The Investment Scientist

Archive for the ‘Economics & Markets’ Category

images-54Recently, a prospective client of mine sent me an email asking about my thoughts on Bill Bernstein’s new book “Deep Risk.” I have not read the book yet, but I do have my own ideas about deep risk vs shallow risk.

I define shallow risk as a potential loss that you can recover from and deep risk as a loss that you cannot recover from.

Market volatility, for example, is a shallow risk. It is very visible and it is scary, there is even a TV channel devoted to it. (That TV channel is called CNBC.)

But taking on shallow risk is how you earn your investment keep. Thus, it should not be feared, it should be welcomed.

Now what are the deep risks you should ardently avoid? I can think of three: inflation risk, behavior risk and agency risk.

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Image2013 has been a stellar year for stocks. As of today, the S&P 500 is up more than 25%. There are about ten trading days left and barring unforeseen circumstance, the index will end the year in the 20+% range.

A few of my clients are concerned; with the market doing so well this year, what does that bode for 2014? Well, I don’t have a crystal ball, so all I can do is to look at historical data to make an imperfect reference.

To answer the question, I asked my intern Nahae Kim to do a study of the relationship of immediately subsequent year returns. Specifically, can one year return predict the next year?

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ImageThat was a message I got from a new client of mine. I must admit, it really bites. Yes, I sold his Apple stock. And yes, since then the price has gone up 15%. So of course, I can understand he’s upset and beginning to question whether I know what I am doing.

Having studied improvisational comedy, I’m aware that regardless of how I feel, it is wise to always validate others’ feelings. So I replied, “Yes, I should have asked you before I sold it.”

Afterward, I sent him some data to mull over.

Nasdaq just crawled its way back to 4000 a few days ago, and this time Apple is the biggest and hottest stock in the Nasdaq 100.

Last time when Nasdaq passed 4000, the top ten tech stocks (try saying that ten times fast) were, Microsoft, Cisco, Intel, Qualcom, Oracle, JDSU, Nextel, Sun Micro, Veritas and MCI Worldcom.

Since the last time Nasdaq passed 4000, Microsoft has gone down 34%, Cisco 59%, Intel 53%, Qualcomm, the only up stock in the group, has gone up 25%, Oracal has gone down 67%, JDSU 98% and the remaining four are no longer in business; they were either merged out of existence or end ignominiously.

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images-42It is exceedingly difficult for mutual funds to beat market indexes. For the past decade, Standard and Poor’s has methodologically documented returns by mutual funds and what they found is something those fund managers do not want you to know: the majority of mutual funds under-performed their respective indexes literally every single time.

Here is an infographic published by MoneySense, a Canadian financial magazine, that shows 90% of Canadian money managers under-performed the market index in 2012; I can assure you that US money managers are doing no better.

                                      FundManagers

JingToday I went to listen to Professor Jing of Renmin University speaking about US – China relations. The last time I went to listen to the same subject, it was Professor Mearsheimer of the University of Chicago speaking. His theory predicts that the US and China will come into conflict inevitably. I was curious to hear a Chinese perspective.

When I told Professor Jing about Dr. Mearsheimer’s theory and prediction, I was surprised to learn that the two professors are friends. In fact, Dr. Mearsheimer teaches at Dr. Jing’s Renmin University as a visiting scholar.

Dr. Jing does not agree with Professor Mearsheimer’s theory and prediction.

He does however agree that the rivalry between China and the US will intensify in coming years. In his words, “This is structural.” No matter how hard the leaders of the two nations try, the most powerful nation on earth and the second most powerful will always be suspicious of each other.

However, Professor Jing believes this rivalry need not result in open conflict. “Both the US and China are nuclear states. Should war break out between us, only cockroaches will survive.”

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One very very sharp reader of my blog sent an email to me, and here is what it said:

Aren’t these 2 philosophies opposites of each other? If the market prices correctly based on all available information, how can the stock price be different from the expected dividend? Aren’t these 2 prize winning economists speaking in opposites?

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ImageAs far as investment philosophy is concerned, I am solidly in the camp of Nobel Prize winner Eugene Fama and Vanguard founder Jack Bogle. They both believe that the market is by and large efficient, and there is no point in picking stocks.

Most of my money is in broad-based passively managed asset class funds, but I do set aside 5% just to have some fun with and right now I only have three stocks in my fun account.

Safeway

I bought SWY last November after going to the Chicago Booth Entrepreneur Advisory Meeting. From the meeting, I learned that big retailers routinely write off their inventory at a huge loss. The reason being that they can not control demands as they have little information about the needs of the individual consumer, though they can usually make a rough guess on aggregate needs.

I noticed my wife had been shopping at Safeway more and more. After a little digging, I found out Safeway had set up a technology system to track each individual’s needs and price sensitivities. Then it can make targeted offers to shoppers like my wife that unfailingly brought her back over and over. I recalled my earlier meeting and realized they would save tons of money just from better inventory management.

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ImageIt really caught me by surprise when Eugene Fama, the newly minted Nobel laureate in Economics said: “It doesn’t matter that much.” when speaking about investing outside of the US.

OK sure, I can understand his point. Why invest outside of the US when the US markets already account of 40% of world capitalization? “The U.S. market is so well-diversified already that combining it with global markets doesn’t really matter,” so said Fama.

However, I think it actually does matter ….

Proportionally, the US market is getting smaller. Right after the second world war, the US market accounted for 70% of world capitalization, now it only accounts for 40%. For a country that boasts only 5% of of the world’s population, this is still exceptionally high.

For the foreseeable future, there are better than even odds that the combined markets outside of the US will grow faster than the US market will do alone. Why forego those opportunities?

The diversification benefit you’d get is certainly not negligible either. During the so-called ‘lost decade’ of 2000 to 2009, the US market, as measured by the S&P 500, had a net loss of 9.1%, while international developed markets went up by an anemic 12.4%, but emerging markets went up by a whopping 154.3%.

It would have made a bog difference if you have a piece of emerging markets in your portfolio.

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I jumped out of my chair in delight when I learned that Eugene Fama and Robert Shiller had won this year’s Nobel Prize in Economics. These are two economists that greatly influenced my investment philosophy and their works have been an integral part of how I help my clients build and preserve wealth.

Let me explain their contributions:

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ImageWhen I was in California, I had a very intelligent debate with a doctor. He mentioned that in 2012, the US took in $2.5T in revenue and spent $3.6T in government expenditures.

He accurately pointed out, “If I spent like that, I would be bankrupt in a few years.” He believes so strongly that the US is going the way of national bankruptcy that he has moved substantial amounts of his money overseas and has invested a great deal in gold.

I happen to believe that gold is the most unproductive of assets, since it does not generate dividends or interest and it actually costs money for upkeep in a safe in a Singapore bank.

On top of that, by throwing so much money into gold, one could over prepare for a disaster that is very unlikely to happen and thereby miss out on all the opportunities to grow wealth in this country.

But I still need to explain why the US won’t go bankrupt anytime soon. Here are two explanations:

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There have been 17 government shutdowns in history. Today I asked my intern Taro Taguchi to analyze the market performances subsequent to shutdowns.

Using the closing price prior to the day of government shutdown as a base line, he found on average, the market rose 0.97% in one month, 2.38% in three months and 13.42% in a year.

If we isolate the 5 most severe shutdowns that lasted more than 10 days, the picture is a bit worse, but not by much. On average the market fell 4.19% in one month, fell .18% in three months and rose 9.63% in a year.

These historical precedents confirm my gut feeling that a government shutdown is really no big deal, as far as the market is concerned.

More worrisome is the upcoming debt ceiling fight. There is no precedent of US default to guide my outlook on this, but the longer the government shutdown lasts, the deeper heels get dug in by both parties and the more likely a default. Nevertheless, I’m still thinking that will also be a storm in a tea cup.

The bottom line is these are issues beyond our control, there is no point worrying about them. If worst comes to worst (ie default,) and the market should drop 20%. That’s actually great because then we can buy shares at a discount!

Image1. “The gross revenues for the financial services industry in 2010 were $1.129 trillion. That year, total US financial assets stood at $50.38 trillion, meaning that the financial services industry as a whole is skimming 2.25% a year out of everyone’s wealth.” This is an excerpt from a post on Wealthcare Capital entitled “Investment Expenses – The Other Millionaire You Make.” How about I help you cut those expenses by half?

2. Shocking! Shocking! Your elected representatives want the financial industry to continue ripping you off!

3. Ike Devji wrote a piece “Investment Fraud Red Flag for Physicians.” It is packed full of useful tips. I have one thing to add though, never work with a broker, regardless how clean his or her broker check record. These people are not legally obliged to watch out for your best interest.

4. A very succinct piece in Physicians’ Monday Digest about How Rising Interest Rates Would Affect You.

5. Taxpayers beware, AccountingToday has a piece on tax deductions expiring in 2014.

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ImageIf you are a typical investor, given the choice between investing in a small cap value fund or a large cap growth fund, which one would you choose?

You would probably go with the large cap growth since “large cap” sounds a lot safer than “small cap,” and “growth” sounds a lot more promising than “value.”

To prove how wrong you are, I did a study of the relative performances of these two styles in the eight decades between 1931 and 2010. Here is what I found.

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Look forward when investing.

It is well established that investors’ sense of risk reward is shaped by immediate past experience.

However, investing based on immediate past experience is like driving while only looking through your rear view mirror. It’s a disaster waiting to happen.

The proper way to think about risk reward is to see investing as a risk taking occupation. When there are more job openings than job seekers, wages will rise. When there are many job seekers chasing too few openings, wages will be lower. It’s just simple economics.

In academic circles, this wage of taking risk is called risk premium.

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teenreader1. ThinkAdvisor highlighted a Maryland study which showed that states which pay the highest fees to Wall Street (for managing pensions) have the lowest returns. That says it all about Wall Street. No wonder Rick Ferri wants you to steer clear of actively managed funds.

2. Reuters Money reported how Health Savings Accounts (HSAs) can be used as retirement savings accounts. This information is especially useful for small business owners and self-employed individuals who tend to neglect their retirement savings and face high deductibility in their health insurance. Here is the garden variety of ways they can save for retirement.

3. DIY Investor Robert Wasilewski encountered a bear while hiking. He survived to write about it, but he mused that the same reactions that kept him in the gene pool will surely “eliminate you from the investment pool.”

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Rebalancing your portfolio

Rebalancing your portfolio

Recently, I visited a prospective client in New Jersey. He is currently a client with Fisher Investments, and his advisor told him never to rebalance since that involves market timing.

I have to hand it to this financial advisor for recognizing that market timing is an unproductive endeavor, but he is so wrong about rebalancing that I am compelled to write this article.

Rebalancing is not a market timing activity, it is calendar-driven or condition-driven. For instance, you may decide that you will rebalance your portfolio on January 1st of each year or whenever an asset class allocation is off by 20%.

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Author

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

Twitter: @mzhuang

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