Worth reading

[Norbert Schlenker]

Maybe dead simple is really good enough ...

In this paper, we wish to evaluate the performance of simple asset-allocation strategies such as allocating 1/N to each of the N assets available. To do this, we compare the out-of-sample performance of such simple allocation rules to about ten models of optimal asset-allocation (including both static and dynamic models) for ten data sets. We find that the simple assetallocation rule of 1/N is not very inefficient. In fact, it performs quite well out-of-sample: it typically has a higher Sharpe ratio, a higher certainty equivalent value, and a lower turnover than the policies from the optimal asset allocation. The intuition for the good performance of the 1/N policy is that the loss from naive rather than optimal diversification is smaller than the loss arising from having to optimize using moments that have been estimated with error. Simulations show that the performance of policies from optimizing models relative to the 1/N rule improves with the length of the estimation window (which reduces estimation error) and also with N (which increases the gains from optimal diversification). But, even with an estimation window of 50 years, the difference in the performance of the 1/N policy and the policies from models of optimal asset allocation is not statistically significant.

[Bylo Selhi]

Mandelbrot(*) and Taleb: How the Finance Gurus Get Risk All Wrong [Fortune, 06Jul05]

It was in the third century of our era that the skeptical philosopher and physician Sextus attacked blind reliance on dogmas; his stance earned him the name Sextus Empiricus (Sextus the Empirical). Depressingly, medicine took 13 centuries to follow his recommendations, become empirical, and integrate surgeons' observations of the human body. The same resistance to reality characterizes finance. The inapplicability of the bell curve has long been established, yet close to 100,000 MBA students a year in the U.S. alone are taught to use it to understand financial markets. For those who teach finance, a number seems better than no number—even if it's wrong.

(*) Trivia: Among Benoit Mandelbrot's many distinctions is that he was the PhD thesis advisor to Eugene Fama

[Gus]

In prospect evaluation in oil exploration the risk evaluation methodology used is different from financial risk assessment, and there may be some value in comparing the two approaches with Mandlebrot's ideas.

The probability of success or failure of an exploration well will be estimated using statistics for a certain prospect type in a particular basin, combined usually with a lot of subjective input to account for the peculiarities of the individual prospect. Oil explorers, confusingly for financial types, refer to this parameter as the "risk" or "chance of success" of a venture.

The range in possible size of the discovered pool will be estimated (before drilling and updated later whenever new data are available) using a log-normal distribution of pool sizes. This is often calculated by mutiplying together distributions of log-normal or normal distributions of various input parameters, using Monte Carlo techniques. This parameter is referred to as "uncertainty" and is equivalent, roughly to "risk" as used by fianancial analysts.

It seems to me that some of the objections of Mandlebrot could be dealt with if fianancial analysts also considered the possibility of failure of a single stock (bankruptcy) or index (a crash). Incorporating small risks of total disaster into portfolio projections could be done using historical statistics and would produce conservative results. I am surprised that fianancial analysts and advisors have not (AFAIK) implemented this factor because it would also cover their professional backsides in the event of a crash or an Enron.

My main methodological objection to a lot of the Monte Carlo risk modelling done by financial analysts is the frequent assumption of independance of parameters. As everyone acknowledges, some stocks move together (eg energy stocks to oil prices) and other asset classes move together but in opposite directions (eg, airline stocks and oil stocks to oil price changes).

One of the key observations in the oil industry that comes from lookbacks of uncertainty estimation is that explorers always tend to underestimate the uncertainty of a venture. Geologists always think they know more than they actually do.


But I'm not sure that Mandlebrot's approach would work for stock markets. The key historical trend in stocks is upwards, which is why most of us invest at all. The record is too short to determine whether this trend is indeed upwards forever or part of a long cycle that will see a future century or more of steady declines. Who knows whether the seemingly random walk pattern of stock prices looks the same at whatever time scale you examine it; ie, is it truly fractal? I suspect not, since very different factors influence prices over different time scales. The saying about the market being a short-term voting machine and a long-term weighing machine comes to mind.

I'm not much of a mathemetician and I may well have got this last point all wrong...

[nadreck]

In prospect evaluation in oil exploration the risk evaluation methodology used is different from financial risk assessment.

I would agree with that if what you mean by financial risk assesment is the assumption that past volatility relative to a an index somehow measures risk when fundamentals of individual business and the sector or sectors it operates in are far more relevant to predicting the levels of risk.

The failing this method has is two fold: there is no way to measure how accurate the methodology is; and, there is no way to be sure one has identified all the specific elements that both could impact the bottom line and can be assessed as a probability.

However despite those failings it is a far more appealing method of analyzing risk to me than to just assume that the amount of correlation a stock had relative to an appropriate index in the past has any bearing on its risk level. To me that is blindly driving by the rear view mirror.

[Norbert Schlenker]

A couple of items that came to my attention today.

Bill Bernstein has penned a new article nominally about US estate taxes but actually about rags to riches to rags in three generations. Read it here.

This is an article by Katharine Richardson on the Financial Planning Association's website about documenting tangible assets. While some of the verbiage is fluff (IMO; to use an example from the article, if I had bought a table at a yard sale for $125 that was actually worth $250k, I think I wouldn't want to know ), most of it is useful. While the article focuses on insuring things properly, I consider it as important to go through a process like this if your "stuff" is going to be divided among children. You wouldn't believe what wars can result among siblings over trivial stuff after parents' deaths.

[Norbert Schlenker]

The FPA Journal had an article that referenced Motivating Americans to Develop Constructive Financial Behaviors, but there is lots of other good stuff lying around as well at NEFE. An excerpt of headings from the article link:

Spending Tips

Resist "buy" messages...
Share financial information with your family...
Consider the consequences of your financial behavior...
Distinguish between wants and needs...
Follow basic principles...
Keep debt under control...
Test your desire to buy...

Saving Tips

Begin with a single step...
Start saving early...
Manage your risk and take advantage of employee benefits options...
Stay focused on life goals...
Seek out programs designed especially for low-income individuals...
Conduct financial business only with banks and credit unions...
Take responsibility for managing your own finances...
Find a financial balance...
Examine the past for insights on the future...

[George$]

David F. Swensen's forthcoming book "Unconventional Success: A fundamental Approach to Personal Investing", (in August from Free Press) may be worth looking at.

He is Yale's $8 billion man

Diversify.
Investors should hold six asset classes: U.S. stocks, foreign developed-market stocks, emerging market stocks, U.S. government bonds, inflation-indexed bonds, and real estate. For true diversification, each asset class should account for a minimum of 5 percent and a maximum of 30 percent of assets.

Avoid certain asset classes.
Corporate bonds, high-yield bonds, and foreign bonds don't belong in an individual's portfolio. Nor do hedge funds, leveraged buyout partnerships, or venture capital partnerships. "Because of the enormous difficulty in identifying and engaging superior, active managers," Swensen writes, "prudent investors avoid asset classes that derive returns primarily from market-beating strategies."

Rebalance.
Once investors have set their target asset allocations, they should rebalance their portfolios regularly to stay close to the targets. Rebalancing forces investors to act against the crowd by selling asset classes that are doing well and buying those that are doing poorly.

Don't try to outsmart the market.
Few individual investors have the time or resources to pick stocks. "Individuals who attempt to compete with resource-rich money management organizations simply provide fodder for large institutional cannon," he writes.

Buy index funds -- but shop carefully.
Well-constructed indexes from investor-owned mutual fund companies like Vanguard and TIAA-CREF are the best way for most investors to buy stocks. The S&P 500 and the Wilshire 5000 are well-constructed U.S. stock indexes, while the Russell 2000 is not. Index funds offer lower costs, low turnover, and better tax efficiency

[Bylo Selhi]

Well-constructed indexes from investor-owned mutual fund companies like Vanguard and TIAA-CREF are the best way for most investors to buy stocks.

Warning: TIAA-CREF may no longer be the bargain that it once was. TIAA-CREF's Fees Headed in the Wrong Direction

[George$]

I came across the following list of investment books suggested by Barton Biggs from Morgan Stanley

I published this list .... (2-page pdf file)

I published this list ten years ago and I keep getting requests
to update it, so here it is in all its infamy. Reading books
about investing does two things for you. First, as investors,
we are only the limited product of our own experiences and
therefore vulnerable unless we read and assimilate the
accumulated wisdom of the great ones. Second, as it says on
the façade of the Library of Congress: “Those who have not
studied the past are condemned to repeat it.” Economic and
particularly financial history definitely tends to repeat itself.
I have two long shelves of the best books I have read that
relate one way or another to investing. Since investing is
about everything, my books relate to diverse subjects ranging
from history to psychology. In no particular order here is my
list, with star rankings from 1 to 5. The whole exercise is
completely subjective. Readability counts.

[Norbert Schlenker]

Two interesting JREPM papers about the diversification benefits of real estate / REITs in investment portfolios here and here.

[bender]

Some great commentary from Jeremy Grantham at

http://www.gmo.com/america/

Free but reg required. Q2 commentary highlights include evidence that the oil price may be the first financial bubble not to mean revert; and a simple "behavioural" P/E model.

Also on site is a nice 7 year asset class forecast.

Disclaimer: newbie so don't trust me or my sources

Moderator: Per http://bugmenot.com/ , nobody@nowhere.com and hellooo work for the email address and password.

[SilverVette]

A year or two back, the Globe & Mail had a writer named Fabrice Taylor who produced the Vox column. Taylor was one of those very rare financial writers who could deliver a measured opinion of a stock without getting rah-rah and, on the other hand, without burying his opinion in a morass of statistics. Until I read him I didn't realize financial writing could be an art. When he wrote about a company I usually finished with clear reasons to buy or sell and as a result made some excellent capital gains on Telus and Apple, two stocks which are currently riding high but were seriously out of favour when he first discussed them.

He's gone now, his place taken by Derek deCloet, but I am wondering if anyone knows where he hangs his hat these days. I asked the G&M but they claim not to know.

[yielder]

I asked the G&M but they claim not to know.

They weren't being very frank with you.

[Bylo Selhi]

I asked the G&M but they claim not to know.

They weren't being very frank with you.

Nor do they read their own rag (where the article first appeared.) Frank magazine to return on-line

See also A new vox [May 27, 2005]

Fabrice Taylor will be familiar to Globe and Mail readers as the former voice of Vox, the hard-hitting investing column he authored for three years... These days, Fabrice works as an analyst at Pollitt & Co.--an independent Toronto brokerage--and, I'm thrilled to announce, will moonlight as a columnist for this magazine, bringing the same energy and insight that were his hallmarks at the paper.

...although Fabrice has yet to be sighted at his moonlight gig and I can't find a website for his day job to verify that he's still there. One could, of course, phone (416) 365-3313 on Monday and ask for Fabrice.

[SilverVette]

Thanks for that. It was a few months back when I inquired, so perhaps they didn't know at that time although you'd think they would keep track of former star employees.

"will moonlight as a columnist for this magazine"
[quote]

What magazine are they talking about and how does one access it?
[/quote]

[Bylo Selhi]

What magazine are they talking about and how does one access it?

Presumably they mean ROB Magazine.

[nadreck]

I just finished an excelent book for those who are introspective on the successes and failures they have had on the market and in life called "Fooled by Randomness" by Nassim Nicholas Taleb. A truly thought provoking book. It may greatly influence what I report and how I report it, though I am still digesting its message.

Nassim makes a variety of points about how most people have two opposite biases that they apply in hindsight to events, they are more likely to presume that a random success in the past was a result of their skill and they are more likely to attribute failure in the past to randomness (bad luck). The book is quite light on the mathematics, and while he quotes the odd bit of mathematics, economics and philosophy (with a great set of notes and bibliography for the curious) it is written in a very readable and anecdotal style.

What has fascinated me with this book though is the impact that his main thesis about our perceptions, and misperceptions, of randomness has both on my activities investing (why I picked up the book in the first place) but also on my hobby of 'reporting' some investment news and sectoral fundamentals and even my technology column. I think it will probably effect more of a change on that little bit of armchair journalist in me than the investor in me. Not that I won't add some more levels of introspection to my investing activities as well. Of course, like any good book with a bibliography, my reading list also got a lot longer.

Particularly I am interested in a piece he mentioned called "Fashionable Nonsense"

[Shakespeare]

Many of us have read that book. Perhaps the most striking point that Taleb makes is that most models (and most investors) underestimate the probability of unlikely events.

[Bylo Selhi]

Perhaps the most striking point that Taleb makes is that most models (and most investors) underestimate the probability of unlikely events.

As does Mandelbrot in The (Mis)Behavior Of Markets. Chapter 5 is available for free on his site and/or see How the Finance Gurus Get Risk All Wrong.

[nadreck]

Many of us have read that book. Perhaps the most striking point that Taleb makes is that most models (and most investors) underestimate the probability of unlikely events.

I thought it was very insightful how he described the role of the media in keeping the effect of "noise" front and centre in peoples minds. I credit that with so many missing the pottential for the unlikely events. In other words the media makes its living exagerating the importance of random every day events which probably inures us to the impacts that the less likely ones have.

In any case, his observations on how casually media ascribes meaning to "noise", certainly demeans the value of traditional media.

[yielder]

In other words the media makes its living exagerating the importance of random every day events which probably inures us to the impacts that the less likely ones have.

What do the Weather Channel and ROBtv/CNBC have in common? They have 24 hours to fill with content and they have to [s]attract viewers[/s] sell advertising.

What does the weather channel do if there are no stories, ie, no hurricanes, no floods, no tornadoes, no weather disasters? They play up the routine, "There's a x% chance of late afternoon thunderstorms" in order to make something out of nothing.

What does ROBtv/CNBC do if there are no stories? They create stories, "U.S. shares were mixed, as concern over rising energy costs weighed on investor sentiment." No one knows what moves the market on most days yet they ascribe a reason every single day.

Most daily fluctuations are noise; most "news" is noise.

[Norbert Schlenker]

As Two Economists Debate Markets, The Tide Shifts

[Bylo Selhi]

From Norbert's link:

Defending efficient markets has gotten harder, but it's probably too soon for Mr. Thaler to declare victory. He concedes that most of his retirement assets are held in index funds, the very industry that Mr. Fama's research helped to launch. And despite his research on market inefficiencies, he also concedes that "it is not easy to beat the market, and most people don't."

Another behaviourist who agrees is Andrew Lo:

He invests by buying and holding index funds, because "I'm too busy teaching and doing research to pay enough attention to more active trading."

[Norbert Schlenker]

From the IFID website.

4% works pretty darned well

If your net worth is 30 times your income, you don't need life insurance

Buying an annuity before age 65-70 is not a good idea

An early portfolio disaster will doom your retirement

[Feeonly.ca]

4% works pretty darned well

Note, the paper discusses an all equity portfolio with an expected Std Dev. of 20%. That degree of uncertainty during deaccumulation requires a lower withdrawal rate than is necessary. IMO, few people would or should hold an all equity portfolio.

Buying an annuity before age 65-70 is not a good idea

Note, the paper discusses Variable Annuities not Fixed Annuities. I'm not keen on Variable Annuities at any age.

If you want to defease longevity risk the Variable Annuity is a very poor choice compared to the Fixed Annuity. They are completely different products.

Having said that, 65-70 is generally the time to considering a Fixed Annuity.

An early portfolio disaster will doom your retirement

Not once you own a Fixed Annuity, you have no market risk