The Investment Scientist

Predicting the market is a dangerous business, but there are enough people asking me this question that I thought I’d give it a try.

First things first, Covid19 is not a Pandemic yet.  It is primarily in China and even within China, 88% of the cases and 95% of deaths are in Hubei province which has 60mm people. The second worst-hit province is Guangdong (my hometown). There are 586 existing cases and 7 deaths there as of this writing and this goes up by one or two cases every day. Guangdong has a population of 113mm people. So my sense is that outside of the epicenter province, the situation is under control within China.

That said, the virus has spread beyond  China and infected hundreds of people in Japan, Korea, Italy, and Iran. The first three countries are unlikely to implement draconian measures limiting movements of people, the latter country does not have the medical resources to detect and fight the virus. The chances of Covid19 becoming a pandemic are increasing. So asking how that will affect your investments is a reasonable question.

The best way to answer the question is to study close historical precedents. The most recent, I believe, is the H1N1 swine flu pandemic. We have the added benefit that this virus was first detected in the U.S., which took the worst economic hit. Covid19 has barely reached the U.S. shores yet. Whatever impact it will have economically, it should be less than H1N1.

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Part of Wall Street analysts’ job is to make earning forecasts of covered firms so as to guide investors’ actions. In 1996, Professor Rafael La Porta discovered an interesting phenomenon: the better the forecasts, the worse the returns! Twenty years have passed since his last paper, now we have two more decades of data. Does the new data confirm or contradict his original discovery? Well, see this graph, which I lifted right from his new paper.

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Before we discuss the cost of advanced taxation (or the benefit of deferred taxation,) I need to first introduce the concept of time value of money. That is to say, $100 a year from now is different from $100 today.

Let’s say I owe $100 in taxes due to be paid next year, but for some tricky reason, the IRS wants me to pay that now. How costly is this advanced taxation to me? Well, if I didn’t have to pay the tax today, I could invest the $100. Let’s also assume the return is 8%, so by next year, I would  have had $108. I could pay the $100 tax and get to keep the remaining $8. If I have to pay $100 today, I forgo that $8. That’s the cost of advanced taxation. 

With this concept established, now let me run an experiment with the following assumptions:

  • The investment cycle is 20 years.
  • The investment return per year is 8%.
  • Of  the 8%, 2% is dividend distributions that are taxed at a 50% marginal income tax rate.
  • The remaining 6% is the capital gain. Capital gain distributions (“CGD”) range from 0% to 5%, and they are taxed at the long-term capital gain tax rate of 20%.

The study is about how changing the CGD rate affects the investor’s tax liability as a percentage of initial principal investment.

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km1-taxation-in-germany.jpgThe following is a hypothetical but highly realistic example of mutual fund advanced taxation. You invest $100,000 in a stock mutual fund on Dec 20th. You get a distribution of $10,000 on Dec 23rd. The distribution is reinvested. When you go check your account balance at year-end, the account balance has gone down a little to $99,950. No big deal.

In January, you get a 1099-DIV form from the mutual fund company showing you have dividend income of $2,000 and capital gains of $8000. (They add up to $10,000). You have to pay taxes on those! You jump from your chair: “What! I lost money in the investment, and I have to pay taxes on income and gains I don’t see?! What gives?”

It turns out that mutual funds are required by law to distribute any dividend incomes and all net capital gains by year-end. Usually, they have a record date in December. If you are a fund-holder on record at that time, you will receive the distributions. Most mutual funds have their record dates fall between December 10 and December 20.  Read the rest of this entry »

Last week’s newsletter article “Why It’s Awesome To Have a Loser in Your Portfolio” has proven to be quite controversial. More than a few of my readers emailed me to warn that my Finance professor at Oxford was full of bullshit. Let’s put that aside for now, and consider this question:

If there is an investment that has an average return of 25%, would you invest in it? 

If you did not jump in right away, you are a smart investor! Investment A falls 50% in one year and gains 100% the next, giving it exactly a 25% average return. If you invest $1000, however, you make absolutely $0 on this investment. On the other hand, investment B gains 25% in both years, so it also has exactly a 25% average return, but now the gain from $1000 investment is $562.5. You can not pick an investment in isolation of its volatility. Because …

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Don’t take my word for it, this was covered in my Finance class at Oxford. Let me see if I can get the gist across with a few graphs.

The graph below shows the risk/return profiles of a continuum of two stock portfolios of Coca-Cola and Intel. The vertical axis represents the expected return, and the horizontal axis represents volatility risk.


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As you can see, Coca-Cola by itself is a low risk – low return stock, while Intel by itself is a high risk – high return stock. By using different weighting in the two stock portfolios, we can create different risk return trade-offs, represented by the curve.  Read the rest of this entry »

4c458964d197788163d689ce046fbe26.jpgThis happened over the past weekend. A reader of my newsletter signed up for my free 2nd opinion financial review.

As I went over his 401k investments, I saw that he had invested the entire balance in a target-date fund which normally is a good choice. Upon closer examination, I realized that the target-date fund has an expense ratio of 0.8%. That’s high. I went through the list of available investment options since most 401k plans limit them. I found an S&P 500 index fund, an international stock index fund, and a bond index fund, all with an expense ratio of only 0.05%. I constructed a portfolio made up of these three funds, saving him 0.75% a year. The entire exercise took me around 15 minutes.

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Michael Zhuang is principal of MZ Capital, a fee-only independent advisory firm based in Washington, DC.

Twitter: @mzhuang

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