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You Can Be Right And Still Be A Moron

I stumbled across a really good quote from Dr. Daniel Crosby’s The Laws of Wealth that I may have printed and laminated into a wall-sized poster:

… on Wall Street, doing what is “right” can lead to a negative short-term result and doing what is “wrong” can be spectacularly profitable in the short run. Consider the story related by Paul DePodesta, a baseball executive made famous in the book Moneyball. He says on his blog, It Might be Dangerous:

Many years ago I was playing blackjack in Las Vegas on a Saturday night in a packed casino. I was sitting at third base, and the player who was at first base was playing horribly. He was definitely taking advantage of the free drinks, and it seemed as though every twenty minutes he was dipping into his pocket for more cash.

On one particular hand the player was dealt 17 with his first two cards. The dealer was set to deal the next set of cards and passed right over the player until he stopped her, saying: “Dealer, I want a hit!” She paused, almost feeling sorry for him, and said, “Sir, are you sure?” He said yes, and the dealer dealt the card. Sure enough, it was a four.

The place went crazy, high fives all around, everybody hootin’ and hollerin’, and you know what the dealer said? The dealer looked at the player, and with total sincerity, said: “Nice hit.”

I thought, “Nice hit? Maybe it was a nice hit for the casino, but it was a terrible hit for the player! The decision isn’t justified just because it worked.”

My shorthand for the concept illustrated by DePodestra’s story is, “you can be right and still be a moron.” Perhaps you know a friend who gambled big on a single stock and made a great return. Results notwithstanding, your friend is a moron. Maybe you jumped out of the market right before a precipitous drop because of nothing more than a guy feeling. Lucky you, but you’re still a moron.

Exceptional investing over a lifetime cannot be predicated on luck. It must be grounded in a systematic approach that is applied in good times and in bad and is never abandoned just because what is popular in the moment may not conform to longer-term best practices.

Charles here. You could also sum this up with “don’t confuse brains with a bull market.”

We’ve all been there. You made a terrible trade based on faulty logic (or no logic at all). You misassigned probabilities or ignored the risk you were taking. You shot from the hip. And maybe it worked out. (I’m not picking on you, by the way. I’ve done it too…)

Just don’t learn the wrong lesson from it. A good outcome doesn’t mean it was a good decision. And plenty of good decisions have really lousy outcomes. Randomness is a big part of it. This is the nature of a world in which we have to make decisions with imperfect information.

 

 

 

Disclaimer: This material is provided for informational purposes only, as of the date hereof, and is subject to change without notice. This material may not be suitable for all investors and is not intended to be an offer, or the solicitation of any offer, to buy or sell any securities nor is it intended to be investment advice. You should speak to a financial advisor before attempting to implement any of the strategies discussed in this material. There is risk in any investment in traded securities, and all investment strategies discussed in this material have the possibility of loss. Past performance is no guarantee of future results. The author of the material or a related party will often have an interest in the securities discussed. Please see Full Disclaimer for a full disclaimer.

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Book Review: High Returns from Low Risk

We all know that higher returns come at the cost of higher risk. This is one of the basic fundamentals of investing.

But what if it isn’t true?

In High Returns from Low Risk: A Remarkable Stock Market Paradox, Pim van Vliet and Jan de Koning challenge this assumption and find that, in fact, high-risk (i.e. high-volatility) stocks actually underperform their more conservative, staid peers. Van Vliet and de Koning found that, over the past 86 years, a portfolio of the least volatile stocks (lowest decile) outperformed a portfolio of the most volatile stocks (highest decile) with annualized returns of 10.2% and 6.4%, respectively.

Van Vliet and de Koning are anomaly hunters, and I would include them among the growing evidence-based “smart beta” movement that seek to build a better mousetrap than traditional cap-weighting indexing.

It would be easy enough to stop here and suggest that Van Vliet and de Koning’s advice was simply to buy and hold low-volatility stocks. (You could argue that this is essentially what Warren Buffett’s strategy at Berkshire Hathaway has been for the past several decades, buying a leveraged low-vol portfolio with insurance float.) But Van Vliet and de Koning take the analysis a step further, incorporating value and momentum strategies into the mix.

Van Vliet and de Koning suggest using a combination of dividend yield and buyback yield (collectively called “shareholder yield” in certain cases, though Van Vliet and de Koning do not use that phrase in the book) to screen for value. But as a way of avoiding value traps — stocks that are cheap for a reason — they also suggest using a momentum filter. In plain English, they look to avoid cheap stocks that just keep getting cheaper.

As for why these anomalies persist, Van Vliet and de Koning have their theories. The need by professionals to hug their benchmarks, excessive short-termism by both professional and retail investors, and low-volatility stocks’ overall lack of sex appeal are all factors.

The question in my mind is whether the anomalies are sustainable, as profit opportunities tend to get arbitraged away. Van Vliet and de Koning ask the same question towards the end of the book and reach the conclusion that, so long as asset managers continue to chase performance relative to a benchmark, low-vol investing should continue to outperform.

Disclaimer: This material is provided for informational purposes only, as of the date hereof, and is subject to change without notice. This material may not be suitable for all investors and is not intended to be an offer, or the solicitation of any offer, to buy or sell any securities nor is it intended to be investment advice. You should speak to a financial advisor before attempting to implement any of the strategies discussed in this material. There is risk in any investment in traded securities, and all investment strategies discussed in this material have the possibility of loss. Past performance is no guarantee of future results. The author of the material or a related party will often have an interest in the securities discussed. Please see Full Disclaimer for a full disclaimer.

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Book Review: Get Rich With Options

I recently had the opportunity to pick up a copy of Lee Lowell’s 2009 book Get Rich With Options: Four Winning Strategies Straight from the Exchange Floor.

Lee wrote an excellent primer on options trading, but the publisher probably should have put a little more thought into the title. Get Rich With Options has very little to do with getting rich with options. Instead, it is a level-headed explanation of various low-risk options trading strategies that generate small, consistent profits over time.

(Though to be fair, “Generate Small, Consistent Over Time With Options” doesn’t look quite as good in print.)

For readers who are accustomed to thinking of options trading as a high-risk/high-return endeavor, Lee’s book will be a real eye-opener.

Most of what Lee does revolves around selling options rather than buying them. Yet interestingly, his first strategy is buying deep-in-the-money options as a substitute for stocks.

This is the polar opposite of how most options speculators operate. Most tend to buy cheap out-of-the-money options with something of a lottery-ticket mentality. The returns to buying out-of-the-money options are potentially much higher. Of course, there is also the high likelihood that the option expires worthless and you lose your entire investment.

When an option is deep in the money, it moves in virtual lockstep with the underlying stock. (For the experienced options traders out there, Lee generally recommends buying the deepest in-the-money options available with a delta of at least 90 percent.) But, you initial investment is significantly lower. So, you get the same potential upside on a much smaller investment with lower downside. For a short-term stock trade, that makes all the sense in the world.

Lee’s next strategy is my personal favorite: selling naked put options. Though I rarely sell puts personally, I regularly use outside managers that do. It’s a fantastic strategy for generating consistent income and functions, in principle, like an insurance company. Like an insurance company, the seller collects consistent premiums, though once in a while, disaster (i.e. a market decline) will strike, and you have to pay out a “claim.” (Note: The insurance analogy is mine, not Lee’s. I don’t want to put words in his mouth.)

Lee sees two important elements to put selling. First, selling the options generates immediate income. But secondly, put selling can allow you to buy a stock you want at the price you want. It’s a coin toss in which you win both ways. Heads, the stock rises and you keep the options premium. Tails, the stock price falls, you still keep the option premium, but you buy the stock at a price you consider reasonable. There is the risk that the stock could fall much lower than your stock price, but you would have carried that same risk had you simply bought the shares outright. There is really nothing not to like here.

Lee’s third strategy — his favorite — is actually a collection of spread strategies that involve using multiple options contracts to limit the cost of trading. This is something that many new traders may find intimidating, but Lee does a good job of breaking down the trades into digestible pieces that even a beginner can understand.

And finally, Lee’s fourth strategy is covered call writing. In Lee’s first strategy, he recommends buying options that are deep in the money. But covered calls are a different animal. When you sell a call option against a stock you own, you’ll looking to earn a little extra income from the stock above and beyond its dividend and regular capital gains. But you’re not wanting the option to get exercised, as that means selling the stock. Ideally, a covered call option expires worthless and you simply pocket the premium.

I would add that, in today’s low volatility environment, Lee’s options strategies are less profitable than they would be in a more “normal” volatility regime. That’s ok. This is the time to read up on the strategies so as to be prepared when the opportunities reappear.

If you are new to options trading — or even if you are an experienced hand — I recommend giving Get Rich With Options a read.

 

 

Disclaimer: This material is provided for informational purposes only, as of the date hereof, and is subject to change without notice. This material may not be suitable for all investors and is not intended to be an offer, or the solicitation of any offer, to buy or sell any securities nor is it intended to be investment advice. You should speak to a financial advisor before attempting to implement any of the strategies discussed in this material. There is risk in any investment in traded securities, and all investment strategies discussed in this material have the possibility of loss. Past performance is no guarantee of future results. The author of the material or a related party will often have an interest in the securities discussed. Please see Full Disclaimer for a full disclaimer.

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Book Review: Joel Tillinghast’s Big Money Thinks Small

Joel Tillinghast is not a household name, even among active investors.

He should be.

Tillinghast is the manager of the Fidelity Low-Priced Stock Fund, and he’s beaten both the S&P 500 and the Russell 2000 by 4% per year since 1989. And while 4% might now sound like a large number, it makes an enormous difference compounded over time. A dollar invested with Tillinghast in 1989 would have grown to $32 over the past 27 years, whereas that same dollar invested in an index fund would have grown to $12.

So, Tillinghast is a manager you should take seriously. And in Big Money Thinks Small: Biases, Blind Spots, and Smarter Investing, Tillinghast shares some of the tricks of the trade he’s used over the past three decades.

Tillinghast breaks the investment process down into five basic principles:

  1. Make decisions rationally
  2. Invest in what you know
  3. Work with honest and trustworthy managers
  4. Avoid businesses prone to obsolescence and financial ruin
  5. Value stocks correctly

Making decisions rationally sounds obvious, but it can be exceedingly difficult in the stock market. As Tillinghast puts it, “…the folklore of stock exchanges has depiscted them as crowded, anonymous carnivals of mass delusion and mayhem, with a whiff of sin. In a venue where avarice and envy are constants, no one expects decisions to be morally ideal.”

That’s not exactly an ideal environment for thoughtful, detailed stock research… which is why so few investors succeed.

Tillinghast walks us through some of the psychological minefields first explored by Daniel Kahneman and Amos Tversy, who are considered to be the pioneers in behavioral finance. But he stops short of throwing human active managers completely under the bus and using purely mechanical investing strategies. As he puts it,

“Given all these oh-so human frailties, some argue that rules-based investing by the numbers is the solution. I don’t fully agree. Algorithms, bots and screens do take the emotion out of investing… [But] I worry that quants forget that stocks are not just numbers but part ownership of businesses, run by people. For now, I think humans are better at gauging whom to trust and visualizing how societies, institutions, and technology might interact and evolve. My ideal is Spock: half human, half Vulcan.”

Tillinghast’s advice to invest in what you know echoes Peter Lynch, the legendary manager of the Fidelity Magellan fund. And interestingly, it was Lynch who got Tillinghast hired by Fidelity in the 1980s.

“Buy what you know” is one of the most misunderstood nuggets of wisdom I’ve ever encountered. No successful investor buys a stock simply because they know or like its products. Warren Buffett didn’t buy Coca-Cola because he likes Cherry Coke.

Buying what you know means investing within your core areas of competence. This comes into play later, in avoiding businesses prone to obsolescence and financial ruin and in valuing stocks correctly. These last two principles are impossible without an in-depth understanding of the business and industry.

And speaking of valuation, Tillinghast relies heavily on the earnings yield (the inverse of the P/E ratio) and on the Shiller P/E or CAPE. He tends to keep his valuation analysis simple, as additional complexity generally just increases the odds of failure.

Perhaps Tillinghast’s best advice is to be comfortable with ambiguity and failure, as being right 55% of the time is actually really good in the world of investing. As he puts it, “…during raging, thematic momentum bull markets, I lag pathetically.”

That’s important to remember. Even the greatest investors get it wrong quite regularly and often underperform their benchmarks for long stretches. So longevity in this business often comes down to embracing failure and learning from mistakes.

If you want to better understand value investing, pick up a copy of Tillinghast’s Big Money Thinks Small. My compliments to the author on a solid, well-researched book written from decades of experience.

 

 

Disclaimer: This material is provided for informational purposes only, as of the date hereof, and is subject to change without notice. This material may not be suitable for all investors and is not intended to be an offer, or the solicitation of any offer, to buy or sell any securities nor is it intended to be investment advice. You should speak to a financial advisor before attempting to implement any of the strategies discussed in this material. There is risk in any investment in traded securities, and all investment strategies discussed in this material have the possibility of loss. Past performance is no guarantee of future results. The author of the material or a related party will often have an interest in the securities discussed. Please see Full Disclaimer for a full disclaimer.

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Book Review: The Best Investment Writing

Cambria Investment Management’s Meb Faber has always done excellent research. I read his first published book, the Ivy Portfolio, years ago and keep a copy in my office.  Ivy did a lot to change my views on alternative investments, which I now use extensively in my practice.

Faber rarely tries to reinvent the wheel. In fact, a lot of his work centers around studying and replicating the work done by others. That was the focus of Ivy and his more recent Invest With the House: Hacking the Top Hedge Funds, his collaboration with AlphaClone, and his excellent blog The Idea Farm.

True to form, Faber has compiled recent work from some of the best investment writers in the business into eminently readable new book, The Best Investment Writing: Selected Writing From Leading Investors and Authors.

As Faber comments, investors today are completely saturated with information and choice; “too many market experts shouting too many conflicting opinions at us,” which leads to bad investment decisions.

Faber has done his readers a service by hacking through the noise and leaving them with a curated volume of very solid and mostly timeless investment advice. This is not a “how to” book that will teach you a new trading system, and it certainly won’t give you a top-ten list of stocks to buy. But it will make you a better investor and give you a more nuanced perspective.

Every essay included in the book is worth your time to read, but there are a couple that particularly stuck with me. Jason Zweig, a respected columnist for the Wall Street Journal, writes about his experiences trading antiques with his parents as a child. In the 1970s, long before the internet and Antiques Roadshow, the collectibles market was extremely opaque and illiquid. If you were an astute collector who had done their research and knew what they were doing, you had a major information advantage and could earn excellent returns.

Today, that’s no longer the case. The returns Zweig consistently earned with his parents are simply not possible when you have an army of collectors with smartphones able to do instant research at every estate sale in America. Of course, the parallels to stock investing are clear. As Zweig writes,

Decades ago, stock-picking was a handicraft in which information moved slowly and unevenly, so the person who knew the most could perform the best – by a wide margin. Think of Warren Buffett buying such tiny flecks of corporate plankton as Sanborn Map and Dempster Mill Manufacturing. Today, with more than 120,000 chartered financial analysts and 325,000 Bloomberg terminals worldwide and with Regulation FD requiring companies to disclose material information simultaneously to all investors, the playing field is close to perfectly level.

If you’re applying the tools that worked so well in the inefficient markets of the past to the efficient markets of today, you are wasting your time and energy. An investor who devotes weeks or months of research to analyzing a single widely-traded stock is like an antique dealer driving across the back roads of New England searching for bargains that, for the most part, disappeared decades ago. It isn’t impossible that you will find a bargain, but the odds that the rewards will justify the pursuit are low.

I also found Patrick O’Shaughnessy’s essay “Alpha or Assets” to be particularly insightful, and I’d recommend it to anyone looking to hire a money manager or advisor. O’Shaughnessy writes that “strategies should be built for alpha, not scale,” which should be obvious. A manager with a fiduciary responsibility to act in his client’s best interest should be most concerned with the performance of the portfolio, not his ability gather more assets. O’Shaughnessy writes:

Professionally managed investment strategies have two components: an investing component (seeking alpha) and a business component (seeking assets). Outperformance is one goal, scale is another… In the asset management business, two variables matter: fees and assets…. When fees fall, assets need to rise. For assets to rise across a business, the strategies offered need to be able to accommodate more invested money.

He points out that more assets are great for the business, but they’re often terrible for returns, as the manager can’t trade smaller or more thinly traded securities without moving the market.

This brings up interesting questions about fees. In a vacuum, low fees are wonderful. But if low fees force a manager to compensate by gathering more assets… and reducing the effectiveness of their strategy in the process… that low fee can prove to be quite expensive.

I’ll wrap this up with what is probably the best headline for article I’ve seen in years: “Even God Would Get Fired as an Active Investor.”

Wes Gray, whose work I’ve reviewed in the past, showed empirically that “an active manager who was clairvoyant (i.e. ‘God’), and knew ahead of time exactly which stocks were going to be long-term winners and long-term losers, would likely get fired many times over if they were managing other people’s money.”

When even the Almighty would get fired, you know it’s a rough business.

My compliments to Meb Faber and to each of the writers he highlighted for putting together a very solid volume.

Disclaimer: This material is provided for informational purposes only, as of the date hereof, and is subject to change without notice. This material may not be suitable for all investors and is not intended to be an offer, or the solicitation of any offer, to buy or sell any securities nor is it intended to be investment advice. You should speak to a financial advisor before attempting to implement any of the strategies discussed in this material. There is risk in any investment in traded securities, and all investment strategies discussed in this material have the possibility of loss. Past performance is no guarantee of future results. The author of the material or a related party will often have an interest in the securities discussed. Please see Full Disclaimer for a full disclaimer.

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