Asset classes and the inadequacy of labels

Labels and bad jargon can lead to cloudy thinking and poor investing. Or as Orwell wrote: “the slovenliness of our language makes it easier for us to have foolish thoughts.” The institutional investment world, by consensus, labels asset classes such: -Absolute Return -Fixed Income -Equities -Private Equity -Real Assets (Real estate and commodities) See the […]

“I just pick stocks!” – Alpha

I have often heard many professional stock pickers, whether they be long-only managers or long/short managers, say: “I just pick stocks. I don’t look at the economy or macro events. I’m just a bottom-up/long-only investor.” I regard this as ignorance, investment malpractice, or both. After 2008, it’s a stubborn adherence to a failed mental model. […]

Narratives in Investing – Alpha

Have we hit an equity markets bottom? Recent narratives by the press (planted in the press?) suggest we have. A well-documented bias of investors is the availability bias. That is, news or data widely available (typically blared through the press) is over-weighted, while patchwork and non-interconnected, less-available news is underweighted (page 13 news in 4 places). When combined with the narrative effect, which is investors’ ability to form a coherent story, whether or not it is true, these biases can lead to silly market herding movements. See a fuller overview here: Fuller and Thaler (2003) and Mullainathan and Shleifer (2005). So here are two stories to chew on, the well-trumpeted bull story, and the lurking quietly bear story.

Investing as a Zero Sum Game

“Investors operate within what is for the most part a zero-sum game. While it is true that the value of all companies usually increases over time with economic growth, market outperformance by one investor is necessarily offset by another’s underperformance.” -Seth Klarman, 2005 Baupost Value Partners Letter

“The model I like—to sort of simplify the notion of what goes on in a market for common stocks—is the pari-mutuel system at the racetrack. If you stop to think about it, a pari-mutuel system is a market. Everybody goes there and bets and the odds change based on what’s bet. That’s what happens in the stock market. Any damn fool can see that a horse carrying a light weight with a wonderful win rate and a good post position etc., etc. is way more likely to win than a horse with a terrible record and extra weight and so on and so on. But if you look at the odds, the bad horse pays 100 to 1, whereas the good horse pays 3 to 2. Then it’s not clear which is statistically the best bet using the mathematics of Fermat and Pascal. The prices have changed in such a way that it’s very hard to beat the system. And then the track is taking 17% off the top. So not only do you have to outwit all the other betters, but you’ve got to outwit them by such a big margin that on average, you can afford to take 17% of your gross bets off the top and give it to the house before the rest of your money can be put to work.” -Charles T. Munger, A Lesson on Elementary, Worldly Wisdom As It Relates To Investment Management & Business, USC Business School, 1994

The following quotations intelligently sum up the conventional wisdom, but are only half true, or perhaps false? Life is full of paradoxes and investing is no different, so I present the proposition that “Investing need not be a zero-sum game.”

Warren Buffett’s 2008 Letter

A friend of mine, now a restructuring banker at a major firm, e-mailed me this today: ” The Berkshire letters are neither funny nor interesting any more (several years in a row). Too bad…”

Warren Buffett’s recent letters as Berkshire Hathaway’s chairman are not as funny. 2008 was a bad year, so a sober tone is understandable. In recent years, Buffett decried excesses. While he tried to avoid being shrill, he was not as entertaining.

Price Earnings Ratios and Other Yardsticks Bankers Use to Bamboozle You

In today’s WSJ (“The S&P Gets Its Earnings Wrong“), Wharton professor Jeremy Siegel (my former economics teacher) argues that Standard & Poor’s miscalculates earnings, and so the S&P 500’s price/earnings (P/E) ratio is lower than reported (hence stocks are cheap). Both Standard & Poor’s and Siegel are wrong. They are missing the forest for the trees. P/E ratios themselves are the problem, because the “E” is fictitious.

Boaz’s Billion Dollar Losses – A Case Study in Risk

The media has recently reported on the trading blow-up of Boaz Weinstein, 36, a prop desk trader formerly at Deutsche Bank, here: Deutsche Bank Fallen Trader Left Behind $1.8 Billion Hole. For background on Mr. Weinstein, see here: “Young traders thrive in stock/bond nexus.“A credit derivative, such as a credit default swap (CDS), is an insurance contract that allows a trader to bet that a bond will rise or fall in value (technically that the default risk of the bond will increase or decrease). Broker-dealers like Deutsche Bank or Morgan Stanley match buyers with sellers, and earn huge fees – often their own prop traders take positions. Mr. Weinstein was an early gambler (uh… trader) in this market, earning Deutsche Bank a few hundred million dollars in profits each year for four or more years, and tens of millions of dollars for himself personally. He then lost it in the crash in Fall 2008, losing Deutsche Bank $1.8bn (this is the WSJ estimate – I’ve had some CDS traders who were counterparties say this loss was $3bn or more).