The Investment Scientist

When something seems too good to be true, it is often not true. But there is one exception in the financial world: I bonds. 

I bonds are federal government bonds sold to individual investors that pay a very high-interest rate that is linked to inflation. For instance, the current rate is 7.12%. On the first business day of May, the Treasury Department will announce a new rate that will be close to 10%. Some expected it to be 9.62%. Nowhere in the world can one get this high of an interest rate, guaranteed by none other than the US government.

So what is the catch?

Well, there is no catch, but there are some limitations.

Last week I completed the Venture Capital class at Oxford, and I have at least two take-aways  I’d like to share with my readers. Today, let’s talk about SPACs since a few of you have asked me if we should invest in those, and before I had not felt qualified to answer the question.

What are SPACs?
The name SPAC is a shorthand for the Special Purpose Acquisition Vehicle. These are companies backed by famous investors/entrepreneurs (sponsors) that raise a sum of money via IPO then search for a private company to buy.

For venture-backed companies that want to go public, this is a great option since they don’t have to go through the IPO process – roadshows, book building, the whole nine yards. All they need to do is to sell to a SPAC. 

Last week I shared an example of how you could still lose money on an investment that gives you a 20% average annual return. I ended the article with five questions:

1. Can the average return tell you if you will make or lose money?
2. Can the average return tell you how much money you make or lose?
3. What else determines if you make or lose money?
4. Why do hedge funds love to use average returns?
5. Why do I use asset class diversification to reduce client portfolio return variability? (Note that this will make the return number look smaller.)

Here are the right answers:

1. No.
2. No.
3. Return variability or volatility. It is also called volatility drag – the higher the volatility, the lower the return. Here is an article on this subject I wrote 13 years ago.
4. It’s great for marketing.
5. One word: I am a fiduciary. (Ok, four words.)

Sure you can! Look at the following stylized example.

Hedge Fund A has a first-year return of 100%, and a second-year return of -60%. The hedge fund’s average return is (100-60)/2 = 20%. But if you have invested $100k in this hedge fund, by the end of the second year, you will only have 100*(1+100%)*(1-60%) = 100*2*0.4 = $80k. In other words, Hedge Fund A gives you 20% average annual return, but you still lose $20k or 20% of your money!

What gives?! Let’s look at the following 6 investments, all of which have a 20% average return. Some are profitable and some are not. All assume an initial investment of $100,000.

Near-Field Communication  (contactless) payment either through your smart phone or through your credit card chip has revolutionized commerce.  Instead of swiping or inserting your credit card, waiting for a printout and signing your name, you can just wave your phone, wait for the beep and go. But just a moment ago, I learned the hard way that this technology is not secure.

I went to Giant to buy a bottle of Diet Coke. I do that because I know soda is a bad habit so I don’t keep it in my refrigerator. When I want to drink Coke, I will drive to the nearby Giant and buy only one.

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By the close of the market yesterday, the Dow was discounted by 32% from its peak just three weeks ago. This level of discount happens once a decade. The last two times were during the 2000 dotcom bubble burst and 2008 financial crisis. 

I have been busy rebalancing portfolios for myself and my clients. What is a rebalancing? Imagine a client has a target allocation of 60/40, that is, 60% in stocks and 40% in bonds. After the last round of discounts, the allocation becomes 45/55. To get back to the target, I must sell bonds worth 15% of the portfolio and use the money to buy stocks.

All investors set out to buy low and sell high, but when the market is giving them a 30% discount, most of them freak out and want to sell every stock instead. There are a few human judgement heuristics and biases at play here that were studied by Nobel Prize winner Daniel Kahneman, like representative bias, base rate neglect, availability bias, anchoring and framing heuristic. When I have time, I will write about those heuristics and biases.

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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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On Dec 17th, 2017, that’s one year and some days ago, BTC (bitcoins) punched through

the $20,000 level, peaking at $20,042.91. Only twenty days earlier BTC reached $10,000 and it was during this 20-day period that I got the most intense client pressures to get their money into BTC and other cryptocurrencies. I am glad I kept them away from it, since as of today, BTC is at $3700. That’s a loss of 81.5% in a year.

BTC is not a stock since it’s not even a real business. Here’s how some stocks that were red-hot a mere few months ago have been faring …

Apple, the perennial darling of the investment world, just lost nearly 40% from its peak after today’s close. That’s a whopping $460 billion loss. The loss itself is larger than the market capitalization of all but four publicly traded companies.

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Investors are extraordinarily good at hurting themselves. They all plan to buy low and sell high, and yet what they all end up doing is buying high and selling low.

They do that by 1) piling onto the market when it is riding high and bailing when it is dropping low; 2) chasing the immediate past “winner” whether that is gold, emerging market stocks or the S&P 500 only to see the winning streak fizzle. Basically, they are systematically overpaying for assets.

If that sounds like you, well you are not alone. But here is the good news. I am going to give you a simple trick that can help correct your destructive tendency and thereby make you a much better investor.

So are you ready? Drum Roll, please …..

Treat your investment portfolio the same way you would treat your wardrobe.

What are you talking about? Are these two even comparable?

For simplicity’s sake, let say you acquire your entire wardrobe from Neiman Marcus. If Neiman Marcus has an across-the-board 50%-off sale, would you throw up your hands in despair and say,“Darn it, my entire wardrobe just lost half of its value. I better sell it all at the flea market or I will lose everything?”

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In my last newsletter I wrote about how a Health Saving Account (HSA) is the best retirement saving vehicle with triple tax benefits. However, not everybody can have a HSA – you must have a High Deductible Health Plan (HDHP.) Those of you who have traditional PPO/HMO health insurance are not eligible.

This begs the question, who should use the HDHP with a HSA? Here are the simple answers followed by a discussion.

1. High income folks especially those in top three tax brackets of 32%, 35% and 37% should use a HDHP.
2. Healthy folks should use a HDHP.
3. Low income folks who are frequently sick should stay with PPO/HMO.

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