Interesting: An index or not an index - that is the question..

I've blatantly extracted this from Kon who writes on the Black Swan forums: it's so -to -the point that I just had to include it..

"A fund is either an index, or it is not. If it is not, avoid it, because managers who think too much of themselves will eventually torpedo your portfolio. If you are hell-bent on going active, the rules are more complex, but must still include 1) low or below average turnover 2) management investing in their own fund (avoid if they don't!) and 3) sticking to style (probably most important), and of course 4) having a defined style to begin with! 5) lower than average management cost"

The problem of WHEN we talk about Risk..

As a fund-analyst and product manager between 2001-2008 I was struck by the absence of market risk discussions from 2006 into 07.. Many insightful bods were talking about credit bubbles and historically low cross-sector volatility from about 2006 and yet little was out in the open. I was running large cross-sector comparisons and the price correlations (Rsquared) did indeed look pretty alarming; also there were large rotations in sales flows (20% of total market) away from less risky asset classes into those with much more: overall market size had also grown by at least 20% (which means that at least 1 in every 5 trades was borrowed or loaned to someone) - herding patterns looked sentiment driven; investors were reacting to media and moving irrationally into a small number of distinct directions, to find better returns, unaware of the rising levels of passive market risk they were creating by doing this. By the start of 2007 all the markets needed was a catalyst to convert that risk into loss..

Cue credit crunch and the doom merchants move in; crunch gave way to recession.. before we knew it we were heading back to 1931 (or worse).. Suddenly 'Risk' was all the vogue.

At risk of becoming yet another self-prophesising hindsight peddler; I will say this.. talking about 'Risk' in the trough of a bear market (like 2008) was akin to playing Russian roulette and worrying about an unloaded gun after it had fired the bullet.. sure there was plenty of toxic debt, unemployment, thrift paradox, stagnant GDP, plenty of write-downs, falling prices, busts, economic symptoms everywhere but the 'Risk' of these events happening became virtually nil in 2008-09 because they had already happened.

No, 'Risk' should be the likelihood of when/where something might happen.. before it happens. Risk is quantifiable; uncertainty is unidentifiable. As we move into a recovery phase I again see the 'Risk' conversations disappear from the table.. just when we should be talking about it again!

Recession v Recovery? On the basis that Risk in a recession is quite different to during a recovery then I will try to relate risk in this way: think of Risk as consisting of 2 parts Active and Passive Risk - in a newtonian sense there is a constant level of risk to the investor that simply doesn't go away; it merely changes from active to passive and back again. The change is brought about by investor reactions and the flow of money. By tracking investor herding patterns and attitude to risk we can better understand where risk is/isn't for most of the time.

The first thing to appreciate is that there are ALWAYS TWO sides to the market: the Bulls and the Bears - which direction the market takes depends on who is winning the argument - by winning the argument I mean which side investors believe and move towards.. the more whom defect then the greater the chance of driving market prices in that direction.

When investors reach consensus on something and trade (BUY/SELL) in the same direction then this is called 'herding'

When I mean markets I of course mean the stock exchanges; economies are less driven by immediate investment decisions; or obvious sentiment, but economies do display symptoms over a longer time period. Many believe there is about a 6-18month lag effect between the markets and economies: they drive each other but tend to always be out of sync. Much like investors and 'Risk'.

Depending on market performance, different behaviours will emerge from the Bulls and the Bears.. we can test the current point in this cycle by tracking investor buying patterns.

More to the point: I hope to highlight risk levels back to you as we make our investment decisions.

Zen Investing: Bill Mann's 10 easy steps..

I wanted to drop something in about Zen Investing.. this blog is from Bill Mann from early 2007 and is about the easiest read I could find and; although I don't endorse fully, I like his notion of a balanced view on all decisions, value of debating opposing views, awareness of change and need for discipline.

In the 90s I used to study Aikido which is a defensive martial art that means the 'art of harmony' and so much of Zen Investing appeals to me.. I was pretty rubbish at it but there are many things in Aikido teaching that I can relate to investing such as Ki No Nage which is the 'flow of energy' and (for you phycisists) feels not unlike fluid dynamics pioneered by Bernoulli...something I will pick back up on; (minus the science) when I later come to look at how to be a contrarian investor based on investor (sales) flow patterns..

Frankly I have used this peice on 'Zen' as I couldn't have written it any better myself.. I also like it as it was written at the end of the momentum market and cited form the start of the recovery market in 2004 (pre-Crunch) yet talks of discipline and therefore avoids the blatant hindsight so common among current journals. 'Zen' applies to mutual funds, ETFs, stocks.. property.. just about anything you can think of to invest in:

http://bigpicture.typepad.com/comments/2004/04/the_zen_of_trad.html

'The Zen of Trading'

The ten steps I outline below are not from a book, nor were they learned at the knee of a mentor. They are the result of actual experience -- blood, sweat and tears -- and of course, real dollars lost.


If what "Happy feet" truly wants are specific trading rules, there are plenty on the net which will tell you how to "scan and track and buy stocks." The following search will yield 100s of specifics rules.


But that is not what the floundering rookie trader needs. No one can give you the "Ten Steps to Wealth and Happiness." Its the old cliché: "Give a man a fish, and you feed him for a day; Teach a man to fish, and you feed him for a lifetime."


Any equity trading skill you may learn will be worthless without a frame of reference in which to practice them. These rules will provide you with that frame of reference. They were as true 100 years ago as they will be true 100 years from now. All but one of them applies to any tradable asset: futures, commodities, options, bonds, currencies or equities.


No one is going to give you wealth and happiness; Perhaps I can help teach you to fish. Here is a frame work within which you can develop your own 10 "Ten Steps to Wealth and Happiness."


1. Have a Plan: If you are going to actively trade, you must have a comprehensive plan. All too many investors I deal with have no strategy at all -- its strictly seat of the pants reaction to each and every market twitch. The old cliché "If you fail to plan, than you plan to fail" is absolutely true.


I suggest that traders write up a business plan for their strategy, as if they were asking Venture Capitalists for money for a start up; In fact, you are asking an investor for capital -- just because that investor is someone you know a long time (you) doesn't mean you should skip the planning stages.


2. Expect to be Wrong: Accept this fact: You will be wrong, and often. The plea for help is at least a tacit recognition that you are doing something wrong -- and that means you are a giant leap ahead of many failing traders.


Egotists who refuse to recognize the simple truism of being wrong often give up unacceptable amounts of capital. It is only stubborn pride -- and lack of risk management -- that keeps people in stocks down 50% or more.


Even the best stock pickers in the world are wrong about half the time.


Michael Jordan has the best quote on the subject: "I've missed more than 9,000 shots in my career. I've lost almost 300 games. Twenty-six times, I've been trusted to take the game winning shot and missed. I've failed over and over and over again in my life. And that is why I succeed."


Mike is the greatest player of all times not merely because of his superb physical skills: He understands the nature of failure -- and its importance -- and places it within a larger framework of the game


3. Predetermine Stops Before Opening Any Position: Once you have come to understand that you will be frequently wrong, it becomes much easier to use stops and sell targets.


I suggest signing a "prenuptial agreement" with every stock you participate in: When it hits a predetermined point, regardless of methodology -- below support or a moving average or a specific percentage amount or the monthly low or whatever your stop loss method is -- that's it, you're out, end of story. No hopin' or wishin' or prayin' or . . . (Apologies to Dusty Springfield)


The prenup means you are making the exit decision before you are in a trade, and when you are neutral and objective.


4. Discipline is Everything: The greatest rules in the world are meaningless if you do not have the personal discipline to see them through. I can recall every single time I broke a trading rule of my own, and it always cost me money.


A friend (GBS) mentions that every time some Hedge Fund blows up -- chock full of Nobel Laureates or Ivy League whiz kids -- you invariably hear the following mea culpa: If only we hadn't overrode the system, we would have been okay.


A lot of people recommend the book Market Wizards -- I read it when I first got into the business, and every few years, I reread it. The single most repeated theme echoed by nearly all of the trading Wizards interviewed? The importance of Discipline.


5. Emotion is the enemy of investors: Therefore, you must have a methodology which relies on a variety of data points, and not your gut instinct. My own assortment of factors are too long to go into here. The purpose of Rules 1, 2 and 3 (especially 2) is to eliminate the impact of the natural Human response to stress -- fear and panic; It also helps avoid the flip side of the coin -- greed (also known as "fear of missing the rally").


Lets face it, you are a herd animal who has evolved to run away from Sabre Tooth Tigers and fight off angry Neanderthals. We were never "hard-wired" for the capital markets. Such is the plight of being slightly cleverer pants wearing primates.


You must know yourself: Your instinctive "fight or flight response" did not evolve to deal with crossing moving averages or restated earnings. Emotions cause people to sell at the bottom and chase stocks up at the top. To buy when there is blood running in the streets, or to sell when everyone else is clamouring to buy takes a detached objectivity not possible when trading on gut emotion.


6. Take responsibility for your self, your capital and your trades. I recently wrote a note in response to some of the "The game is fixed" whining that been endemic lately. (Its titled "Taking Responsibility").


Its part of our national culture of blame passing, and it infected investing long ago: Enron did not cause your losses, nor did stock touting analysts or Arthur Anderson or the talking heads on CNBC; You did. The sooner you understand this the better.


I once read a Chinese proverb which struck me as particularly insightful as applied to trading: "He who blames others has a long way to go on his journey. He who blames himself is halfway there. He who blames no one has arrived."


7. Constantly Improve: You must seek to constantly raise your skill level. Generally, you should try to learn as much as possible about the markets, the economy, trading technologies, various schools of thought. As you read all this, you must do so with a keenly sceptical eye, while retaining an open mind ('taint that easy to do).


As to the specific mechanics of trading, I find keeping a log to be very helpful. I track why I bought something, the price, the timing, even my reservations about the trade at the time. I do a post-mortem, trying to figure out why a certain trade didn't work and why some did. I started ranking trades on a 1 - 10 scale before I entered the position, then I tracked my results. If I only did the "nines" and "tens," my returns would have been spectacular, my costs much lower, and my trading would have flowed more naturally.


A subheading under "Constantly Improve" is this: (7A) Develop an Expertise in Some Aspect of Trading. Find something for which you have a peculiar natural proclivity, or a particular gift, and develop it. It may be moving averages or position sizing or MACD or Bollinger Bands or the Arms index; The specific area of expertise does not matter so much as merely having one. I'll bet that those who have been trading for a while know exactly what I am referring to.


8. Change is Constant: Heraclitus was a Greek philosopher who is best known for his "Doctrine of Flux." It simply states: "The only thing that remains constant is change." Therefore, you must endeavour not only to constantly upgrade your skills, you must be supple enough to adapt to an ever-changing field of play.


Skiers have all seen the sign on the slopes: "Beware of changing terrain conditions." Its true in any market, and in fact, any modern endeavour.


Human nature -- especially in herds - is unchanging. But these behaviours must be contemplated within their larger context. Add a new element -- PCs, lower trading costs, the internet, vast amounts of cheap data, even CNBC, -- and you introduce a new factor which impacts all the players on the field.


As conditions change, you must decipher how they impact your strategy, your emotions, and your trading -- and adjust accordingly.


9. Short is not a four letter word: Learn to play both sides of the fence, both long and short. If you "have been so burned by buying," then perhaps there is a lesson there you are not heeding? The market is telling you something. Whenever a particular strategy stops working, the thoughtful trader must consider whether there are bigger issues than their own trading mechanics.


Every law student goes through moot court, where you had to be ready to switch teams and argue either side of a case. I learned that you never truly knew a case until you could argue both for and against it.


The corollary moot court rule for trading is that you should never own a stock unless you comprehend what might make it an attractive short. Each buy and sell decision should be an argument pro and con.


Likewise, you need to be able to play the downside when it’s appropriate.


The market is cyclical; you can count on a bear market every 4 years or so. Unless you plan on sitting out for 18 - 24 months twice or so each decade -- up to 4 years put of 10 -- you better learn to short.


10. Stock selection matters less than sector and market direction. This will be the only stock specific rule I will share: I have been convinced by several studies that demonstrate only 30% or so of a stock's progress is determined by the stock itself; The stock's sector is at least equal to another 30% (if not more). The overall direction of the market is the biggest factor of all, counting for at least 40%.


You can own the very best company in the wrong sector, or buy the greatest stock when the broader market is going the other way --- both will still be losers.


That’s my ten, and I hope those of you looking for specific trading ideas aren't too disappointed. I have lots of other rules, but since we limited this list to just 10, I went with the broadest and most important.


Some other strategies are natural derivations of these: being patient, using risk management, position sizing, not forcing trades, resource allocation, diversification, etc. These are all specific trading mechanics, and "Happy feet" is not quite ready for them yet.

Bob Freedland of Bob's Advice for Stocks: http://bobsadviceforstocks.tripod.com/
http://www.fool.com/investing/small-cap/2007/03/21/the-zen-of-investing.aspx

By Bill Mann March 21, 2007

Metals: A nice little Commodity run for Xmas.. (value buying)

With the snow outside I took advantage to look at my SIPP account, take some profit; (lots of red all over that will need to simmer for a while longer).

So I SOLD my ETF holdings in non-Gold metals y'day: A nice little 7% return over the last 5 weeks - modest but then I like modest stealth type plays. Admittedly a bit of a spread play (i.e. you play the relative value of one index against another that you believe are broadly price-correlated) - metals tend to move in bands against each other depending on the relative supply-demand - that makes them a little easier to be 'lucky'. The main reason was also to set up some cash for my New Year allocations.. the NY always bring a new run and it gives me about 2 weeks to look for some new opportunities.

Beta risk is sometimes referred to as market sensitivity: the risk of the price of your investment being driven by markets and not the underlying asset value of the investment: particularly from events that might not be obviously related to the investment but brought about by opinion (sentiment) that leads to trading flows in that investment (i.e. herding).

Yes there is beta risk in metals BUT allow short-term volatility to subside and price is king - focus on your in and out points (BUY and SELL). The success of certain metals are easily attributed to certain industries and countries.. their relative value to other metals makes contrarian buying a little easier. Be careful whether you choose a non-leveraged or leveraged index - remember leveraging increases the magnitude of price movements.. great for potential upside returns but always with that potential for greater downside. If you choose a leveraged index then be sure you have strong conviction of the current price and how long you intend to HOLD (your holding period aka 'horizon'). The BUY point is critical as the price trends in metals are very pronounced - BUY near the top and it's a long way down..

Value buying is simply buying an asset that is priced well below what you believe the intrinsic value to be.. in other words you disagree with the market, you are contrarian to the consensus ('herd') and you believe the price will reflect the true worth over time

Value traps are where something appears to be worth more than the market price but hides underlying factors for the loss of confidence - if the herd then never agrees with you then the price may fall further and you are stuck in a 'trap' - accept the loss or HOLD longer.. here again herding is at play and/or you have relied on inaccurate information..

Gold on the other hand is always an oddity as its price has come to reflect economic conditions, inflation, sovereign reserves for investors - to take contrarian positions here requires larger balls and patience than usual.. since 2002 Gold has become much more sentiment driven and should be approached with more caution.. a strong 'value' approach for instance but bear in mind you are now up against very large economics..

HFT: Why the New World Order could be decided in a Nanosecond

If you haven't heard of 'HFT' then it stands for 'High Frequency Trading'.. in the US it is already responsible for a high % of the volume of trades and it's spreading.. fast!

You may think 'who cares'.. and in truth the advent itself should be no cause for alarm - indeed many observers; and those involved in its technology, view it as a means to reduce market risk by reducing the size of single trades and minimising human error and morale hazard.

The race is on: financial centres in the East are competing with the New York Stock Exchange (NYSE) and London (LSE) to process faster trades; banks and financial firms are also competing to develop faster and more clever HFT and algorithm programmes and trading platforms to process trades faster. There is huge scope for market manipulation here and for me sentiment risk rises because so many more trades can be processed per second. I heard the LSE can process about 30-40 trades per second; the NYSE can process approx 600. I also recall back to the server problems at the LSE this year: these were attributed to software issues. How many more system risks can we expect as the financial system winds up the 'clock'??

Moreover those who can process faster will become leaders: it's worth bearing this in mind when setting your asset allocation as it's a risk that is wholly unreflected in a stock price. Will London fall behind NY and Asia and what will be the impact of that on the investor? Only global corporations are able to diversify country risk - us investors tend to have to trade locally. This all encourages much more focus on liquidity risk and the movement/flow of assets at country vs global level. It also creates a huge imbalance between the common investor and the financial sharks, the Big institutions that still dominate (according to multiple research) by trading more volume faster. This is one issue for investors but is it my biggest fear?

No - my biggest fear about HFT is it's untested nature - like the butterfly effect - a minor change in any system can be amplified down the line. We simply don't know what effect HFT will have.. and when.. is HFT capable of accelerating market-wide risk (sometimes known as contagion or systemic risk). Ultimately could HFT process a full market drawdown in a single day, hour, minute....?

A market 'drawdown' is sometimes called a bear market - when the majority of stocks are in a price 'free-fall': when everyone wants to SELL and no one wants to BUY.  If the NYSE can trade 590+ trade per second then how quickly could past drawdowns have ocurred and did this contribute to the unprecedented rate of decline in the credit crunch through 2008..?

These thoughts are not based on specific research or any regression analyses but the gaps in what I don't know about HFT - what Taleb might refer to as anti-knowledge. It's simply a question - make up your own mind - food for thought to know what you might be up against the next time you make an investment. Where you trade may become as important as what you trade..

Agree; disagree - it's all good.

Xmas has started.. Rage Against the Machine!

Rage Against the Machine's 'Killing in the Name' has just gone #1 in the UK Singles Chart!!

After destroying both knees in the subsequent 5 minutes of what can only be described as victory head-banging (1992/1993 - a track I listed to 24/7 when I was 18/19, picture university, hair, tee-shirt, combats, boots...) Messy!

After recovering, and hobbling up the stairs, I thought I'd post quickly to wish everyone a Merry Xmas and consider the wider ramifications of what has just happened. Not since the Cadbury's Wispa campaign has the power of social networking become reality for industry magnates - it is spreading everywhere and shows what a group of people can do with a collective thought.

Fact: Any industry is scared of a disengaged customer base it can't control. To enact change requires numbers yes but think of the similarities between controlled music sales and pooled investments - both are driven by the flow of sales; both can be controlled by investors, both tend to spoon-feed the individual with information and dumbed-down advertising. Both perpetuate a division of wealth.

Although I don't propose to make anything like the waves of the RATM campaign; armed with memories of long hair and the mosh pit; I am heartened that we can make a difference. I appeal to all of those with similar memories of rebellion; the only difference is that 18 years on we will more likely do it from the PC screen than the demonstration line.

Not sure Che would appreciate the use of financial instruments but then again.. PTTP!

Cutting through the Mayonnaise: Debunk the junk!!

To encourage a broad group; including layman investors, I'm challenging myself to first speak in plain-English!

The Investment Condition: I realised that the longer I was in the industry the more remote my language became. To be usable - I have to stop and take a critical eye over some of my past work and debunk the junk! Over the last year I have taken a break from investments into wider marketing and it's an opportunity to improve my communication skills.

I then realised that what I do is excatly what a lot of the financial industry has done for years - information is power and it's used to keep an imbalance between them (the providers) and investors.

I want to start blowing up myths that perpetuate at lower levels in our industry - among advisers, fund professionals etc. The best way to expose myths within technical mayonnaise is to cut out the cra@p. Consensus then needs more than one opinion - by sharing ideas simply and clearly I will better ellicit opinions and responses from you. Please bear with me in the short-term; I will get there..

and I hope that you will help me.
JB

Future State: Are investors really moving towards boutiques?

Headline from Dow Jones 6months ago: "MORE THAN A THIRD OF WEALTHY INDIVIDUALS ARE LIKELY TO REVIEW OR CHANGE THEIR WEALTH MANAGER IN THE WAKE OF THE FINANCIAL CRISIS, ACCORDING TO DOW JONES WEALTH BULLETIN RESEARCH"

Courtesy of Global Wealth Forum (Linkedin) http://www.wealth-bulletin.com/home/content/1054438495/

JB: Personally I think there are conflicting trends between this and the CapGemini reports from the start of the year - yes people want more tailored solutions; yes they felt let down by black box and private banks, large investment houses in general, but they also want transparency - private banks had to change to meet those needs; if they are unsuccessful then it would seem boutiques are well-placed - I wonder how the position has changed in the last 6 months since the Dow report?

"The Wealth Management After The Crunch report, co-authored by Dow Jones Wealth Bulletin and experienced industry consultant, Bruce Weatherill, surveyed more than 150 wealth management executives, nearly 100 high net worth individuals and 65 industry intermediaries globally. The top line findings are published online today at www.wealthbulletin.com

The research found that 42% of clients were likely to review or change their wealth manager in the wake of the financial crisis while 30% were unlikely to do so. Only one in four clients said they would recommend their wealth manager to a friend, family member or colleague."

Caveat: BUT boutiques will only do well as long as they don't disappoint since they have little recognition of brand values to fall back on.. UBS for instance were reported to be on the back-foot in H1. Bear in mind boutiques flooded the hedge market and that has experienced what can only be described as a 'bumpy ride'.. However some players such as Barclays Wealth look better positioned due to their simple messaging and investor personality profiling; (and the nice back up of BarCap and good G'teed product line-up).

In short - the future state seems to revolve around tailored solutions, investor specific performance and addressing transparency and fee structures to facilitate. Whether wealth managers, banks, IFAs, large savings providers or fund houses gain advantage is still unclear. As investors gain access to DIY tools - the jury remains out about active versus passive investing, the role of the adviser and the expectation put upon the mutual fund manager or stockbroker..

The old Active-Passive debate trundles on..

Q. How have Exchange Traded Funds ('ETFs') changed the landscape for investing in active funds?


Ahh the good old active-passive debate is back in 2009 - simply put 'active' means giving your money to a fund manager or stockbroker to invest for you and you pay them a fee against the hope of better returns. Plan B is to buy simpler products that replicate the market indices (also known as beta).

What has re-energised this debate is the expansion of Exchange Traded Funds ('ETFs').. You may or may not have heard of these but one of the best known are 'IShares'.. (created by Barclays; sold to Blackrock).. In the US the Vanguard brand really cracked the market wide-open in 2008 to become one of the largest investment managers.. and they are expanding overseas.

Before we consider the performance patterns of ETFs.. One of the first points I want to make (something we'll pick up later) is the issue of fee structures and industry business models used for mutual funds. They rely on 'sticky assets'.. i.e. the investor leaves the money with the manager for a period longer than 1 year. To encourage this they often add redemption fees to nullify profits and generally make it harder for average investors to redeem over short time periods. It is interesting to note that the division of wealth at play here between the common 'A' share versus 'I' class investors: the haves and have-nots). So what does the average investor do?

What's changed? Firstly I think ETFs offer genuine options for investors through low cost trading and redemption fees, which for the first time allow investors to be more tactical without being exposed to single stock risk etc. A chance to buy pure index, transparently. Secondly that notion of 'transparency' has also been very strong out in Asia and to a lesser extent in Europe/UK - it departs from complex 'black box' strategies where the risks can be hidden.. in favour of simple index and no-catch g'teed products. Although the risks in an index can still surprise; there is more expectation of the mechanics plus instant visibility down to individual stock level. For the Internet generation tracking an investment shouldn't be easier.

Meanwhile Active and Managed fund managers have been busily creating defences to compare costs over longer time periods. This has been largely propaganda and misses the point. Fact: the common mutual fund income model is designed around a reoccurring annual charge (the 'AMC') that is blind of the performance of the investor's portfolio. Many hedge fund managers have based their fees on performance (waterlines, fulcrums) and have had to such is the volatility in their returns but also as a way to increase revenues for above-target performance.

Performance related fees aside; the only path open to active managers is to prove their counter-cyclical prowess, consistently - to outperform the market over key time horizons. The problem with this is that few do and consistently over time. I continue to believe that if managrs moved to performance-linked fees then investors would be more willing to wait for recovery - as is fees levied on top of losses only compounds investor frustration!
The obvious downside to index buying is the cyclical and unexpected nature of the markets themselves - the ETF will track up and down markets faithfully. In the middle of 2 cycles index buyers often find their portfolios have made no positive returns - this encourages a more tactical and disciplined approach; (rather than the time-old buy and hold aka 'fire and forget').

The good news is that it is becoming increasingly easy to buy index funds across a range of risk categories and asset types. Coupled to a disciplined tactical approach can be profitable; the onus moves onto the quality of information available to the investor and the buy and sell points (also known as the investment horizon).

Less obvious downsides - liquidity risk - any index tracking product will react to large changes in trading volume; an active manager can short adverse movements or diversify. BUT again these can also be done through building an active asset allocation around ETFs.

I will continue posting around these themes over the coming weeks.. stay tuned!

Simple says.. Does Core-Satellite Investing still work?

The old addage of diversification - BUT does it still hold true? How do investors normally diversify risk:

Invest in uncorrelated asset classes

Spread portfolios to avoid concentrations (E.g. single company or country risk)

Tranche investing (such as £/$/€ cost averaging)

Economic hedging - e.g. by currency or high inflation versus low inflation

Time - lifecycling, rebalancing

Hedging (including use of derivatives) or Total Return Investing (Capital v Income)

Risk-budgetting - such as different volatilities, market sensitivities

Active versus passive strategies

Below is a very atypical core-satellite portfolio used in 2007-2008.. imagine each globe as a portfolio of different investments - the links could show 'diversify' points between investments or otherwise possible combinations of investments.. NB: this is not an actual portfolio nor should be used as such; (you of course make up your own mind anyway)..

BUT are there other ways..?

The Compelling argument for Reversion: Did Yale make the market rally in 2009?

I do often witter about the power of herding and this is something I will illustrate soon.. In the meantime the attached analysis, by Yale in 2008, was one of the most compelling 'bull' arguments I became involved with - Yale built it around a rough 200 year proxy of performance of the S&P 500. Rightly or wrongly - the thing about historical arguments like these is that they are so bloody compelling - we are not around long enough on this rock to be fully confident in dismissing them out of hand.. we are often quickly impressed by history. It provides weighty narrative, compact key sellers that promise vast volumes of data to back-up + halo effect from an institution like Yale = hard to argue against message.

The idea of something being 'cheap' often relies on a historical yard-stick - the mean return of a fund, stock or index for example. This is actually quite different to 'value' buying which is all about comparing the current market (or dirty) price of an investment against the intrinsic (underlying/expected) net asset value. One looks backwards; the other forwards. So recovery is not about value but about 'reversion to mean' - here is the S&P chart - to the left shows the current position in 2008 as was at the time (early Q408) iirc. The top-line message and key facts delivered the neccessary punch and you can assume this message was broadcast to millions of investors at the end of 2008 (directly or indirectly to pensions and fund managers). What we now know is that the market did indeed bottom around November 2008. - what seems less certain is why..

Unprecedented Market Conditions: S&P 500 (1825 – 2008)

Positive Years: 70%
Most Common Result: 0-10%
(Over 24% of the times)

Since 1927 the S&P 500 annualised return is 6%

Just in 1931 and YTD 2008 the S&P 500  performed below -40%

The assumption was that this would carry into market products such as ETFs (index) and active mutual funds. Below we see the expectation of recovery: historical mean versus current position.

Contrarian view: What if markets rallied on the assumption that markets had to rebound because of their position to the mean and not on fundamentals? Certainly they rallied well before economic recovery was fully recognised; (as they so often do). Raising capitalisations fuel balance sheets, capex, spending, inflation and employment. Talk now of a 'W' shaped recovery then may be seen as the symptom that perhaps markets herded too soon into a bull market; falling confidence may precipitate a drawdown. What we need is to see the money flow.. and measure sentiment changes corresponding.

Conventional view: “ Histograms are useful graphical descriptions for quantitative variables in large data sets. They break the range of the values of a variable into intervals and display only the frequency (or relative frequency) of the observations that fall into each interval.”

Influences - why attitude to risk is such a day-to-day state of mind..

Previously I wrote:

"Often the fear of being wrong; for many investors, is stronger than the ambition of being right and beating the market. Many investors overestimate or underestimate their attitude to risk and react differently to their original investment decisions. This may be because they became confused or distracted; were asked or asked themselves the wrong questions. The problem is that many of those questions are already influenced by a huge array of sources in their daily lives.."

What do these sources look like? I propose the following diagram - please let me know what I've missed or if you agree/disagree.

My question - how can the investor; let alone the adviser or investment provider, ever distil the impact, be consciously cognizant of their effect or indeed know how that state of mind will change with subsequent events...?

Investment U: 'Take Profits on Gold: The Media’s Dead Wrong'

Thoughts on gold anyone?

Anyone liked to pick up the 'for' or 'against' angles?

http://www.investmentu.com/IUEL/2009/December/take-profits-on-gold.html?utm_source=feedburner&utm_medium=feed&utm_campaign=Feed%3A+InvestmentU+%28InvestmentU%29

What supports my assertion that gold prices are headed lower in the near-term? Both behavioral and technical factors… Behavioral: Think back to the dot com bubble in 1999 and 2000 when all anyone could talk about was the stock market. Today, we’ve got a similar situation in the gold market.

It’s not just financial/business shows talking about gold. Mainstream news shows are covering the topic, too. Typically, they rarely mention the financial markets (unless there’s a crisis). After all, there’s too much other valuable information to share with the American public, like the newest woman to say she slept with Tiger Woods or who Reese Witherspoon is dating.When a financial instrument becomes the topic of mainstream news, that’s often a sign of the top.

Many thanks.. small beginnings.. next steps?

A big thanks to everyone who has subscribed so far and thanks for participating on the polls.. from small beginnings. Pls share this site with like-minded people - the aim is to build up an eclectic bunch of misfits who like a good argument and seem wired to want to reject the status quo.

Next steps?
What I hope to do with the first 50 subscribers is to offer 'author' rights - so that you can post up your own investment questions/stories/ideas (or otherwise) .. the whole point of this forum is that we get away from this notion of 'experts'.. that somehow funds mangers and pundits are better than us, that somehow common knowledge is less valuable than the conventional wisdoms of people with glasses and letters after their name (ahh, see what I did there..)//

For those who would like to post then please send me your email address to: info@lbmracing.com and I'll happily add you on.

No, this is about you guys - I want to share ideas rather than try and understand the entire world around me.. I believe in consensus when it's dynamic and challenging (the opposite of following the herd)..

With enough supporters we can create a collegiate atmosphere - we take turns posting new ideas, manifestos or questions and someone else in the group plays devil’s advocate (by default I'll happily assume said mantle) - we can then all cross-examine.. Once all colourful profanities have been exchanged and sufficient derision duly dealt out then we become the jury and simply put it to the vote.

Once voted, investment ideas suddenly become rated in a very different way - consensus rating (for/against) is only the start of how we can re-examine investments from a contrarian point of view. Others can be the 'herd' rating: i.e. how universally upheld is a view, and supported, sales momentum that I touched on in my previous posts, media risk (how powerful is the media trying to push the idea tested by a lack of conflicting media views).. geopolitical risk.. There will be many others - hope to find at least 6 'tests' and open to ideas.. (I'll try and keep macroeconomics out of it for a while).

Now this all sounds a bit ambitous - the core will be the consensus and we'll see where things develop.

Let me know if this appeals to you (I'm hoping 'yes'). If you have any ideas or topics you would like covered but not yet ready to post then feel free to leave some comments here.

I'm wittering again. The main thing I want to close on is that this isn't about knowledge levels - if you follow any of the work of Taleb, or any of my ramblings thus far on this blog, then we are here because you agree that most of the information is a load of bollocks, the experts can't tell us the future and yet society and the investment industry wants to lie to us - to tell us to invest in a certain way. Frankly the less biased, and exposed, you are towards investments the better!! For that very same reason - don't believe me; trust the consensus.

JB

Money Flows and Mutual Momentum

Part 2. Find New tools: Active v Passive Risk

Rising markets contain large amounts of 'Passive Risk', in other words Risk that is contained within positive volatility (i.e. profit). Periods of Passive Risk often correspond to markets driven by liquidity (increased investing), fuelled by credit expansion and/or earnings growth expectations. These are often referred to as 'bull' markets; when driven mostly by liquidity they are sometimes called 'momentum' markets, the last occurring 2004-2006 (ignoring the 2009-2010 recovery for now). 'Active Risk' on the other hand is best illustrated by periods of high volatility or falling growth, and sometimes referred to as a 'bear' or drawdown market.

However Active Risk is present in any market where high volatility, widening sector ranges and low correlation exists. The previous full drawdown market occurred 2000-2003; 2007 displayed significant negative volatility as the credit crunch kicked in, but both were well exceeeded by the rapid drawdown brought about by recession-fuelled sentiment of 2008-09.

Active Risk then is the most measurable and visible form of risk to investors, intermediaries, asset allocators, product managers, sales consultants or marketers. However it is not necessarily the most important risk for future financial planning, allocation, product development or campaign planning.

Money Flows and Mutual Momentum

Are Investors Passengers?

Market commentators often depict investors as somewhat helpless passengers of the market cycle and many investors will feel that to be the case during periods of market upheaval. For many it is easier to think that markets have a life of their own. We believe that only when investors react to information does the market react to events. Analysis into behavioral investing has indicated that all types of investor respond to the events around them, their reaction in turn creates the Risk whether the effect is immediately recognized or not. By building global samples of investor sales flows we can better understand how investors reacted to different situations, the effect on their attitude to risk and how these patterns are changing.

Money Flows and Mutual Momentum

Re-thinking the Bull and the Bear

Markets (and investors) today remain preoccupied about whether they are in a rising or falling market. These markets have become widely known as 'bull' and 'bear' cycles and as high a profile gauge that you will find investors respond to.

Traditionally this concept holds we should expect bull markets and at other times bear markets, it's familiar, straightforward and casts the 'bear' as the villain profit-taker and the bull as the hero profitmaker. It assumes that Risk falls and rises cycle on cycle. Simple. Following the ongoing development of Modern Portfolio Theory, since the 1950s, we track Risk in both falling and rising markets, the level of underlying Risk remaining constant in the simplest of Newtonian lessons (i.e. it doesn't fall or rise, it simply changes). The 'force' that changes Risk is the money flow (or liquidity) of investors buying and selling as the react to the availability of assets, credit and market information.

Money Flows and Mutual Momentum

Part 1. Understanding investor behaviour

Re-thinking the Bull and the Bear?

Often the fear of being wrong; for many investors, is stronger than the ambition of being right and beating the market. Many investors overestimate or underestimate their attitude to risk and react differently to their original investment decisions. This may be because they became confused or distracted; were asked or asked themselves the wrong questions. The problem is that many of those questions are already influenced by a huge array of sources in their daily lives

Turbulence, the New World Order. [article]

Turbulence, the New World Order. An interesting (?) article posted on one of the wealth forums.

'We (Ontonix) think that the turbulence of the economy is never going to decrease (unless traumatic events take place).'

http://www.ontonix.com/index.php?page=31&vedidoc=y&IDDOC=420

Good, bad, indifferent.. is it telling us how to suck eggs or did it impress you?

Black Swans and Passive Risk: Not what I intended (a bit heavy to start) but why not..

This wasn't what I had planned as the first proper post but it came up on Nick Gogerty's Black Swan linked-in group.

The original question: What should regulators do if they cannot predict the next black swan?

http://www.linkedin.com/groupAnswers?viewQuestionAndAnswers=&gid=80474&discussionID=9531762&commentID=8993665&report%2Esuccess=8ULbKyXO6NDvmoK7o030UNOYGZKrvdhBhypZ_w8EpQrrQI-BBjkmxwkEOwBjLE28YyDIxcyEO7_TA_giuRN#commentID_8993665

In Taleb-land I was thinking in an anti-knowledge perspective (say for risk management) - what can regulators and risk functions do when confronting reform following the latest market events? I made reference to Michael Gambanelli of LSE and Y/Zen - he recommended less regulation not more.

Safe to say the discussion went on tangents and drew on and on - lots of models were discussed, challenged and debated. Eventually all lo-fi forms of MPT*-based analysis was thrown out.*(Modern or Markowitz Portfolio Theory).

One of the last posts: "Ok, how about this. If you assume a constant variance, and variance is actually time varying, you get a chance to see how much you can lose when variance spikes instantaneously to a very large number that you did not expect, taking the covariance matrix with it. I think this is the very definition of 'meaningless' in the risk management business. You blow up and you don't know it - your numbers don't tell you that you can EVER blow up. How bad is that?

What is beta? Another meaningless and static measure that doesn't capture the complexity of a multifractal random process that is the stock market.

You are assuming a Gaussian world, whereas the world is definitely not. Use the right measures for the right world, or else get ready to blow up when you least expect it. This should be one of the big lessons from this crisis, imho."

I like Taleb's book and his reference to the 'GIF'... (Great Intellectual Fraud) that is the 'bell curve or Gaussian' and sets the tone for his Black Swan book. To that end I agree that few models rarely allow for enough his 'extremistan'.. and tha complex models are perhaps best consigned for the bin but simpler models still hold value. We'll talk more about the bell-curve soon.

[Gaussian is basically the guy who invented the law of large numbers (over time results form a bell shaped histogram), which is described as 'mediocrestan' - the assumption of mediocre/average events. 'Extremistan' is then Taleb's opposite: i.e. unexpected 'extreme' events like the credit crunch but also more often things like war, political coups etc.]

I recommend reading The Black Swan: The Impact of the Highly Improbable by Nassim Nicholas Taleb, perhaps alongside Market Prophets: Can Forecasters Predict the Financial Future? by David Stamp.

All this chat took me back to the analysis I was running between 2006-2008. This included the correlations of approx 6500 mutual funds as well as the tracking of money flows in a sample of about 50,000 mutual funds across the globe. My only point was that because MPT sets out some expected outcomes - numbers were already popping up unexpected well before the credit crunch kicked in. Of course we couldn't predict the future or what would happen next but we did take action - from this I am now convinced that risk is actually a constant in size; expanding and contracting for liquidity/information, and kinetic in that it changes from active to passive risk and back again. Interestingly MSCI Barra's model did flag the risk well before Q3 2007 iirc.

No, my biggest problem in 2006 was that no one in the firm wanted to talk about 'risk' when the 1, 3 and 5 year returns looked so marketable - the same was true across the industry, as investors were lured in on past performance. This I would come to call 'passive' risk.

Risk doesn't go away just because it's effect is variable; it's probably not a black swan either since the potential for calamity seems always present by the fact we continue to invest, powered along by herding and sentiment. What changes is information - the media mask and escalate risk variablly against other stories to sell news.

I read a Talinn Institute research paper into noise 'kernels' and non-MPT dispersions around 2007, which combined with the MSCI Barra research, and that pointed me in a direction. Kernels are basically clusters of positive and negative performance returns. Traditional MPT states an expected distribution of returns; the Talinn Institute and Taleb disagree. It was a bit heavy but made me realise that performance can come in all shapes and sizes.

I'll post up the concept proper shortly - what I call 'mutual momentum'.. for me it's a simple tool for the contrarian investor - a way to invest/time based on herding patterns, to manage 'passive risk' resulting. Handily it also doubles up as a simple proxy/index of investor sentiment.

In essence - yes we should be aware that extreme events cannot be predicted easily; while robust (simple) triggers can be used practically to align your portfolio. I realised that by only looking at performance regressions; and any models thereon, we were only looking at some of the information critically needed to make contrarian calls.

Appreciate this is all a bit dense for the first post; we'll break this down into much more compact investment ideas going forward. Promise.

Ideas.. ideas. .ideas

Another day - another post..

I have a number of ideas that I will be posting over the next week or so.. the start of threads that I hope will evolve.. a collation of various analyses I have been involved with over the last few years, ones I want to share with fellow investors.

However I'm hopeful others will sign up and post their own ideas.. With enough people; and enough ideas, then we can begin to formulate some fundamental questions, poll for consensus and set out some practical investing ideas to explore.. together!

In time 'consensus' themes could be worked into basic lo-fi asset allocation strategies.

Stay tuned.
JB

The First Post.. Dear World, I hope this isn't dull !

Dear World,
Having navigated the ordeal of logging a name for this new blog; I am now faced with the very real dilemma of what to post at 11.30pm. Before I wade into the murky depths of the investment world; (and all its angels and demons) I'll set out my stall..

Simply put I'm here to engage with like-minded people who have grown tired of the old business model - one that takes management fees and returns losses, that delivers volatility without goals. This site doesn't have to just cover investments (all things are connected) and discussions can range from economics to politics to the environment. What is common is that ideas are discussed, challenged and a consensus found.. consensus rules!

E.g. for investments I can do this primarily through:

1. Developing new tools and applications to support investor decisions
2. Share investment and risk ideas with like-minded investors
3. Create online educational material to support my fellow consortium
4. Post new stories and highlight topics for discussion

To somehow create a community here (or elsewhere) and to nurture it into a 'consortium' of investors. One that takes charge for its own investments, to reach consensus and collectively decide buy/sell asset allocation ideas minus the burdens of the industry.

Above all I hope this isn't dull..

JB