Sweet Vacation ... Back Monday July 10th...

Hi readers. Thanks to everyone for dropping by since I started my blog in February.

I'm taking a brief holiday, and don't expect that I'll be doing any posting until as late as July 10th (although I may post late the prior week).

In the interim, I'm going to be thinking about how to tie together two recent postings. And I'm going to think about how to apply the Kelly Criterion in a forward-looking manner. I can't promise it'll happen, but I'll be thinking about it.

In any case, see you by July 10th at the latest.


JW

The Confused Capitalist

Asset allocation: how much is enough/too much?

Successfully outperforming the index requires identifying sufficient favorable trends to give you a distinct advantage, and then pressing that advantage to the maximum within a reasonable context of overall portfolio safety.

Said another way, for consistent outperformance, it's not good enough just to identify favorable investment opportunities, but you must also identify how much of your assets to allocate to the take full advantage of the opportunity. In other words, how much to weight your portfolio with that particular holding.

Generally, amateur investors like myself who hold focused portfolios, have some instinctual understanding that positions must be overweighted to outperform the index. We may reference general comments and schools of thought, like knowing that superinvestor Warren Buffett once held over 50% of his net worth in a single stock (GEICO), and also once invested more than 25% of his public stock holdings in American Express to help us with our portfolio weightings.

But the question remains of how much, scientifically, to allocate to a particularly favorable opportunity in our own portfolios. The Kelly Criterion (link also provides an example of how to use it, based on your own historical trading success and patterns) provides one such answer. I'm going to borrow a different and simpler example (using the Kelly Criterion) to illustrate the point.

Suppose, on a coin toss, you were to receive $2 for every time the coin turned up heads, but had to pay $1 for every time it turned up tails. How much should you allocate to maximize winnings, while ensuring that a few coin tosses don't send you to ruin? The Kelly Criterion says you can effectively maximize winnings by using this formula:

• Edge/Odds = Allocation percentage (the answer we're seeking)
  

The edge is calculated by comparing how much of an advantage, over an infinite period of time, this particular coin toss strategy has. It's calculated by comparing the odds of winning, against the odds of losing. In this case, you can expect that 50% of the time, you'll win $2. This is part [a]: (50% x $2 = $1). However, in 50% of cases, you'll lose $1. This is part [b]: (50% x $1 = $0.50). You now subtract [b] from [a] to determine your edge, thusly: $1.00 - $0.50 = $0.50. This is your edge ($0.50), the top part of the equation.

The odds are calculated by knowing how often this the event will turn out favorably. Since we know the coin has only two sides, and one sides value is double the other, then we know that the odds are 2:1 (ie. $2/$1). So the odds figure is $2.

We then divide one figure (edge, $0.50), by the other (odds, $2), to arrive at the suggested allocation for the portfolio, or "the bet". In this instance, $0.50/$2.00 = 25%. This suggests we should allocate 25% of our portfolio in each particular round, to this particular "bet" (assuming all odds and edge factors remain the same).

This system has several noteworthy features:

1. It's theoretically impossible to go bankrupt, given that money is theoretically infinitely divisible (down to the 1 cent level anyway);
2. The system produces the maximum return in the shortest period of time, on average;
3. The returns are very noticeable and lumpy - for example, if your first three coin tosses were negative, and you started with a $10 bankroll, you'd be down to $4.22.
   

If you want to use this system, I suggest you study the materials in both links I've provided until you have a good understanding of the benefits and drawbacks of it.

Hat tip to Abnormal Returns for sending us out there ...


JW

The Confused Capitalist

Thinking like John Maynard Keynes

Picture: Famed British Economist and Asset Manager John Maynard Keynes.

Not only was Keynes far ahead of his time on certain economic issues - including the establishment of a world bank with a world currency - but he was also a first rate investment manager. Managing the investment portfolio for for Kings College, Cambridge between 1928 and 1945, his investing acumen resulted in a return rate of 13.2% annually, a period that also covered the Crash of '29.

This compared to the general market in the U.K. (a local benchmark) declining by 0.5% annually over that same period.

Keynes had a couple of thoughts on investing that I intend to expand on over the next few days, so I thought I'd leave you with both to cogitate on:

"It is a mistake to think one limits one's risks by spreading too much between enterprises about which one knows little and has no reason for special confidence ... One's knowledge and experience are definitely limited and there are seldom more than two or three enterprises at any given time in which I personally feel myself to put full confidence."

and ...

"To suppose that safety-first consists in having a small gamble in a large number of different [companies] where I have no information to reach a good judgment, as compared with a substantial stake in a company where one's information is adequate, strikes me as a travesty of investment policy."

This is something I've talked about generally before, that is, having a "focused portfolio" to enhance your probability of outperformance. I'll explore one particular aspect of this in the near future.

Some other postings dealing with outperfomance are here and here.


JW

The Confused Capitalist

Real estate values still to be knocked down ...

There's an interesting report on the value of housing in America, updated this month. The Global Insights/National City report suggested, based on 21 years of data, that of 317 metropolitan areas around the US, covering 84% of the housing stock, only 88 markets are currently undervalued (by any amount).

Against that, there are some 71 metro markets - covering 39% of the housing stock - that are "extremely over-valued", meaning that the valuations are at least 34% above what their model projects as correct values. The report further notes that as recently as the first quarter of 2004, only three metro markets were "extremely" overvalued.

And for those that think the housing market is due for a rebound (and prices aren't yet statistically showing up as falling much), the report states that the median correction in overvalued markets in the past 21 years is 17% and that it lasts 14 quarters. That's three and a half years folks. To those that like the seemingly cheap valuation metrics of home-builders and development companies, may I suggest .... patience.

In Canada, however, things are different as the good times appear to roll on for as far as the eye can see. Although there's no apparent signs of a real estate bubble here, perhaps some leading edge indicators suggest that a bubble may be in the early stages of forming.

ReMax just reported that sales of high-end luxury houses are booming across the country, with sales volumes up year over year by 31% in Toronto, by 90% in Vancouver, and by 124% in oil-rich Calgary.

Another five or ten years of this, and we might end up in the same boat as the US market is!

JW

The Confused Capitalist

Emerging Market Commentary from the front lines

This is the first (or last, depending on how you look at it), of a trifecta of late day bloggerings today, on the longest day of the year.

I've been reading a blog recently that concentrates on India. In India, apparently by an Indian person. Seems they - financially - have many similar concerns to us here - inflated house and asset prices, etc. In a recent posting, the writer states ...

"While it is not the end of the real estate rally, in general, like any commodities, property prices also go through the boom and bust cycle (in fact, the rise in property prices is not just unique to India!). The reason why we thought it is relevant to highlight the property market to our readers is that even after the fall in the stock markets in the last one and half months, we still hear brokers selling 'real estate' stories to retail investors. While some companies have a long-term strategy to tide volatility in prices, it is pertinent that we, as investors, exercise caution in our judgment. Ultimately, it is our hard earned money!"

In any case, the blog is well worth a visit, if you're considering investing in more than just Indian cuisine.



JW

The Confused Capitalist

Weighing the odds of emerging market outperformance

Well, as sports fans here know, I'm a big fan of many emerging markets, mainly because I consider them to be cheap. For that, you get a good growth profile, better than ever ROEs and current account surpluses - all good stuff. Having said that, all emerging markets are not alike.

A recent UBS report makes many of these same points, suggesting that they offer a good investment profile. As to whether the market continues its' emotional response in the face of further inflationary pressures, or some sort of crisis, is yet to be determined. I suspect that will be the case: in other words, EM market volatility will continue for awhile. I personally hope to profit on this volatility: that in the next plunge, these values will discount at a higher beta than the S&P500.

Yet, the UBS report makes the case that many offer good value, particularly my personal favorite, South Korea.

I suspect that one day off in the not too too distant future (timing, as always Stella, remains the question), the US market and EM market will finally disconnect, with the EM market finally being accorded more respect and lower volatility.

May I suggest you peruse the report?


JW

The Confused Capitalist

Climbing back into the market

Although many investment types warn against market timing, I'm going to suggest that it is a small but important part of any fairly successful investor's repertoire. Basically - at the most correct level - it involves selling assets when they are above a realistic value, and being slow to redeploy proceeds when few or no bargains can be spotted.

Once cash is in hand, however, you should prepare a plan on how to redeploy those proceeds, when "the market" you like (through an ETF), or a particular stock you like, is marked down to the right level.

And just like someone picking his or her way up or down a rock, this involves some careful consideration. For example, since I believe that the market is poised for a fall, I've constituted a plan whereby I step back into the market at pre-determined levels. In some cases, this might be when a specific stock or ETF has hit a certain level, while in others, it's just based on a broader market decline.

The point is, is that I haven't selected a single entry point as the time to redeploy my idle cash back into equities. I have a phased plan. For me, my re-entry points are (generally speaking), a three-tiered structure, using a point around a 15-20% decline in the S&P500 for re-deploying about 50% of my idle cash, and two further points at 25% and 30% declines for the balance.

While some of these points might not be reached, at least I've made a plan on how to maximize the inevitable upswing. And of course that's not to say I'm out of the market entirely - one way bets using all of one's assets aren't a particularly prudent way to invest, in my opinion.


JW

The Confused Capitalist

Do it yourself stock investing is extraordinarily difficult because ...

... because the knowledge base required is fairly extensive, complicated and mostly because the feedback loop takes a long time to complete.

As peoples barely removed from the hunter-gather stage of development, as investors we are still barely above our fight or flight method of handling things. Fight or flight is a fabulous mechanism when being chased down by a lion, but not all that great for quelling an emotional response to a stock market beating.

So, while we think we've done a good job analyzing an investment and weighting the odds of success in our favor (both by the investment itself, and by the relative weighting of that investment in our portfolio), we don't have a whole lot more to go on for some period of time. As superinvestor Warren Buffett has frequently noted, over the short term the stock market is an emotion measuring machine, but over the long term it is a weighing machine.

However, we're always looking for the constant feedback that tells us if we're doing something right or wrong. In sports, like soccer, we get very good immediate feedback. If we keep getting beat to the inside by a striker, we learn to back up more, or take better body positioning. After a couple of games and practices, we find it's not happening so frequently.

In investing however, we look for immediate feedback and validation that we've made a correction (or incorrect) choice from the market. Unfortunately, proper market feedback (i.e. the weighing machine, not the emotion machine) often takes several years to materialize. In the interim, we have turned to the measure of observing the daily (hourly?) price change of our securities to provide the feedback loop we desire.

But we really know that this isn't going to work too well. My suggestion would be to turn off your computer and re-visit your holdings every quarter or so. Benchmark it against a comparable investment set. Then give yourself some feedback.

I fully intend to do just this ... but I just need to check my holdings just once more ... or so ...


JW

The Confused Capitalist

Raising the Median - Gas Mileage - Global Warming

In light of this morning's posting, I'll offer up a very small suggestion. Reduce your global warming load with a cheap bike conversion.

200 mpg, 20 mph+. All for a $400 conversion. Paid for once you've saved the cost of five fill-ups for your SUV.

Great for those small trips under six or seven miles or so. Fifty dollars gets first crack at it! As seen in Popular Science.

Better and cheaper than a Segway.

More here on the revolution.

And since this IS an investment blog, the extra savings you can put into the market. (OK, it's weak, I know, but hey ... you've got to try ... can't give up ...)

"I am only one, but still I am one. I cannot do everything, but still I can do something; and because I cannot do everything, I will not refuse to do something that I can do."

- Helen Keller


JW

The Confused Capitalist

Investing in a Hothouse World

I often lament to some friends that I don't understand why a few souls don't seem to get the whole "global warming" thing. For those of us in the great white north (Canada), we are well aware of how dramatically our winters have changed over the past twenty years.

Because of this dramatic change, most folks here don't subscribe to any of the junk science school of thought claiming that global warming is either:

1. Not occurring, or
2. Due to naturally occurring phenomena

To most of us Canadians, it's pretty clear what's going on. Recently, asset manager Eric Sprott of Sprott Asset Management, a firm with $3.4 billion under management, weighed in with a 56 page missive, entitled Investment Implications of an Abrupt Climate Change. In that document, Mr. Sprott says it's "shockingly clear" we've caused a spike in greenhouse gases, and further says that ...

"We are now in uncharted territory and may well be on the cusp of a warming of the planet at a rate well beyond what can be predicted using our limited knowledge of history."

Mr. Sprott considers further trends such as the massive industrialization of much of the world's remaining rural populations, and other trends in place as not projecting a bright future for the planet. Water shortages, food shortages, droughts, too much rainfall in places, rising sea levels, ever accelerating weather change, etc. Pretty much the usual bane of stuff that we manage to ignore every day, without too much thought or effort.

In any case, a goodly portion of the paper is directed to current statistics, events, and trends relating to global warming. (But I must tell you I learned something new: the paper suggests that the melting of the permafrost and its' sequestered methane gases as being an absolute tipping point - page 25 is a must read page).

By page 28, Mr. Sprott arrives at the investment risks and opportunities. He suggests the following sectors are at risk, if there is a 20% emissions constraint regulated:

• Automobile
  
• Chemicals
• Electric utilities
• Metals and mining
• Oil and Gas
• Banks (some banks have high rates of commercial loans, whose clients may be subject to various types of business risk from global warming)

Unfortunately, Mr. Sprott doesn't offer too many investment opportunities. He points to obvious ones, such as nuclear, wind and solar power as being some. He suggests however, that the ethanol craze is just adding to the global warming load (production of ethanol fuels requires more energy inputs than they produce), and that hydrogen as a fuel isn't quite ready for prime time. He suggests that micro power projects may offer some potential as well.

Finally, he suggests a hyper-inflationary environment could ensue at some point, thereby accelerating demand and prices for commodities in general, and gold in particular.

As one sentence in the document points out, a Swiss Re (insurance) executive stated that ...

"Global warming has accelerated from a problem that might affect our grandchildren, to one that could significantly disturb the social and economic conditions of our lifetime."

In light of this, may I suggest one further solution we can provide as investors? Perhaps directly investing a very small portion of our investable assets, towards some source of lowering the warming load. Whether this is in a company that is in nuclear, solar, wind power, or any other investment that lowers or reduces the warming load, it doesn't really matter. By helping to provide more abundant equity available, we'll help spur the advance of technologies to save the life of this planet. Sometimes we have obligations beyond that just of short-term investors - we have obligations as human beings.

May I suggest 1/10 of 1% of your investable assets this year, or a minimum $100, increasing by a similar amount every year for nine more years? Consider it a donation - a donation in an area we have special knowledge and awareness in - the investment field. If we wait too long, the cost may be far, far too high.


The Confused Capitalist

Inside the Private Equity World

I've been reading a blog recently that's both educational and interesting, and highly amusing. If you want to look into the world of leveraged buy-outs, go and visit
Going Private, The Sardonic Memoirs of a Private Equity Professional.

Start with the "Start Here" link, and dig into the links. Enjoyable.

JW

The Confused Capitalist

Dividend Divas

Ain't dividends grand?

Boy I remember back in the bad old days of the late 1990's, when dividend-paying stock-owners were looked down upon, by their Nasdaq-investing friends. Their stocks seemingly soared, while boring old dividend-paying stocks just kind of coasted along. Time has shown of course, that many Nasdaq-type stocks were destined to crash and burn, while the dividenders did nothing more than produce reliable consistent wealth growth.

A recent study by RBC Dominion Securities show how dramatic that difference has been. They isolated stocks into three silos, one which was stocks that paid no dividends over the past ten years, another consisting of stocks with stable dividends, and the last consisting of stocks that consistently increased their dividend over the period.

In the US market, to May 30, the average annual rate of return was as follows:

1. No dividends: 6.5% annually
2. Stable dividends: 8.8% annually
3. Increasing dividends: 9.6% annually.

In Canada, the difference was even starker, and more remarkable:

1. No dividends: 1.3% annually
2. Stable dividends: 15.5% annually
3. Increasing dividends: 17.2% annually

Just to remind you of exactly what kind of return 17.2% is - that'll double your wealth in just over four years. Please bore me some more!



JW

The Confused Capitalist

Conundrum solved

The other day, I was challenging some conventional wisdom, and it seems that a more elaborate answer was recently discussed by a Legg Mason manager, Michael Mauboussin, who the Legg Mason site advises is the ... "Chief Investment Strategist of Legg Mason Capital Management (LMCM), Legg Mason's cornerstone equity fund management subsidiary."

Here are his comments, directly:

"Jack Bogle provides what may be the most sobering statistic in the investment industry: from 1983-2003, index funds tracking the S&P 500 returned 12.8 percent and the average mutualfund gainedd 10.0 percent annually. Meanwhile, the average investor only earned 6.3 percent annual returns. This seemingly impossible result is attributable to one crucial variable: market timing.

The Bogle data refer to average percentage changes, not dollar-weighted changes. When you consider the extraordinary proclivity for investors to invest in the wrong place at the wrong time, the data start to make sense.

For example, at the height of the technology and telecom bubble in the first quarter of 2000, investors poured a record $140 billion into growth funds while pulling $40 billion out of value funds. In the subsequent five years, value funds substantially outperformed growth funds. Using over twenty years of market data, Evergreen Capital Management paired mutual fund flows with a valuation measure to generate buy and sell signals.

High inflows and high valuation triggers a sell signal, while large outflows and cheap valuations mean buy. Following a sell signal across various investment styles, the return of the investment strategy underperformed the S&P 500 by an average of 490 basis points over the subsequent two-year period. Buy signals generated an even more impressive 870 basis points of excess returns in two years. As noteworthy, the sell signal was reliable nearly 80 percent of the time, while the buy
signal was accurate over 90 percent of the time.

Why do investors make this mistake? The most likely explanation is the recency bias, which says individuals tend to extrapolate recent outcomes without giving full weight to the full time series or prevailing circumstances. This bias defines one of the most reliable sources of inefficiency in the market.

Recent academic research, spanning twenty years of data, shows the buying and selling patterns of individual investors provide a hard-to-beat contrary indicator. More specifically, researchers found heavy buying leads to above-average short-term results and below-market returns in the subsequent year. The mirror image holds true for stocks individuals sell. "

Thinking about buying or selling one of your investments? Sobers one, doesn't it?


JW

The Confused Capitalist

Santa Claus is coming to town ... make your list too!

You better watch out, you better not cry, ... yada, yada, yada ... he's making a list, and checking it twice, yada, yada ...

Time to make your list too! As regular readers of this blog are well aware, I think that some sort of correction is in the offing, if not now, probably within the next six months. I remain skeptical of whether current market levels can be maintained in what I see as signs of rising inflation, which must ultimately be met by rising interest rates. Against a backdrop of PE ratios at or above historical norms, I believe that this sets the stage for a market decline.

So while I've raised some cash in my portfolio, I happily await the correction. This should give me the opportunity to purchase some of my desired stocks and ETFs at nice discounts. I'm hoping for some of the following top-quality names to drop far enough for me to purchase nice big chunks that'll fuel my portfolio for awhile to come. Some of the blue-chip names I'll be following include:

• Coke (KO)
• Pfizer (PFE)
• Brookfield Asset Management (BAM)
• Wells Fargo (WFC)
• Goldman Sachs (GS)
• Procter & Gamble (PG)
• Manulife Financial (MFC)
  
  

and a few Canadian blue-chip stocks I'll be keeping my eye on ...

• Bank of Nova Scotia (BNS)
• Power Financial (PWF)
  
• TSX Group (X)
  

and I'll also be looking for deep, deep discounts in some emerging markets, including Brazil, South Korea, Taiwan, and Russia.

So, during this phoney war, don't waste your time either. Make your list and check it twice too.



JW

The Confused Capitalist

Challenging conventional wisdom

As investors, it's important - if we want to outperform the indices - to think differently. And that means challenging accepted conventional wisdoms, by continually asking questions that reveal underlying assumptions. Also, looking at the quality and quantity of the data before us, can also help us become better investors too.

I enjoy reading articles that consider common investing mistakes, so that I can hopefully minimize these mistakes myself. One recent one I read (by way of Abnormal Returns) was a list of 15 common biases reported at The Kirk Report, from the investor magazine, Trader Monthly. The list is full of good stuff.

But I finally (i.e. years late) suffered some cognitive dissonance when reading item #12 on the list ...

12) Asymmetry of risk tolerance: Investors are risk-averse with regard to gains (preferring to sell "winners" and ensure the gain) but risk-takers when it comes to losses (preferring to hang on to "losers").

Now this isn't the first time or place that I've read this statement, but I finally realized that this is in complete contrast to two other accepted wisdoms I've read multiple times over the years:

a) That investors in mutual funds - in the aggregate - underperform the performance of the mutual fund itself, primarily because they pile into the latest hot fund (whose performance decays thereafter), and

b) That reversion to the mean exists, meaning that stocks and mutual funds that have underperformed for a relative period, generally outperform in the following period.

Something has got to give - all of the above statements cannot be true. While I'm not certain which of the three has to give, I personally think it's the first one. Having seen more than a few investors, I tend to believe that a) is true, and by reasonable extrapolation, also applies to most other investors (i.e. not just those who invest in mutual funds).

I've also seen a fair number of studies showing that underperforming stocks rebound typically have a rebound (because they got priced too cheaply) and outperforming stocks often falter (because they became too expensive ... "priced for perfection). So I tend to think that b) is also true.

So, I'm going to say that I think bias #12 is probably false - and I think in fact it might be the opposite - investors holding "winners" for too long, and dumping "losers" too early.

But what do you think?


JW

The Confused Capitalist

Upside Downside complete review

I've now finished a decent book relating to risk management, Upside Downside: Simple Rules of Risk Management for the Smart Investor. The three main ideas of the book are profiled here (a call for scenario thinking, instead of most-likely case forecasting) here, (know what you own) and here (anticipate "regret" in your investing).

While these three ideas are certainly worthy of consideration for any investor, it's a small book (nothing wrong with that), but it feels "stretched out" with some narrative stories in attempting to hit 200 pages (not quite done, if you exclude the index). So it seems relatively expensive at $29.95.

The book was co-authored by Dr. Ron S. Dembo whom the dustcover describes thusly ...

"... is the founder and former president of Algorithmics Incorporated, and grew it ... to the largest enterprise risk management software company in the world, with ... over half of the world's top banks as clients. He was a professor at Yale ... and holds a number of patents in computational finance. ... In 2003, he was among the first fifty people indducted into the Risk Hall of Fame."

One of the pieces of advice given several times in the book relates to portfolio insurance (and in fact is the concluding sidebar piece), suggesting a good way to achieve this is to invest in a zero (stripped) coupon bond for the face amount of your investable capital, and the balance in some type of stock market investment. In one of the later examples, of a 55 year old looking to the next ten years (i.e. retirement at age 65), takes the investable capital of $200,000, places $130,000 in the strip bond (which has a $200,000 face value at maturity in 10 years), and then uses the other $70,000 to invest in a broad market EFT, which the book suggests could double over the ten years, resulting in a total of $340,000 at retirement. It suggests that this is a well-protected investment.

While that may be the case, this doesn't seem like a particularly good way to invest, given the overall return rate is only 5.3% which isn't a lot better than could be achieved simply by investing the entire amount in a bond which hasn't been stripped. It also suggests that buying futures (puts/calls etc.) is another way to protect a portfolio. Again, while this is true it will generally reduce the rate of return for most portfolios. Insurance always costs money.

All in all, I'd give the book 3.5 stars out of five. Good ideas, but a feeling of having stretched out the book and some examples that don't show particularly strong risk-risk/reward management techniques, in my own opinion.


JW

The Confused Capitalist