reasonings). Throughout his investment cases, Bos illustrates that the long term is what matters, that deep value investing, at its very core involves limiting the downside while having a substantially high upside potential, and is not as risky as the crowd believes.

Perhaps the most important lesson that Bos reinforces; is that there are no golden rules in deep value investing, all variations can be appreciated and every investment case has its own unique merit. It is virtually impossible to find a “perfect” deep value stock, as they all come with their own distinctive history and, as Bos describes,”their negative baggage”.

All in all, deep value investing involves swimming against the tide, buying stocks that are beaten up, and selling them when everyone else is buying. Jeroen Bos’ contribution is nothing short of exceptional, and definitely and eye opener for newer investors. Of course, deep value is more detailed than this post has intended to explain. Bos’ provides the reader with an invaluable perspective, rather than strict formulas and quantitative valuation methods. I would recommend deep value investing be practiced by more seasoned investors, and not the novice (but it doesn’t hurt to know). You can find this book here.

As I started with a quote from Oscar Wilde, it is only plausible that I close with one. If you are an investor seeking deep value stocks, you will find this particular analogy interesting.

The only difference between a saint and a sinner is that every saint has a past and every sinner has a future.

-Oscar Wilde

Nature,Value and Investing

November 9, 2016May 22, 2017 / 416Investor / Leave a comment

“Notice that the stiffest tree is most easily cracked, while the bamboo or willow survives by bending with the wind”.

– Bruce Lee

In our early biology class, we learn about Charles Darwin, influential biologist and father to the “survival of the fittest” theory; Darwinism. We know that in a given environment, when two of the same species collide, the one with even the slightest edge, be it the bigger horn, muscle mass, the quarter inch bigger claw, will emerge victorious over the long run. As the dominant species reproduce amongst each other, the inferior species will eventually become extinct. All species are subject to natural selection, and it isn’t so different either in the economic world; as “The Nature of Value” by Nick Gogerty parallels the science of economics, evolution and ecology.

To begin, Gogerty discusses the most essential aspect of economics and investing; price in relation to value. Unfortunately, the popular belief that equates value with price foolishly assumes that everything is worth its current price. Price is a reflection of perceived value, and is often, poorly reflected. For instance, the daily changes of stock price means that the perceived value by market participants have changed, but frequently, the firm’s “true” value has not altered. Because the day to day price changes occur, investors slowly forget about the true intrinsic value of the firm, ultimately leading to under or over-valuations of equities.

Another important factor for the allocator is the firm’s competitive advantage. Gogerty draws from Richard Dawkin’s “The Selfish Gene” to illustrate the resemblance between evolution and economics. Organisms have different types of genes, organizations have what the author calls “inos”. Inos are like genes, collecting knowledge and changes that are expressed as an organization’s capabilities. It’s an informational unit, capable of innovation and adding value to a company. Of course, not all inos are value adding; for instance, a mattress store may open-up a drive thru section, but that doesn’t mean it will add positive value to the firm. Therefore, not all inos become sustainable knowledge or useful in a firm’s quest for survival. However, inos that do add value can be reflected in the firm’s competitive advantage; creating additional value.

Another argument draws from Larry Keeley’s “Ten Types of Innovation”, inos improve simple capabilities, and little by little compound to competitive advantages. The 10 capabilities are: business model, networking, enabling process, core process, product performance, product system, service, channel, brand and customer experience. Every firm, according to their industry, will excel in some, while averaging or lagging in some other of the 10 capabilities; ultimately creating its unique position within its competitive environment. The serious allocator should pay close attention to these 10 important aspects when making decisions.

The capabilities of the firms will place them in their own clusters. Gogerty describes 4 types of clusters: Lollapaloozas, Cash Cows, Lotteries, and Red Queens.

The investor should seek the rare “Lollapalooza” cluster; firms that are stable and growing, with few competitors and high barriers to entry. Firms in this type of category have a higher ability to grow revenues and margins. The Cash Cow cluster is dominated by already stable participants, usually with high yields, and high barriers to entry, but limited growth. Lottery cluster can be described as newer firms, fast growth but unstable and low barriers to entry, therefore, these firms do not have established moats and competitors can easily replicate their strategies. Finally, Red Queen cluster participants compete amongst each other in industries that are very capital intensive. This cluster requires participants to continuously exhaust their resources on new innovations and strategies to survive, but most of the value flows to the customers instead of the shareholders. An example of a Red Queen could be the evolution of the TV industry; firms must continuously exhaust their capital to create new strategies and innovate technology or will fall behind, but notice how increasing technology and competition, has added greater value for the customers (with lower prices and greater technology-notice how TVs got cheaper in the past decade?) rather than returning the value to the shareholders. A long-term value oriented investor should avoid the last two clusters (Lotteries and Red Queens).

Lastly, investing based on the nature of value rather than price can help mitigate risk; purchasing moated firms at a discount and holding it for the long-run has proven to be rewarding.

The latter paragraphs were just a glimpse of the distinctive knowledge you will gain from exploring “The Nature of Value“. It is exceptionally informative and well-written, unique in its own league, and deserves a spot in every serious investor’s library.

Finally, finding economic value is the goal of all value-oriented investor. Finding true value is the quest of all human beings. Where should one search for such meaning? Fortunately, there is an answer to your quest; as Gogerty puts it:

“Prioritizing the value of friends, family and freedom ensures that the wealth of a lifetime will be correctly measured in the creation of memories, loving relationships, and a reputation for integrity. Never compromise these forms of value for mere money”.

Put differently; money makes the world go round; but love makes the ride worthwhile.

Thank you for reading. As always, JMO (just my opinion).

Things to Remember when Investing

September 26, 2016May 22, 2017 / 416Investor / Leave a comment

Here are some of the most important rules to remember when investing:

You can find the free PDF version here: things-to-remember-when-investing-www-the416investor-com

Never stop learning. Always do your own research, do not buy things you do not know. Do not be irrational.

Seek value in relationship to price. Look to pay $0.50 for $1. “Price is what you pay. Value is what you get”. Price alone is useless. High P/E stocks can be dangerous.

Seek the NCAV minus total debt to be positive, preferably bigger than the total market cap or per share value. This is usually found in small or medium caps, and “boring” businesses.

Seek companies with strong moats and hold them for the long run. Preferably, ones with little to no total debt, and positive free cash flow. Be careful of deteriorating fundamentals and value traps. Seek “Lollapaloozas”.

Be honest, control your emotions and be rational. “The investor’s chief problem- and even his worst enemy, is likely to be himself”. Admit when you are wrong; excessive ego will do more harm than good.

In the short run, being early and being wrong may be hard to differentiate. It can be a lonely road, but have the courage to standby an excellent stock pick through downturns. Change when the facts or fundamentals change.

Value takes longer to change than price. Patience is a virtue; make time your friend, not your enemy. Always have a margin of safety.

Leverage is a double-edged sword. Use with extreme caution, avoid as much as possible.

A good place to start is with the balance sheet. Do not depend on a single metric or ratio.

There is no such thing as get rich quick; nobody can predict the future with accuracy. Avoid hot “tips” and hot stocks.

It is not easy to find a good stock; it’s not suppose to be. There is no universal golden rule. Know yourself. Find an investing style that works for you. Nothing of value comes easy.

Ultimately, value is the human perception of what is important. The most precious and significant types of values are measured in the creation of memories, loving relationships and happiness. Never compromise these rarities for mere money.

What are your most important factors to consider when investing? I welcome you to share them in the comments. Of course all this, JMO (just my opinion).

You can download the free PDF here: things-to-remember-when-investing-www-the416investor-com

The person that turns over the most rocks wins the game.

– Peter Lynch

The Fault in Ourselves

August 22, 2016May 22, 2017 / 416Investor / 2 Comments

“The fault, dear investor, is not in our stars- and not in our stocks- but in ourselves…”

-Benjamin Graham

Winner of the Nobel Prize in Economics, Daniel Kahneman fascinatingly explains the fault that is in our intuition, biases, decision making, and sheds light to rationality. In economics and finance, we are taught theories that assume rationality and well-informed decision making of individuals, but we must learn these theories with much caution, as Kahneman’s Thinking Fast and Slow illustrates that human decision-making is indeed more flawed in reality, and certainly more than we notice. I will illustrate a few of his examples below that will (hopefully) spark your interest, and likely bend your mind, as it did to me.

To begin, Kahneman explains the mind as two systems, System 1 which is intuition (thinking fast) and System 2, which is your analytical system (thinking slow). For instance, the last time you were mad over something small and had to embarrassingly apologize afterwards, might have been due to your System 1, thinking (too) fast. Your emotions clouded your System 2 (your analyzing system) from working and you acted irrationally. Note that your System 2 is also quite “lazy”, so the majority of the time, you’re on auto-pilot with System 1, and (thankfully) most of the time it’s right. But other times when System 2 is needed, and fails to show up or to properly analyze, decision-making results can be devastating.

Here’s a quick test of your systems.

What’s 2 x 2? What’s 2+2?

Right away you knew the answer for both were 4 (that’s your intuitive System 1). Now:

What’s 28 x 9? What’s 38 x 17?

Your pupils moderately dilated, your blood pressure slightly increased; your System 2 was engaged into computing the answer, as your System 1 was unable to quickly solve it. For some, it is possible that the latter questions came intuitively via their System 1; they’ve practiced a great deal of mathematics that allowed them to generate the answer automatically. For those who had to employ their lazy System 2, don’t you regret not practicing math a little more when you were younger? I sure do…(252, 646, btw).

Speaking of regret; Kahneman defines it as an emotion and a punishment we do to ourselves. Frequently, we lag in our decision making due to the fear of regret. It stems from a deviation from the norm, or the default position (p.348). For instance, when you buy a stock the default is to hold it, when you enter a relationship, the default is to stay, when you finish seeing your friends, the default is to say goodbye; selling a stock too early, ending a relationship badly and even not saying goodbye can produce regret. Here’s another example: You’re the coach of a team that just badly lost your last game. You’re expected to make a change in players or strategy; failing to do so will produce regret (p.348). Notice how here, a specific action is the default, deviating from that will produce unpleasant emotions. Regret does indeed affect the decision of many, but there is good news: people generally anticipate more regret than they will actually experience, this is because we underestimate the efficacy of our psychological defences (p.352).

Here’s an unnoticeable pitfall people tend to make that may lead to regret, it’s called the The Sunk Cost Fallacy. More often than not, this fallacy makes us stay in things longer than we should. A bad job, a poor performing stock with no turnaround in sight; we would rather continue wasting our resources in a failing project than to stop, admit defeat and have a bad stain in our record .

Somewhat related to the Sunk Cost Fallacy is the disposition effect. A (unfortunately) real example for many investors is the following: when choosing to sell stocks in their portfolio, often times they choose to sell the winning stocks rather than the losers; they want to add a win to their record, instead of closing out losing stocks which would add a loss. Simply put it, gaining is pleasure and losing is pain, and we would much rather choose pleasure than pain. But, pleasure does come with its price, and in this case choosing purely based on a current winner and loser can be irrational and devastating. According to Kahneman, you should have a thorough analysis of your portfolio and sell the stock that is less likely to perform well in the future, not whether it is a winner or loser.

Here’s another pitfall that can significantly influence our optimism or pessimism when decision-making is “Framing“. Consider the following scenario:

How would you feel if I said the following before you entered a life-saving surgery:

90% of the people who receive this surgery survive.

Now If I told you this:

10% of people who receive this surgery die.

Both statements have the same probability of success-failure, but the way it was framed, did indeed give you different mental pictures. Another example of framing within Thinking Fast and Slow is the following:

You receive $70

Would you rather:

Keep $30 or Lose $40

As you’ve noticed, both options are objectively the same, but most individuals prefer the keeping $30 than the losing $40 option. Being able to reframe this question objectively, and not emotion-bound, takes much effort of your System 2, and since it efforts exhausts our energy, we passively accept decision problems as they are framed (p. 367).

Here’s a final- shortened example of framing that will bend your mind, it comes straight from the framing experiment conducted by Kahneman and his friend, Amos (p.368):

Imagine that the United States is preparing for an outbreak of some unknown disease. It is expected to kill 600 people, but there are two types of action plan that can be implemented to fight this disease:

-Action Plan A: 200 people will be saved.

-Action Plan B: There is a one-third chance that 600 people will be saved, and a two-thirds probability that no one will be saved.

What’s your choice? Think carefully. The majority of respondents chose A; taking the sure option rather than the gamble.

Now the experiment is framed differently. Consider the following options:

-Action Plan A: 400 people will die.

-Action Plan B: There is a one-third probability that nobody will die and a two-thirds probability that 600 people will die.

What’s your choice? Again, think carefully. The majority of respondents chose B, as you may have as well. “Decision makers tend to prefer a sure thing over a gamble when the outcomes are good. They tend to reject the sure thing and accept the gamble when both outcomes are bad”(p.368). Note how you’ve accepted a gamble with a 67% (rounded) chance of failure, even though it’s a bad gamble (numerically), it seemed like a good choice in this case.

Here’s the interesting part: You chose to save 200 lives for sure (Action Plan A) in the first question, and chose to gamble with Action Plan B, rather than accept 400 deaths in the second; there’s an inconsistency in the choices you make. Think about it…

We could go on forever in discussing the biases and faults in our intuition provided in this book (there’s a lot more), but let’s end with the Anchoring Effect. This happens when “people consider a particular value for an unknown quantity before estimating it” (p.119). For instance, if you are looking to purchase a house, you are likely to be influenced by the asking price (the anchor). You would feel a price of $1 million is expensive if the asking price was $700k. On the contrary, you would feel a price of $1 million is cheap if the asking price was $1.3 million. If I said the number 30 and asked you to provide an estimate of Shakespeare’s age at death, you’ll likely give a lower number than if I said the number 90. You’ll be inclined to use the number provided as an anchor and work your way up or down from it. This shows that we are susceptible to subconscious biases from an anchor and recognizing that can help us avoid poor decisions. This technique is used in sales and negotiations, so next time you’re negotiating a price, make sure you don’t get anchored by a number.

When you choose to read this book, you’ll learn valuable rationality lessons such as the law of small numbers, optimistic biases, the possibility effect and much, much more in Kahneman’s astonishing literature. After giving Thinking Fast and Slow a read, your thought process and decision-making will surely be enriched, as mine was.

Much of the recognition of our intuitive faults will seem unnatural to do, and indeed hard to consistently notice when we act irrationally. But nothing good comes easy. By being aware that it is easy to fall into the traps of our own irrational decision-making; we can avoid making potentially devastating mistakes, and make more sound decisions. For the investor, the chief problem, and even his worst enemy is very likely to be himself. You should give this one a read, you probably won’t regret it 😉 Find it here.

5 Must-Read Investing Books

July 29, 2016May 22, 2017 / 416Investor / 2 Comments

The most successful leaders always had one thing in common: they never stopped learning. As Charlie Munger, Vice Chairman of Berkshire Hathaway puts it:

“Those who keep learning will keep rising in life“

If you’re looking on improving your investing knowledge, you’ve come to the right place! Here are the 5 must-read investing books:

1. The Intelligent Investor by Benjamin Graham

Benjamin Graham forever changed the investing world with this timeless contribution. He builds the foundation of value investing by providing the concept of Mr. Market, defensive investing and margin of safety. This iconic book is considered by many the bible of investing, and for Warren Buffett:

“I picked up a copy of The Intelligent Investor. It not only changed my investment philosophy, it really changed my whole life- I’d be a different person in a different place if I hadn’t seen that book…it was Ben’s ideas that sent me down the right path.”

Pick up your copy of this classic: here.

2. The Most Important Thing Illuminated by Howard Marks

Howard Marks shares his thoughts on value investing in this mind-shattering book. He gets straight to the point on investing subjects such as second-level thinking, market efficiencies, value, contrarianism, risk, randomness and the other aspects that make up the 20 most important things. To make this book even better, there are even commentaries from other leading investing managers such as Seth Klarman, Christopher Davis and Joel Greenblatt. Marks’ work is even praised by legendary founder and former CEO of The Vanguard Group, John C. Bogle:

“Few books on investing match the high standards set by Howard Marks in The Most Important Thing…If you seek to avoid the pitfalls of investing, you must read this book!”

Find this invaluable book: here.

3. A Random Walk Down Wall Street by Burton G. Malkiel

Burton G. Malkiel’s best seller is jam-packed with quality investment insights and financial history. It takes a look at stocks and their values, analyzes both fundamental and technical analysis while comparing them to the random walk theory. Furthermore, he explores the concepts of EMH (efficient market hypothesis), smart-beta and rebalancing. He puts much emphasis on indexing and diversification through no-load, low cost funds and ETFs. The later chapters consists of personal finance and investing strategies for different age groups. Whether you’re a starter or expert in investing, this book is a must-read. Find it: here.

4. Common Stocks and Uncommon Profits by Philip A. Fisher

Known as a pioneer of Growth Investing, Philip A. Fisher’s contribution to the investing world will not be forgotten. In this book, consisting of 3 parts, he lays out the a general description in what to look for in stocks, and when to buy. He opens the book with his concept of “Scuttlebutt”, then puts in 15 detailed points to look for in common stocks, as well as 10 investor don’ts. In the second part, Fisher outlines his 4 dimensions in which he describes cues to look for in companies, such as the company’s superiority in production, research, marketing and financial skills. He notes the importance of employees and management, investment characteristics of certain businesses, conservative investments and much more. Fisher closes the book with his philosophy along with its evolution that has made him one of the most influential investors. Find this book: here.

5. Technical Analysis of the Financial Markets by John J. Murphy

John J. Murphy provides the fundamentals of technical analysis in simple enough terms for anyone to understand. You’ll learn the trends and essentials of chart analysis. This book gives excellent graphical examples of various price patterns and reversals. Furthermore, it teaches the basic methods of analysis, you’ll learn about moving averages, MACD, RSI, Bollinger Bands, and all the other fancy technical indicator terms. Whether you’re a beginner or experienced investor, this is a classic for the technical investor. Find it: here.

Through chances various, through all vicissitudes, we make our way…

-Aeneid

Those are the first words printed on The Intelligent Investor. I read this timeless classic some years ago and this quote made an impression on me. I’ve revisited it twice since, and every time I read it, not only does it get better, but I appreciate this quote more and more.

If it’s your very first time reading The Intelligent Investor, know that I am envious of you, the feeling of learning new knowledge of this quality is rare, and no words can describe that state of enlightenment. I invite you take your time and enjoy the invaluable information you will gain. I hope you will enjoy it as much as I have, and that you will revisit it in years to come.

Kickstart your Day with 5 Funny Economics Jokes

July 21, 2016May 22, 2017 / 416Investor / Leave a comment

Here are some economic jokes that will brighten up your day at work, or give your boss a good laugh. And if you’re in the economic discipline like myself, it doesn’t hurt to laugh at yourself once a in a while. Since these jokes have been passed around and modified, they might differ from the “original”, but the core is still the same:

1. A chemist, a physicist and an economist are stuck on a deserted island with no food. A can of food floats ashore. The physicist says “let’s smash it open with a rock”. The chemist says “let’s build a fire, and heat it first”. The economist says “let’s assume that we have a can opener…”

2. Economic forecasters assume everything, except for responsibility.

3. A mathematician, an accountant and an economist all apply for the same job. The interviewer calls in the mathematician and asks: “What do two plus two equal?” The mathematician replies “Four.” The interviewer asks “Four, exactly?” The mathematician firmly looks at the interviewer and says “Yes, four, exactly.”

It’s the accountant’s turn, the same question is asked: “What do two plus two equal?” The accountant answers “On average, four – deviated around ten percent, but on average, four.”

Then the interviewer calls in the economist, tells him to sit down and asks the same question: “What do two plus two equal?” The economist gets up, locks the door, closes the shade, sits down right next to the interviewer and says “What do you want it to equal?”

4. If you teach a parrot to say “supply and demand”, you have an economist.

5. A chemist, an engineer and an economist are shipwrecked with no food except for a single can of soup. They have no tools, and can’t afford to spill the insides as it is their only means of survival. The chemist sets up evaporating pans to collect caustic salts to etch the can lid through. The engineer piles sand to build a drop, that with precise calculation will be tall enough to crack the can open without spilling the insides. And the economist lays down on the beach, relaxing and laughing at them. After a day’s hot labor with nothing achieved, frustrated, the chemist, bursts out at the economist and says, “Okay, you’re so smart, how would you do it?!?!” The economist picks up the can and stands up straight, shining with confidence he presents the can grandly to the other two, and says, “ASSUME this can is open.”

All jokes aside, economics is a great discipline. Many economists have changed the world with their lifelong contributions, notably Adam Smith, John Maynard Keynes, John Kenneth Galbraith and many more. If you are interested in reading a book to understand the very basics of economics, I would recommend: Basic Economics by Thomas Sowell. It was well put together and covered much of the essentials for understanding the basics and flow of the economy. I will have a review for it soon. Meanwhile, you can find the book here. Of course, JMO (just my opinion).

We all love ourselves more than other people, but care more about their opinion than our own.

-Marcus Aurelius

For starters: Index and ETFs investing in your 20s according to Burton G. Malkiel

July 21, 2016May 25, 2017 / 416Investor / 2 Comments

Suppose you are new to investing, and would like to participate in the market but don’t have the time or knowledge to research individual stocks (or you’re just lazy), what should you do? Let’s explore a few options from the book: A Random Walk Down Wall Street by Burton G. Malkiel. For this article, let’s focus on two things, the importance of low fees and the asset allocation for the folks in their 20s according to Burton G. Malkiel.

HIGH FEES? WE DON’T NEED NO STINKIN’ HIGH FEES.

Now before you purchase that mutual fund your bank advisor is trying shove down your throat, consider looking at the different expense fees. Recently, many funds have come under criticism for their high fees and poor performance (compared to the benchmark), and rightfully so. Be aware of the MER, TER, front and back loads on these funds. A MER (Management Expense Ratio); is whats going to cost you for them to manage your money per year. A simple example is the following:

You find a nice mutual fund you’d like to invest in, and decide to place your hard earned $10,000 into that fund with an MER of 2.5% (this is high, and quite common). Essentially, you’ll lose $250 just to management expense fees. Now let’s assume the benchmark is the market, and it’s returning about 7%. Simply put it, you better hope your fund returns at least 9.5% just to get even with the market. Note that many funds, after fees don’t consistently outperform the market.

Now I know what you’re thinking, what’s 2.5% to you? Don’t think 2.5% is a lot?

Consider the following:

Let’s say you choose a fund that performs just as well as the market but has an MER of 2.5%. You invest $10,000 for 20 years.

Market performance: $10,000 at 7% compounded for 20 years: $38,697.

Fund performance: $10,000 at 4.5% (7-2.5) compounded for 20 years: $16,386.

You’ve indirectly lost $22,311, or about 136% to that “tiny” 2.5% fee. The longer the time, the more you lose indirectly to fees. High fees are crippling, and most people (especially starters) don’t notice them, so be careful.

“It is not necessary to do extraordinary things to get extraordinary results… By periodically investing in an index fund, the know-nothing investor can actually outperform most investment professionals.”

– Warren Buffett

For beginners, Burton G. Malkiel recommends diversifying to decrease risk by purchasing different Indexes or ETFS: Stocks, Bonds and REITs and by weighing them differently during the stages of your life. For starters in their early 20s, diversify, seek a no-load, low expense, broad-based index funds, and it’s advisable to make these purchases in a Tax-Free Savings Account (TFSA).

Because you’ve got much time in your 20s before retirement, Malkiel recommends consistent contributions (to a no-load fund) and that the majority of your holdings:

–(70%) be of stocks. He recommends to put one half in U.S. small cap growth stocks (no-load, low expense Index and ETFs) and the other half in international stocks, including emerging markets.

-Cash (5%) should be in money-market fund or short term bond funds.

-Real estate (10%) should consist of high quality REIT portfolio.

-The remaining bonds (15%) should contain: no-load, high grade corporate bond fund, foreign bonds, some Treasury inflation protection securities or dividend growth stocks.

Some Equity Index Funds and ETFs tickers from A Random Walk Down Wall Street:

FSTMX, SWRXX, VFIAX, VOO, VTI, IWB, TWOK, VEMAX, VTIAX.

Now as you enter your 30s, 40s and so on, the mix of stocks, bonds, real estate (REITs) and cash will change. For instance, according to Malkiel, in your 30s, your Stocks-Cash-Bonds-Real Estate allocation would be: 65%-5%-20%-10%, respectively. You would slowly move to “safer” investments as you age.

If you’re relatively new to stocks, don’t expect quick gigantic returns, especially not from Malkiel’s recommendation. This type of diversified allocation has the goal to decrease risk through exposure of broad indexes. Long term index and ETFs are made to pay off in the long term. Briefly, for starters: the takeaway would be to look out for high fees and contribute to index and ETF funds according to your age. Always do your own research.

All in all, you can find the full asset allocation by age from: A Random Walk Down Wall Street. It was an amazing book, written like no other and it sheds new light to numerous important topics such as the efficient market hypothesis (EMH), behavioural finance, random walk theory, diversification and much more. I will have a review on this book soon. Meanwhile, you can find the book here.Of course all this, JMO (just my opinion).

In investing money, the amount of interest you want should depend on whether you want to eat well or sleep well.

-J. Kenfield Morley

Disclosure: I have no positions in any of the recommended ETFs or Indexes at the date of this article. I wrote this article myself and it expresses my own opinions, I am not a financial advisor. I do not get any compensation from this, other than from Amazon Affiliate links and advertisements. On the date that this article was posted, I have no affiliation with any of the ETFs or Indexes.

The416Investor

Business Essentials Made Simple

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http://www.econ.yale.edu/~shiller/data/ie_data.xls

http://www.econ.yale.edu/~shiller/data/ie_data.xls

10 Investment Books Everyone Should Read

Disclosure: I wrote this article myself and it expresses my own opinions, I am not a financial advisor. This is for educational purposes only. I do not get any compensation from this, other than from Amazon Affiliate links and advertisements.

The Basics of Value Investing

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5 Must-Read Investing Books

1. The Intelligent Investor by Benjamin Graham

2. The Most Important Thing Illuminated by Howard Marks

3. A Random Walk Down Wall Street by Burton G. Malkiel

4. Common Stocks and Uncommon Profits by Philip A. Fisher

5. Technical Analysis of the Financial Markets by John J. Murphy

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For starters: Index and ETFs investing in your 20s according to Burton G. Malkiel