Worth reading

[Brix]

Freebies to the right, freebies to the left:

- a PDF of Henry Hazlitt's (all-too-classic, maybe) book, Economics in One Lesson.

- a clumsily-kerned PDF of Doug Henwood's Wall Street: How It Works and for Whom.

(Brad DeLong reviews Hazlitt here and Henwood here.)

More freebies at John Norstad's excellent Finance Page -- he's ported his old MacOS Monte Carlo simulator Random Walker to Java, and lately added PortOpt, a Java portfolio-optimization demo. The whole page is well worth reading, of course, and not just to grasp what the software is about.

(If you encounter problems running these things with Java, it's probably best not to bug John with questions, but to search for Java info via Google -- certainly both programs run without a hitch in Linux with Java 2 Standard Edition.)

[Gus]

I enjoyJohn Kay's weekly column in the Financial Times, although the quality of his columns is uneven, with some real duds from time to time.

I particularly enjoyed his article on obliquity, which I think was also published in the G&M some time ago. My previous employer, with its relentless focus on a single profitable strategy could learn something from this article but won't. This company may well end up like Boeing or ICI, focussed, highly profitable in the short term but lacking new ideas for growth and unable to respond to change.

[Norbert Schlenker]

Many troublesome (for me as indexer ) anecdotes re value investing starting here.

[DenisD]

Do Ads Influence Editors? Advertising and Bias in the Financial Media

We find that major personal finance magazines (Money, Kiplinger's Personal Finance, and SmartMoney) are more likely to recommend funds from families that have advertised within their pages in the past, controlling for fund characteristics like expenses, past returns and the overall levels of advertising. We find little evidence of a similar relationship for mentions in the New York Times or Wall Street Journal.

[Norbert Schlenker]

A StatsCan digest (full study) of income and tax trends from 1990-2002.

Somehow I suspect this won't be making the NDP's campaign platform any time soon.

The one-tenth of Canadian taxfilers who were in the highest earnings bracket provided more than one-half of the revenue from federal personal income tax in 2002, according to a new study. In addition, their share of the tax pie has been increasing since 1990.

In 1990, this 10% of taxfilers accounted for 46.0% of total federal personal income tax; by 2002, this group accounted for 52.6%. This increase reflects faster income growth and a smaller reduction in effective tax rates for this group relative to others.

At the other end of the scale, the one-half of taxfilers with the lowest incomes saw their share of the tax pie decline during the same period.

In 1990, this group accounted for 6.7% of total federal personal income tax paid; in 2002, this proportion had declined to 4.4%. In fact, this group paid less federal personal income tax in 2002 than in 1990, in spite of higher incomes. ...

[Gus]

Somehow I suspect this won't be making the NDP's campaign platform any time soon.

There are many ways to portray the statistics and I would give the NDP a little more credit for ingenuity in this regard, for example:

Part of the increase in the tax contribution of the rich 10% is because they have got richer faster than the poor 90%.

Marginal rates for the rich (and others, of course) have gone down in the last few years. I would bet that the absolute amount of these tax reductions have benefitted the rich more per capita in absolute terms.( Especially because of the elimination of the surtaxes.)

Effective marginal rates for some low income people who get GST and child benefits are still shockingly high.

I guess we'll soon find out what the NDP really has to say....

[Norbert Schlenker]

If you've ever come across the book Running Money by Andy Kessler, you'll know that he's a pretty entertaining writer. You can get a preprint of his next book, which is apparently what the editor cut out of Running Money for the sake of brevity but which will be on store shelves this summer, for free today at this link.

Surf safely. A throwaway email address (and name) seemed worthwhile to me.

[Added the next day: Hmmm. 200+ pages of interesting anecdotes re technological and capital market development but in desperate need of an editor. Bernstein's The Birth of Plenty makes a lot more sense.]

[Norbert Schlenker]

An amusing account of Economics Nobel Prize winners' investing habits. It's from the LA Times and registration may be required. An excerpt ...

Harry M. Markowitz won the Nobel Prize in economics as the father of "modern portfolio theory," the idea that people shouldn't put all of their eggs in one basket, but should diversify their investments.

However, when it came to his own retirement investments, Markowitz practiced only a rudimentary version of what he preached. He split most of his money down the middle, put half in a stock fund and the other half in a conservative, low-interest investment.

"In retrospect, it would have been better to have been more in stocks when I was younger," the 77-year-old economist acknowledged.

At least Markowitz invested more wisely than some of his fellow Nobelists. Several of them concede that they have significant portions of their nest eggs in money market accounts, some of the lowest-returning investment vehicles available.

"I know it's utterly stupid," confessed George A. Akerlof, a UC Berkeley professor and 2001 winner of the Nobel Prize in economics. ...

[Brix]

In an essay whose style uncannily resembles that of one of the most informative and entertaining posters on this forum, economist Micheal Hudson relates current stock-market valuations to proposals to reform the US social security system.

The one sure mark of a con, though, is the promise of free money. In fact, the only way the stock market is going to grow is if we the people put a lot more of our money into it. What Bush seeks to manufacture is a boom—or, more accurately, a bubble—bankrolled by the last safe pile of cash in America today. His plan is a Ponzi scheme, and in that scheme it is Social Security that is being played for the last sucker.

Talk of bubbles has become popular in recent years, but most discussions miss the key point. Although optimism is inherent in the human spirit, it rarely effloresces into the kind of frenzy necessary to float a bubble without help from the government. In fact, many of history’s most famous bubbles have been sponsored by governments in order to get out of debt. Britain, in 1711, persuaded bondholders to swap their bonds for stocks in the South Sea Company, which was expected to get rich off the growth industry of its day, the African slave trade. By the time the South Sea bubble collapsed, the government had indeed paid off its war debt—and speculators were left holding worthless “growth sector” stocks. In 1716, John Law organized France’s Mississippi bubble along the same lines, retiring France’s public debt by selling shares to create slave-stocked plantations in the Louisiana territories. It worked, for a while.

The U.S. government is now attempting to run the same kind of scam. Bush would like to persuade Social Security claimants to exchange the security of U.S. Treasury bonds for a chance to buy growth stocks on which a much higher return is hoped for. No modern blue-sky venture comparable to the South Sea or Mississippi companies is needed. The stock market itself has become a bubble, borne aloft from the burden of generating actual goods and services by a constant flow of new retirement dollars.

There is no denying that channeling trillions of Social Security dollars into the stock market would produce short-term gains. But once this money is spent, the markets are likely to retreat. That is what happens after a financial bubble. Then we will be right back where we are today, only much the poorer and with no guaranteed pension system for elderly Americans—who will, of course, need guaranteed pensions more than ever as they watch their stock holdings continue to shed value.

[Bylo Selhi]

Arnott via Mauldin: The Problem With [Cap-Weighted] Indexes

Can we improve on cap weighting? Absolutely! Any index that is replicable, objective, and focused on large and liquid companies which are easily tradable is a potentially useful index. Any such index that is valuation-indifferent should beat the stock market. If it doesn't care what PE ratios are or what the price is when setting how large your investment in an asset should be, it should beat cap weighting.

Added 15May05: Redefining Indexation paper by Arnott, Hsu and Moore [PDF]

[George$]

Nassim Taleb

and

Trader Risk Management Lore : Major Rules of Thumb

Some text

Trader Risk Management Lore : Major Rules of Thumb


--------------------------------------------------------------------------------

Rule 1 - Do not venture in markets and products you do not understand. You will be a sitting duck.

Rule 2 - The large hit you will take next will not resemble the one you took last. Do not listen to the consensus as to where the risks are (i.e. risks shown by VAR). What will hurt you is what you expect the least.

Rule 3 - Believe half of what you read, none of what you hear. Never study a theory before doing your own prior observation and thinking. Read every piece of theoretical research you can - but stay a trader. An unguarded study of lower quantitative methods will rob you of your insight.

Rule 4 - Beware of the trader who makes a steady income. Those tend to blow up. Traders with very frequent losses might hurt you, but they are not likely to blow you up. Long volatility traders lose money most days of the week. (Learned name : the small sample properties of the Sharpe ratio).

Rule 5 - The markets will follow the path to hurt the highest number of hedgers. The best hedges are those you are the only one to put on.

Rule 6 - Never let a day go by without studying the changes in the prices of all available trading instruments. You will build an instinctive inference that is more powerful than conventional statistics.

Rule 7 - The greatest inferential mistake: this event never happens in my market. Most of what never happened before in one market has happened in another. The fact that someone never died before does not make him immortal. (Learned name: Hume's problem of induction).

Rule 8 - Never cross a river because it is on average 4 feet deep.

Rule 9 - Read every book by traders to study where they lost money. You will learn nothing relevant from their profits (the markets adjust). You will learn from their losses.

[Norbert Schlenker]

I bet you never thought insurance might be as interesting as this. Read all about Nicole Kidman's knee.

[Shakespeare]

Read all about Nicole Kidman's knee.

In comparison:
To minimize costs, the production wasn't insured -- and the actors did their own stunts.

[George$]

Eric Sprott's May 16, 2005

This is us again, your beloved investment managers at SAM. One of the prevailing themes among the “Voices of Reason” that we’ve quoted is that we have lived, and continue to live, in a bubble – an ongoing bubble that has morphed into various forms since the late 1990s but which for all intents and purposes has yet to “burst”. Living off illusory asset bubbles, as the world has become accustomed to doing, and as economists (not to mention central bankers) for the most part condone, isn’t the new “paradigm”. The world has seen this type of economy before and it never has a happy ending. Why should now be any different?


History shows that all previous attempts at excess liquidity creation have ended badly – all the more so because the existence of (albeit illusory) wealth gives people a false sense of security. Based on recent financial market behaviour, this party may be ending here and now. We’re not trying to preach doom and gloom here. We’re not saying that it will be the end of the world. Our survival as a species will likely continue intact. But in the interim, as this bubble bursts, violent adjustments in financial markets can occur which can lead to substantial loss of wealth. This is what we want to protect against.


We want our readers and investors to know that we fear the current market environment. It is for this reason that, unlike the many hedge funds that are speculatively levered, ours has a much more defensive
flavour. There has been much reported in the media about trouble in the hedge fund world. However, there are hedge funds and then there are hedge funds. The term “hedge fund” is a misnomer for many of these investment vehicles – many “hedge funds” don’t hedge at all but rather use shorting to lever a speculative bet. We do not have such funds. Rather, we see considerable risk for both the economy and financial markets going forward, and are positioned accordingly.


We are happy to say that as far as the foundations for these fears are concerned… we are in good company. We would like to thank Mr. Roach, Dr. Richebächer, and Mr. Noland for being the voices of reason in this convoluted financial world we live in.

and his other

Markets at a Glance

[ghariton]

From the authors of Freakonomics, in today's New York Times:

But in a clean and spacious laboratory at Yale-New Haven Hospital, seven capuchin monkeys have been taught to use money, and a comparison of capuchin behavior and human behavior will either surprise you very much or not at all, depending on your view of humans.

<snip>

Something else happened during that chaotic scene, something that convinced Chen of the monkeys' true grasp of money. Perhaps the most distinguishing characteristic of money, after all, is its fungibility, the fact that it can be used to buy not just food but anything. During the chaos in the monkey cage, Chen saw something out of the corner of his eye that he would later try to play down but in his heart of hearts he knew to be true. What he witnessed was probably the first observed exchange of money for sex in the history of monkeykind. (Further proof that the monkeys truly understood money: the monkey who was paid for sex immediately traded the token in for a grape.)

This is a sensitive subject. The capuchin lab at Yale has been built and maintained to make the monkeys as comfortable as possible, and especially to allow them to carry on in a natural state. The introduction of money was tricky enough; it wouldn't reflect well on anyone involved if the money turned the lab into a brothel. To this end, Chen has taken steps to ensure that future monkey sex at Yale occurs as nature intended it.

Whatever happened to multiculturalism?

George

[Chuck]

George, you left out the best paragraph:

But these facts remain: When taught to use money, a group of capuchin monkeys responded quite rationally to simple incentives; responded irrationally to risky gambles; failed to save; stole when they could; used money for food and, on occasion, sex. In other words, they behaved a good bit like the creature that most of Chen's more traditional colleagues study: Homo sapiens.

[George$]

Rules of finance? What are they? Are there any rules?

A financial perspective from a physicist by training

My Life as a Quant : Reflections on Physics and Finance by Emanuel Derman

To quote Derman quoting MIT Professor Andrew Lo: "Physics has three laws that explain 99% of the phenomena, and economics has 99 laws that explain 3% of the phenomena."

"In physics, you are really playing against God, and He sets the laws once and for all, and you are trying to figure them out, and He doesn't really change them too often. And if you figure out what the laws are, then He kind of gives up and says, 'You're right.' In finance, you are really playing against God's creatures, people like us, who value assets based on their ephemeral feelings. ... They overshoot, they undershoot, and they sometimes don't know when they've lost the game. They keep on trying to play, and they keep trying to change the rules on you."

Living with lawlessness on Wall Street

This is the best description I've seen of the difference between how markets work and the laws of physics. I frequently do my best to try to infer what the markets are concluding, though that effort is complicated by the fact that there's often a high noise-to-signal ratio. (That, by the way, may be higher than normal now.)

The bottom line to take away from Derman's book: There are no hard-and-fast rules in markets (as opposed to science) -- just relationships that are constantly changing.

[ghariton]

There are no hard-and-fast rules in markets (as opposed to science) -- just relationships that are constantly changing.

Is that just another way to say that there is a lot more randomness out there than we believe?

George

[Norbert Schlenker]

A quick search for Ernie Zelinski's name turns up nada. Substantial portions of his two books are available free and online here and here.

[beaverlodge]

I see no connection between finance and physics.
Any connection would be tenuous and unrelated.

[George$]

I see no connection between finance and physics.
Any connection would be tenuous and unrelated.

Quantitative analysis is intrinsic to physics. So is skepticism and a real concern for the limitations of ones understanding.

From another review of

My Life as a Quant provides an invaluable firsthand account of the quantitative revolution in finance from the 1980s onward. Derman is insightful about the interplay of money and ego on Wall Street, as well as the personality gulf separating traders and quantitative analysts. He lends insight into the process of creating models, while also stressing their limitations. "We are always trying to shoehorn the real world into one of the models," Derman observes. That constitutes a sound warning; as many traders have learned to their sorrow, market prices do not know about the models to which they are supposed to conform.

[DenisD]

Noticed this quote on the Diehards forum from an article by Fidelity comparing growth and value investing.

In the three years ending February 2000, growth outperformed value by 19.2%. Following those three years, value outperformed growth by 21.9%. These consecutive three-year periods have been the greatest performance differences in the growth and value styles in the 25-year history of the Russell indexes. Statistically, both periods are greater than two standard deviations from the mean which represents only a 5% probability.

[Norbert Schlenker]

It's hard to know where to put this because it can affect mutual funds and income trusts and, in this case, pension funds. IIRC, there was a lengthy discussion at the old TWB re internal / external managers, particularly with income trusts, and the general conclusion was that internal was better than external from the point of view of share/unitholders.

OMERS got itself into hot water a few years ago by letting some employees carve out a profitable piece of the portfolio and externalize the portfolio management, keeping all the fees for themselves when they wouldn't have been paid nearly as handsomely as internal staff. The company's name was Borealis and, in the end, OMERS had to buy it back from the employees when the shit hit the fan.

There's a wee note in the G&M today that makes it sound like they're doing it all over again.

Look for OMERS to spin out part of its private equity team next week, as the pension fund finishes digesting last year's buy-in of Borealis Capital.

Ian Collier, who rejoined the Ontario municipal employees plan last February, is expected to strike out with a nine-person team. Internal announcements detailing the move were made last Friday, and OMERS insiders say Mr. Collier will depart with a mandate to run an existing portfolio that holds about $350-million worth of investments, but OMERS won't commit to backing any funds that the team launches in the future.

OMERS, one of the country's largest pension funds with $33-billion in assets, is expected to stay very much involved in private equity. It will still be home to a number of professionals who will work on the sector after Mr. Collier and his colleagues move on. This isn't a wholesale departure, as Borealis veterans now run OMERS real estate and infrastructure arms.

Mr. Collier was running the private equity arm of Borealis, spun out of OMERS in 1997, then brought back into the fold last February by newly appointed OMERS president and CEO Paul Haggis. In pension fund circles, Mr. Haggis is winning high marks for trying to improve the way OMERS is run.

That whole outsourcing experiment with Borealis proved expensive, and controversial. The Canadian Union of Public Employees is suing the fund manager over the way Borealis exited, then re-entered the fold. CUPE represents about 44 per cent of the 340,000 workers whose retirements will be paid for by OMERS.

Repurchasing Borealis, which was owned by its employees and outside investors that included the CPP Investment Board, cost OMERS $49.9-million, according to the fund's recently released 2004 annual report. That report showed Mr. Collier banked a $400,000 bonus and $356,154 salary last year, when he was back with OMERS.

Plus ca change, plus c'est la meme chose.

[Norbert Schlenker]

Some uncommonly good advice from Business Week.

[yielder]

A great collection of mutual fund shareholder letters.